Question 1

A(n) _____ can be exchanged for shares of equity at the owner's discretion.

Accepted Answer

A convertible bond gives the bondholder the option to convert the bond into a predetermined number of shares of equity at any time before maturity at their discretion. Therefore, a convertible bond can be exchanged for shares of equity at the owner's discretion.

Question 2

If the yield to maturity (the market rate of return) of a bond is less than its coupon rate, the bond should be selling at a discount; i.e., the bond's market price should be less than its face (maturity) value.

Accepted Answer

If the yield to maturity is less than the coupon rate, meaning the bond is paying a higher interest rate than the current market rate, the bond may actually sell at a premium, meaning the market price is higher than the face value.

Question 3

If there are two bonds with a simple interest rate yield of 9%, and one bond is compounded quarterly while the other bond is compounded monthly, then the bond compounded quarterly will have a higher effective annual yield.

Accepted Answer

The bond compounded monthly will have a higher effective annual yield because more frequent compounding results in a higher yield.

Question 4

Regardless of the size of the coupon payment, the price of a bond moves in the opposite direction to interest rate movements. For example, if interest rates rise, bond prices fall.

Accepted Answer

This is a fundamental principle of bond investing, known as the inverse relationship between bond prices and interest rates. When interest rates rise, the fixed coupon payment on an existing bond becomes less attractive compared to newly issued bonds with higher coupon rates, so the price of the existing bond must fall in order to attract buyers. Conversely, when interest rates fall, existing bonds become more attractive and their prices rise.

Question 5

In the event of liquidation, a(n) _____ has a claim on assets only after the senior debt has been paid off.

Accepted Answer

A subordinated debenture is a type of debt instrument that has a lower priority for payment than other debt securities issued by the same entity. In the event of liquidation, senior debt holders are paid first, followed by subordinated debt holders who have a lower claim on the assets. Therefore, a subordinated debenture has a claim on assets only after the senior debt has been paid off.

Question 6

A debt backed by some form of specific property is known as a:

Accepted Answer

A mortgage bond is a type of bond that is backed by a specific property, such as real estate. If the borrower defaults on the loan, the bondholders have the right to foreclose on the property and sell it to recover their investment.

Question 7

There is an inverse relationship between bond ratings and the required return on a bond. The required return is lowest for AAA rated bonds, and required returns increase as the ratings get lower (worse).

Accepted Answer

This statement is true. Bond ratings are based on the creditworthiness of bond issuers, and higher rated bonds are considered less risky, so they generally offer lower required returns than lower rated bonds.

Question 8

Because short-term interest rates are much more volatile than long-term rates, an investor would, in the real world, be subject to much more interest rate price risk if he or she purchased a 30-day bond than if he or she bought a 30-year bond.

Accepted Answer

Long-term bonds are generally more sensitive to interest rate changes than short-term bonds, meaning an investor in a 30-year bond would typically face more interest rate price risk than an investor in a 30-day bond.

Question 9

A bond with a $100 annual interest payment and $1,000 face value with five years to maturity (not expected to default) would sell for a premium if interest rates were below 9% and would sell for a discount if interest rates were greater than 11%.

Accepted Answer

This is because when interest rates are below the bond's coupon rate of 10% (100/1000), investors are willing to pay more for the bond to lock in its relatively high return. Conversely, when interest rates are above the bond's coupon rate, investors can find higher yielding investments elsewhere and are therefore willing to pay less for the bond.

Question 10

If a bond is selling for less than its face, or maturity, value and the market interest rate remains unchanged during the life of the bond, then the price (value) of the bond will increase as the maturity date nears.

Accepted Answer

This is because as the bond approaches its maturity date, the amount of interest payments remaining decreases, making the bond less risky for investors. As a result, investors are willing to pay more for the bond, driving up its price.

Question 11

Other things held constant, if a bond indenture contains a call provision, the yield to maturity (YTM) on the bond that would exist without such a call provision will be _____ the YTM with the call provision.

Accepted Answer

The answer of Other things held constant, if a bond...

Question 12

A bond's value will increase with increases in interest rate over time.

Accepted Answer

When interest rates increase, the value of existing bonds decreases because new bonds are issued with higher yields, making older bonds with lower yields less attractive to investors. Therefore, the value of a bond will decrease with increases in interest rate over time.

Question 13

A bond differs from a term loan in that:

Accepted Answer

Bonds typically have higher issuance costs due to underwriting, legal, and registration fees compared to term loans.

Question 14

A bond that only pays interest if the firm has sufficient earnings to cover the interest payments is called a(n):

Accepted Answer

An income bond is a type of bond that only pays interest if the firm has sufficient earnings to cover the interest payments. It is also known as an adjustment bond or profit bond.

Question 15

A contract that is negotiated directly with a bank and under which the borrower agrees to make a series of interest and principal payments to the bank on specific dates is called:

Accepted Answer

A term loan is a type of debt financing where the borrower agrees to make a series of interest and principal payments on specific dates directly to the bank or lender that negotiated the contract. This type of loan typically has a fixed interest rate and a set repayment schedule. Commercial paper (B) refers to unsecured short-term debt issued by corporations, while preferred stock (A) and convertible debt (C) are types of securities that represent an ownership interest in a company or the right to convert debt into equity, respectively. A bond issue (E) is a type of long-term debt that is typically sold to investors through an underwriting process.

Question 16

The longer the maturity of the bond, the more significantly its price changes in response to a given change in interest rates.

Accepted Answer

This is because long-term bonds have more time for interest rates to affect their future cash flows. As a result, changes in interest rates have a greater impact on their present value.

Question 17

The terms and conditions of a bond are set forth in its:

Accepted Answer

The terms and conditions of a bond are set forth in its indenture, which is a legal document outlining the rights and responsibilities of both the bond issuer and the bondholder. This includes details on the bond's interest rate, maturity date, repayment terms, and any covenants or restrictions that must be followed.

Question 18

Which of the following is generally considered an advantage of term loans over publicly issued bonds?

Accepted Answer

Term loans can be arranged more quickly than publicly issued bonds, allowing firms to access funds faster.

Question 19

Bonds issued by BB&C Communications that have a coupon rate of interest equal to 10 percent currently have a yield to maturity (YTM) equal to 8 percent. Based on this information, it is understood that BB&C's bonds must currently be selling at a premium in the financial markets.

Accepted Answer

When the coupon rate of a bond is higher than its yield to maturity (YTM), the bond is selling at a premium because its interest payments are more attractive compared to the current market rates.

Question 20

A 20-year original maturity bond with 1 year left to maturity has more interest rate price risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal coupon rates.)

Accepted Answer

Both bonds have the same duration (time left to maturity) and therefore the same interest rate price risk, assuming all other factors like coupon rates and default risk are equal.

Quiz 6: Bonds Debtcharacteristics and Valuation