Gypsy

Which of the following is the most appropriate strategy for a fixed income portfolio manager under the anticipation of an economic expansion?

A) Sell corporate bonds and purchase Treasury bonds.

B) Purchase corporate bonds and sell Treasury bonds.

C) Sell lower-rated corporate bonds and buy higher-rated corporate bonds.

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During periods of economic expansion corporate yield spreads generally narrow, reflecting decreased credit risk. If yield spreads narrow, the prices of corporate bonds increase relative to the prices of Treasuries. Selling lower-rated bonds and buying higher-rated bonds is an appropriate strategy if an economic contraction is anticipated.

Gypsy

If investors expect greater uncertainty in the bond markets, you should see yield spreads between AAA and B rates bonds:

A) slope downward.

B) narrow.

C) widen.

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With greater uncertainty, investors require a higher return for taking on more risk. Therefore credit spreads will widen.

Gypsy

If a U.S. investor is forecasting that the yield spread between U.S. Treasury bonds and U.S. corporate bonds is going to widen, then which of the following is most likely to be CORRECT?

A) The economy is going to expand.

B) The economy is going to contract.

C) The U.S. dollar will weaken.

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If economic conditions are expected to get worse, then the probability that corporations may default increases and causes credit spreads to widen.

Gypsy

Which of the following is the reason why credit spreads between high quality bonds and low quality bonds widen during poor economic conditions?

A) default risk.

B) indenture provisions.

C) interest risk.

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During poor economic conditions the probability of default increases and thus credit spreads widen.

Gypsy

As compared to an equivalent noncallable bond, a callable bond’s yield should be:

A) the same.

B) higher.

C) lower.

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A callable bond favors the issuer. Hence, the value of the bond is discounted by the value of the option, which means the yield will be higher.

Gypsy

As compared to an equivalent nonputable bond, a putable bond’s yield should be:

A) the same.

B) higher.

C) lower.

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A putable bond favors the buyer (investor). Hence, a premium will be paid for the option, which means the yield will be lower.

Gypsy

Relative to a bond sold as part of a large issue, an otherwise equivalent bond that is sold as part of a smaller issue will be sold for a:

A) lower price and have a higher yield to maturity.

B) lower price and have a lower yield to maturity.

C) higher price and have a lower yield to maturity.

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Bonds that are sold as part of a smaller issue have higher liquidity risk than bonds that are sold in a large issue. Investors will demand a higher yield to maturity to cover the liquidity risk; therefore, these bonds will be sold for less than bonds from larger issues.

Gypsy

Consider three corporate bonds that are identical in all respects except as noted:

• Bond F has $100 million face value outstanding. On average, 200 bonds trade per day.
• Bond G has $300 million face value outstanding. On average, 200 bonds trade per day.
• Bond H has $100 million face value outstanding. On average, 500 bonds trade per day.

Will the yield spreads to Treasuries of Bond G and Bond H be higher or lower than the yield spread to Treasuries of Bond F?

A) Higher for both.

B) Higher for one only.

C) Lower for both.

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Liquidity is attractive to investors, so they will pay a higher price (demand a lower yield) for a more liquid bond than for an identical bond that is less liquid. Bond G is more liquid than Bond F because of its greater size. Bond H is more liquid than Bond F because it trades in greater volume. Therefore both Bond G and Bond H will tend to have lower yield spreads to Treasuries than Bond F.

Gypsy

A municipal bond carries a coupon of 6.75% and is traded at par. To a taxpayer in the 28% tax bracket, this bond provides an equivalent taxable yield of:

A) 6.75%.

B) 8.53%.

C) 9.38%.

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ETY = Yield/(1 − Marginal Tax Rate)
0.0675/(1 − 0.28) = 9.38%

Gypsy

A 6% annual coupon paying bond has two years remaining to maturity and is priced at par. Assuming a 40% tax rate, the after-tax yield for this bond is closest to:

A) 4.8%.

B) 3.6%.

C) 2.4%.

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Since the bond is trading at par, its yield to maturity is equal to its coupon rate of 6.0%. The after-tax yield is (1 − 0.4)(6.0%) = 3.6%.