Fixed Income. 15 question(s) in this unit's pool
(2 above the exam). Free up to ten a day; the coach picks which ones based on what you have
already answered and when each is next due.
Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own
explanation. Questions you have already answered correctly and confidently stay out of the way until they
are due for review again.
Question 1Exam level
A bond indenture is most likely described as:
How sure are you?
Correct: A. The indenture (also called a trust deed) is the legal contract specifying the obligations of the issuer and the rights of bondholders. It is administered by a trustee. Option A is YTM (unrelated). Option C is a yield spread.
B. Option C is a yield spread.
C. Option C is a yield spread.
Unit: fixed-income-instrument-features
Question 2Exam level
Which of the following is most likely an example of a NEGATIVE covenant in a bond indenture?
How sure are you?
Correct: B. Negative covenants restrict what the issuer CAN DO. Prohibiting the issuance of senior debt protects existing bondholders from being subordinated. Options A, B, and D are all affirmative covenants. They specify things the issuer MUST DO (maintain ratios, make payments, provide disclosures). The exam consistently tests this affirmative = must do, negative = cannot do distinction.
A. Choosing A might seem logical if you think any obligation on the issuer qualifies as a negative covenant, but this is an affirmative covenant because it requires the issuer to take a specific action, which contrasts with the restrictive nature of a negative covenant like the correct answer.
C. You might find this option tempting because providing financial statements seems like a restriction on the issuer, but in reality, this is an affirmative covenant as it requires the issuer to take a specific action, which contrasts with the negative covenant in the correct answer that restricts the issuer from taking a specific action.
Unit: fixed-income-instrument-features
Question 3Exam level
A callable bond gives the option to call (redeem early) to, most likely:
How sure are you?
Correct: B. A callable bond gives the ISSUER the right to redeem the bond before maturity. The issuer calls when rates fall so they can refinance at a lower rate. Exactly as a homeowner refinances a mortgage. The call option is HARMFUL to the investor (their bond is called away when it's most valuable). The exam frequently tests who holds the option: callable = issuer holds it, putable = bondholder holds it.
A. This assigns the call option to the wrong party. A call option in a callable bond belongs to the issuer, not the bondholder, who has no say in whether the bond is redeemed early. When rates fall it is the issuer who benefits from calling the bond and refinancing at the new lower rate, while the bondholder actually loses out, their high-coupon bond gets taken away right when it is most valuable.
C. Choosing C might seem logical if you think the issuer would want to call the bond when rates rise to avoid higher interest payments, but this confuses the issuer's incentive; when rates rise, the issuer benefits from the existing lower rate and has no incentive to call the bond, as calling would mean issuing new debt at a higher rate.
Unit: fixed-income-instrument-features
Question 4Exam level
A putable bond is MOST likely to be exercised by the bondholder when:
How sure are you?
Correct: B. A put option gives the bondholder the right to sell the bond back to the issuer at par before maturity. When rates rise, the bond's market price falls below par. The bondholder exercises the put to sell at par rather than at the depressed market price. This is the mirror image of a call: callable bonds benefit the issuer when rates fall; putable bonds benefit the investor when rates rise.
A. You might think that improved credit quality makes the bond more valuable and thus more likely to be put, but in reality, improved credit quality reduces the likelihood of default, making the bond less risky and less likely to be put; instead, rising interest rates decrease the bond's market value below par, making the put option more attractive.
C. Choosing C might seem logical if you think a premium price indicates a favorable market condition, but remember, a putable bond's value to the holder lies in selling at par when the market price is below par, not above it, which makes exercising the put when the bond trades at a premium counterproductive.
Unit: fixed-income-instrument-features
Question 5Exam level
A zero-coupon bond is issued at $700 with a par value of $1,000 maturing in 5 years. The bondholder's return comes PRIMARILY from, most likely:
How sure are you?
Correct: A. Zero-coupon bonds pay NO periodic interest. They are issued at a deep discount and return par value at maturity. The entire return is the $300 capital appreciation ($1,000 - $700). Option A describes a coupon-paying bond's reinvestment return. Option C describes a floating-rate note. Zero-coupon bonds are important for duration calculations later: their Macaulay duration equals their maturity.
B. You might be thinking that any bond offers periodic payments, but floating rate notes, unlike zero-coupon bonds, provide regular interest payments based on a reference rate, which contradicts the zero-coupon bond's characteristic of having no intermediate payments.
C. You might be thinking of convertible bonds, which can be converted into equity shares, but a zero-coupon bond does not have this feature; its return comes from the difference between the purchase price and the par value at maturity, not from equity conversion.
Unit: fixed-income-instrument-features
Question 6Exam level
Which type of bond issuer is MOST likely to have its bonds considered free of default risk for analytical purposes?
How sure are you?
Correct: B. Sovereign governments issuing debt in their own currency are considered to have negligible default risk because they can theoretically print money to repay obligations. This is why US Treasuries, UK Gilts, and German Bunds serve as benchmark 'risk-free' rates. Supranational organizations (D) have very low but not zero risk. Municipal and corporate issuers carry credit risk. The CFA exam uses 'government bonds' as the benchmark for yield spreads (G-spread).
A. You might be tempted by the backing of a general obligation, thinking it provides a strong guarantee, but municipal bonds still carry credit risk and are not considered free of default risk like a sovereign government issuing debt in its own currency.
C. You might be tempted by the World Bank's strong financial position and global standing, but remember that even supranational organizations rely on member contributions and do not have the sovereign power to print money, unlike a government issuing debt in its own currency.
Unit: fixed-income-instrument-features
Question 7Exam level
A floating-rate note (FRN) with a reference rate of 3-month Euribor + 150 bps will most likely have its coupon reset:
How sure are you?
Correct: A. FRN coupons reset periodically. Usually every 90 days for a 3-month reference rate. Each reset, the new coupon equals the prevailing reference rate plus the fixed spread (150 bps here). This is critical for price behavior: FRNs trade close to par because their coupon adjusts with market rates, unlike fixed-rate bonds which fluctuate in price. Option C describes a cap provision (a feature that may exist but is not the standard reset mechanism).
B. Option C describes a cap provision (a feature that may exist but is not the standard reset mechanism).
C. Option C describes a cap provision (a feature that may exist but is not the standard reset mechanism).
Unit: fixed-income-instrument-features
Question 8Exam level
In the context of bond seniority, which of the following claims is most likely paid LAST in the event of issuer bankruptcy?
How sure are you?
Correct: C. The priority waterfall in bankruptcy: secured creditors first, then senior unsecured creditors, then subordinated creditors, then preferred equity, then common equity last. While preferred equity ranks above common equity, it is paid after ALL debt obligations. This is the capital structure priority concept. Preferred equity (D) is junior to all three bond categories listed.
A. You might be tempted to choose senior unsecured bondholders because they seem less secure than secured bondholders, but in the capital structure hierarchy, senior unsecured bondholders are still paid before preferred equity shareholders, making them not the last to be paid.
B. You might be tempted to choose subordinated bondholders because they seem less secure than senior bondholders, but remember that all bondholders, including subordinated ones, have priority over equity holders like preferred shareholders in the capital structure.
Unit: fixed-income-instrument-features
Question 9Exam level
A convertible bond allows the bondholder to convert the bond into shares of the issuer's common stock. This feature is MOST beneficial to the bondholder when:
How sure are you?
Correct: B. The conversion option has value when the stock price exceeds the conversion price (par value / conversion ratio). If the bond converts into 20 shares and the stock trades at $60 vs a conversion price of $50, the bondholder gets $1,200 in equity for a $1,000 bond. When the stock price is below the conversion price, the investor ignores the conversion option and holds the bond for its fixed income characteristics. The conversion option creates equity-like upside for the bondholder.
A. You might think rising interest rates make convertible bonds more attractive, but in reality, higher interest rates typically decrease the value of fixed-income securities like bonds, making the equity conversion less beneficial compared to when the stock price exceeds the conversion price.
C. You might be tempted to think that a discount to par value makes the bond more attractive, but this overlooks the equity upside; the conversion feature is most beneficial when the stock price exceeds the conversion price, not when the bond itself is discounted.
Unit: fixed-income-instrument-features
Question 10Exam level
Which statement most likely distinguishes mortgage-backed securities (MBS) from asset-backed securities (ABS)?
How sure are you?
Correct: A. MBS are securitized debt backed specifically by pools of mortgage loans (residential or commercial). ABS is the broader category. Backed by non-mortgage financial assets like auto loans, student loans, or credit card receivables. Both MBS and ABS carry prepayment risk (Option C is wrong. MBS have significant prepayment risk). Both can have fixed or floating coupons (D is wrong). Both are issued by special purpose vehicles, not governments or corporations directly (A is wrong).
B. Option C is wrong. MBS have significant prepayment risk).
C. Option C is wrong. MBS have significant prepayment risk).
Unit: fixed-income-instrument-features
Question 11Harder
An affirmative covenant in a bond indenture MOST likely requires the issuer to:
How sure are you?
Correct: C. Affirmative covenants specify what the issuer MUST DO. They are positive obligations. Maintaining insurance on assets is a classic affirmative covenant. Options A (restricting dividends) and B (limiting leverage) are both NEGATIVE covenants. They restrict the issuer's actions. Option C is a hybrid trigger covenant but the restriction framing makes it negative. The key exam signal: 'must do' = affirmative; 'cannot do' or 'must not exceed' = negative.
A. You might be tempted by choice A because it sounds like a condition the issuer must meet, but maintaining a debt-to-equity ratio below a certain level is actually a negative covenant that restricts the issuer's ability to take on more debt, unlike the affirmative obligation to maintain insurance on assets.
B. Option C is a hybrid trigger covenant but the restriction framing makes it negative.
Unit: fixed-income-instrument-features
Question 12Exam level
Treasury Inflation-Protected Securities (TIPS) most likely differ from conventional Treasury bonds primarily because:
How sure are you?
Correct: A. TIPS (or inflation-linked bonds) have a FIXED coupon rate, but that rate is applied to a principal that adjusts with the Consumer Price Index (CPI). If inflation is 3%, the principal grows from $1,000 to $1,030, and the coupon is paid on $1,030. At maturity, investors receive the inflation-adjusted principal. The coupon rate does not float (C is wrong). TIPS pay periodic coupons (D is wrong). TIPS yields are LOWER than nominal Treasuries because they offer inflation protection (A is wrong).
B. You might be tempted by B because it seems logical that inflation protection would involve floating coupons, but TIPS actually have a fixed coupon rate applied to an inflation-adjusted principal, not floating-rate coupons directly tied to the CPI.
C. You might be thinking that TIPS resemble zero-coupon bonds, but TIPS actually pay periodic coupons based on a fixed rate applied to an inflation-adjusted principal, unlike the zero-coupon structure suggested by choice C.
Unit: fixed-income-instrument-features
Question 13Exam level
A bond with a par value of $1,000 and a coupon rate of 6% paid semi-annually will most likely pay coupons of:
How sure are you?
Correct: A. Annual coupon = coupon rate x par value = 6% x $1,000 = $60 per year. Semi-annual payment = $60 / 2 = $30 per period. Semi-annual payment frequency is the standard for US corporate and government bonds. This is the most basic bond calculation and appears implicitly in every bond valuation question. Getting the period coupon wrong propagates errors into price and YTM calculations.
B. Choosing B might tempt you if you overlooked the semi-annual payment frequency, leading you to double the correct semi-annual payment; however, this violates the basic rule that the annual coupon rate of 6% on a $1,000 par value bond equates to a $60 annual payment, split into two $30 payments per year.
C. Choosing C might tempt you if you mistakenly divide the annual coupon rate by four instead of two, confusing semi-annual payments for quarterly ones, but a 6% coupon rate on a $1,000 par value bond means $60 annually, paid in two $30 installments semi-annually, not $15 installments.
Unit: fixed-income-instrument-features
Question 14Above the exam
A bond has an embedded call option AND a step-up coupon feature (the coupon rate increases on specified future dates). Combining how each feature separately affects a bond's value to the investor, compared to an otherwise identical option-free, fixed-coupon bond, this bond's value to the investor is most likely:
How sure are you?
Correct: B. An embedded CALL option belongs to the ISSUER, not the investor: the issuer can redeem the bond early (typically when rates have fallen, forcing the investor to reinvest at lower rates), so a callable bond is worth LESS to the investor than an equivalent option-free bond, all else equal (Value of callable bond = Value of option-free bond - Value of the call option). A step-up coupon, by contrast, benefits the investor by raising the coupon over time, adding value; combining the two, the call feature reduces value while the step-up feature adds some value back, so the net effect versus a plain fixed-coupon bond depends on the relative size of each, but the call's negative effect on the investor is never simply erased by other features.
A. An embedded call option is a right that benefits the ISSUER, not the bondholder; it does not add value from the investor's perspective, it reduces it, since the issuer will only exercise the call when it is advantageous to the issuer (and therefore disadvantageous to the investor).
C. Embedded options and non-standard coupon structures are explicitly priced DIFFERENTLY from plain, option-free, fixed-coupon bonds; that is the entire reason bond valuation separates out the value of embedded options and special coupon features rather than treating every bond identically.
Unit: fixed-income-instrument-features
Question 15Above the exam
An investor is comparing a plain-vanilla fixed-rate bond to an otherwise identical bond that is puttable by the investor (the investor can force early redemption at par on specified dates). Combining who holds the embedded option with typical interest rate scenarios, the puttable bond is most likely to be exercised by the investor, and is most valuable relative to the plain bond, when:
How sure are you?
Correct: A. A put option embedded in a bond belongs to the INVESTOR: it gives the investor the right to sell the bond back to the issuer at a specified price (typically par), which is most valuable when the bond's market value would otherwise have fallen below that price, exactly the case when interest rates have risen (pushing bond prices down) or the issuer's credit has deteriorated (also pushing the bond's market price down). Because this benefits the investor, a puttable bond is worth MORE than an equivalent option-free bond (Value of puttable bond = Value of option-free bond + Value of the put option).
B. This reverses the logic of who benefits from a put option and when; if rates FALL, bond prices RISE, and the investor would have no reason to put the bond back at par when it is already worth more than par in the market. The put becomes valuable specifically when rates rise (or credit worsens), not when they fall.
C. The put option is regularly exercised in real markets precisely under the rising-rate or deteriorating-credit conditions described, and it is explicitly priced as a real, valuable component added to the option-free bond's value, not treated as worthless.