Understanding yield spreads (Reading 56)

Exercise Problems:

1. Which of the following is least likely a tool used by the U.S. Federal Reserve Bank to directly influence the level of interest rates?

A. Verbal persuasion.

B. Open market operations.

C. Setting the rate on 30-year bonds.

Ans: C;

C is correct because the U.S. Federal Reserve Bank (Fed) uses policy tools to directly influence short-term interest rates. It only indirectly influences long-term interest rates. The market, not the Fed, sets rates on 30-year bonds.

The four interest rate tools of the Fed are as follows:

The discount rate: the rate at which banks can borrow reserve from the Fed;

Open market operations: buying or selling of Treasury securities by the Fed in the open market;

Bank reserve requirements: the percentage of deposits that banks must retain;

Persuading banks to tighten or loosen their credit policies.

2. A bond market analyst states, “The current term structure of interest rates is upward sloping which implies the market believes short-term interest rates will rise in the future.” Which theory of the term structure of interest rates does the analyst most likely believe?

A. Pure expectations theory.

B. Liquidity preference theory.

C. Market segmentation theory.

Ans: A;

A is correct because under the pure expectations theory the only reason the yield curve will be upward sloping is because market participants believe that short-term rates will rise in the future.

B is not correct because under the liquidity preference theory, the yield curve may take on any of the shapes we have identified. Even if the market believes short-term interest rates will decline in the future, adding a liquidity premium to the resulting downward sloped yield curve can result in an upward sloping yield curve.

C is not correct because under the market segmentation theory, the term structure is consistent with any yield curve shape. It is supply and demand for debt securities at each maturity range that determines the yield for that maturity range.

3. According to the market segmentation theory, an upward sloping yield curve is most likely due to:

A. investor expectations that short-term interest rates will fall in the future.

B. an increasing yield premium required by investors for bearing interest rate risk.

C. different levels of supply and demand for short-term and long-term funds.

Ans: C;

C is correct because the market segmentation theory asserts that the supply and demand for funds determine the interest rates for each maturity sector.

A is not correct because pure expectations theory rather than market segmentation theory states that the yield for a particular maturity is an average of the short-term rates that are expected in the future. If the short-term rates are expected to rise in the future, the yield curve will be downward sloping.

B is not correct because liquidity premium theory rather than market segmentation theory believes that investors require a risk premium for holding longer term bonds and bearing greater interest rate risk (duration).

4. If investors expect stable rates of inflation in the future, the pure expectations theory suggests that the yield curve is currently:

A. upward sloping.

B. flat.

C. inverted.

Ans: B;

B is correct because pure expectations theory states that the yield for a particular maturity is an average of the short-term rates that are expected in the future. If the short-term rates are expected to be stable in the future, the yield curve will be flat.

5. According to the Liquidity Preference Theory, is the term structure of interest rates most likely related to:

A. expectations about future rates.

B. interest rate risk.

C. both expectations about future rates and interest rate risk.

Ans: C;

C is correct because the liquidity preference theory believe that in addition to expectations about future short-term rates, investors require a risk premium for holding longer term bonds. Therefore, the term structure of interest rates is related to both expectation about future rates and interest rate risk.

6. According to the Liquidity Preference Theory, if the yield curve is upward sloping, expectations of short-term rates in the future:

A. must be rising.

B. must be declining.

C. can either be rising or declining.

Ans: C;

Case 1: if the market believes short-term interest rates will risk in the future, adding a liquidity premium to the resulting upward sloped yield will keep the upward sloping trend of the yield curve;

Case 2: even if the market believes short-term interest rates will decline in the future, adding a liquidity premium to the resulting downward sloped yield curve can result in an upward sloping yield curve;

Therefore, C is correct.

7. If the yield on a 5-year U.S. corporate bond is 7.45% and the yield on a 5-year U.S. Treasury note is 4.33%, the relative yield spread of the bond is closest to:

A. 3.12%.

B. 172.06%.

C. 72.06%.

Ans: C;

C is correct because

Relative yield spread

= (Bond yield – Benchmark yield)/Benchmark yield

= (7.45% – 4.33%)/4.33% = 72.06%.

A is not correct because 3.12% is the absolute yield spread = 7.45%-4.33%=3.12%

B is not correct because 172.06% is the yield ratio = 7.45%/4.33% = 172.06%

8. A bond portfolio manager is considering three Bonds – A, B, and C – for his portfolio. Bond A allows the issuer to call the bond before stated maturity, Bond B allows the investor to put the bond back to the issuer before stated maturity, and Bond C contains no embedded options. The bonds are otherwise identical. The manager tells his assistant, “Bond A and Bond B should have larger nominal yield spreads to a U.S. Treasury than Bond C to compensate for their embedded options.” Is the manager most likely correct?

A. Yes.

B. No, Bond A’s nominal yield spread should be less than Bond C’s.

C. No, Bond B’s nominal yield spread should be less than Bond C’s.

Ans: C;

A call option benefits the bond issuer so yield spreads will be higher for a callable bond compared to the same bond without a call feature;

A put option allows the bond holder to put the bond back when the price of the bond goes lower so the bond holder will require a lower yield spread for a putable bond than an option-free bond.

Therefore C is correct because Bond B’s embedded put option benefits the bondholder and the yield spread will therefore be less than the yield spread of Bond C, which does not contain this benefit.

9. The spread between the yields on a Ginnie Mae passthrough security and a comparable Treasury security is best explained by:

A. prepayment risk.

B. reinvestment risk.

C. credit risk.

Ans: A;

Mortgage-backed securities expose an investor to prepayment risk.

10. Consider two ten-year bonds, one that contains no embedded options and the other that gives its owner the right to convert the bond to a fixed number of shares of the issuer’s common stock. The convertibility option in the second bond cannot be exercised for five years. The bonds are otherwise identical. Compared with the yield on the convertible bond, the yield on the bond with the embedded option is most likely:

A. lower.

B. the same.

C. higher.

Ans: A;

A is correct because the convertibility option provides a benefit to the investor, who will accept a lower yield on the convertible bond compared with the option-free bond.

11. An investor whose marginal tax rate is 35% is analyzing a tax-exempt bond offering a yield of 5.40%. The tax-equivalent yield of the bond is closest to:

A. 8.31%.

B. 3.51%.

C. 6.94%.

Ans: A;

C is correct because

Tax-equivalent yield

= Tax-exempt yield/(1 – Marginal tax rate)

= 5.40%/(1 – 0.35) = 8.31%

12. A U.S. investor has purchased a tax-exempt 10-year municipal bond at a yield of 3.75% which is 100 basis points less than the yield on a 10-year option-free U.S. Treasury. If the investor’s marginal tax rate is 33.5%, then taxable equivalent yield and the yield ratio is closest to:

Taxable equivalent yield Yield ratio

A. 7.14 0.79

B. 5.64 0.79.

C. 5.64 1.19.

Ans: B;

Taxable equivalent yield

=3.75%/ (1-33.5%)

=5.64

Yield ratio

= (yield on tax-exempt bond) / (yield of US Treasury)

=3.75% / (3.75%+ 1%)

= 3.75 / 4.75

=0.79

13. Credit spreads are most likely to widen during economic:

A. expansion.

B. contraction.

C. expansion and contraction.

Ans: B;

B is correct because credit spreads are most likely to widen during economic contraction and tend to narrow during economic expansion.

14. Recent economic trend suggests that the economy is increasingly likely to enter a recession stage. What is the most likely impact on the yields of lower-quality corporate bonds and on credit spreads of lower-quality versus higher-quality corporate bonds?

A. One will increase and one will decrease.

B. Both will increase.

C. Both will decrease.

Ans: B;

Yields of lower quality increases: During economic contractions, the probability of default increases for lower- quality issues and their yields increase.

Credit spreads increases: when an economic contraction is likely, investors tend to sell low-quality issues and buy high-quality issues, causing credit spreads of lower quality versus higher quality bonds to widen.

15. Larger size debt issues normally have:

A. greater yield spread.

B. the same yield spread with smaller size debt issues.

C. lower yield spread.

Ans: C;

C is correct because larger issues normally have greater liquidity because they are more actively traded in the secondary market and therefore have lower yield spreads when compared with smaller issues.

16. The yield on a U.S. Treasury STRIPS security is also known as the Treasury:

A. spot rate.

B. forward rate.

C. yield spread.

Ans: A;

Spot rates are the appropriate discount rates for cash flows that come at different points in time; while yield to maturity is the single discount rate that makes the present value of a bond’s promised cash flows equal to its market price. Therefore, yield to maturity is flat while spot rate is not flat because the discount rate for a payment that comes one year from now is not necessarily the same discount rate that should be applied to a payment that comes five years from now.

Conceptually, spot rates are the discount rates for zero-coupon bonds, securities that have only a single cash flow at a future date.

A is correct because a STRIPS security is a zero-coupon bond with no default risk and therefore represents the appropriate discount rate for a cash flow certain to be received at the maturity date for the STRIPS.