Amortization Of Bond Premium

A bond purchased at 102 is:

1. A.At a premium, amortized toward parCorrect - 102 is a premium price.
2. B.At a discountThis has the reference point reversed. A discount is a price below 100, and 102 sits two points above it.
3. C.At parPar is the single price 100, not a range around it. Two points of difference is small in dollar terms but still puts the bond above par.
4. D.In defaultDefault is a payment failure by the issuer, and price alone does not establish it. If anything the signal points the other way, since buyers paying above par are not pricing in a missed payment.

Why: A price above par (100) is a premium; the premium is amortized toward par by maturity.

For a municipal bond bought at a premium in the secondary market, the premium is:

1. A.Amortized toward par (no capital loss at maturity)Correct - required amortization.
2. B.Ignored until maturityIgnoring the premium would leave the customer holding a cost basis above par and claiming a capital loss when the bond redeems at 1,000. Amortization is mandatory on municipal premiums precisely to prevent that result.
3. C.Added to incomeThis runs the adjustment backwards. Accretion adds to the holder's basis and reported income on a bond bought at a discount; a premium bond amortizes downward, reducing basis and effective interest income each year.
4. D.Deducted as an immediate lossThe premium is not written off in the year of purchase. It is spread over the remaining life of the bond, stepping the cost basis down toward par a little at a time.

Why: Municipal bond premiums must be amortized toward par, so the bond reaches par at maturity with no capital loss.

For a bond bought at a premium and held to maturity, the premium is:

1. A.Ignored entirelyThe premium cannot be ignored. It is amortized over the holding period, writing the adjusted cost basis down so that it equals par at maturity.
2. B.Added to the coupon as incomeThis reverses the direction of the adjustment. Amortizing a premium REDUCES the effective interest income the holder reports, because part of each coupon is really a return of the price paid above par.
3. C.Recognized as a capital loss at maturityThis is tempting because the investor paid more than par and receives only par back. But amortization has already reduced the basis to par year by year, so nothing is left to claim as a loss at maturity.
4. D.Amortized down to par by maturityCorrect - basis declines to par.

Why: A bond premium is amortized so the adjusted basis reaches par at maturity, producing no gain or loss then.

An investor wants CMO exposure with the MOST predictable cash flows, accepting a lower yield. Her best choice among the tranches is:

1. A.An interest-only (IO) stripWrong. IO cash flows are extremely prepayment-sensitive.
2. B.A support (companion) trancheWrong. Support tranches absorb the prepayment swings the PAC sheds.
3. C.A planned amortization class (PAC) trancheCorrect. The PAC schedule is protected by the support tranches.
4. D.A Z-tranche (accrual bond)Wrong-but-tempting. Z-tranches receive NOTHING until prior tranches retire - long, uncertain deferral.

Why: PAC tranches maintain scheduled principal payments across a wide band of prepayment speeds because companion (support) tranches take the excess or shortfall; investors pay for that stability through lower yields. Citation: CMO structure fundamentals; Series 7 outline. Takeaway: PAC = stability; support = volatility premium.