Investment Fixed Income and Bonds 2 — Questions and Answers
Question 1: What is a 'callable bond'?
- A bond that can be traded on any exchange
- A bond the issuer can redeem before its maturity date (Correct answer)
- A bond that pays variable coupon rates
- A bond backed by collateral
Correct answer: A bond the issuer can redeem before its maturity date
A callable bond gives the issuer the right to repay the principal before the stated maturity date, usually when interest rates fall and the issuer can refinance at lower cost.
Question 2: What is the primary risk that causes high-yield ('junk') bonds to offer higher interest rates than investment-grade bonds?
- Liquidity risk
- Inflation risk
- Credit (default) risk (Correct answer)
- Reinvestment risk
Correct answer: Credit (default) risk
High-yield bonds are issued by companies with lower credit ratings, meaning there is a greater probability the issuer may default on interest or principal payments.
Question 3: A zero-coupon bond is sold at $600 and matures at $1,000 in 5 years. How does the investor earn a return?
- Through semi-annual interest payments
- Through the difference between purchase price and maturity value (Correct answer)
- Through dividends paid annually
- Through capital gains from selling the bond above par
Correct answer: Through the difference between purchase price and maturity value
Zero-coupon bonds pay no periodic interest; instead, investors earn the return from the discount at purchase, receiving the full par value at maturity.
Question 4: What is the 'spread' in the context of bond investing?
- The difference between a bond's bid and ask price
- The difference in yield between a bond and a benchmark (e.g., Treasuries) (Correct answer)
- The bond's duration minus its maturity
- The range of coupon payment dates
Correct answer: The difference in yield between a bond and a benchmark (e.g., Treasuries)
In bond markets, spread most commonly refers to the yield difference between a bond (such as a corporate bond) and a comparable-maturity Treasury, reflecting additional risk.
Question 5: Which of the following best describes a 'municipal bond'?
- A bond issued by a corporation to fund operations
- A bond issued by a state or local government, often tax-exempt (Correct answer)
- A bond issued by the Federal Reserve
- A bond denominated in foreign currency
Correct answer: A bond issued by a state or local government, often tax-exempt
Municipal bonds are issued by state and local governments to fund public projects; interest income is typically exempt from federal income tax and sometimes state and local taxes.
Question 6: What is 'reinvestment risk' for a bond investor?
- The risk that the bond's price will decline
- The risk that coupon payments will be reinvested at lower rates (Correct answer)
- The risk that inflation erodes purchasing power
- The risk that the issuer will call the bond early
Correct answer: The risk that coupon payments will be reinvested at lower rates
Reinvestment risk is the uncertainty that future coupon payments can only be reinvested at rates lower than the original yield, reducing the total realized return.
Question 7: An investor buys a 10-year bond with a 4% coupon. If inflation rises to 6%, what has the investor experienced?
- A capital gain, since bond prices rise with inflation
- Negative real return, as inflation exceeds the coupon rate (Correct answer)
- No impact, since bonds are inflation-protected
- An increase in yield to maturity
Correct answer: Negative real return, as inflation exceeds the coupon rate
When inflation exceeds the coupon rate, the real purchasing power of the fixed interest payments declines, resulting in a negative real return for the investor.
