NASAA Series 65 — All Questions

A forward contract differs from an exchange-traded futures contract because a forward is:

• a.Standardized in size and guaranteed by a central clearing organization
• b.Listed on an organized exchange and marked to market on a daily basis
• c.Privately negotiated and carries the credit risk of the counterparty✓
• d.Required to be settled in cash rather than by physical delivery of goods

Forwards are customized private agreements between two parties, so the terms fit the users but each side depends on the other's ability to perform. Futures are standardized in size, quality, and delivery date, trade on an exchange, and are novated to a clearinghouse that guarantees performance and requires daily mark-to-market variation margin. That counterparty guarantee is the defining difference.

An investor holding a corporate zero-coupon bond in a taxable account must:

• a.Report no income until the bond is sold or reaches its stated maturity
• b.Pay tax only on the coupon payments actually received during the year
• c.Treat the entire gain received at maturity as a long-term capital gain
• d.Report the annual accretion of the discount as taxable interest income✓

A corporate zero pays no cash, but the Internal Revenue Code requires the holder to accrete the original issue discount and report it as interest income each year. Because tax is owed on income never received, this is called phantom income, and it is the reason corporate zeros are often recommended for tax-deferred accounts. Accretion on a municipal zero is generally tax-exempt, following the character of the underlying interest.

A $1,000 par convertible debenture has a conversion price of $40. Its conversion ratio is:

• a.25 shares✓
• b.2.5 shares
• c.4 shares
• d.40 shares

Conversion ratio = par value / conversion price = $1,000 / $40 = 25 shares per bond. Parity (conversion value) is then 25 shares multiplied by the market price of the stock, so at a $44 share price the bond's parity value is $1,100. Conversion is attractive only when parity exceeds the bond's market price.

A government or retail money market fund seeks to maintain which of the following characteristics?

• a.A floating net asset value that moves each day with market prices, as an equity mutual fund's does
• b.Principal insured up to $250,000 per depositor by the FDIC, as in a bank savings account
• c.A stable net asset value, typically $1.00 per share, with high liquidity✓
• d.Higher income from long-term corporate bonds with maturities of ten to thirty years

Under Rule 2a-7(c)(1), a government or retail money market fund may use amortized cost or penny rounding to keep a stable net asset value, typically $1.00 per share, while holding short-term, high-quality instruments that stay highly liquid. Other money market funds, such as institutional prime funds, must float their net asset value, which is why the stem names government or retail funds. An equity-style floating value is therefore not the goal of the funds described. Money market fund shares are neither FDIC-insured nor guaranteed by the government, so deposit-style insurance is wrong. The funds hold very short-term paper, not long-term bonds.17 CFR 270.2a-7(c)(1)

Under FINRA Rule 2341, the maximum aggregate sales charge on shares of an open-end fund that has no asset-based sales charge is:

• a.8.5% of the public offering price✓
• b.6.25% of the public offering price
• c.9.0% of the net asset value
• d.5.0% of the net asset value

FINRA Rule 2341(d)(1) caps aggregate front-end and deferred sales charges at 8.5% of the offering price for a fund without an asset-based sales charge; the cap drops to 8.0%, 7.75% or 7.25% if the fund lacks rights of accumulation, quantity discounts, or pays a service fee. 6.25% is the cap that applies to funds with an asset-based sales charge. The charge is measured against the public offering price, not NAV, and 5% of NAV is not the rule.FINRA Rule 2341(d)

A long-term, fixed-rate U.S. Treasury bond is generally considered:

• a.Free of purchasing power risk but exposed to reinvestment risk
• b.Free of default risk and of interest rate risk, but exposed to purchasing power risk and reinvestment risk
• c.Free of interest rate risk because the coupon rate is fixed, but exposed to default risk
• d.Free of default risk but still exposed to interest rate risk and purchasing power risk✓

Treasuries carry the full faith and credit of the U.S. government, so default risk is treated as negligible. A long-term bond still has substantial duration, so its market price falls when yields rise, and its fixed coupons lose purchasing power if inflation accelerates. A fixed coupon does not remove interest rate risk, and Treasuries are not free of purchasing power risk. Treasury interest is taxable federally but exempt from state and local income tax.

To qualify for pass-through tax treatment, a real estate investment trust must distribute at least what share of its taxable income each year?

• a.50% of its net rental receipts
• b.100% of its total net income, including capital gains
• c.75% of its gross rental receipts
• d.90% of its REIT taxable income✓

A REIT keeps its pass-through status by paying out at least 90% of REIT taxable income (net capital gain is excluded from that base). The 50% and 75% figures do not describe the distribution test; 75% appears only in asset and income tests. Paying out 100% is not required, and the trust can retain net capital gain and pay tax on it.IRC 857(a)(1)

Besides distributing most of its income, a REIT must also have:

• a.Shares that trade on a national securities exchange
• b.At least 100 shareholders at every moment of each taxable year, including its first
• c.Five or fewer individuals who together own more than half of its shares
• d.At least 100 shareholders, for at least 335 days of a 12-month year✓

The Code requires beneficial ownership by 100 or more persons for at least 335 days of a 12-month taxable year, and the requirement does not apply to the first taxable year for which the REIT election is made. It also bars a closely held structure in which a handful of individuals own most of the shares, so a five-owner majority is the reverse of what is required. Exchange listing is common but not required, since non-traded REITs qualify too.IRC 856(a)(5), (a)(6), (b), (h)

A publicly traded master limited partnership avoids corporate-level tax only if at least 90% of its gross income is:

• a.Reinvested in new partnership properties within twelve months of receipt
• b.Qualifying income, such as rents, interest and natural resource income✓
• c.Distributed to unit holders as cash during the same taxable year, with no retention
• d.Earned from active operating businesses located inside the United States

Under Section 7704(c), a publicly traded partnership keeps partnership treatment when 90% of gross income comes from qualifying sources. There is no mandatory cash payout, no U.S.-location test, and no reinvestment requirement in the test.IRC 7704(c)

A unit holder in a master limited partnership receives tax information on:

• a.No form, because distributions are a return of capital
• b.Form 1099-B only, because the units trade on an exchange
• c.Form 1099-DIV, because the MLP pays dividends
• d.Schedule K-1, because the MLP passes income and deductions to its partners✓

An MLP is taxed as a partnership, so each unit holder gets a Schedule K-1 showing a share of income, gains and deductions. Dividend reporting on a 1099-DIV belongs to corporations. A 1099-B reports only sales. Distributions reduce basis but still come with K-1 reporting.

Commercial paper is exempt from Securities Act registration when its maturity at issuance is no more than:

• a.Five years
• b.Thirty days
• c.Nine months (270 days)✓
• d.Twelve months

The exemption in Section 3(a)(3) covers short-term notes with a maturity at issuance not exceeding nine months, which is why paper is issued at 270 days or less. A 30-day limit and a 12-month limit do not match the statute, and a five-year term fits medium-term notes.15 USC 77c(a)(3)

An exchange-traded fund differs from an open-end mutual fund mainly because the ETF:

• a.Is redeemed by the fund only, at the day's closing net asset value
• b.Must hold shares of a single company
• c.Pays no distributions to its shareholders
• d.Trades throughout the day at a price set by the market✓

ETF shares trade on an exchange all day, so the price can sit above or below net asset value. An open-end fund redeems at the end-of-day NAV. ETFs hold diversified baskets, and they pass through dividends and capital gains like other funds.

An investor places an order to buy open-end mutual fund shares at 11:00 a.m. The order will be filled at:

• a.A live price at 11:00 a.m. based on the fund's current holdings
• b.The next NAV calculated once the order has been received✓
• c.The price at which the fund manager's next trade is executed
• d.The previous day's closing NAV, because it is already published

Open-end funds use forward pricing: the order executes at the next NAV computed, which is normally at the close of trading. Using yesterday's NAV would let investors trade on known results. Funds do not price on manager trades or provide intraday quotes.Rule 22c-1

An investor in the 24% federal bracket owns a municipal bond yielding 3.8%, exempt from federal tax. The taxable yield that gives the same after-tax return is:

• a.4.7%
• b.5.0%✓
• c.2.9%
• d.15.8%

Taxable-equivalent yield = 3.8% / (1 - 0.24) = 3.8% / 0.76 = 5.0%. Multiplying by 0.76 gives 2.9%, and dividing by the tax rate alone gives 15.8%. Adding 24% of the yield to it gives 4.7%, which does not gross up for tax correctly.

Treasury Inflation-Protected Securities adjust the principal for changes in the Consumer Price Index. Compared with a conventional Treasury, a TIPS holder in a taxable account:

• a.Owes no federal tax on the adjustment at any time during the holding period
• b.Receives the adjustment as extra cash interest paid every six months
• c.Owes tax on the adjustment only when the bond matures or is sold
• d.Owes tax each year on the inflation adjustment to principal✓

Principal increases on TIPS are taxable in the year they occur, even though the cash arrives only at maturity or sale. They are not tax-free, and they are not deferred to maturity. The adjustment raises principal rather than being paid out with the coupon.

Mortgage pass-through securities issued by Ginnie Mae are backed by:

• a.Only the pool of mortgages, with no government support
• b.The credit of the banks that originated the loans
• c.The Federal Reserve's holdings of agency bonds
• d.The full faith and credit of the U.S. government✓

Ginnie Mae guarantees timely payment of principal and interest, and that guarantee carries the full faith and credit of the United States. Prepayment risk remains, so the cash flows are uncertain even though credit risk is low. The Fed and the originators do not stand behind the pool.

Market yields fall well below the coupon on a callable bond that the investor owns. The risk the holder most faces is that the issuer will:

• a.Redeem the bond early, forcing reinvestment at lower rates✓
• b.Skip the next coupon, because the price is above par
• c.Extend the maturity, because rates are low
• d.Convert the bond into common stock at par

When market yields drop below the coupon, issuers call bonds and refinance more cheaply, leaving holders to reinvest at lower rates. A drop in yields does not signal a missed coupon, and a plain callable bond has no maturity-extension or conversion feature.

A company has cumulative preferred stock outstanding and has skipped its last two dividends. Before it can pay any common dividend, it must:

• a.Issue additional common shares to the preferred holders as compensation
• b.Pay only the current preferred dividend and carry the earlier ones forward
• c.Offer to repurchase the preferred shares from holders at par value
• d.Pay the two missed preferred dividends and the current one✓

Cumulative preferred dividends that are passed accumulate as arrears, and all arrears plus the current dividend come ahead of common. Paying only the current dividend ignores the cumulative feature. A buyback and a share issue are not required.

A U.S. investor buys an American depositary receipt for a foreign company. In addition to the company's business risk, the investor takes on:

• a.No additional risk, since the receipt trades in dollars
• b.Interest rate risk set by the Federal Reserve alone
• c.Default risk of the depositary bank
• d.Currency risk between the home currency and the dollar✓

The ADR is priced in dollars but reflects shares of a company whose value is tied to a foreign currency, so exchange-rate changes affect return. Dollar pricing does not remove that exposure. The depositary holds the shares and does not guarantee them.

An investor buys 100 shares at $50 and sells one call contract at a $55 strike for a $2 premium. The breakeven price and the maximum gain per share are:

• a.Breakeven $57; maximum gain unlimited
• b.Breakeven $48; maximum gain $2
• c.Breakeven $52; maximum gain $5
• d.Breakeven $48; maximum gain $7✓

Breakeven = $50 - $2 = $48. Maximum gain = ($55 - $50) + $2 = $7 per share, reached if the stock is at or above $55. Adding the premium gives a $52 breakeven wrongly. Keeping only the premium ignores the stock gain to the strike. Unlimited gain belongs to an uncovered long position.

An investor buys a put with a $40 strike for a premium of $3. At expiration the stock is at $34. The investor's profit per share is:

• a.A loss of $3
• b.$3✓
• c.$9
• d.$6

Intrinsic value = $40 - $34 = $6, and subtracting the $3 premium leaves a $3 profit. The $6 figure ignores the cost, $9 adds the premium instead of subtracting it, and a $3 loss is the result only if the put expired worthless.

A 45-year-old owner of a nonqualified deferred annuity withdraws some of the account's earnings. In addition to ordinary income tax, the owner generally faces:

• a.A 25% additional tax on the entire withdrawal
• b.A 10% additional tax on the taxable part of the withdrawal✓
• c.A 10% tax on the owner's basis returned
• d.No additional tax, because annuities are insurance products

Earnings withdrawn from an annuity before age 59 1/2 are subject to a 10% additional tax unless an exception applies. The tax applies only to the taxable portion, not the return of basis, and the 25% rate is the RMD penalty, which is unrelated. Insurance status gives no exemption from it.IRC 72(q)

Under the tax rules for a nonqualified annuity contract purchased after 1982, partial withdrawals are treated as coming first from:

• a.Earnings, taxed as ordinary income, and then from basis✓
• b.Whichever source the owner names on the withdrawal request form
• c.Basis, which comes out tax-free, and only then from earnings
• d.Earnings and basis in the same proportion as they sit in the contract

Withdrawals from a nonqualified deferred annuity follow last-in, first-out order, so gains come out first and are taxed as ordinary income; basis comes out afterward without tax. Basis first is the rule for other investments, proportional treatment applies to annuitized payments through an exclusion ratio, and the owner cannot elect the source.IRC 72(e)

If a 529 college savings plan distribution is not used for qualified education expenses, the earnings portion is generally subject to:

• a.Ordinary income tax only, with no further charge
• b.Ordinary income tax and a 10% additional tax✓
• c.Ordinary income tax and a 20% additional tax on the earnings
• d.The 10% additional tax only, with no income tax

Earnings withdrawn for non-qualified purposes are taxed as income to the recipient and carry an additional 10% tax under the rule that treats 529 plans like Coverdell accounts. Neither charge applies alone, and 20% is the rate for nonqualified health savings account withdrawals, not for 529 plans. The owner's age gives no exemption. The contributions themselves come back without tax or penalty.IRC 529(c)(6); IRC 530(d)(4)

A person holds the Series 65 license in good standing and has income below the usual accredited-investor thresholds. For purposes of Regulation D, that person:

• a.Qualifies only while employed at a registered adviser
• b.Qualifies only for offerings sponsored by a broker-dealer
• c.Qualifies as an accredited investor because of the license✓
• d.Does not qualify unless income exceeds $200,000

Under Rule 501(a)(10), the Commission's order of August 2020, effective December 8, 2020, designated the Series 7, Series 65 and Series 82 licenses, held in good standing, as qualifying a natural person as an accredited investor regardless of income or net worth. The income and net worth tests are alternatives to it. Nothing in the order ties the status to the holder's current employer or to the sponsor of the offering.17 CFR 230.501(a)(10); SEC Order, Release No. 33-10823

A mutual fund's Class A shares carry a front-end sales charge that falls at set purchase amounts, such as $50,000 and $100,000. These purchase levels are called:

• a.Breakpoints✓
• b.Twelve-b-1 fee tiers
• c.Contingent deferred sales charges
• d.Wrap fee schedules

A breakpoint is the purchase amount at which the sales charge percentage on a front-end load fund drops. A contingent deferred sales charge is a back-end fee for selling early. A 12b-1 fee is an annual distribution expense, and a wrap fee is a bundled advisory charge.

A bond with a 6% coupon trades at 104. Its yield to maturity is:

• a.Equal to 4%, the amount of the premium over par
• b.Below 6%, because the investor pays more than par and gets par back✓
• c.Above 6%, because a higher price signals a higher return
• d.Equal to 6%, because the coupon is fixed for the life of the bond

A bond bought above par returns less than its coupon rate, because the premium is lost at maturity, so yield to maturity is under 6%. A higher price lowers yield. The coupon is fixed, but yield depends on the price paid. The 4% figure is a price premium, not a yield.

An investor buys one call and one put on the same stock with the same strike price and expiration date. The position profits if the stock:

• a.Moves far enough up or down to cover both premiums paid✓
• b.Stays near the strike price until expiration
• c.Rises sharply but loses money on any decline
• d.Falls sharply but loses money on any increase

A long straddle pays off from a large move in either direction, once the gain on one option exceeds the combined cost of both. The call alone would profit from a sharp rise only, and the put alone from a sharp fall only. A stock near the strike leaves both options near worthless, which is the maximum loss.

If a corporation liquidates, which group has the last claim on its assets?

• a.Common stockholders✓
• b.Employees owed unpaid wages
• c.Preferred stockholders
• d.Holders of the company's debentures

Common stockholders are residual owners and are paid only after creditors and preferred holders. Preferred stock ranks ahead of common, debenture holders are creditors with claims above all equity, and employees owed wages have priority claims under bankruptcy law.

During the accumulation phase of a variable annuity, the investment risk of the subaccounts is carried by:

• a.The state guaranty association, which backs subaccount returns
• b.The insurer, which guarantees a minimum value for every subaccount
• c.The broker-dealer that sold the contract to the owner
• d.The contract owner, whose value rises and falls with the subaccounts✓

In a variable annuity the owner picks subaccounts and bears their investment results, which is why the contract is a security. The insurer guarantees the fixed account and optional riders, not subaccount values. A state guaranty association protects against insurer failure, and the selling firm does not underwrite returns.

A mutual fund may describe itself as a no-load fund only if its annual 12b-1 fee does not exceed

• a.0.75% of average net assets
• b.0.50% of average net assets
• c.1.00% of average net assets
• d.0.25% of average net assets✓

Under FINRA Rule 2341, a fund calling itself no-load can charge a 12b-1 fee of no more than 0.25% of average net assets, and it cannot carry a front-end or deferred sales charge. A 0.50% fee is not a Rule 2341 threshold. The 0.75% figure is the cap on the asset-based sales charge portion for funds that do charge loads. A 1.00% figure is the combined cap of sales charge and service fee.FINRA Rule 2341

Under the typical terms in a load fund's prospectus, an investor signs a letter of intent to reach a sales-charge breakpoint. How long does the investor have to complete the purchases?

• a.2 years
• b.6 months
• c.1 year
• d.13 months✓

Fund prospectuses typically give the investor 13 months from the start of the letter of intent to complete the purchases needed for the breakpoint. Whether earlier purchases may be counted toward the commitment differs from fund to fund and is set out in each prospectus. Six months and one year are shorter than the period funds allow, and two years is longer.Fund prospectus letter-of-intent terms (13-month period)

A fund's net asset value is calculated at 4:00 p.m. Eastern. An investor's purchase order reaches the fund's agent at 4:20 p.m. At which price will it be filled?

• a.The NAV calculated at the next close✓
• b.The opening price on the next trading day
• c.The NAV calculated at the 4:00 p.m. close
• d.The NAV at the time the order is entered

Mutual funds use forward pricing under Rule 22c-1: orders received after the pricing time get the next computed NAV. The 4:00 p.m. NAV is already set and cannot be given to a later order. A price set when the order is entered would be intraday pricing, which funds do not use. Funds do not price at an opening price, since NAV is based on closing values.Rule 22c-1

A mutual fund has total assets of $510 million, liabilities of $10 million, and 25 million shares outstanding. What is its net asset value per share?

• a.$19.60
• b.$21.00
• c.$20✓
• d.$20.40

NAV per share = (assets - liabilities) / shares = $500 million / 25 million = $20. A $20.40 figure divides assets without subtracting the liabilities. A $19.60 figure subtracts the liabilities twice. A $21.00 figure comes from adding the liabilities to the assets.Net asset value

A closed-end fund has a net asset value of $20 per share and trades at $18 on the exchange. The fund is trading at

• a.a 10% premium to NAV
• b.a 2% discount to NAV
• c.a 10% discount to NAV✓
• d.an 11% discount to NAV

The discount is (NAV - price) / NAV = $2 / $20 = 10%. A premium would mean the price is above NAV. An 11% figure divides the gap by the market price instead of NAV. A 2% figure treats the $2 gap as a percentage.Closed-end funds

After a variable annuity is annuitized, whether each payment is higher or lower than the prior one depends on how the separate account performs compared with

• a.the insurer's declared fixed-account rate
• b.the S&P 500 total return index
• c.the assumed interest rate (AIR)✓
• d.the contract's surrender charge schedule

Annuity unit values rise when separate account performance exceeds the assumed interest rate and fall when it is below it, so payments move with that comparison. A stock index is not the benchmark. The declared fixed-account rate applies to the general account, not to the separate account. Surrender charges apply to early withdrawals during accumulation and have nothing to do with payout amounts.Variable annuities

A 45-year-old takes a partial withdrawal from a non-qualified annuity. How is it taxed?

• a.Earnings and basis are taxed pro rata at capital gains rates
• b.Earnings come out first as ordinary income, plus a 10% penalty✓
• c.Cost basis comes out first and is not taxed or penalized
• d.Earnings come out first as long-term gain, with no penalty

For non-qualified annuity contracts, withdrawals are treated as earnings first (last in, first out), taxed as ordinary income, and the taxable amount incurs a 10% additional tax before age 59 1/2. Basis-first treatment applies to the annuitized payout through the exclusion ratio, not to partial withdrawals. Pro rata treatment does not apply to the contract, and annuity earnings are never taxed as capital gains.Annuity taxation

Which exchange can generally be made tax-free under Internal Revenue Code Section 1035?

• a.An annuity contract for shares of a mutual fund
• b.A life insurance policy for an annuity contract✓
• c.An annuity contract for a life insurance policy
• d.Shares of common stock for an annuity contract

Section 1035 allows a life policy to be exchanged for a life policy, an endowment, or an annuity, and an annuity for an annuity. The exchange cannot run from an annuity to a life policy. Exchanges into or out of mutual fund shares and stock are ordinary taxable sales.IRC Section 1035

To avoid paying corporate income tax, a REIT must distribute at least what percentage of its taxable income to shareholders?

• a.100%
• b.50%
• c.75%
• d.90%✓

A REIT qualifies for pass-through treatment by distributing at least 90% of its taxable income. Fifty percent is below the requirement. The 75% figure is the share of assets and income that must come from real estate. Distribution of 100% is not required, though it avoids tax on retained income.Real estate investment trusts

A private fund relying on the Section 3(c)(1) exclusion of the Investment Company Act may have no more than how many beneficial owners?

• a.100✓
• b.35
• c.2,000
• d.250

Section 3(c)(1) excludes a fund with 100 or fewer beneficial owners that does not offer securities publicly. The 35 figure is the cap on non-accredited purchasers in a Rule 506(b) offering. The 2,000 figure is the holder-of-record threshold for Exchange Act registration. Two hundred fifty is not a standard in either rule.Private funds

In a Rule 506(b) private offering, how many non-accredited purchasers are permitted?

• a.No more than 100
• b.No more than 10
• c.None, because every buyer must be accredited
• d.No more than 35✓

Rule 506(b) permits up to 35 non-accredited purchasers if they are sophisticated and receive the required disclosure, but general solicitation is prohibited. Requiring every purchaser to be accredited describes Rule 506(c). The numbers 10 and 100 do not apply to Rule 506(b).Regulation D

Under Regulation D, which income test qualifies an individual as an accredited investor?

• a.$200,000 in each of the last two years ($300,000 jointly)✓
• b.$250,000 in the last year ($400,000 jointly)
• c.$150,000 in the current year ($250,000 jointly)
• d.$100,000 in each of the last two years ($150,000 jointly)

An individual qualifies with income above $200,000 in each of the two most recent years, or $300,000 with a spouse, and a reasonable expectation of the same in the current year. The other thresholds are not Regulation D standards. The net worth test is separate, at over $1 million excluding the primary residence.Accredited investors

An investor holds restricted stock of a company that files periodic reports with the SEC. What is the minimum holding period before the shares may be resold under Rule 144?

• a.9 months
• b.3 months
• c.6 months✓
• d.2 years

Restricted securities of a reporting company have a six-month holding period under Rule 144, while securities of a non-reporting issuer require a year. Three months is too short for non-affiliates. Nine months and two years are not Rule 144 periods.Rule 144

An investor sells stock at a loss on March 10 and buys the same stock on April 2. How is the loss treated for tax purposes?

• a.It is deductible but limited to $3,000 against ordinary income
• b.It is deductible in full because the purchase came after the 30-day window
• c.It is disallowed now and added to the cost basis of the new shares✓
• d.It is permanently disallowed with no effect on the new shares

A repurchase of substantially identical stock within 30 days before or after a sale at a loss triggers the wash sale rule. April 2 is 23 days after the sale, so the loss is disallowed currently but added to the basis of the replacement shares, preserving it for later. The 30 days fall inside the window. The $3,000 limit is the net capital loss deduction, which is a separate rule. The disallowed loss is deferred, not lost.Wash sale rule

Interest on which municipal bond may be a tax preference item for the federal alternative minimum tax?

• a.A pre-refunded bond secured by escrowed Treasuries
• b.A revenue bond financing a public water system
• c.A general obligation bond financing a school
• d.A private activity bond✓

Interest on private activity bonds can be an AMT preference item. General obligation bonds for schools and revenue bonds for essential public facilities are governmental-purpose bonds, whose interest is not an AMT preference. A pre-refunded bond keeps the tax status of the original issue, which is governmental here.Municipal bonds

A taxable investor holds Treasury Inflation-Protected Securities. How is the annual increase in principal from inflation adjustments taxed?

• a.Deferred until the bond matures or is sold, then taxed as income
• b.Taxed as a long-term capital gain when the bond matures
• c.As ordinary income in the year it accrues, though unpaid✓
• d.Exempt from federal tax, like the interest on municipal bonds

The inflation adjustment to TIPS principal is taxable federal income each year it accrues, creating phantom income because the cash arrives only at maturity or sale. Deferral to maturity is not allowed. TIPS interest and adjustments are exempt from state and local tax, not federal. The adjustment is ordinary income, not capital gain.TIPS

Which Treasury security is sold at a discount from face value and pays no periodic interest?

• a.Treasury note
• b.Treasury inflation-protected security
• c.Treasury bill✓
• d.Treasury bond

Treasury bills mature in one year or less, are sold at a discount, and pay face value at maturity. Notes and bonds pay interest every six months. TIPS also pay semiannual interest on the inflation-adjusted principal.Treasury securities

The duration of a zero-coupon bond is equal to its

• a.current yield times its time to maturity
• b.time to maturity divided by two
• c.time to maturity✓
• d.coupon rate times its time to maturity

With no interest payments, all cash flow arrives at maturity, so duration equals the time remaining. Half the time to maturity would be a rough guide for a bond with level payments, not a zero. A zero has no coupon rate to multiply. Current yield is zero for a zero-coupon bond, so the product would be meaningless.Zero-coupon bonds

A callable bond trades at a premium to par. Which of its yields is likely to be the lowest?

• a.Yield to call✓
• b.Yield to maturity
• c.Current yield
• d.Nominal yield

A premium bond called early returns par sooner, so the premium is amortized over a shorter period and yield to call is below yield to maturity. For a premium bond, yield to maturity is below current yield, and current yield is below the nominal (coupon) yield, so those cannot be the lowest.Callable bonds

A $1,000 par convertible bond has a conversion price of $40. The common stock is trading at $44. What is the bond's conversion value?

• a.$1,000
• b.$1,760
• c.$1,100✓
• d.$910

The bond converts into $1,000 / $40 = 25 shares, worth 25 x $44 = $1,100. A $1,000 figure is par. A $1,760 figure multiplies the stock price by the conversion price. A $910 figure divides the conversion price by the stock price.Convertible securities