Evaluate Bond Risk Features - Series 65

State the tax-equivalent yield formula for a municipal bond with yield $y$ and tax rate $t$ .

$\text{TEY} = \frac{y}{1 - t}$ . This formula adjusts the tax-free yield to compare it with taxable alternatives, accounting for the investor's marginal tax rate.
Which rating indicates higher credit quality: $A$ or $BBB$ ?

$A$ . Higher ratings reflect stronger financial stability and lower default probability, with $A$ superior to $BBB$ .
What does a bond rating primarily measure: market price volatility or default risk?

Default risk (credit risk). Bond ratings assess the issuer's ability to meet interest and principal payments, focusing on creditworthiness.
What does liquidity risk mean for a fixed income security?

Risk of selling quickly at a fair price due to limited market trading. Illiquid securities may require price concessions for quick sales, increasing overall investment risk.
What is a make-whole call provision designed to do?

Compensate holder using a Treasury-based discount rate plus a spread. Ensures bondholders receive the present value of remaining payments, making them indifferent to the call.
Which bond type has no call risk: callable, putable, or noncallable?

Noncallable. Noncallable bonds lack issuer redemption options, eliminating call risk for investors.
Which market is generally more liquid: U.S. Treasury bonds or most corporate bonds?

U.S. Treasury bonds. Treasuries benefit from high trading volume and government backing, facilitating easier buying and selling compared to corporates.
What does a typical call protection period provide to the bondholder?

Bond cannot be called for a stated initial period. Offers bondholders protection from early call risk, ensuring a minimum period of interest payments.
Which yield measure is most relevant when a bond is likely to be called: YTM or YTC?

YTC (yield to call). YTC calculates return assuming the bond is called at the earliest date, which is appropriate when call is probable due to falling rates.
What is the federal tax treatment of interest from corporate bonds?

Fully taxable as ordinary income at the federal level. Corporate bond interest is taxed as ordinary income to reflect the private nature of the issuer's obligations.
What is the federal tax treatment of interest from U.S. Treasury securities?

Taxable federally; generally exempt from state and local income tax. Treasury interest is subject to federal tax but exempt from state and local taxes to support federal borrowing.
What is the typical relationship between liquidity and yield, all else equal?

Lower liquidity generally requires a higher yield. Investors require compensation for the added risk and inconvenience of lower liquidity through higher yields.
Which bond generally offers a higher yield, all else equal: callable or noncallable?

Callable (higher yield to compensate for call risk). Investors demand higher yields on callable bonds to offset the risk of early redemption and reinvestment at lower rates.
What is a call premium on a bond?

Amount paid above par when the issuer calls the bond. Provides additional compensation to bondholders for the early redemption, often declining over time until par.
Which rating indicates higher credit quality: $AA$ or $A$ ?

$AA$ . Higher ratings indicate superior creditworthiness, with $AA$ denoting very strong capacity to meet obligations compared to $A$ .
What is a put feature in a bond?

Holder right to sell the bond back to issuer at stated price/date. Gives bondholders the option to return the bond if rates rise, providing protection against interest rate risk.
What is the standard term for bonds rated below investment grade?

High-yield (speculative) or junk bonds. These bonds carry higher default risk, requiring greater yields to attract investors.
Identify what a rating downgrade typically does to a bond's price, all else equal.

Price decreases. A downgrade signals increased default risk, leading investors to demand higher yields and thus lowering the bond's market value.
Identify the best yield choice for a premium callable bond: use YTM, YTC, or yield to worst?

Yield to worst (lowest yield across all call/maturity scenarios). Represents the most conservative yield estimate by considering the lowest possible return from various call and maturity outcomes.
What is the standard investment-grade cutoff for bond ratings?

BBB-/Baa3 or higher is investment grade. Ratings at or above this level indicate lower default risk, making bonds suitable for conservative investors.
What is a bond call feature?

Issuer right to redeem the bond before maturity at stated terms. Allows issuers to refinance debt if interest rates decline, benefiting them at the expense of bondholders.
Identify the relationship between interest rates and the likelihood a callable bond is called.

Rates fall: call likelihood rises; rates rise: call likelihood falls. Issuers call bonds to refinance at lower rates when market rates drop, but are less likely when rates increase.
Which option describes a sinking fund provision most accurately?

Issuer retires part of the issue periodically, reducing outstanding debt. Requires issuers to systematically retire portions of the bond issue, managing debt levels and potentially supporting prices.
What is call risk for a bondholder?

Risk the bond is redeemed early, forcing reinvestment at lower rates. Early redemption by the issuer exposes investors to reinvestment risk in a lower interest rate environment.
What is the federal tax treatment of interest from municipal bonds?

Generally exempt from federal income tax. Municipal bond interest is tax-exempt to encourage investment in public projects, reducing effective borrowing costs for issuers.

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