Fundamentals of Investing, 11e (Gitman/Joehnk/Smart)
Chapter 10 Fixed-Income Securities
1) Bondholders can earn income both from interest and from capital gains.
2) The primary reasons for owning bonds are the income they provide and also the stability they
bring to an investment portfolio.
3) From 1996 through 2005, the bond market outperformed the stock market by a slim margin.
4) As investors approach retirement age, they should hold more bonds and less stock.
5) In 2006 and 2007, low yielding government bonds outperformed stocks by a significant
margin.
6) Bond prices are stable over any five- to ten-year period.
7) Bonds are typically a good investment choice for an individual who is seeking long-term
preservation of capital.
8) Corporate bonds are actively traded in the secondary markets.
9) Which of the following are advantages of owning bonds?
I. diversification properties
II. higher long-term returns than equity holdings
III. current income
IV. relatively low risk
A) I and II only
B) I, III and IV only
C) I, II and III only
D) I, II, III and IV
10) When bonds are initially added to an all-equity portfolio the
A) level of risk of the portfolio is impacted more than the rate of return.
B) rate of return on the portfolio is impacted more than the level of risk.
C) level of risk and the rate of return are equally impacted.
D) rate of return is not impacted but the level of risk is lowered.
11) the phenomenon known as “flight to quality” causes yields on government bond and
corporate bonds
A) to rise in tandem.
B) to fall in tandem.
C) to move in opposite directions.
D) to become less volatile.
12) Which of the following types of risk affect bonds?
I. call risk
II. business risk
III. purchasing power risk
IV. liquidity risk
A) III and IV only
B) II, III and IV only
C) I, III and IV only
D) I, II, III and IV
13) The bond market is considered bearish when
A) market interest rates are low or falling.
B) market interest rates are high or rising.
C) the risk-free rate of return exceeds the required rate of return.
D) more bonds are called than issued over a given period of time.
14) Under normal economic conditions, the major source of risk faced by investors who
purchase investment grade bonds is
A) purchasing power risk.
B) interest rate risk.
C) liquidity risk.
D) default risk.
15) In a severe recession, the major source of risk faced by investors who purchase corporate
bonds is
A) purchasing power risk.
B) interest rate risk.
C) liquidity risk.
D) default risk.
16) Which type of risk is based on the financial integrity of a bond issuer?
A) liquidity risk
B) call risk
C) business risk
D) interest rate risk
17) Discuss at least three differences between investing in stocks and investing in bonds.
1) Each interest payment on a 6%, semi-annual bond is $60.
2) Each interest payment on a 6%, semi-annual bond is $30.
3) When a bond is called, the bondholder generally faces a rate of return that is lower than
expected.
4) The holder of a serial bond receives both semi-annual interest and principal payments over the
life of the bond.
5) The risk premium component of a bond’s market interest rate is related to the characteristics of
the particular bond and its issuer.
6) Most bonds pay interest quarterly.
7) A bond which is noncallable for a period of time after which it is freely callable is called a
deferred call bond.
8) The initial call price of an 8% bond could be as high as $1,080.
9) A single bond issue with multiple maturity dates is called a
A) callable bond.
B) premium bond.
C) serial bond.
D) term bond.
10) A note is generally defined as debt with an initial term to maturity of
A) zero to two years.
B) one year or less.
C) two to ten years.
D) ten to thirty years.
11) Under which bond provision is the issuer required to retire portions of the bond issue prior to
maturity?
A) call feature
B) refunding provision
C) subordination clause
D) sinking fund feature
12) Most bonds pay interest
A) annually.
B) semi-annually.
C) quarterly.
D) monthly.
13) A bond which has a deferred call
A) does not have to be redeemed when it reaches maturity.
B) can be retired at any time prior to maturity provided six months notice is given.
C) cannot be retired for a specific period of time after which it can be retired at any time.
D) can be retired at any time during the initial call period but after that time can not be redeemed
prior to maturity.
14) Lee is considering buying one of two newly-issued bonds. Bond A is a twenty-year, 7.5%
coupon bond that is non-callable. Bond B is a twenty-year, 8.25% bond that is callable after two
years. Both bonds are comparable in all other aspects. Lee plans on holding his bond to maturity.
What should Lee do if he feels that interest rates are going to decline by 2% in the near future
and then remain relatively stable thereafter?
A) purchase Bond A
B) purchase Bond B
C) purchase neither A nor B at this time
D) negotiate a higher rate on Bond A
15) Which of the following is(are) senior bonds?
I. equipment trust certificates
II. mortgage bonds
III. debentures
IV. collateral trust bonds
A) I and II only
B) II and IV only
C) III only
D) I, II and IV only
16) Which one of the following is the most junior in terms of its claim on earnings and assets?
A) subordinated debenture
B) mortgage bond
C) collateral trust bond
D) equipment trust certificate
17) Bonds are least likely to be called if
A) they are selling at a substantial premium.
B) they are selling at a substantial discount.
C) the price is close to par value.
D) if they do not mature for at least 5 years.
18) Which of the following will tend to improve a bond’s rating?
I. an improvement in the firm’s cash flow
II. an increase in corporate debt
III. an increase in net profits
IV. an increase in net working capital
A) I, II and III only
B) II, III and IV only
C) I, III and IV only
D) I, II, III and IV
19) Bonds with one of the top four ratings (Aaa through Baa, or AAA through BBB) are
designated as
A) split bonds.
B) investment grade bonds.
C) illiquid bonds.
D) high-yield bonds.
20) When the economy is moving toward a recession, the yield on riskier bonds will tend to
A) rise.
B) fall.
C) stagnate.
D) become volatile.
21) If a bond rating moves from a BB to a BBB rating
A) the bond will still be classified as junk.
B) it must also move from a Ba to a Baa rating.
C) the market yield on the bond will rise.
D) the market price of the bond will rise.
22) Which of the following factors are included in the rating analysis of a corporate bond?
I. the issue’s indenture provisions
II. the liquidity position of the issuing company
III. the issuing company’s relative debt burden
IV. the stability of the company’s earnings
A) I and II only
B) I, II and III only
C) II, III and IV only
D) I, II, III and IV
23) Bond ratings are an important element of the bond market. Explain what bond ratings are,
who issues the ratings, and what the ratings mean to the average investor.
24) Every bond is issued with a call feature. Explain what it means for a bond to be “called,” then
briefly describe the three most common types of call features. Also explain why investors suffer
when bonds are called.
1) When interest rates change, the prices of short-term bonds will change more than those of
long-term bonds.
2) Interest rates and bond prices are directly related.
3) An increase in the market rate of interest can cause a bondholder to realize a capital loss on
the sale of their bonds.
4) Fixed coupon rates cause bond yields to lag inflation rates when inflation rates begin to
increase significantly.
5) If you want to reduce the price volatility of your bond portfolio, you should shorten the time–
to-maturity of your portfolio.
6) If you feel interest rates are going to drop significantly, you could potentially realize large
capital gains by purchasing long-term zero coupon bonds prior to the rates decreasing.
7) Investment-grade bonds are more interest rate sensitive than junk bonds.
8) Which one of the following variables has the greatest effect on bond prices?
A) economic growth
B) interest rates
C) inflation
D) stock market returns
9) An increase in the market rate of return on an outstanding bond will
A) increase the coupon rate.
B) decrease the coupon rate.
C) increase the bond price.
D) decrease the bond price.
10) The Franklin Company issued a 6% bond three years ago at par value. The market interest
rate on comparable bonds today is 5%. The Franklin Company bond currently pays ________ a
year in interest and the bond sells at a ________.
A) $60; discount
B) $60; premium
C) $50; discount
D) $50; premium
11) Two years ago, Mathew purchased a 10 year government bond with a yield of 4.75%. Today,
the interest rate on government bonds with 8 years to maturity is 3.5%. If Mathew sells his
bond today, he most likely will
A) realize a capital gain.
B) realize a capital loss.
C) sell the bond at face value.
D) sell the bond at par value.
12) At the time you purchase a bond, you know the exact holding period return you will earn if
A) the bond is called at any time prior to maturity.
B) you resell the bond in exactly one year from the date of purchase.
C) the market rate of interest declines within the next year.
D) you hold the bond to maturity.
13) When the market rate of return exceeds the coupon rate, a bond will sell at
A) par.
B) face value.
C) a premium.
D) a discount.
14) Which one of the following combination of features causes bond prices to be the most
volatile?
A) low coupon, short maturity
B) high coupon, short maturity
C) low coupon, long maturity
D) high coupon, long maturity
15) Bob expects to retire in a few years and his primary goal is to avoid major losses in his 401–
K account. Which of the following bond characteristics should he be seeking?
I. Long maturities
II. High ratings
III High yields
IV. Short maturities
A) I and III only.
B) I, III, and III only
C) II and IV only
D) II, III, and IV only.
16) If you expect market interest rates to rise, you should purchase
A) short term, low coupon bonds.
B) short term, high coupon bonds.
C) long term, low coupon bonds.
D) long term, high coupon bonds.
17) A bond quoted at a price of 101.2
A) is a deep discount bond.
B) yields 10.12%.
C) yields 12%.
D) has a coupon rate that exceeds the market rate.
1) A debenture is secured only by the issuer’s promise to repay the debt.
2) The par value of a Treasury inflation-indexed obligation is established as $1,000 over the life
of the bond.
3) In an inflationary environment, the interest payments on Treasury inflation-indexed
obligations increase over time.
4) If the inflation rate is 2%, the principal of a Treasury inflation protection security will from
$1,000 to $1,020.
5) If you hold a zero-coupon bond to maturity, the fully compounded rate of return is virtually
guaranteed to be equal to the rate stated at the time the bond was purchased.
6) Zero coupon bonds have very limited price volatility.
7) Municipal bonds are most attractive to residents of states with high income tax rates.
8) Mortgage-backed bonds are issued primarily by state governments and are secured by home
mortgages.
9) Mortgage-backed securities are self-liquidating.
10) One disadvantage of mortgage backed securities is their uncertain maturity date.