Question 1

The practical application of bond portfolio immunization to investors is that immunization

Accepted Answer

Immunization is a strategy used to ensure that a bond portfolio will achieve a specified rate of return over a given investment horizon, regardless of interest rate changes.

Question 2

A major advantage of passive bond strategies is low transaction costs.

Accepted Answer

Passive bond strategies involve holding bonds until maturity or maintaining a consistent investment profile, which results in lower transaction costs compared to active strategies that frequently buy and sell to outperform the market.

Question 3

Suppose you sell the bonds you purchased at $1,070 at $945 and purchase an equal amount of bonds with the proceeds. You are executing

Accepted Answer

A tax swap involves selling securities at a loss to offset capital gains tax liabilities and then reinvesting in similar securities. Selling bonds at a loss ($1,070 to $945) and buying similar bonds with the proceeds fits this strategy.

Question 4

Reasons for using a bond ladder strategy include
I. typically higher rates on long-term bonds.
II. uncertainty concerning future interest rates.
III. lower tax rates on bonds held to maturity.
IV. reducing the amount of time spent managing the bond portfolio.

Accepted Answer

A bond ladder strategy involves purchasing bonds with varying maturities, which can provide typically higher rates on long-term bonds (I) and help manage uncertainty concerning future interest rates (II). It also reduces the amount of time spent managing the bond portfolio (IV) by having a systematic approach to reinvestment and diversification. Tax rates on bonds held to maturity (III) are not a reason for using a bond ladder strategy, as tax rates are determined by tax law and not by the investment strategy.

Question 5

When conducting a tax swap, an investor must use identical issues in order for the swap to be allowed by the IRS.

Accepted Answer

A tax swap involves selling a security that has incurred a loss and simultaneously buying a similar, but not identical, security to replace it. The IRS prohibits the deduction of losses from "wash sales," which occur when an investor sells a security at a loss and buys the same or a substantially identical security within 30 days before or after the sale. Therefore, the securities involved in a tax swap must not be identical to avoid the wash sale rule.

Question 6

A bond has a YTM of 6.75%, a modified duration of 14.05 years, a duration of 15 years and a 20 year maturity. By what percentage will the bond's price change if market interest rates decrease by 0.75%?

Accepted Answer

The bond's price will change by approximately +10.53 percent if market interest rates decrease by 0.75%. This is calculated using the modified duration, which measures the price sensitivity of a bond to a change in interest rates. The formula is: Price Change (%) = -Modified Duration * Change in Yield. Here, it's -14.05 * (-0.75%) = +10.53%.

Question 7

Explain the basic concept of bond duration and why this measure is meaningful to investors.

Accepted Answer

The answer of Explain the basic concept of bond duration...

Question 8

Active bond trading strategies include
I. buy and hold.
II. trading on forecasted interest rate behavior.
III. bond ladders.
IV. bond swaps.

Accepted Answer

Active bond trading strategies involve making decisions based on market forecasts and conditions, such as trading on forecasted interest rate behavior and bond swaps. Buy and hold and bond ladders are more passive strategies.

Question 9

Investors using a passive bond investment strategy will need to
I. buy or sell in anticipation of expected changes in interest rates.
II. replace bonds as they mature.
III. replace bonds as they are called.
IV. replace bonds when major changes in risk ratings occur.

Accepted Answer

Passive bond investment strategies do not involve anticipating changes in interest rates, which is an active management strategy. Instead, they may involve replacing bonds as they mature, are called, or when there are significant changes in their risk ratings to maintain the portfolio's credit quality and duration targets.

Question 10

In building a bond ladder, an investor invests an equal amount in a series of bonds with staggered maturities.

Accepted Answer

A bond ladder is a strategy where an investor divides their investment equally among bonds with different maturities, creating a staggered pattern of investments that mature at different times. This approach helps in managing interest rate risk and providing a steady income stream.

Question 11

Explain the concept of bond immunization and the benefits derived from using this technique.

Accepted Answer

The answer of Explain the concept of bond immunization and...

Question 12

Suppose you sell the 10-year, A-rated 7 percent bonds you own, which are yielding 8 percent, and replace them with an equal amount of 10-year, A-rated 8 percent bonds that are priced to yield 9 percent. In this situation, you are executing

Accepted Answer

A yield pickup swap involves selling one bond and replacing it with another bond that has a higher yield. In this scenario, you are selling bonds yielding 8 percent and buying bonds yielding 9 percent, which is a classic example of seeking to increase the income from your bond investments, hence a yield pickup swap.

Question 13

If the bond market undergoes a large change in yield (for example, more than 100 basis points), then a bond's modified duration will

Accepted Answer

The answer of If the bond market undergoes a large...

Question 14

Some common types of bond swaps are
I. tax swaps.
II. yield pickup swaps.
III. substitution swaps.
IV. credit default swaps.

Accepted Answer

Tax swaps, yield pickup swaps, and substitution swaps are common types of bond swaps. Credit default swaps are a type of derivative, not a bond swap.

Question 15

A bond ladder is a useful tool for taking advantage of the higher rates that come with longer maturities while obtaining a regular cash flow.

Accepted Answer

A bond ladder is a strategy where an investor divides their investment into bonds with different maturities. As each bond matures, the principal is reinvested in new bonds at the longer end of the ladder, potentially capturing higher yields of longer maturities while ensuring regular cash flow from the bonds maturing in the short term.

Question 16

Once a bond portfolio is initially immunized, an investor should maintain the portfolio as it is until the end of the investment horizon.

Accepted Answer

Immunization is not a one-time process; as interest rates change and time passes, the portfolio's duration and the target duration may no longer match, requiring adjustments to the portfolio to maintain immunization.

Question 17

Buying bonds in anticipation of an expected decline in interest rates is a risky strategy.

Accepted Answer

Buying bonds in anticipation of an expected decline in interest rates is a risky strategy because if interest rates rise instead, the value of the bonds will decline.

Question 18

Which of the following climates would be most favorable for an aggressive bond strategy?

Accepted Answer

A downward sloping yield curve indicates that short-term interest rates are higher than long-term interest rates. This makes it more attractive to invest in long-term bonds, which offer higher returns than short-term bonds.

Question 19

Explain the technique and the purpose of building bond ladders.

Accepted Answer

The answer of Explain the technique and the purpose of...

Question 20

The mathematical link between a bond's price and interest rate changes is the

Accepted Answer

The modified duration of a bond measures the sensitivity of a bond's price to changes in interest rates, providing a mathematical link between the two. It adjusts the Macaulay duration to account for interest rate changes, making it a more direct measure of interest rate risk.

Quiz 11: Bond Valuation