NASAA Series 65, Uniform Investment Adviser Law ExaminationInvestment Vehicle CharacteristicsMedium
A portfolio manager is constructing a diversified portfolio and is considering an investment that provides a fixed income stream with an interest rate that adjusts periodically based on a predetermined benchmark, such as LIBOR or the prime rate. The client is concerned about rising interest rates affecting bond values but still desires income. Which type of debt security should the manager consider?
- AFloating-Rate Note (FRN)
- BZero-Coupon Bond
- CConvertible Bond
- DFixed-Rate Bond
Show answer & explanationAnswer & explanation
Correct answer: A. Floating-Rate Note (FRN)
A Floating-Rate Note (FRN) has an interest rate that adjusts periodically, which helps mitigate interest rate risk for investors concerned about rising rates while still providing income.
Why the other options are wrong
- B. A zero-coupon bond does not pay periodic interest, which does not meet the client's desire for a fixed income stream, and its value is highly sensitive to interest rate changes.
- C. A convertible bond can be converted into equity but typically has a fixed interest rate, and its primary benefit is equity participation, not protection against rising rates for income.
- D. A fixed-rate bond's value would decline if interest rates rise, which is precisely what the client is concerned about.
Floating-Rate Note (FRN)
A debt instrument with a variable interest rate that is tied to a benchmark rate (e.g., LIBOR, Prime Rate) and is reset periodically.
- Interest rate adjusts periodically
- Provides protection against rising interest rates
- Offers a variable income stream
Memory trick: FRN: Floating Rate, Risk Neutralizer.