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Question:

The full price of a bond:

A includes accrued interest.

explanation

The full price is clean price plus accrued interest.

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Ann Lloyd, CFA, observes that a 3-year senior unsecured bond of Hawk, Inc. has a rating of Baa3/BBB– and a 3-year senior unsecured bond of Osprey, Inc. has a rating of Ba1/BB+. Based only on this information, Lloyd can most appropriately conclude that:

The Hawk bond is investment grade and the Osprey bond is non- investment grade.

The classifications "investment grade" and "non-investment grade" are based on ratings from recognized credit rating agencies. Bonds rated Baa3/BBB– or higher are classified as investment grade, while bonds rated Ba1/BB+ or lower are classified as non-investment grade. However, an analyst should not rely exclusively on credit ratings to draw conclusions about the credit risk or loss severity of bond investments.

A waterfall structure in a securitized bond issue:

gives some bondholders a higher priority of claims than others.

In a securitized bond issue with a waterfall structure, the bonds are issued in tranches with varying levels of seniority. Any losses arising from the underlying assets are absorbed first by the tranches with the lowest seniority. Thus, tranches have different levels of default risk and therefore are likely to have different credit ratings. The structure is a form of internal credit enhancement.

Consider the following statements:
Statement 1: The coupon rate and principal amount on a capital‐indexed bond increases with a specified index.
Statement 2: In a Bermuda‐style call, the issuer has the right to call bonds on specified dates following the call protection period.
Which of the following is most likely?

Only Statement 2 is correct.

In a capital‐indexed bond, a fixed coupon rate is applied to a principal amount that increases with a specified index, such that the coupon payment also rises with the index. Statement 2 is indeed correct.

An investor is considering the purchase of Security X, which matures in ten years and has a par value of SI,000. During the first five years, X has a 6% coupon with quarterly payments. During the remaining five years, X has an 8% coupon with quarterly payments. The face value is paid at maturity. A second 10-year security, Security Z, has a 6% semiannual coupon and is selling at par. Assuming that X has the same bond equivalent yield as Z, the price of Security X is closest to:

$1,067.

1212The bond equivalent yield rate on the par bond (Z) is 6% or a 3% semiannual rate. The equivalent quarterly rate,

. Security X makes 20 quarterly payments of 15 and 20 quarterly payments of 20. We need to use the cash flow function as follows: CFQ - 0; CFj = 15; Fj = 20; CF9 = 20; CF3 = 1,020;
F3 = 1; I = 1.4889; CPT -> NPV = 1,067.27. Note that CF3 contains the final quarterly payment of 20 along with the 1,000 face value payment.

Consider the following statements:
Statement 1: Generally speaking, floating‐rate notes have less interest rate risk than fixed‐rate bonds.
Statement 2: The spread on a floating‐rate note varies with the issuer’s creditworthiness during the term of the bond.
Which of the following is most likely?

Only Statement 1 is correct.

FRN’s have lower interest rate risk than fixed‐rate bonds because the coupon rate on a FRN is reset periodically and brought in line with market interest rates. The spread on a floating‐rate note is determined at issuance based on the issuer’s creditworthiness at issuance.

Bonds that are issued by a corporation, but paid from a pool of the corporation’s assets that is legally bankruptcy-remote, are best described as:

covered bonds.

Covered bonds are an obligation of the corporation that issues them but their interest and principal payments are provided by a pool of assets that are legally recognized as bankruptcy-remote. They are different from securitized bonds, which are issued by a special purpose vehicle.

With respect to fixed income markets, the "grey market" refers to trading in:

bonds that have not yet been issued.

"Grey market" refers to trading of bonds on a when-issued basis.

If a callable bond has an option-adjusted spread (OAS) of 75 basis points, this most likely suggests:

the bond has a zero-volatility spread greater than 75 basis points.

For a bond with an embedded call option, the OAS is less than its zero-volatility spread by the option cost. Therefore, the zero-volatility spread is greater than the OAS for callable bonds. If the embedded call option has any value to the issuer, a callable bond with an OAS of 75 basis points will have a Z-spread that is greater than 75 basis points. Because the OAS represents the bond's spread to the spot yield curve excluding the effect of the embedded option, it does not include any compensation for the volatility risk related to the option. The implied cost of an embedded option is the difference between the bond's zero-volatility spread (not the nominal spread) and its OAS.

The current 4-year spot rate is 4% and the current 5-year spot rate is 5.5%. What is the 1-year forward rate in four years?

11.72%.

1212

A synthetic collateralized debt obligation is backed by a portfolio of:

credit default swaps.

Synthetic CDOs have portfolios of credit default swaps as the underlying collateral.

A bond pays a quarterly coupon of 8% minus one-half of annual 90-day LIBOR. This bond is most accurately classified as a:

leveraged instrument.

An inverse floater is classified as a leveraged instrument. The example given here is a deleveraged inverse floater because the multiplier for the reference rate is less than one.

Consider the following statements:
Statement 1: The drawback of credit‐linked bonds is that they can contribute to further downgrades or eventual default of the issuer.
Statement 2: TIPS offer investors a fixed real return that is protected from inflation risk.
Which of the following is most likely?

Both statements are correct.

Because a rating downgrade results in higher interest payments on credit‐linked bonds, they can contribute to further downgrades or even an eventual default of the issuer. Treasury Inflation Protection Securities are inflation‐linked bonds. They are long-term assets with a fixed real return that is protected from inflation risk.

Consider the following Treasury spot rates expressed as bond equivalent yields:
If a Treasury note with two years remaining to maturity has a 5% semiannual coupon and is priced at $1,008, the note is:

underpriced.

1212The market value of the Treasury note is the present value of the remaining coupons plus the present value of the principal, discounted at the semiannual rates available from dividing each annual spot rate in the table by two.
value of T-note =

At 1,008, the T-note is priced below the present value of its cash flows (1,010) and is therefore underpriced.

The duration of Renburg's bond portfolio is closest to:

6.8

Portfolio duration is the weighted average of component securities, using full prices: (2,400,000 / 7,200,000) x 4.625 + (3,600,000 / 7,200,000) x 7.322 + (1,200,000 / 7,200,000) x 9.3 = 6.753.