8.3 Bonds: An Introduction

Which of the following is TRUE if a company goes bankrupt?

I. The bondholders are paid back first

II. The stockholders are paid back last

III. The stockholders must pool assets to pay back all bondholders

• I only

• III only

• I and II only

• I and III only

If you invest $1,000 in a new bond issue and earn a coupon rate of 7% per year, how much will you receive when the bond matures?

• Nothing

• $1,000

• $70

• $1,700

Answer explanation

Bonds typically return the face value of the bond to the owner of the bond at the time of maturity

What is the coupon payment for a bond with a face value of $1,000 that currently sells for $1,200 if the coupon rate is 6%?

• $60

• $66

• $72

• There is not enough information available to answer this question

Answer explanation

The coupon rate (payment) is based on the terms of the bond when issued.

Rate (as a decimal) * Initial Bond Value

Griffin recently purchased a bond for $1,100. The bond has a par value of $1,000 and a coupon rate of 5%. Based on this information, you know that Griffin's current effective-interest rate earned on the bond is ____; when the bond matures, he will receive ____

• 4.55%; nothing

• 5.00%; $1,000

• 4.55%; $1,000

• 5.00%; $1,100

Answer explanation

The coupon rate (payment) is based on the par value of the bond when its issued (par value is also known as face value). In this case, the coupon rate is 5%, and thus the coupon payment is $50 ($1,000 x .05). However, Griffin paid $1,100 for the bond, making the current-interest rate earned 4.55% ($50/$1,100).

Mikki is currently in a high-income tax bracket. She would prefer to own an investment that generates tax-free income. If Mikki buys a municipal bond issued by a state other than her own, the interest she earns will be:

• tax-free at the federal level

• taxable at the federal level but tax-free at the state level

• taxable at both the state and federal level

• considered a dividend and taxed at a maximum rate of 10% at the federal level

What is the tax-equivalent interest rated needed if you can purchase a municipal bond with a face value of $10,000, a coupon rate of 3%, and a maturity date of 10 years? Assume you are in the 25% marginal federal tax bracket.

• 2.25%

• 3.75%

• 4.00%

• 5.25%

Answer explanation

Equivalent Taxable Bond Interest Rate Formula

Imagine a period of time in the future when general prices in the economy begin to move up rapidly. The increase in prices results in inflation, which in turn causes interest rates to rise. When this happens, bond investors can expect:

• the value of their bonds to increase

• the coupon rate of existing bonds to readjust upward

• the value of their bonds to decrease

• the par value of existing bonds to increase

How is a bond different from a stock?

• A bond is a loan you give to an organization while a stock is partial ownership in the company.

• Bonds are typically riskier than stocks but have the potential to earn higher returns. 

• A bond is usually issued by smaller, startup companies while stocks are with well established organizations. 

• Bonds are best for earning high returns while stocks are best for providing a stable source of income. 

Which of the following most accurately describes what a bond is?

• A bond is a government loan made to an individual investor with the expectation that it will be paid back with interest

• A bond is an investment in which a corporation lends an individual investor money with the expectation that it will be paid back with interest

• A bond is a government loan made to a corporation with the expectation that it will be paid back with interest

• A bond is an investment in which an investor lends money to a corporation or government with the expectation that it will be paid back with interest

Jill buys a bond that has a fixed coupon rate of 3%. Six months later, similar bonds that are issued have a coupon rate of 4%. Which of the following is TRUE if she chooses to sell the bond before maturity?

• The price of Jill’s bond will increase

• More investors will be willing to buy Jill’s bond

• The interest rate of Jill’s bond will increase to reflect the current market

• The price of Jill’s bond will decrease