Exam 8: The Risk Structure of Interest Rates: Defaults, Prepayments, Taxes, and Other Rate-Determining Factors

The number of credit-rating agencies worldwide is declining.

The expectation in the financial marketplace of a significant decline in market interest rates should increase the differential between required rates of interest on new callable and non-callable bonds.

A loan-backed security derives its value from the income-earning potential of the pool of loans that backs these securities.

If the yield to maturity on comparable quality instruments is 14 percent, what should be the market value (price) of each security issued against this particular pool of credit-card loans?

Investors find convertible bonds less attractive than nonconvertible bonds because the corporation can convert them to stock at any time.

The Tax Reform Act of 1986 eliminated the favorable tax treatment of capital gains. Such gains became taxed at ordinary income tax rates.

In what ways are security ratings (sometimes called credit quality ratings) designed to reflect default risk?

Recent studies cited in the textbook suggest that the default rate on junk bonds has averaged just over 15 percent of the greater of par or market value of those bonds.

If the following events happened to Alvernon Way Corporation what is likely to happen to the company's stock price, all other factors held constant?

Explain the relationship between an investor and a taxpayer's marginal tax rate and the after-tax rates of return on corporate and municipal bonds. Would municipals be a worthwhile investment for you today? Please explain why or why not.

Convertibles typically carry lower yields than nonconvertibles of the same maturity and risk class. Can you explain why?

So-called "investment grade securities" carry Moody's bond ratings of Aaa down to:

There is positive relationship between a security's marketability and its yield.

Exactly what are junk bonds? Why are they issued? How does their actual yield compare to their degree of default risk? Why do you think this is so?

If the risk-free rate is 6.25%, the inflation premium is 2% and the liquidity premium is 0.5%, the long-term Treasury bond rate should be:

Callable securities usually sell at lower prices and higher interest rates than non-callable securities.

If we subtract the default-risk premium from the yield on a risky security we derive the promised marginal yield on a risky security.

The rise in new junk bond offerings during the 1990s can be traced to more borrowing companies bypassing rigid and expensive bank loans as a source of credit and an upward surge of corporate mergers financed by junk bond issues.

The economic basis for the rise of credit rating agencies has to do with the economies of scale in hiring and training credit (default risk) analysts.

Municipal bonds are a good investment for recent college graduates because the default risk is so low.