CIM CIM Fixed Income & Debt Securities 2 — Questions and Answers
Question 1: Credit spread represents the difference between:
- A bond's coupon rate and its purchase price
- The yield on a corporate bond and the yield on a comparable maturity Treasury bond (Correct answer)
- The bid and ask price of a bond on the secondary market
- A bond's par value and its market value
Correct answer: The yield on a corporate bond and the yield on a comparable maturity Treasury bond
Credit spread is the additional yield an investor earns above the risk-free Treasury rate to compensate for the credit risk of a non-government issuer.
Question 2: Which of the following best describes a mortgage-backed security (MBS)?
- A municipal bond secured by property tax revenue
- A bond backed by a pool of mortgage loans that passes interest and principal payments to investors (Correct answer)
- A Treasury inflation-protected security linked to home price indices
- A derivative contract on real estate futures
Correct answer: A bond backed by a pool of mortgage loans that passes interest and principal payments to investors
An MBS is a securitized product where the cash flows from a pool of mortgage loans are passed through to investors as interest and principal payments.
Question 3: Prepayment risk is a concern for MBS investors primarily because:
- Homeowners may default during rising rate environments
- When rates fall, homeowners refinance early, returning principal at an inopportune time for investors (Correct answer)
- The government can accelerate MBS maturities without notice
- Rising home prices reduce the collateral value of the pool
Correct answer: When rates fall, homeowners refinance early, returning principal at an inopportune time for investors
Prepayment risk means investors receive principal back sooner than expected — often when rates are low — forcing reinvestment at lower yields.
Question 4: The yield to maturity (YTM) of a bond assumes which of the following?
- The bond will be sold at a premium before maturity
- All coupon payments are reinvested at the YTM rate until maturity (Correct answer)
- The issuer will call the bond at the first opportunity
- Interest rates will rise throughout the bond's life
Correct answer: All coupon payments are reinvested at the YTM rate until maturity
YTM is calculated under the assumption that all coupon payments are reinvested at the same YTM rate, which may not hold in practice.
Question 5: Treasury Inflation-Protected Securities (TIPS) protect investors from inflation by:
- Providing fixed coupons at above-market rates
- Adjusting the bond's principal value in line with the Consumer Price Index (CPI) (Correct answer)
- Investing proceeds in commodity futures
- Offering a variable coupon tied to the federal funds rate
Correct answer: Adjusting the bond's principal value in line with the Consumer Price Index (CPI)
TIPS adjust their principal upward with CPI increases, so both the principal at maturity and the coupon payments grow with inflation.
Question 6: A bond trading at a discount to par value implies its:
- Coupon rate is higher than its yield to maturity
- Current market yield is higher than its stated coupon rate (Correct answer)
- Credit rating has recently been upgraded
- Maturity date has been extended by the issuer
Correct answer: Current market yield is higher than its stated coupon rate
When a bond's market yield exceeds its coupon rate, investors pay less than par (a discount) to achieve the required return.
CIM CIM Fixed Income & Debt Securities 2
Credit spread represents the difference between: