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CHAPTER 5—BONDS, BOND VALUATION, AND INTEREST RATES
TRUE/FALSE
1. If a firm raises capital by selling new bonds, it is called the "issuing firm," and the coupon rate is
generally set equal to the required rate on bonds of equal risk.
2. A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically,
calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal
amount back and reinvest it elsewhere at higher rates.
3. Sinking funds are devices used to force companies to retire bonds on a scheduled basis prior to their
maturity. Many bond indentures allow the company to acquire bonds for a sinking fund by either
purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered by the
trustee through a call at face value.
4. A zero coupon bond is a bond that pays no interest and is offered (and subsequently sells initially) at
par. These bonds provide compensation to investors in the form of capital appreciation.
5. The desire for floating-rate bonds, and consequently their increased usage, arose out of the experience
of the early 1980s, when inflation pushed interest rates up to very high levels and thus caused sharp
declines in the prices of outstanding bonds.
6. The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope
of selling it at a profit, may be estimated by determining future cash flows and then discounting them
back to the present.
7. For bonds, price sensitivity to a given change in interest rates is generally greater the longer before the
bond matures.
8. As a general rule, a company's debentures have higher required interest rates than its mortgage bonds
because mortgage bonds are backed by specific assets while debentures are unsecured.
9. Other things equal, a firm will have to pay a higher coupon rate on its subordinated debentures than on
its second mortgage bonds.
10. There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus,
the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get
lower.
11. A bond that had a 20-year original maturity 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, and they cannot be called.)
12. Because short-term interest rates are much more volatile than long-term rates, you would, in the real
world, generally be subject to much more interest rate price risk if you purchased a 30-day bond than if
you bought a 30-year bond.
13. Junk bonds are high risk, high yield debt instruments. They are often used to finance leveraged
buyouts and mergers, and to provide financing to companies of questionable financial strength.
14. A bond that is callable has a chance of being retired earlier than its stated term to maturity. Therefore,
if the yield curve is upward sloping, an outstanding callable bond should have a lower yield to
maturity than an otherwise identical noncallable bond.
15. Income bonds pay interest only if the issuing company actually earns the indicated interest. Thus, these
securities cannot bankrupt a company, and this makes them safer from an investor's perspective than
regular bonds.
16. You are considering 2 bonds that will be issued tomorrow. Both are rated triple B (BBB, the lowest
investment-grade rating), both mature in 20 years, both have a 10% coupon, neither can be called
except for sinking fund purposes, and both are offered to you at their $1,000 par values. However,
Bond SF has a sinking fund while Bond NSF does not. Under the sinking fund, the company must call
and pay off 5% of the bonds at par each year. The yield curve at the time is upward sloping. The
bond's prices, being equal, are probably not in equilibrium, as Bond SF, which has the sinking fund,
would generally be expected to have a higher yield than Bond NSF.
17. Floating-rate debt is advantageous to investors because the interest rate moves up if market rates rise.
Since floating-rate debt shifts interest rate risk to companies, it offers no advantages to issuers.
18. A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity,
cannot be called, and is not expected to default. The bond should sell at a premium if interest rates are
below 10% and at a discount if interest rates are greater than 10%.
19. You have funds that you want to invest in bonds, and you just noticed in the financial pages of the
local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with
annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value.
You should buy the bond if your required return on bonds with this risk is 12%.
20. If the required rate of return on a bond (rd) is greater than its coupon interest rate and will remain
above that rate, then the market value of the bond will always be below its par value until the bond
matures, at which time its market value will equal its par value. (Accrued interest between interest
payment dates should not be considered when answering this question.)
21. "Restrictive covenants" are designed primarily to protect bondholders by constraining the actions of
managers. Such covenants are spelled out in bond indentures.
22. The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-
coupon bonds, other things held constant.
MULTIPLE CHOICE
23. Which of the following statements is CORRECT?
a.
The time to maturity does not affect the change in the value of a bond in response to a
given change in interest rates.
b.
You hold two bonds. One is a 10-year, zero coupon, bond and the other is a 10-year bond
that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the
market rate rises from the current level, the zero coupon bond will experience the smaller
percentage decline.
c.
The shorter the time to maturity, the greater the change in the value of a bond in response
to a given change in interest rates.
d.
The longer the time to maturity, the smaller the change in the value of a bond in response
to a given change in interest rates.
e.
You hold two bonds. One is a 10-year, zero coupon, issue and the other is a 10-year bond
that pays a 6% annual coupon. The same market rate, 6%, applies to both bonds. If the
market rate rises from the current level, the zero coupon bond will experience the larger
percentage decline.
24. Which of the following events would make it more likely that a company would choose to call its
outstanding callable bonds?
a.
Market interest rates rise sharply.
b.
Market interest rates decline sharply.
c.
The company's financial situation deteriorates significantly.
d.
Inflation increases significantly.
e.
The company's bonds are downgraded.
25. A 10-year bond with a 9% annual coupon has a yield to maturity of 8%. Which of the following
statements is CORRECT?
a.
The bond is selling below its par value.
b.
The bond is selling at a discount.
c.
If the yield to maturity remains constant, the bond's price one year from now will be lower
than its current price.
d.
The bond's current yield is greater than 9%.
e.
If the yield to maturity remains constant, the bond's price one year from now will be
higher than its current price.
26. Which of the following statements is CORRECT?
a.
An indenture is a bond that is less risky than a mortgage bond.
b.
The expected return on a corporate bond will generally exceed the bond's yield to
maturity.
c.
If a bond's coupon rate exceeds its yield to maturity, then its expected return to investors
exceeds the yield to maturity.
d.
Under our bankruptcy laws, any firm that is in financial distress will be forced to declare
bankruptcy and then be liquidated.
e.
All else equal, senior debt generally has a lower yield to maturity than subordinated debt.
27. Ranger Inc. would like to issue new 20-year bonds. Initially, the plan was to make the bonds non-
callable. If the bonds were made callable after 5 years at a 5% call premium, how would this affect
their required rate of return?
a.
There is no reason to expect a change in the required rate of return.
b.
The required rate of return would decline because the bond would then be less risky to a
bondholder.
c.
The required rate of return would increase because the bond would then be more risky to a
bondholder.
d.
It is impossible to say without more information.
e.
Because of the call premium, the required rate of return would decline.
28. Under normal conditions, which of the following would be most likely to increase the coupon rate
required to enable a bond to be issued at par?
a.
Adding a call provision.
b.
The rating agencies change the bond's rating from Baa to Aaa.
c.
Making the bond a first mortgage bond rather than a debenture.
d.
Adding a sinking fund.
e.
Adding additional restrictive covenants that limit management's actions.
29. Which of the following bonds would have the greatest percentage increase in value if all interest rates
fall by 1%?
a.
20-year, 10% coupon bond.
b.
20-year, 5% coupon bond.
c.
1-year, 10% coupon bond.
d.
20-year, zero coupon bond.
e.
10-year, zero coupon bond.
30. Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds
would have the largest percentage increase in price?
a.
A 1-year bond with a 15% coupon.
b.
A 3-year bond with a 10% coupon.
c.
A 10-year zero coupon bond.
d.
A 10-year bond with a 10% coupon.
e.
An 8-year bond with a 9% coupon.
31. Which of the following bonds has the greatest interest rate price risk?
a.
A 10-year, $1,000 face value, zero coupon bond.
b.
A 10-year, $1,000 face value, 10% coupon bond with annual interest payments.
c.
All 10-year bonds have the same price risk since they have the same maturity.
d.
A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments.
32. If its yield to maturity declined by 1%, which of the following bonds would have the largest
percentage increase in value?
a.
A 1-year bond with an 8% coupon.
b.
A 10-year bond with an 8% coupon.
c.
A 10-year bond with a 12% coupon.
d.
A 10-year zero coupon bond.
e.
A 1-year zero coupon bond.
33. Which of the following statements is CORRECT?
a.
Most sinking funds require the issuer to provide funds to a trustee, who saves the money
so that it will be available to pay off bondholders when the bonds mature.
b.
A sinking fund provision makes a bond more risky to investors at the time of issuance.
c.
Sinking fund provisions never require companies to retire their debt; they only establish
"targets" for the company to reduce its debt over time.
d.
If interest rates have increased since a company issued bonds with a sinking fund, the
company is less likely to retire the bonds by buying them back in the open market, as
opposed to calling them in at the sinking fund call price.
e.
Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is
most likely to occur if interest rates decline after the bond has been issued.
34. Nicholas Industries can issue a 20-year bond with a 6% annual coupon. This bond is not convertible, is
not callable, and has no sinking fund. Alternatively, Nicholas could issue a 20-year bond that is
convertible into common equity, may be called, and has a sinking fund. Which of the following most
accurately describes the coupon rate that Nicholas would have to pay on the convertible, callable
bond?
a.
It could be less than, equal to, or greater than 6%.
b.
Greater than 6%.
c.
Exactly equal to 8%.
d.
Less than 6%.
e.
Exactly equal to 6%.
35. The YTMs of three $1,000 face value bonds that mature in 10 years and have the same level of risk are
equal. Bond A has an 8% annual coupon, Bond B has a 10% annual coupon, and Bond C has a 12%
annual coupon. Bond B sells at par. Assuming interest rates remain constant for the next 10 years,
which of the following statements is CORRECT?
a.
Since the bonds have the same YTM, they should all have the same price, and since
interest rates are not expected to change, their prices should all remain at their current
levels until maturity.
b.
Bond C sells at a premium (its price is greater than par), and its price is expected to
increase over the next year.
c.
Bond A sells at a discount (its price is less than par), and its price is expected to increase
over the next year.
d.
Over the next year, Bond A's price is expected to decrease, Bond B's price is expected to
stay the same, and Bond C's price is expected to increase.
e.
Bond A's current yield will increase each year.
36. A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000).
Which of the following statements is NOT CORRECT?
a.
The bond's yield to maturity is 9%.
b.
The bond's current yield is 9%.
c.
If the bond's yield to maturity remains constant, the bond will continue to sell at par.
d.
The bond's current yield exceeds its capital gains yield.
e.
The bond's expected capital gains yield is positive.
37. Which of the following statements is CORRECT?
a.
If a bond's yield to maturity exceeds its coupon rate, the bond will sell at par.
b.
All else equal, if a bond's yield to maturity increases, its price will fall.
c.
If a bond's yield to maturity exceeds its coupon rate, the bond will sell at a premium over
par.
d.
All else equal, if a bond's yield to maturity increases, its current yield will fall.
e.
A zero coupon bond's current yield is equal to its yield to maturity.
38. Stephenson Co.'s 15-year bond with a face value of $1,000 currently sells for $850. Which of the
following statements is CORRECT?
a.
The bond's current yield exceeds its yield to maturity.
b.
The bond's yield to maturity is greater than its coupon rate.
c.
The bond's current yield is equal to its coupon rate.
d.
If the yield to maturity stays constant until the bond matures, the bond's price will remain
at $850.
e.
The bond's coupon rate exceeds its current yield.
39. A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which of
the following statements is CORRECT?
a.
If the yield to maturity remains at 8%, then the bond's price will decline over the next
year.
b.
The bond's coupon rate is less than 8%.
c.
If the yield to maturity increases, then the bond's price will increase.
d.
If the yield to maturity remains at 8%, then the bond's price will remain constant over the
next year.
e.
The bond's current yield is less than 8%.
40. Which of the following statements is CORRECT?
a.
On an expected yield basis, the expected capital gains yield will always be positive
because an investor would not purchase a bond with an expected capital loss.
b.
On an expected yield basis, the expected current yield will always be positive because an
investor would not purchase a bond that is not expected to pay any cash coupon interest.
c.
If a coupon bond is selling at par, its current yield equals its yield to maturity.
d.
The current yield on Bond A exceeds the current yield on Bond B; therefore, Bond A must
have a higher yield to maturity than Bond B.
e.
If a bond is selling at a discount, the yield to call is a better measure of return than the
yield to maturity.
41. A 15-year bond has an annual coupon rate of 8%. The coupon rate will remain fixed until the bond
matures. The bond has a yield to maturity of 6%. Which of the following statements is CORRECT?
a.
The bond is currently selling at a price below its par value.
b.
If market interest rates remain unchanged, the bond's price one year from now will be
lower than it is today.
c.
The bond should currently be selling at its par value.
d.
If market interest rates remain unchanged, the bond's price one year from now will be
higher than it is today.
e.
If market interest rates decline, the price of the bond will also decline.
42. An 8-year Treasury bond has a 10% coupon, and a 10-year Treasury bond has an 8% coupon. Both
bonds have the same yield to maturity. If the yield to maturity of both bonds increases by the same
amount, which of the following statements would be CORRECT?
a.
Both bonds would decline in price, but the 10-year bond would have the greater
percentage decline in price.
b.
The prices of both bonds would increase by the same amount.
c.
One bond's price would increase, while the other bond's price would decrease.
d.
The prices of the two bonds would remain constant.
e.
The prices of both bonds will decrease by the same amount.
43. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield
to maturity, and the YTM is expected to remain constant. Which of the following statements is
CORRECT?
a.
The prices of both bonds will remain unchanged.
b.
The price of Bond A will decrease over time, but the price of Bond B will increase over
time.
c.
The prices of both bonds will increase by 7% per year.
d.
The prices of both bonds will increase over time, but the price of Bond A will increase by
more.
e.
The price of Bond B will decrease over time, but the price of Bond A will increase over
time.
44. Assume that interest rates on 15-year noncallable Treasury and corporate bonds with different ratings
are as follows:
T-bond = 7.72%
A = 9.64%
AAA = 8.72%
BBB = 10.18%
The differences in rates among these issues were most probably caused primarily by:
a.
Tax effects.
b.
Default risk differences.
c.
Maturity risk differences.
d.
Inflation differences.
e.
Real risk-free rate differences.
45. Which of the following statements is CORRECT?
a.
All else equal, long-term bonds have less interest rate price risk than short-term bonds.
b.
All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds.
c.
All else equal, short-term bonds have less reinvestment rate risk than long-term bonds.
d.
All else equal, long-term bonds have less reinvestment rate risk than short-term bonds.
e.
All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds.
46. Which of the following statements is CORRECT?
a.
Long-term bonds have less interest rate price risk but more reinvestment rate risk than
short-term bonds.
b.
If interest rates increase, all bond prices will increase, but the increase will be greater for
bonds that have less interest rate risk.
c.
Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more
interest rate price risk but less reinvestment rate risk.
d.
Long-term bonds have less interest rate price risk and also less reinvestment rate risk than
short-term bonds.
e.
One advantage of a zero coupon Treasury bond is that no one who owns the bond has to
pay any taxes on it until it matures or is sold.
47. Which of the following statements is CORRECT?
a.
Liquidity premiums are generally higher on Treasury than corporate bonds.
b.
The maturity premiums embedded in the interest rates on U.S. Treasury securities are due
primarily to the fact that the probability of default is higher on long-term bonds than on
short-term bonds.
c.
Default risk premiums are generally lower on corporate than on Treasury bonds.
d.
Reinvestment rate risk is lower, other things held constant, on long-term than on short-
term bonds.
e.
If the maturity risk premium were zero and interest rates were expected to decrease in the
future, then the yield curve for U.S. Treasury securities would, other things held constant,
have an upward slope.
48. Which of the following statements is CORRECT?
a.
If a coupon bond is selling at a discount, its price will continue to decline until it reaches
its par value at maturity.
b.
If interest rates increase, the price of a 10-year coupon bond will decline by a greater
percentage than the price of a 10-year zero coupon bond.
c.
If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a
premium.
d.
If a coupon bond is selling at a premium, its current yield equals its yield to maturity.
e.
If a coupon bond is selling at par, its current yield equals its yield to maturity.
49. A Treasury bond has an 8% annual coupon and a 7.5% yield to maturity. Which of the following
statements is CORRECT?
a.
The bond has a current yield greater than 8%.
b.
The bond sells at a discount.
c.
The bond's required rate of return is less than 7.5%.
d.
If the yield to maturity remains constant, the price of the bond will decline over time.
e.
The bond sells at a price below par.
50. Bonds A and B are 15-year, $1,000 face value bonds. Bond A has a 7% annual coupon, while Bond B
has a 9% annual coupon. Both bonds have a yield to maturity of 8%, which is expected to remain
constant for the next 15 years. Which of the following statements is CORRECT?
a.
One year from now, Bond A's price will be higher than it is today.
b.
Bond A's current yield is greater than 8%.
c.
Bond A has a higher price than Bond B today, but one year from now the bonds will have
the same price.
d.
Both bonds have the same price today, and the price of each bond is expected to remain
constant until the bonds mature.
e.
Bond B has a higher price than Bond A today, but one year from now the bonds will have
the same price.
51. Which of the following statements is NOT CORRECT?
a.
All else equal, bonds with longer maturities have more interest rate (price) risk than bonds
with shorter maturities.
b.
If a bond is selling at its par value, its current yield equals its yield to maturity.
c.
If a bond is selling at a premium, its current yield will be greater than its yield to maturity.
d.
All else equal, bonds with larger coupons have greater interest rate (price) risk than bonds
with smaller coupons.
e.
If a bond is selling at a discount to par, its current yield will be less than its yield to
maturity.
52. Which of the following statements is CORRECT?
a.
If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then
dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a
premium above its $1,000 par value.
b.
Other things held constant, a corporation would rather issue noncallable bonds than
callable bonds.
c.
Other things held constant, a callable bond would have a lower required rate of return than
a noncallable bond.
d.
Reinvestment rate risk is worse from an investor's standpoint than interest rate price risk if
the investor has a short investment time horizon.
e.
If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a
10% yield to maturity, and if interest rates then dropped to the point where rd = YTM =
5%, the bond would sell at a premium over its $1,000 par value.
53. Which of the following statements is CORRECT?
a.
The total yield on a bond is derived from dividends plus changes in the price of the bond.
b.
Bonds are riskier than common stocks and therefore have higher required returns.
c.
Bonds issued by larger companies always have lower yields to maturity (less risk) than
bonds issued by smaller companies.
d.
The market value of a bond will always approach its par value as its maturity date
approaches, provided the bond's required return remains constant.
e.
If the Federal Reserve unexpectedly announces that it expects inflation to increase, then
we would probably observe an immediate increase in bond prices.
54. Which of the following statements is CORRECT?
a.
If rates fall after its issue, a zero coupon bond could trade at a price above its par value.
b.
If rates fall rapidly, a zero coupon bond's expected appreciation could become negative.
c.
If a firm moves from a position of strength toward financial distress, its bonds' yield to
maturity would probably decline.
d.
If a bond is selling at a premium, this implies that its yield to maturity exceeds its coupon
rate.
e.
If a coupon bond is selling at par, its current yield equals its yield to maturity.
55. You are considering three different bonds for your portfolio. Each bond has a 10-year maturity and a
yield to maturity of 10%. Bond X has an 8% annual coupon, Bond Y has a 10% annual coupon, and
Bond Z has a 12% annual coupon. Which of the following statements is CORRECT?
a.
Bond X has the greatest reinvestment rate risk.
b.
If market interest rates decline, all of the bonds will have an increase in price, and Bond Z
will have the largest percentage increase in price.
c.
If market interest rates remain at 10%, Bond Z's price will be 10% higher one year from
today.
d.
If market interest rates increase, Bond X's price will increase, Bond Z's price will decline,
and Bond Y's price will remain the same.
e.
If the bonds' market interest rates remain at 10%, Bond Z's price will be lower one year
from now than it is today.
56. Bonds A, B, and C all have a maturity of 15 years and a yield to maturity of 9%. Bond A's price
exceeds its par value, Bond B's price equals its par value, and Bond C's price is less than its par value.
Which of the following statements is CORRECT?
a.
Bond A has the most interest rate risk.
b.
If the yield to maturity on the three bonds remains constant, the prices of the three bonds
will remain the same over the next year.
c.
If the yield to maturity on each bond increases to 8%, the prices of all three bonds will
decline.
d.
Bond C sells at a premium over its par value.
e.
If the yield to maturity on each bond decreases to 6%, Bond A will have the largest
percentage increase in its price.
57. Which of the following statements is CORRECT?
a.
A 10-year, 10% coupon bond has less reinvestment rate risk than a 10-year, 5% coupon
bond (assuming all else equal).
b.
The total return on a bond during a given year is the sum of the coupon interest payments
received during the year and the change in the value of the bond from the beginning to the
end of the year.
c.
The price of a 20-year, 10% bond is less sensitive to changes in interest rates than the
price of a 5-year, 10% bond.
d.
A $1,000 bond with $100 annual interest payments that has 5 years to maturity and is not
expected to default would sell at a discount if interest rates were below 9% and at a
premium if interest rates were greater than 11%.
e.
10-year, zero coupon bonds have higher reinvestment rate risk than 10-year, 10% coupon
bonds.
58. Which of the following statements is CORRECT?
a.
The market value of a bond will always approach its par value as its maturity date
approaches. This holds true even if the firm has filed for bankruptcy.
b.
Rising inflation makes the actual yield to maturity on a bond greater than a quoted yield to
maturity that is based on market prices.
c.
The yield to maturity on a coupon bond that sells at its par value consists entirely of a
current interest yield; it has a zero expected capital gains yield.
d.
On an expected yield basis, the expected capital gains yield will always be positive
because an investor would not purchase a bond with an expected capital loss.
e.
The yield to maturity for a coupon bond that sells at a premium consists entirely of a
positive capital gains yield; it has a zero current interest yield.
59. Which of the following statements is CORRECT?
a.
If a coupon bond is selling at a discount, then the bond's expected capital gains yield is
negative.
b.
If a bond is selling at a discount, the yield to call is a better measure of the expected return
than the yield to maturity.
c.
The current yield on Bond A exceeds the current yield on Bond B. Therefore, Bond A
must have a higher yield to maturity than Bond B.
d.
If a coupon bond is selling at par, its current yield equals its yield to maturity.
e.
If a coupon bond is selling at a premium, then the bond's current yield is zero.
60. Which of the following statements is CORRECT?
a.
If the maturity risk premium (MRP) is greater than zero, then the yield curve must have an
upward slope.
b.
Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury
bonds will always be higher than yields on short-term T-bonds.
c.
If the maturity risk premium (MRP) equals zero, the yield curve must be flat.
d.
The yield curve can never be downward sloping.
e.
If inflation is expected to increase in the future, and if the maturity risk premium (MRP) is
greater than zero, then the yield curve will have an upward slope.
61. Assume that the current corporate bond yield curve is upward sloping. Under this condition, then we
could be sure that
a.
The economy is not in a recession.
b.
Long-term bonds are a better buy than short-term bonds.
c.
Maturity risk premiums could help to explain the yield curve's upward slope.
d.
Long-term interest rates are more volatile than short-term rates.
e.
Inflation is expected to decline in the future.
62. Which of the following statements is CORRECT?
a.
The most likely explanation for an inverted yield curve is that investors expect inflation to
increase.
b.
The most likely explanation for an inverted yield curve is that investors expect inflation to
decrease.
c.
If the yield curve is inverted, short-term bonds have lower yields than long-term bonds.
d.
Inverted yield curves can exist for Treasury bonds, but because of default premiums, the
corporate yield curve can never be inverted.
e.
The higher the maturity risk premium, the higher the probability that the yield curve will
be inverted.
63. Bonds for two companies were just issued: Short Corp.'s bonds will mature in 5 years, and Long
Corp.'s bonds will mature in 15 years. Both bonds promise to pay a semiannual coupon, they are not
callable or convertible, and they are equally liquid. Further, assume that the Treasury yield curve is
based only on expectations about future inflation, i.e., that the maturity risk premium is zero for T-
bonds. Under these conditions, which of the following statements is correct?
a.
If the Treasury yield curve is downward sloping, Long's bonds must under all conditions
have the lower yield.
b.
If the yield curve for Treasury securities is upward sloping, Long's bonds must under all
conditions have a higher yield than Short's bonds.
c.
If the yield curve for Treasury securities is flat, Short's bond must under all conditions
have the same yield as Long's bonds.
d.
If Long's and Short's bonds have the same default risk, their yields must under all
conditions be equal.
e.
If the Treasury yield curve is upward sloping and Short has less default risk than Long,
then Short's bonds must under all conditions have the lower yield.
64. Bond A has a 9% annual coupon, while Bond B has a 7% annual coupon. Both bonds have the same
maturity, a face value of $1,000, and an 8% yield to maturity. Which of the following statements is
CORRECT?
a.
Bond A trades at a discount, whereas Bond B trades at a premium.
b.
If the yield to maturity for both bonds remains at 8%, Bond A's price one year from now
will be higher than it is today, but Bond B's price one year from now will be lower than it
is today.
c.
If the yield to maturity for both bonds immediately decreases to 6%, Bond A's bond will
have a larger percentage increase in value.
d.
Bond A's current yield is greater than that of Bond B.
e.
Bond A's capital gains yield is greater than Bond B's capital gains yield.
65. Which of the following statements is CORRECT?
a.
A callable 10-year, 10% bond should sell at a higher price than an otherwise similar
noncallable bond.
b.
Corporate treasurers dislike issuing callable bonds because these bonds may require the
company to raise additional funds earlier than would be true if noncallable bonds with the
same maturity were used.
c.
Two bonds have the same maturity and the same coupon rate. However, one is callable
and the other is not. The difference in prices between the bonds will be greater if the
current market interest rate is above the coupon rate than if it is below the coupon rate.
d.
The actual life of a callable bond will always be equal to or less than the actual life of a
noncallable bond with the same maturity. Therefore, if the yield curve is upward sloping,
the required rate of return will be lower on the callable bond.
e.
Two bonds have the same maturity and the same coupon rate. However, one is callable
and the other is not. The difference in prices between the bonds will be greater if the
current market interest rate is below the coupon rate than if it is above the coupon rate.
66. Cornwall Corporation is planning to raise $1,000,000 to finance a new plant. Which of the following
statements is CORRECT?
a.
If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds
on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds
would be lower than it would be if the entire $1 million were raised by selling first
mortgage bonds.
b.
If two tiers of debt are used (with one senior and one subordinated debt class), the
subordinated debt will carry a lower interest rate.
c.
If debt is used to raise the million dollars, the cost of the debt would be lower if the debt
were in the form of a fixed-rate bond rather than a floating-rate bond.
d.
If debt is used to raise the million dollars, the cost of the debt would be higher if the debt
were in the form of a mortgage bond rather than an unsecured term loan.
e.
The company would be especially eager to have a call provision included in the indenture
if its management thinks that interest rates are almost certain to rise in the foreseeable
future.
67. Which of the following statements is CORRECT?
a.
Subordinated debt has less default risk than senior debt.
b.
Convertible bonds have lower coupon rates than non-convertible bonds of similar default
risk because they offer the possibility of capital gains.
