CSC Fixed-Income Securities Analysis 5 — Questions and Answers
Question 1: What is the primary difference between a debenture and a mortgage bond?
- Debentures pay higher coupon rates than mortgage bonds
- Debentures are backed only by the issuer's general creditworthiness, not specific assets (Correct answer)
- Debentures are issued only by government entities
- Debentures cannot be traded on secondary markets
Correct answer: Debentures are backed only by the issuer's general creditworthiness, not specific assets
Debentures are unsecured bonds backed solely by the issuer's general credit and earnings capacity, unlike mortgage bonds which are secured by specific assets.
Question 2: A floating-rate bond (variable-rate bond) has its coupon payment tied to which of the following?
- The issuer's quarterly earnings
- A reference interest rate such as the prime rate or CDOR (Correct answer)
- The bond's credit rating changes
- The current market price of the bond
Correct answer: A reference interest rate such as the prime rate or CDOR
Floating-rate bond coupons reset periodically based on a reference rate (e.g., prime rate or CDOR) plus a fixed spread, reducing interest rate risk for the holder.
Question 3: Which of the following bond features benefits the investor by allowing them to sell the bond back to the issuer at par before maturity?
- Call provision
- Sinking fund provision
- Extendable feature
- Put provision (retractable feature) (Correct answer)
Correct answer: Put provision (retractable feature)
A put provision (retractable bond feature) gives the investor the right to sell the bond back to the issuer at par on specified dates, protecting against rising interest rates.
Question 4: When analyzing a bond's yield to maturity, which assumption is built into the calculation?
- The bond will be held to maturity and all coupons reinvested at the YTM rate (Correct answer)
- The bond will be sold within one year at its current market price
- The issuer will call the bond at the earliest call date
- The coupon rate will adjust annually based on CPI
Correct answer: The bond will be held to maturity and all coupons reinvested at the YTM rate
YTM assumes the bond is held to maturity and that all coupon payments are reinvested at the same YTM rate throughout the bond's life.
Question 5: What is the effect of convexity on a bond's price change when interest rates change significantly?
- Convexity means the actual price change will be less favorable than duration alone predicts
- Convexity means the actual price increase is greater and the actual price decrease is smaller than duration alone predicts (Correct answer)
- Convexity has no effect on bond price changes for large rate movements
- Convexity only applies to zero-coupon bonds
Correct answer: Convexity means the actual price increase is greater and the actual price decrease is smaller than duration alone predicts
Positive convexity means bond price increases are larger and price decreases are smaller than duration alone suggests, as the price-yield relationship is curved, not linear.
Question 6: In the context of fixed-income securities, what does 'liquidity risk' refer to?
- The risk that the issuer will default on its debt obligations
- The risk that the bond cannot be sold quickly at a fair price (Correct answer)
- The risk that coupon payments will not cover the investor's expenses
- The risk that inflation will erode the bond's real return
Correct answer: The risk that the bond cannot be sold quickly at a fair price
Liquidity risk is the risk that an investor may not be able to sell a bond quickly or at a price close to its fair value, often due to thin trading in that issue.
Question 7: Which of the following best describes the term structure of interest rates?
- The relationship between a bond's coupon rate and its credit rating
- The relationship between bond yields and their terms to maturity at a given point in time (Correct answer)
- The schedule of coupon payment dates for a bond
- The sequence of credit rating upgrades and downgrades for a bond issuer
Correct answer: The relationship between bond yields and their terms to maturity at a given point in time
The term structure of interest rates, depicted by the yield curve, shows the relationship between bond yields and maturities for bonds of the same credit quality at a specific point in time.
CSC Fixed-Income Securities Analysis 5
What is the primary difference between a debenture and a mortgage bond?