Chapter 17 - Corporate Bonds (FRM Part 1 - Book 3)
Chapter 17 - Corporate Bonds
Chapter 17 - Corporate Bonds
1. In which market are publicly traded bonds usually traded?
A. Stock Exchange
B. Commodity Market
C. Over-the-counter (OTC) Market
D. Futures Market
Publicly traded bonds are usually traded in the over-the-counter (OTC) market, not on exchanges.
2. What is the primary way bond dealers earn a profit?
A. Through the coupon payments
B. Through bond maturity
C. By buying and holding bonds until maturity
D. Through the bid-ask spread
Bond dealers make a profit by buying bonds at a lower price (bid) and selling them at a higher price (ask).
3. What happens to bond prices when demand exceeds supply?
A. Price rises
B. Price falls
C. Price remains constant
D. Price fluctuates randomly
According to the laws of supply and demand, when demand exceeds supply, bond prices rise.
4. What is a corporate bond yield primarily a function of?
A. Stock market performance
B. Risk-free return plus a credit spread
C. Government bond yields
D. Inflation rate
Corporate bond yield consists of the risk-free return plus a credit spread to account for default risk.
5. How does the risk of default affect the bond yield?
A. Higher default risk decreases the bond yield
B. Default risk has no impact on the bond yield
C. Higher default risk increases the bond yield
D. Default risk only affects government bonds
A higher risk of default typically leads to a higher yield as investors demand a risk premium.
6. What happens to bond prices when the yield increases?
A. Bond price increases
B. Bond price decreases
C. Bond price remains constant
D. Bond price fluctuates based on demand
Bond prices are inversely related to yield. An increase in yield results in a decrease in bond price.
7. How does bond liquidity affect the yield demanded by investors?
A. Higher liquidity leads to a higher yield
B. Liquidity does not affect the yield
C. Lower liquidity leads to a lower yield
D. Higher liquidity leads to a lower yield
Higher liquidity generally leads to a lower yield demanded by investors, as the bond is easier to buy and sell.
8. What is the primary purpose of a bond indenture?
A. To set the bond yield
B. To define the terms of the issuer's stock offering
C. To set forth the obligations of the issuer and the rights of the bondholders
D. To limit the number of bonds issued
The bond indenture outlines the obligations of the issuer and the rights of the bondholders in the bond agreement.
9. Who typically serves as the corporate trustee in a bond indenture?
A. The bond issuer
B. Banks or trust companies
C. Investment banks
D. The bondholders themselves
Banks or trust companies typically serve as corporate trustees, acting in a fiduciary capacity to protect the bondholders' interests.
10. What is one of the key responsibilities of the corporate trustee in a bond indenture?
A. To make decisions on behalf of bondholders
B. To negotiate with the issuer on behalf of the bondholders
C. To monitor the issuer’s compliance with the indenture’s covenants
D. To approve dividend payments for bondholders
The corporate trustee’s key responsibility is to ensure the issuer complies with the covenants specified in the indenture.
11. How does a corporate trustee protect the rights of bondholders?
A. By overseeing stock trading
B. By providing financial advice to bondholders
C. By setting interest rates for bonds
D. By ensuring the issuer complies with the indenture and protecting bondholder interests
The corporate trustee protects bondholder rights by monitoring the issuer’s compliance with the indenture’s provisions.
12. What does a corporate trustee authenticate in a bond issue?
A. The credit rating of the issuer
B. The bond yield
C. The amount of bonds issued and ensuring it does not exceed the limit in the indenture
D. The maturity date of the bond
The corporate trustee authenticates the bond issue by ensuring the amount of bonds issued does not exceed the limit specified in the indenture.
13. Which type of covenant would require an issuer to maintain key financial ratios above or below a given level?
A. Financial covenant
B. Negative covenant
C. Positive covenant
D. Operational covenant
A financial covenant requires the issuer to maintain certain key financial ratios, such as liquidity or debt-to-equity ratio, within specified limits.
14. How often must the corporate trustee report to bondholders according to the indenture?
A. Once every five years
B. Only when bondholders request it
C. As specified in the indenture
D. Only in case of default
The indenture specifies how and when the corporate trustee must report to bondholders, which could vary based on the terms of the indenture.
15. What happens if the issuer fails to pay interest or principal on a bond?
A. The trustee will take actions as outlined in the indenture
B. The bondholders automatically receive compensation
C. The bonds are automatically canceled
D. The issuer is exempt from penalties
If the issuer fails to pay interest or principal, the trustee will follow the procedures outlined in the indenture to address the default.
16. Which of the following is not a typical bond issuer group?
A. Utilities
B. Transportation companies
C. Industrials
D. Pharmaceutical companies
Pharmaceutical companies are not typically categorized as bond issuers in the primary groups listed, which include utilities, transportation companies, industrials, financial institutions, and internationals.
17. What is the maturity range for short-term notes?
A. 0 to 1 year
B. 1 to 5 years
C. 1 to 5 years
D. 12 to 20 years
Short-term notes typically have maturities ranging from 1 to 5 years.
18. What is the maturity range for medium-term notes?
A. 0 to 1 year
B. 1 to 5 years
C. 5 to 12 years
D. 10 to 15 years
Medium-term notes typically have maturities ranging from 5 to 12 years.
19. What is the maturity period for long-term bonds?
A. 1 to 5 years
B. Greater than 12 years
C. 5 to 10 years
D. 5 to 12 years
Long-term bonds generally have maturities greater than 12 years.
20. Which international organizations might issue bonds?
A. United Nations
B. World Bank
C. International Monetary Fund (IMF)
D. All of the above
International organizations like the World Bank and the IMF are examples of institutions that might issue bonds to raise capital.
21. What type of bonds are typically issued by utilities?
A. Municipal bonds
B. Corporate bonds
C. Government bonds
D. Infrastructure bonds
Utilities typically issue corporate bonds to finance infrastructure projects or other capital-intensive activities.
22. What is a characteristic of fixed-rate bonds?
A. The interest rate changes periodically
B. The interest is paid in a foreign currency
C. The interest rate is fixed for the entire life of the bond
D. The interest is paid based on market conditions
Fixed-rate bonds have a fixed interest rate that remains unchanged for the entire life of the bond issue.
23. Which of the following bonds pays interest linked to a reference rate like LIBOR?
A. Fixed-rate bonds
B. Zero-coupon bonds
C. Floating-rate bonds
D. Corporate bonds
Floating-rate bonds, also known as variable-rate bonds, have an interest rate linked to a reference rate such as LIBOR, plus a fixed spread.
24. What is the key feature of zero-coupon bonds?
A. They pay interest annually
B. They pay the face value at maturity and do not make cash interest payments
C. The interest rate is variable
D. They pay interest in foreign currency
Zero-coupon bonds do not make cash interest payments but pay the face value at maturity. The return is earned by purchasing the bond at a discount to face value.
25. What happens if the issuer of a zero-coupon bond goes into bankruptcy before maturity?
A. Bondholders receive the full face value of the bond
B. Bondholders are entitled to interest accrued up to the bankruptcy date
C. Bondholders are only entitled to the issue price plus accrued interest
D. Bondholders receive a portion of the face value based on the company’s assets
If the issuer of a zero-coupon bond goes bankrupt before maturity, bondholders are entitled only to the issue price plus the accrued interest, not the full face value.
26. Which of the following is an advantage of zero-coupon bonds?
A. Zero reinvestment risk
B. They provide annual interest payments
C. They are not subject to taxation
D. They allow for early interest payments
One advantage of zero-coupon bonds is zero reinvestment risk because the investor does not need to reinvest interest payments as there are none.
27. In some tax jurisdictions, zero-coupon bonds can be advantageous because:
A. They are tax-free
B. The bond interest income may be converted into a capital gain
C. They are exempt from all taxes
D. They pay interest income in a tax-friendly way
In some tax jurisdictions, zero-coupon bonds can be beneficial because the interest income may be treated as a capital gain, which could be taxed more favorably than interest income.
28. What is a key feature of corporate bonds with collateral?
A. They are not affected by a default
B. The collateral is used to pay off bondholders only if the company is reorganized
C. The collateral can be sold to pay off bondholders in case of a default
D. They do not involve any collateral
Corporate bonds with collateral have real property or other assets backing the issue, and the collateral can be sold to pay off bondholders if the issuer defaults.
29. What is the main purpose of the collateral in mortgage bonds?
A. To allow bondholders to purchase additional assets
B. To provide a source of payment for bondholders in case of default
C. To allow bondholders to take control of the company
D. To reduce the interest rate on the bond
Mortgage bonds are backed by collateral, such as real property, and in case of default, the collateral can be sold to pay off the bondholders.
30. What is an after-acquired clause in mortgage bonds?
A. It allows bondholders to purchase additional collateral after the bond issuance
B. It restricts the use of new assets as collateral for future bonds
C. It restricts any assets acquired after the bond issuance to be used as collateral for the existing bonds only
D. It allows bondholders to use acquired assets for new bond issues
An after-acquired clause restricts any assets acquired after the bond issuance to be used as collateral only for the existing bonds, not for new bond issues.
31. What are collateral trust bonds backed by?
A. Real property
B. Stocks, notes, bonds, or other obligations owned by the company
C. Government securities
D. Cash reserves held by the company
Collateral trust bonds are backed by stocks, notes, bonds, or other similar obligations that the company owns, which serve as the collateral.
32. What role does the trustee play in collateral trust bonds?
A. The trustee represents the shareholders of the company
B. The trustee manages the company’s assets for profit
C. The trustee holds the collateral and acts for the benefit of the bondholders
D. The trustee acts as the company’s legal representative
In collateral trust bonds, the trustee holds the collateral and acts for the benefit of the bondholders, not the shareholders.
33. What happens if the value of the collateral backing a bond falls below the value of the loan?
A. The bondholders will receive additional interest
B. The issuer may be required to contribute additional securities to back the bonds
C. The bondholders lose their rights to the collateral
D. The bondholder’s claim on the collateral is reduced
If the value of the collateral falls below the value of the loan, the issuer may be required to contribute additional securities to back the bonds, as specified in the indenture.
34. What is a key feature of Equipment Trust Certificates (ETCs)?
A. The borrower purchases the equipment directly
B. The bondholder directly owns the equipment
C. The trustee purchases the equipment and leases it to the borrower
D. The borrower rents the equipment from the government
In Equipment Trust Certificates (ETCs), the trustee purchases the equipment and leases it to the borrower, who pays rent, and that rent is passed to the bondholders.
35. What happens when the debt on an Equipment Trust Certificate (ETC) is fully paid?
A. The borrower must return the equipment to the trustee
B. The equipment is auctioned to the highest bidder
C. The title of the equipment is transferred to the borrower
D. The bondholders take ownership of the equipment
Upon full payment of the debt, the title of the equipment is transferred to the borrower.
36. What is a characteristic of debentures?
A. They are secured by collateral
B. They are unsecured bonds without collateral
C. They have a lower interest rate than secured bonds
D. They are guaranteed by other companies
Debentures are unsecured bonds, meaning they are not backed by collateral. As a result, they usually offer a higher interest rate.
37. What is the role of a negative-pledge clause in debentures?
A. It allows the issuer to secure the debentures with new collateral
B. It restricts the debenture holders from selling the bonds
C. It ensures that any future secured bonds will have equal security for the debentures
D. It provides a guarantee for the debenture
The negative-pledge clause ensures that if there is no secured debt, future secured bonds will have equal security as the debentures.
38. What is the risk associated with subordinated debenture bonds?
A. They are fully secured by collateral
B. They rank below other unsecured bonds in case of default
C. They provide lower returns compared to other bonds
D. They are guaranteed by other companies
Subordinated debenture bonds have a lower claim in case of default, meaning they rank below other unsecured bonds.
39. What does a guarantee on a bond issue mean?
A. The bond is free of default risk
B. The bond issuer has no financial risk
C. The risk depends on the ability of the guarantor to fulfill obligations
D. The bondholders are guaranteed a fixed return
A guarantee on a bond issue does not eliminate default risk, as it depends on the ability of the guarantor to meet obligations.
40. How does the correlation between the issuer and the guarantor affect the value of a bond guarantee?
A. A positive correlation increases the value of the guarantee
B. A negative correlation decreases the value of the guarantee
C. The value of the guarantee decreases with increased correlation between the issuer and the guarantor
D. The value of the guarantee is not affected by correlation
The value of a bond guarantee decreases as the correlation between the issuer's profitability and the guarantor's profitability increases (or becomes more negative).
41. What is a key feature of call provisions in bonds?
A. They allow the issuer to purchase bonds at a fixed price before maturity
B. They prevent the issuer from issuing new bonds
C. They allow the bondholders to demand early repayment
D. They restrict the issuer from altering the capital structure
Call provisions give the issuer the right to purchase the bonds at a fixed price either in whole or in part before maturity, often allowing them to refinance the debt at a lower interest rate.
42. What is the purpose of a fixed-price call option in bond retirement?
A. To call bonds at a price that increases over time
B. To call bonds at a specific price that generally declines toward par
C. To allow bondholders to redeem the bonds at a premium
D. To guarantee bondholders a fixed interest rate
A fixed-price call allows the issuer to buy back bonds at a price that declines over the life of the bonds, typically starting high and eventually moving toward par value.
43. When are bonds typically not callable under the fixed-price call provision?
A. When the interest rate is fixed
B. In the first few years after issuance
C. When the bondholder has converted the bonds to shares
D. When the company's stock price falls below the conversion price
Typically, bonds are not callable during the first few years of issuance, allowing bondholders some stability before the issuer can buy them back.
44. What is the potential benefit to investors when a call option is combined with a conversion option?
A. The investor can convert bonds to common shares and potentially benefit from a rising stock price
B. The investor can receive a fixed interest rate even if the stock price falls
C. The investor can avoid paying taxes on bond interest
D. The investor can demand early repayment of the bond
The combination of the call and conversion options incentivizes investors to convert bonds to shares before the stock price rises too much, which would make the conversion less attractive.
45. Why would an issuer likely call the bonds if the stock price rises significantly?
A. To lock in higher interest payments for bondholders
B. To avoid issuing stock at the relatively low predetermined conversion price
C. To reduce the overall interest rate paid to bondholders
D. To convert bonds into a more favorable stock option for investors
If the stock price rises significantly, the issuer is likely to call the bonds to prevent issuing stock at the relatively low predetermined conversion price, which would now seem too favorable to the bondholders.
46. What determines the call price in a make-whole call provision?
A. The bond's coupon rate
B. The present value of the bond's remaining cash flows, subject to a floor price equal to par value
C. The market price of the bond at the time of call
D. The yield of comparable-maturity corporate bonds
The make-whole call price is determined by the present value of the bond’s remaining cash flows, with a discount rate based on comparable-maturity Treasury securities, and a floor price equal to par value.
47. How is the present value calculated in a make-whole call provision?
A. Using the coupon rate as the discount rate
B. Using the yield of comparable-maturity Treasury securities, usually plus a premium
C. Using the bond's market price
D. Using the issuer's cost of capital
The present value in a make-whole call provision is calculated using the yield of comparable-maturity Treasury securities, with an added premium to determine the bond’s price.
48. What is a sinking-fund provision in bond issuance?
A. A provision allowing the bondholder to call the bond before maturity
B. A provision requiring the issuer to call back the bond at a fixed price
C. A provision requiring the issuer to retire a specified portion of the debt each year
D. A provision that allows the bondholder to extend the bond’s maturity
A sinking-fund provision requires the issuer to retire a specified portion of the debt each year, either by purchasing the bonds in the open market or through a lottery system.
49. What is an accelerated sinking-fund provision?
A. A provision that allows the issuer to call back more bonds in the early years if market conditions are favorable
B. A provision that accelerates the interest rate payments on the bonds
C. A provision requiring the issuer to buy back bonds at a premium
D. A provision that allows the bondholder to sell the bonds back to the issuer before maturity
An accelerated sinking-fund provision allows the issuer to retire more bonds in the early years if favorable market conditions, such as falling interest rates, make it advantageous for the issuer to do so.
50. What happens when the value of collateral decreases over time in a sinking-fund provision?
A. The issuer is required to reduce the interest rate on the bonds
B. The issuer may need to provide additional collateral or retire a portion of the debt
C. The bonds automatically convert into equity shares
D. The issuer can extend the maturity date of the bonds
If the value of collateral decreases, the issuer may need to retire some of the debt or provide additional collateral to maintain the bond’s backing.
51. What is the primary goal of a Maintenance and Replacement Fund (M&R)?
A. To increase the company's market share
B. To generate additional income for the bondholders
C. To maintain the credibility of the property backing the bonds
D. To reduce the interest rate on the bonds
The primary goal of an M&R fund is to maintain the credibility of the property backing the bonds, ensuring that the value of the underlying assets is preserved.
52. What makes the Maintenance and Replacement (M&R) provision more complex than a sinking-fund provision?
A. It requires the bonds to be repurchased at a fixed price
B. It requires valuation formulas for the underlying assets
C. It does not require any collateral backing
D. It is not required for most firms
The M&R provision is more complex than a sinking-fund because it requires valuation formulas for the underlying assets, ensuring that the value of the property is maintained over time.
53. What is one way to satisfy the Maintenance and Replacement (M&R) provision?
A. Issuing more bonds
B. Extending the bond’s maturity period
C. Acquiring sufficient cash to maintain the health of the firm
D. Increasing the coupon rate
One way to satisfy the M&R provision is by acquiring sufficient cash to maintain the health of the firm, which can then be used to retire debt.
54. How is the sale of collateral typically handled under an M&R provision?
A. The sale proceeds are used to pay the bondholders' interest
B. The sale proceeds are applied toward retiring the bonds early
C. The sale proceeds are kept as cash reserves
D. The collateral is sold to repay only part of the bond's principal
The sale proceeds from collateral under an M&R provision are typically applied toward retiring the bonds early, reducing the issuer’s debt obligations.
55. What is a common method for retiring debt using tender offers?
A. Selling new bonds to buy back the old bonds
B. Openly announcing an interest in buying back bonds at a set price
C. Issuing convertible bonds to retire old bonds
D. Offering bonds with a higher interest rate to bondholders
In tender offers, the firm openly announces an interest in buying back a certain dollar amount of bonds, or all of the bonds, at a set price, usually at a premium.
56. How can a firm use the present value of future cash flows to retire bonds through a tender offer?
A. By offering bonds with a fixed interest rate
B. By buying back bonds at an amount calculated as the present value of future cash flows, based on a specific discount rate
C. By issuing new debt to retire older bonds
D. By using the cash proceeds from collateral sales
A firm can use the present value of future cash flows, calculated based on a specific discount rate, to retire bonds in a tender offer. This may be based on the yield to maturity of comparable Treasury bonds plus a spread.
57. A fixed-income security with a three-year maturity is best classified as which of the following?
A. Money market
B. Short-term note
C. Medium-term note
D. Long-term bond
A fixed-income security with a maturity of three years is classified as a medium-term note. Money market instruments are typically under one year, while long-term bonds have longer maturities.
58. In the event of a bankruptcy, what claim does the holder of a zero-coupon bond have on the bankrupt corporation?
A. The face value of the bond only
B. The issuing price of the bond only
C. The issuing price plus accrued interest
D. Nothing, because zero-coupon bonds are unsecured
Zero-coupon bonds, which do not pay periodic interest, typically have claims equal to their face value in bankruptcy, as they are treated like any other secured debt instrument.
59. Which of the following bond types is most likely to have the lowest interest rate, assuming all other factors are the same?
A. Equipment trust certificates
B. Mortgage bonds
C. Junior debentures
D. Senior debentures
Senior debentures are typically less risky than junior debentures, and they tend to have lower interest rates because they are higher in the priority structure for repayment in the event of liquidation.
60. Which of the following methods for retiring bonds early is generally considered the most detrimental to bondholders?
A. Tender offers
B. Call provision
C. Sinking-fund provision
D. Maintenance and replacement funds
Call provisions can be the most detrimental to bondholders because they allow the issuer to redeem bonds early, often when interest rates have fallen, depriving bondholders of the higher coupon payments.
61. Credit default risk refers to:
A. The risk of the issuer failing to make timely payments of interest and principal
B. The risk associated with fluctuations in the credit spread of the bond
C. The risk related to changes in interest rates
D. The risk of a decrease in bond ratings by the rating agencies
Credit default risk refers to the uncertainty regarding an issuer's ability to make timely interest and principal payments as outlined in the bond’s indenture.
62. Which of the following is the primary method used to evaluate credit default risk?
A. Spread duration
B. Bond ratings from rating agencies
C. Credit spread analysis
D. Comparison with Treasury securities
Credit default risk is most commonly assessed using bond ratings from major agencies like Fitch Ratings, Moody’s, and Standard & Poor’s, which evaluate the likelihood of an issuer defaulting on payments.
63. The term "credit spread" refers to the difference between:
A. The yield on a corporate bond and the yield on a government bond
B. The interest rate on a bond and the benchmark rate
C. The yield on a corporate bond and the yield on a comparable-maturity Treasury security
D. The risk-free rate and the interest rate on a bond
The credit spread is the difference between the yield on a corporate bond and the yield on a comparable-maturity Treasury security, reflecting the added risk of the corporate bond.
64. What is spread duration used to measure?
A. The change in credit rating over time
B. The interest rate sensitivity of a bond
C. The change in a bond’s price due to a change in the credit spread
D. The effect of liquidity on bond prices
Spread duration measures the sensitivity of a bond’s price to changes in the credit spread, assuming that the Treasury rate remains constant.
65. What happens when a bond has a spread duration of 4 and the credit spread changes by 50 basis points?
A. The bond’s value changes by 4%
B. The bond’s value changes by 2%
C. The bond’s value changes by 0.5%
D. The bond’s value remains unchanged
A spread duration of 4 implies that a 50-basis-point change in the credit spread would lead to a 2% change in the bond’s value (50% of 4%).
66. Event risk in corporate bonds refers to:
A. The risk of events that may lead to significant changes in a company's capital structure, such as mergers or leveraged buyouts
B. The risk of a company failing to pay interest or principal on time
C. The risk associated with a company's financial instability due to high leverage
D. The risk of interest rates rising, affecting bond prices negatively
Event risk addresses the potential adverse impact of events like mergers, acquisitions, or leveraged buyouts, which could significantly alter a company's capital structure and reduce the value of its bonds.
67. Which of the following events could trigger event risk in corporate bonds?
A. A downgrade in bond ratings by a rating agency
B. A rise in interest rates in the economy
C. A change in the price of the underlying assets
D. Mergers, recapitalizations, or leveraged buyouts
Events such as mergers, recapitalizations, leveraged buyouts, or acquisitions could significantly change the capital structure of a firm and trigger event risk for its corporate bonds.
68. What is a potential measure used to protect bondholders from event risk?
A. A provision for increasing bond yields
B. A clause that guarantees minimum returns to bondholders
C. A maintenance of net worth clause requiring the company to repurchase debt if net worth falls below a certain level
D. A provision for early redemption of bonds
A maintenance of net worth clause requires the company to maintain a minimum equity level, and if it is breached, the company must repurchase debt to restore the minimum equity level, protecting bondholders.
69. Which of the following events would likely lead to an increase in leverage, triggering event risk?
A. Issuing additional equity shares
B. Acquiring another company through a leveraged buyout
C. Declaring a dividend
D. Refinancing existing debt with lower interest rates
A leveraged buyout (LBO) typically involves borrowing a significant amount of capital to acquire another company, which increases the acquiring firm's leverage and may trigger event risk.
70. High-yield bonds are also known as:
A. Junk bonds
B. Investment-grade bonds
C. Treasury bonds
D. Government bonds
High-yield bonds are often referred to as "junk bonds" because they are rated below investment grade by ratings agencies.
71. Which of the following types of companies are likely to issue high-yield bonds?
A. Companies with strong financial statements
B. Companies with a high level of debt
C. Well-established companies with consistent earnings
D. Young and growing companies with promising prospects but weak financials
High-yield bonds are often issued by companies that are young and growing but may not have strong financials, making them riskier for investors.
72. What is a "fallen angel" in the context of high-yield bonds?
A. A bond issued by a government entity
B. A bond that was originally investment-grade but was downgraded to below investment grade
C. A high-yield bond that is issued with a fixed coupon rate
D. A bond that is issued by an established company with stable cash flows
A "fallen angel" refers to a bond that was originally issued with an investment-grade rating but was later downgraded to below investment grade due to events that reduced the issuer’s creditworthiness.
73. Which of the following types of coupon structures can be found in high-yield bonds?
A. Deferred-coupon bonds
B. Step-up bonds
C. Payment-in-kind bonds
D. All of the above
High-yield bonds can have several coupon structures, including deferred-coupon bonds, step-up bonds, and payment-in-kind bonds.
74. Which type of high-yield bond structure allows the issuer to pay interest by issuing additional bonds?
A. Step-up bonds
B. Deferred-coupon bonds
C. Payment-in-kind bonds
D. Extendable reset bonds
Payment-in-kind bonds allow the issuer to pay interest in the form of additional bonds instead of cash.
75. What does the default rate measure?
A. The amount recovered after a default
B. The probability of an issuer defaulting
C. The par value of bonds that defaulted
D. The total value of bonds outstanding
The default rate measures the probability of an issuer defaulting. It can be calculated in different ways, such as by issuer default rate or dollar default rate.
76. Which of the following is true about issuer default rate?
A. It is calculated based on the dollar amount of bonds that defaulted
B. It is the number of issuers defaulted divided by the total number of issuers at the start of the year
C. It includes the total dollar amount involved in defaults
D. It measures the recovery rate of bonds
The issuer default rate is calculated as the number of issuers who defaulted divided by the total number of issuers at the beginning of the year, and it does not include dollar amounts.
77. How is the dollar default rate calculated?
A. The total number of issuers that defaulted divided by total issuers
B. The recovery rate for all bonds defaulted
C. The percentage change in the yield of defaulted bonds
D. The par value of defaulted bonds divided by the total par value of all bonds outstanding
The dollar default rate is calculated by dividing the par value of all bonds that defaulted by the total par value of all bonds outstanding during the year.
78. What is the recovery rate?
A. The proportion of the total obligation that is recovered after a bond defaults
B. The amount of interest paid to the bondholder after default
C. The dollar amount of bonds that have defaulted
D. The probability of default for an issuer
The recovery rate refers to the proportion of the total obligation that is recovered after a bond defaults.
79. How does seniority affect recovery rates?
A. Bonds with lower seniority have higher recovery rates
B. Senior bonds always have a zero recovery rate
C. Bonds with higher seniority tend to have higher recovery rates
D. Seniority does not affect recovery rates
Bonds with higher seniority tend to have higher recovery rates because they are prioritized in case of a default, which increases the likelihood of recovering the owed amount.
80. What is the formula to calculate the expected return of a bond investment?
A. Risk-free rate + default rate − recovery rate
B. Credit spread − expected loss rate
C. Risk-free rate + credit spread − expected loss rate
D. Risk-free rate + credit rating − recovery rate
The expected return of a bond investment is calculated as the risk-free rate plus the credit spread minus the expected loss rate, where the expected loss rate is determined by the probability of default and the expected recovery rate.
81. How is the expected loss rate of a bond calculated?
A. Default rate × (1 + recovery rate)
B. Probability of default × (1 − expected recovery rate)
C. Credit spread × (1 − recovery rate)
D. Risk-free rate × default rate
The expected loss rate is calculated as the probability of default multiplied by (1 − expected recovery rate), reflecting the portion of the investment that might be lost due to a default.
82. Why is the credit spread greater than the expected loss rate in bond investments?
A. Because credit spread includes recovery rate adjustments
B. Because the credit spread compensates for the risk of default
C. Because credit spread includes both default risk and return for investors
D. Because the credit spread reflects only the risk-free rate
The credit spread is greater than the expected loss rate because it includes both the default risk and the additional return that investors require for taking on that risk.
83. What is the relationship between the credit quality of an issuer and the excess of credit spread over expected loss rate?
A. The excess is higher when the credit quality is lower
B. The excess remains constant regardless of credit quality
C. The excess decreases when the credit quality improves
D. The excess increases when the credit quality improves
The excess of the credit spread over the expected loss rate is lower when the credit quality of the issuer is higher and higher when the credit quality is lower, as more compensation is required for riskier issuers.
84. Which of the following is true regarding the risk-free rate used for corporate bonds?
A. The Treasury rate is always the most appropriate risk-free rate for corporate bonds
B. A higher rate such as the interbank borrowing rate may be more appropriate for corporate bonds
C. Corporate bonds are not compared to any risk-free rate
D. The risk-free rate is irrelevant when calculating expected returns
For corporate bonds, the risk-free rate used may not be the Treasury rate, as a higher rate such as the interbank borrowing rate may better reflect the risks associated with corporate bond investments.
85. Where are publicly traded bonds typically traded?
A. In the stock market
B. In the over-the-counter (OTC) market
C. On the exchange market
D. On the cryptocurrency market
Publicly traded bonds are usually traded in the over-the-counter (OTC) market, where dealers profit through the bid-ask spread.
86. What does a bond indenture define?
A. The risk-free rate for bond investments
B. The obligations of the issuer
C. The price at which bonds are issued
D. The minimum coupon rate of the bond
A bond indenture sets forth the obligations of the issuer. The trustee interprets the legal language and ensures that the issuer fulfills their obligations to bondholders.
87. Which of the following is NOT a common type of high-yield bond coupon structure?
A. Deferred-interest bonds
B. Step-up bonds
C. Fixed-interest bonds
D. Payment-in-kind bonds
High-yield bonds can have coupon structures that help conserve cash, including deferred-interest bonds, step-up bonds, and payment-in-kind bonds. Fixed-interest bonds are not typically used for high-yield bonds.
88. What is the primary function of a trustee in a bond agreement?
A. To invest in bonds for the issuer
B. To ensure the issuer fulfills obligations to bondholders
C. To set the bond coupon rate
D. To manage the bondholder's investments
The trustee interprets the legal language of the indenture and ensures that the issuer fulfills its obligations to the bondholders.
89. Which of the following best describes credit default risk?
A. The risk of changes in the bond's price due to market movements
B. The possibility that the issuer will default on interest payments due to inflation
C. The risk that interest rates will rise
D. The possibility that the issuer does not make the payments specified in the indenture
Credit default risk refers to the possibility that the issuer will fail to make the payments specified in the bond indenture, such as missing interest or principal payments.
90. What is credit spread risk?
A. The risk of issuer default
B. The risk of inflation affecting bond returns
C. The price risk from changes in the spread of a bond’s interest rate over the corresponding Treasury rate
D. The risk of currency fluctuation affecting bond returns
Credit spread risk is the price risk resulting from changes in the spread between a bond's interest rate and the corresponding Treasury rate.
91. What does event risk refer to in the context of bond investments?
A. The risk of changes in interest rates affecting bond prices
B. The possibility that events like mergers or acquisitions increase the risk of the bond by affecting the issuer's ability to pay
C. The risk of inflation impacting bond returns
D. The risk that the bond issuer defaults due to financial instability
Event risk is the possibility that events like mergers, acquisitions, or restructurings increase the risk of the bond by changing the issuer's ability to pay off the bond, such as by significantly increasing leverage.
92. Which of the following bond types pays a fixed cash coupon periodically?
A. Zero-coupon bonds
B. Fixed-rate bonds
C. Floating-rate bonds
D. Equipment trust certificates
Fixed-rate bonds pay a fixed cash coupon periodically, unlike zero-coupon or floating-rate bonds.
93. What type of bonds are backed by stocks and bonds that the issuing company owns?
A. Debentures
B. Mortgage bonds
C. Collateral trust bonds
D. Floating-rate bonds
Collateral trust bonds are backed by stocks and bonds that the issuing company owns, which can be sold to pay off bondholders in case of default.
94. What is unique about equipment trust certificates compared to mortgage bonds?
A. They are unsecured bonds
B. They are backed by real estate property
C. They are backed by stocks and bonds
D. The trustee owns the property and rents it to the bond issuer, often in the form of equipment
Equipment trust certificates are a form of mortgage bond where the trustee owns the property and rents it to the bond issuer. The property is often standardized equipment, such as aircraft, which is easily leased.
95. What type of bonds are unsecured and typically pay higher interest rates due to the lack of collateral?
A. Debentures
B. Mortgage bonds
C. Collateral trust bonds
D. Equipment trust certificates
Debentures are unsecured bonds that typically pay higher interest rates because they are not backed by collateral.
96. What do call provisions allow the issuer of a bond to do?
A. Retire debt early at a given price
B. Buy back portions of debt each year
C. Pay off debt in installments over time
D. Issue new bonds to pay off existing debt
Call provisions allow the firm to retire debt early at a given price, which is generally considered detrimental to bondholders as it might occur when interest rates decrease.
97. How do sinking-fund provisions benefit bondholders?
A. By allowing the firm to retire debt early at a fixed price
B. By giving bondholders the right to purchase more bonds at a lower price
C. By requiring the firm to buy back portions of debt each year, which can reduce the risk of default
D. By reducing the overall interest rate on the bonds
Sinking-fund provisions require the firm to buy back portions of debt each year, which can reduce the overall risk of default and benefit bondholders by improving the firm’s financial health.
98. What is the purpose of a maintenance and replacement fund in relation to bond issuance?
A. To maintain the financial health of the firm and retire debt
B. To increase the total interest rate paid to bondholders
C. To ensure the firm does not default on bond payments
D. To help the firm issue more bonds to pay off existing debt
A maintenance and replacement fund helps maintain the financial health of the firm, and the funds can be used to retire debt, providing more security for bondholders.
99. What is a bond issuer’s tender offer?
A. A method for issuing new bonds to pay off old ones
B. A fixed-price offer to purchase bonds from bondholders
C. A price that is calculated based on the credit rating of the bond
D. An offer to retire debt through a fixed price or a price that varies with market rates
A bond issuer’s tender offer is a method for retiring debt, where the offer price can be either fixed or vary with a market rate, such as the rate on comparable Treasury securities.
100. How is the issuer default rate calculated?
A. Number of issuers that defaulted divided by the total number of issuers at the beginning of the year
B. Total dollar value of defaulted bonds divided by the total dollar value of bonds outstanding
C. Probability of default times the expected recovery rate
D. Total number of defaults in a given year divided by the total number of defaults in the previous year
The issuer default rate is calculated as the number of issuers that defaulted divided by the total number of issuers at the beginning of the year. This metric helps to evaluate the risk of default at the issuer level.
