CISI IoI Equities and Bonds 2 — Questions and Answers
Question 1: What is the primary risk associated with holding corporate bonds compared to UK government gilts?
- Inflation risk
- Credit (default) risk (Correct answer)
- Currency risk
- Liquidity risk
Correct answer: Credit (default) risk
Corporate bonds carry higher credit (default) risk than UK government gilts because companies are more likely to default on their obligations than the UK government. This is why corporate bonds typically offer higher yields than gilts of similar maturity — to compensate investors for the additional risk.
Question 2: What does a bond's 'duration' measure?
- The time remaining until the bond matures
- The bond's sensitivity to changes in interest rates (Correct answer)
- The average credit quality of the bond issuer
- The total return of the bond over its life
Correct answer: The bond's sensitivity to changes in interest rates
Duration measures a bond's price sensitivity to changes in interest rates. A higher duration means the bond's price will be more affected by interest rate changes. While related to maturity, duration specifically captures the weighted average time of all cash flows (coupons and principal) and is used as a risk measure.
Question 3: An investor holds 1,000 ordinary shares in a company that announces a 1-for-4 rights issue at GBP 3.00 per share. How many new shares is the investor entitled to purchase?
- 4,000 shares
- 250 shares (Correct answer)
- 1,000 shares
- 500 shares
Correct answer: 250 shares
In a 1-for-4 rights issue, existing shareholders are entitled to buy 1 new share for every 4 shares they currently hold. With 1,000 existing shares: 1,000 / 4 = 250 new shares at GBP 3.00 each.
Question 4: What is the redemption yield on a bond?
- The annual coupon divided by the current market price
- The total return including both coupon income and any capital gain or loss if held to maturity (Correct answer)
- The yield offered at the initial public offering of the bond
- The yield after deducting all taxes and fees
Correct answer: The total return including both coupon income and any capital gain or loss if held to maturity
Redemption yield (also called yield to maturity or gross redemption yield) takes into account both the annual coupon payments and any capital gain or loss that will be realised if the bond is held to maturity and redeemed at par. It is a more complete measure of return than the simple current yield.
Question 5: What type of share gives the holder the right to receive any unpaid dividends from previous years before ordinary shareholders receive theirs?
- Redeemable preference shares
- Cumulative preference shares (Correct answer)
- Convertible ordinary shares
- Deferred shares
Correct answer: Cumulative preference shares
Cumulative preference shares carry the right to receive any dividends that were not paid in previous years (arrears) before any dividend can be paid to ordinary shareholders. If the company skips a preference dividend, it accumulates and must be paid in full before ordinary dividends resume.
Question 6: Which of the following statements about index-linked gilts is correct?
- Both the coupon and principal are linked to the FTSE 100 index
- Both the coupon and principal are adjusted in line with the Retail Price Index (RPI) (Correct answer)
- Only the coupon is adjusted for inflation; the principal remains fixed
- They are only available to institutional investors
Correct answer: Both the coupon and principal are adjusted in line with the Retail Price Index (RPI)
UK index-linked gilts have both their coupon payments and principal (redemption value) adjusted in line with the Retail Price Index (RPI). This protects investors against inflation by ensuring that both income and capital maintain their real (inflation-adjusted) value.
CISI IoI Equities and Bonds 2
What is the primary risk associated with holding corporate bonds compared to UK government gilts?