manchester88

Which of the following statements concerning municipal securities is NOT correct?

A) Investors may be taxed on any capital gains on municipal securities.

B) A moral obligation bond has no legally binding requirement to be repaid.

C) All interest on municipal securities is tax-exempt at the federal level.

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Some interest on municipal bonds, such as municipal bond issues to build stadiums/arenas, is taxable at the federal level. Note though that most municipal bonds are tax-exempt – taxable munis tend to be the exception rather than the rule.

manchester88

Which of the following statements about fixed income securities is least accurate?

A) Coupon interest and capital gains from municipal bonds are tax exempt at the federal level.

B) The main innovation of CMO is that they offer stable maturities to investors.

C) The corporate bond sector is more important in the US than in Japan and Germany.

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Coupon or interest income is exempt from federal income taxes. Capital gains taxes associated with municipal bonds are not exempt from federal taxes.

manchester88

Which of the following statements concerning municipal bonds is NOT correct?

A) Before-tax yields on municipal bonds are usually lower than before-tax yields on Treasury bonds.

B) Municipal bonds have lower risk than Treasury bonds because of their lower yield.

C) The vast majority of municipal bonds sell at lower yields because their bond interest is exempt from federal income tax.

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Treasury bonds are considered default free and have the least amount of risk. After-tax yields are highest for individuals in the highest tax bracket who benefit the most from the municipal bond’s tax-exempt status. Before tax yields on municipal bonds are lower due to their tax shield.

manchester88

Which of the following statements about municipal bonds is least accurate?

A) A municipal bond guarantee is a form of insurance provided by a third party other than the issuer.

B) Revenue bonds have lower yields than general obligation bonds because there are more revenue bands and they have higher liquidity.

C) Bonds with municipal bond guarantees are more liquid in the secondary market and generally have lower required yields.

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General obligation bonds are backed by the full faith, credit, and taxing power of the issuer.

manchester88

A mortgage-backed security has been divided into three classes or tranches as follows:

• Tranche I receives net interest and all the principal payments until it is completely paid off.
• Tranche II receives its share of net interest and starts receiving all the principal repayments after Tranche I has been completely paid off. Prior to that, it only receives interest payments.
• Tranche III receives monthly net interest and starts receiving all principal repayments after Tranches I and II have been completely paid off. Prior to that, it only receives interest payments.

For a relatively small decline in mortgage interest rates, which of the tranches has the least amount of prepayment risk?

A) Prepayment risk is equal for all three tranches.

B) Tranche I.

C) Tranche III.

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Tranche III has the least amount of prepayment risk since it receives the prepayments last.

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For an investor who is interested in long-term gains, in which tranche should s/he invest?

A) Tranche I.

B) Any of the tranches since mortgage-backed securities generally have a long duration.

C) Tranche III.

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Tranche III has the least amount of prepayment risk; therefore, there is a greater chance that the investor will be able to hold on to the investment for a longer time horizon.

manchester88

Which of the following statements about creating a collateralized mortgage obligation (CMO) is NOT correct? A CMO:

A) redistributes the risk between the tranches on a random basis.

B) redistributes the risk between the tranches on an unequal basis.

C) does not affect the overall risk of prepayment.

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Creating a CMO usually redistributes the risk between the tranches on an unequal basis, not on a random basis.

manchester88

Which of the following is least likely a cash flow that results from a mortgage-backed security?

A) Mortgage processing fees and charges.

B) Prepayments.

C) Net interest.

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Mortgage processing fees and charges are deducted before interest and principal payments are passed through.

manchester88

Which of the following is the least significant risk faced by a holder of a mortgage-backed security?

A) Scheduled principal payment risk.

B) Reinvestment risk.

C) Interest rate risk.

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Interest rate risk and reinvestment risk are both significant for mortgage-backed securities. There is no risk embedded in a scheduled principal payment.

manchester88

Paul Blackburn is describing mortgage backed securities and makes the following statements:
Statement 1: A mortgage passthrough security is formed by pooling a large number of mortgages and issuing certificates that represent ownership shares in the pool. Because each mortgage borrower has the right to prepay the mortgage, the value of a passthrough security behaves as if the security has an embedded put feature.
Statement 2: A collateralized mortgage obligation with sequential tranches is created by pooling mortgage passthrough certificates. Securities are issued in different tranches that have proportionate claims on the cash flows from the passthrough certificates.
With regard to Blackburn’s statements:

A) both are correct.

B) only one is correct.

C) both are incorrect.

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Statement 1 is incorrect. A borrower who prepays a mortgage is in effect exercising a call option, similar to a corporate bond issuer who calls a bond and prepays the principal. Therefore the pool of mortgages and the securities created from it behave as if they had an embedded call feature.
Statement 2 is also incorrect. Sequential tranches issued as a collateralized mortgage obligation do not have proportionate claims on the cash flows from the pool. Instead they have sequential claims. The shortest-term tranche receives principal and interest payments until it is paid off. The cash flows then go to the second tranche until it is paid off, and so on. This structure allows securities with different timing and risk profiles to be issued from the same pool of certificates.

manchester88

Which of the following statements concerning mortgage-backed securities is most accurate?

A) As rates rise, mortgage-backed security holders face reinvestment risk.

B) Curtailment of a mortgage is a prepayment of less than the full principal.

C) Collateralized Mortgage Obligations (CMOs) prioritize the interest payments on mortgages to different sets of investors.

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Curtailment of a mortgage is a prepayment of less than full principal. The other statements are false. Holders of mortgage-backed securities face reinvestment risk as rates decline. Also, CMO’s prioritize the principal payments on mortgages to different sets of investors – all tranches receive interest payments, but each successive tranche does not receive principal payments until the first is paid off.