As you grind your way through Series 7 exam questions, you may be asked to determine the best investment for a particular investor. You need to carefully look at the question for clues to help you choose the correct answer. Consider several factors, including credit rating, callable and put features, and convertible features.
Bond credit ratings
For the Series 7 exam, you can assume that the higher the credit rating, the safer the bond and, therefore, the lower the yield.
The two main bond credit rating companies are Moody’s and Standard & Poor’s (S&P). S&P ratings of BB and lower and Moody’s ratings of Ba and lower are considered junk bonds or high-yield bonds, which have a high likelihood of default.
The plus sign represents the high end of the category, and the minus sign designates the lower end of the category.
If you see no plus or minus sign, the bond is in the middle of the category. Moody’s can further break down a category by adding a 1, 2, or 3. The number 1 is the highest ranking, 2 represents the middle, and 3 is the lowest. The top four ratings are considered investment grade, and the letters below that are considered junk bonds or high-yield bonds.
Here’s a typical bond-ratings question.
Place the following Standard & Poor’s bond ratings in order from highest to lowest.
I. A+
II. AA
III. A–
IV. BBB+
(A) I, II, III, IV
(B) I, III, II, IV
(C) IV, I, II, III
(D) II, I, III, IV
The correct answer is Choice (D). When answering this type of question, always look at the letters first. The only time pluses or minuses come into play is when two answers have the same letters, as in Statements I and III. The highest choice is AA, followed by A+ because it’s higher than A–, which is even higher than BBB+.
Callable bonds and put bonds
Your mission for the Series 7 exam is to know which is better for investors and when bonds are likely to be called or put.
Callable bonds: A callable bond is a bond that the issuer has the right to buy back from investors at the price stated on the indenture. Callable bonds are riskier for investors because investors can’t control how long they can hold onto the bonds. To compensate for this risk, they’re usually issued with a higher coupon rate.
Another type of bond that can be callable is a step coupon bond. Also known as stepped coupon bonds or step-up coupon securities, step coupon bonds typically start at a low coupon rate, but the coupon rate increases at predetermined intervals, such as every five years. The issuer typically has the right to call the bonds at par value at the time the coupon rate is due to increase.
Put bonds: Put bonds are better for investors. Put bonds allow the investor to “put” the bonds back to the issuer at any time at the price stated on the indenture. Because the investors have the control, put bonds are rarely issued. Because these bonds provide more flexibility to investors, put bonds usually have a lower coupon rate.
Remember, there’s a direct correlation between interest rates and when bonds are called or put. Check out the following question to see how this works.
Issuers would call their bonds when interest rates
(A) increase
(B) decrease
(C) stay the same
(D) are fluctuating
The correct answer is Choice (B). Being adaptable when taking the Series 7 exam can certainly help your cause. In this question, you have to look from the issuer’s point of view, not the investor’s. An issuer would call bonds when interest rates decrease because he could then redeem the bonds with the higher coupon payments and issue bonds with lower coupon payments to save money.
Conversely, investors would put their bonds back to the issuer when interest rates increase so they could invest their money at a higher interest rate.
Convertible bonds
Bonds that are convertible into common stock are called convertible bonds. Convertible bonds are attractive to investors because investors have an interest in the bond price as well as the price of the underlying stock. The Series 7 exam tests your expertise on whether converting a bond makes sense for an investor. This determination requires you to calculate the parity price of the bond or stock.
Parity occurs when a convertible bond and its underlying stock are trading equally (that is, when a bond trading for $1,100 is convertible into $1,100 worth of stock).
When answering Series 7 exam questions relating to convertible bonds, you always need to get the conversion ratio. Here’s the formula for the conversion ratio:
You can then use the conversion ratio to calculate the parity price:
parity price of the bond = market price of the stock × conversion ratio
Use the formula to answer the next example question.
Jane Q. Investor purchased a 6-percent DIM convertible bond. Her DIM bond is currently trading at 106, and the underlying stock is trading at 26. If the conversion price is 25, which of the following statements are TRUE?
I. The stock is trading above parity.
II. The stock is trading below parity.
III. Converting the bond would be profitable.
IV. Converting the bond would not be profitable.
(A) I and III
(B) I and IV
(C) II and III
(D) II and IV
The right answer is Choice (D). You can cross out two answers right away. If the stock is trading above parity, converting is always profitable. And if the stock is trading below parity, converting isn’t profitable. Therefore, you can eliminate Choices (B) and (C) right away. Follow these equations:
Currently, the bond is trading for $1,060 (106 percent of $1,000 par) and is convertible into stock valued at $1,040. Because the value of the bond is greater than the converted value of the stock, the stock is trading below parity and converting wouldn’t be profitable.