Practice: 2.1.2 Debt Instruments

Section 2: Understanding Products and Their Risks. 12 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.

Section 2: Understanding Products and Their RisksSIE outline 2.1.2

Today's practice

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

Which of the three agency issuers is a federal agency backed by the full faith and credit of the U.S. government?

A. Ginnie Mae B. Fannie Mae C. Freddie Mac D. The Tennessee Valley Authority

How sure are you?

Sure Fairly sure Guessing

Correct: A. Ginnie Mae is a federal agency, and its paper carries full faith and credit.

B. Fannie Mae is a government-sponsored enterprise that guarantees its own paper, not backed by full faith and credit.

C. Freddie Mac sits in the same row as Fannie Mae, a sponsored enterprise, not full faith and credit.

D. The TVA is a real federal agency, but the manual names it specifically as one that carries no such backing.

Unit: SIE outline 2.1.2

Question 2Exam level

A pass-through security and a collateralized mortgage obligation both pool mortgages. How do they differ in how they pay investors?

A. A pass-through pays every holder pro rata; a CMO pays classes in a set order B. A pass-through pays classes in order; a CMO pays every holder pro rata C. Both pay every holder the identical pro rata share D. Both pay strictly by class, with no pro rata structure available

How sure are you?

Sure Fairly sure Guessing

Correct: A. A pass-through pays every holder the same pro rata share; a CMO cuts the cash flows into classes and retires early classes first.

B. Reverses the two structures.

C. Only the pass-through is pro rata; the CMO sorts cash flows into classes.

D. Only the CMO pays strictly by class; the pass-through is pro rata.

Unit: SIE outline 2.1.2

Question 3Exam level

Long-term mortgage rates fall sharply. What happens to prepayments on an outstanding mortgage-backed pass-through, and why?

A. Prepayments speed up, as borrowers refinance into cheaper loans B. Prepayments slow down, as borrowers refinance into cheaper loans C. Prepayments speed up, because the servicer is forced to call the pool D. Prepayments are unaffected by interest rates

How sure are you?

Sure Fairly sure Guessing

Correct: A. Falling rates make refinancing into a cheaper loan attractive, so principal is repaid early more often.

B. Falling rates make refinancing more attractive, speeding prepayments, not slowing them.

C. No servicer-forced call mechanism exists; the borrower, not the servicer, decides to prepay.

D. Prepayment speed is directly rate-sensitive, per the manual's own prepayment-option framing.

Unit: SIE outline 2.1.2

Question 4Exam level

Are agency mortgage-backed securities exempt from SEC registration, and does that exemption mean they carry no risk?

A. Exempt from registration, yes; risk-free, no B. Exempt from registration, yes; and risk-free, yes, because of the exemption C. Not exempt from registration; and not risk-free D. Exempt from registration only for Ginnie Mae, not for Fannie Mae or Freddie Mac

How sure are you?

Sure Fairly sure Guessing

Correct: A. Agency securities are exempt from SEC registration, but the exemption does not mean guaranteed or riskless; the prepayment option remains a real risk.

B. The registration exemption says nothing about credit or prepayment risk; the two are separate.

C. Agency securities are in fact exempt from SEC registration.

D. The registration exemption applies to federally related institutions and government-sponsored paper alike, not to Ginnie Mae alone.

Unit: SIE outline 2.1.2

Question 5Exam level

A corporation is wound up. After secured bondholders and general creditors (debenture holders) are paid, who is asked next, before either class of stockholder?

A. Subordinated debenture holders B. Common stockholders C. Preferred stockholders D. No one; remaining assets go directly to common stockholders once debenture holders are paid

How sure are you?

Sure Fairly sure Guessing

Correct: A. The claim queue runs secured, debenture, subordinated debenture, preferred, common; subordinated debenture holders stand behind debenture holders but ahead of both classes of stockholder.

B. Common stockholders are last in the queue, after both classes of debt and preferred stock.

C. Preferred stockholders come after subordinated debenture holders, not before them.

D. Subordinated debenture holders sit between general creditors and preferred stockholders; they are not skipped.

Unit: SIE outline 2.1.2

Question 6Exam level

Two bonds from the same issuer, same maturity: one is secured by a first mortgage, the other is an unsecured debenture. Which pays the higher yield?

A. The debenture B. The mortgage bond C. Both pay identical yields, since the issuer is the same D. Neither; yield depends only on maturity, never on security

How sure are you?

Sure Fairly sure Guessing

Correct: A. Secured bonds yield less than comparable unsecured bonds; safety costs coupon.

B. The mortgage bond's added security is exactly what lets the issuer pay it less, not more.

C. The security pledge itself changes the yield, even with an identical issuer and maturity.

D. This contradicts the stated rule that greater security costs yield.

Unit: SIE outline 2.1.2

Question 7Exam level

A bond is callable at the issuer's option. Market rates fall well below the bond's coupon. What is the investor's likely experience, and who controls the timing?

A. The bond is likely called, and the issuer controls the timing, not the investor B. The bond is likely called, and the investor controls the timing C. The bond will not be called under any circumstance while rates are falling D. The investor may exercise a put to force early repayment instead

How sure are you?

Sure Fairly sure Guessing

Correct: A. The issuer holds the call and exercises it when rates have fallen; the investor has no say in the timing.

B. The call is the issuer's own right; the investor never controls when a callable bond is called.

C. Falling rates are exactly the condition that makes a call likely, not one that prevents it.

D. A put belongs to a different bond feature entirely, and this stem describes a call, not a put.

Unit: SIE outline 2.1.2

Question 8Exam level

A bond's indenture includes a sinking-fund provision. What does that provision require the issuer to do, and what is the effect on default risk?

A. Retire a set portion of the issue each year, which lowers default risk through orderly retirement before maturity B. Retire the entire issue at once on the maturity date only, with no effect on default risk C. Repurchase common shares each year, which lowers default risk D. Post additional collateral every year, with no retirement of debt at all

How sure are you?

Sure Fairly sure Guessing

Correct: A. A sinking-fund provision requires the issuer to retire a set portion each year, lowering default risk through the orderly retirement of the issue before maturity.

B. A sinking fund retires the issue gradually over time, not entirely at maturity in one step.

C. A sinking fund retires the issuer's own bonds, not its common shares.

D. A sinking fund retires debt directly; it is not a collateral-posting mechanism.

Unit: SIE outline 2.1.2

Question 9Exam level

Where does the boundary between investment-grade and high-yield ratings sit, per the two major agencies' scales?

A. Baa/BBB and above is investment grade; the next rung down is high yield B. A/A and above is investment grade; Baa/BBB and below is high yield C. Investment grade has no defined boundary; it is a marketing term only D. High yield means a higher stated coupon by definition, regardless of rating

How sure are you?

Sure Fairly sure Guessing

Correct: A. Baa or BBB or better is investment grade; below that line is high yield.

B. A/A sits one full rating category above the actual boundary, overstating where investment grade ends.

C. The boundary is a defined ratings line, not a marketing term.

D. High yield describes a bond with a higher risk of default; it pays more precisely because that risk is higher, not by an unrelated coupon definition.

Unit: SIE outline 2.1.2

Question 10Exam level

A general obligation municipal bond defaults. What may its holders do that a revenue bond's holders generally cannot?

A. Compel a tax levy or legislative appropriation to satisfy the obligation B. Force the sale of the project the bond financed C. Convert their bonds into shares of the issuer D. Demand FDIC reimbursement

How sure are you?

Sure Fairly sure Guessing

Correct: A. On default, general obligation bondholders have the right to compel a tax levy or legislative appropriation, a power tied to the issuer's own taxing authority that a revenue bond does not pledge.

B. Forcing a project sale is not the named GO remedy; the remedy runs through the issuer's taxing power, not the physical asset.

C. Municipal bonds are debt, not convertible into equity of a governmental issuer.

D. The FDIC insures bank deposits, not municipal bond defaults.

Unit: SIE outline 2.1.2

Question 11Above the exam

A corporation issues $50,000 of unsecured, 200-day commercial paper to fund inventory, and a customer separately holds $300,000 in a single ownership category at one FDIC-insured domestic bank, split across two CDs. Is the commercial paper exempt from Securities Act registration, and how much of the customer's CD balance is FDIC-insured?

A. Exempt, since it is a current-transaction note maturing within 9 months; $250,000 of the $300,000 is insured, per depositor, per bank, per ownership category B. Exempt, since the amount is under $10,000,000; the full $300,000 is insured, with no cap C. Not exempt, since 200 days exceeds the 270-day market convention; $250,000 is insured D. Exempt; but splitting across two CDs raises the insured amount to $300,000 automatically

How sure are you?

Sure Fairly sure Guessing

Correct: A. The Securities Act Section 3(a)(3) exemption turns on current-transaction purpose and a 9-month (270-day) maximum maturity, which 200 days satisfies, not on a dollar cap; FDIC insurance is capped at $250,000 per depositor, per bank, per ownership category, so $50,000 of the $300,000 in one category at one bank is uninsured.

B. No $10,000,000 threshold governs the commercial-paper exemption, and FDIC coverage is capped at $250,000 per ownership category, not unlimited.

C. 200 days is well within the 270-day convention (itself inside the 9-month statutory limit), so the paper remains exempt.

D. Splitting one ownership category's funds across two CDs at the same bank does not raise the $250,000 cap; a different ownership category or a different bank would be needed.

Unit: SIE outline 2.1.2

Question 12Above the exam

A resident of State A buys a general obligation bond issued by a city in State B. The bond was issued in 2015. How is the interest taxed at each level, and could the city compel a tax levy if it defaulted?

A. Federally exempt, State A taxable, since the buyer is outside the issuer's own state; and yes, the city could compel a tax levy or legislative appropriation on default B. Exempt from all three levels of tax; and no, only a revenue bond's issuer could compel a levy C. Fully taxable at all three levels; and yes, the city could compel a levy D. Federally exempt, State A taxable; but no, a general obligation issuer can never be compelled to raise taxes after default

How sure are you?

Sure Fairly sure Guessing

Correct: A. Federal exemption follows the bond issued after 1953 regardless of the buyer's residence; state exemption usually requires the bond to be from the buyer's own state, which this is not; and a general obligation issuer's default remedy is compelling a tax levy or appropriation, tied to its own taxing authority.

B. The triple-exemption assumption is exactly the trap the source material names; State A taxation applies since the bond is from a different state.

C. Federal exemption still applies to a post-1953 municipal bond regardless of the buyer's state.

D. This directly contradicts the source's own stated remedy, that holders may compel a tax levy or legislative appropriation on default.

Unit: SIE outline 2.1.2

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