Coupon Rate

Treasury Inflation-Protected Securities (TIPS) shield investors from inflation by:

1. A.Exempting the interest from all federal income taxTIPS interest, and the annual principal adjustment, are subject to federal income tax. Like other Treasuries they are exempt from state and local tax.
2. B.Paying a lump-sum inflation bonus at maturity in addition to full par valueThere is no separate bonus. The adjustment is built continuously into the principal balance.
3. C.Adjusting the principal amount with the consumer price index while the coupon rate stays fixedCorrect. A fixed rate applied to an inflation-adjusted principal makes the dollar interest payment rise with inflation.
4. D.Resetting the coupon rate each period to match the reported inflation rateThe coupon rate on a TIPS is fixed for the life of the security. It is the principal that adjusts.

Why: A TIPS carries a fixed coupon RATE, but its principal amount is adjusted upward or downward with the consumer price index. Because the fixed rate is applied to a rising principal balance, the dollar interest payment grows as inflation grows, and the investor is repaid the inflation-adjusted principal at maturity. The clue is that the rate is fixed while the principal moves.

Kaito Nakamura buys a 26-week Treasury bill with a $10,000 face amount and pays $9,835. He asks when the interest payments will arrive. His adviser should explain that:

1. A.Interest is paid semiannually, as it is on all marketable Treasury securitiesNotes and bonds pay semiannually, which is why this generalizes so easily, but bills do not.
2. B.There are no interest payments; the entire $165 return is the difference between the discounted purchase price and the $10,000 received at maturityCorrect. A bill is issued at a discount, and the accretion to face value at maturity is the whole return.
3. C.Interest accrues monthly and is credited to his account, with the principal returned at maturityNo cash interest is credited at any interval on a bill.
4. D.Interest is paid in a single payment at maturity in addition to the $10,000 face amountHe receives exactly $10,000 at maturity, not $10,000 plus a separate interest payment.

Why: Treasury bills are original issue discount instruments. They pay no periodic coupon; the investor buys at a price below face value and receives the full face amount at maturity, so the entire return is the $165 difference between the $9,835 purchase price and the $10,000 received. The clue is that the purchase price is below face value with no coupon rate stated. Treasury notes and bonds, by contrast, pay semiannual interest. Review the characteristics of Treasury securities.

In bond terminology, "par value" refers to the amount that is...

1. A.The price the underwriter paid the issuer for the bonds at the offeringThat is the underwriting proceeds figure, which reflects the spread the syndicate keeps. It has nothing to do with the redemption amount.
2. B.Repaid to the holder at maturity, and on which the coupon rate is calculatedCorrect. Par is the principal the issuer must return at maturity and the base figure used to compute the coupon payment.
3. C.The current price at which the bond trades in the secondary marketThis confuses par with market price. Market price moves daily with interest rates and credit; par never changes.
4. D.The total interest the bond will pay over its entire lifeThis confuses principal with cumulative coupon income. Total interest depends on the coupon rate and the number of years; par is a single lump-sum repayment.

Why: Par value (also called face value or principal) is the fixed amount the issuer contractually repays the holder at maturity. It is also the base on which the coupon rate is applied. Most corporate and municipal bonds carry a 1,000 dollar par.

A bond's "nominal yield" is best defined as the...

1. A.Total annualized return including the gain or loss to par at maturityThat describes yield to maturity, which folds in the pull to par. Nominal yield ignores price entirely.
2. B.Return the investor earns if the issuer redeems the bond early at the call priceThat is yield to call. It applies only to callable bonds and assumes redemption before maturity.
3. C.Fixed annual interest rate stated on the bond, expressed as a percentage of parCorrect. Nominal yield and coupon rate are the same thing, and both are measured against par.
4. D.Annual coupon divided by the bond's current market priceThat is current yield. It uses the market price as the denominator, so it changes every time the bond's price changes.

Why: Nominal yield is another name for the coupon rate: the fixed annual interest stated on the bond, expressed as a percentage of par. It never changes over the life of a fixed-coupon bond.