Ch.5 Q's
If a mutual fund's objective is income, it would not hold which of the following securities in its portfolio? A)Income bonds B)Preferred stock C)Corporate bonds D)U.S. T-notes
A) income bonds A fund designed to generate current income for its shareholders would not hold an income bond, also known as an adjustment bond. Income bonds pay interest only if the issuer has enough earnings to do so. They are often issued by companies coming out of bankruptcy. As a result, these bonds tend to trade like zeroes.
A convertible corporate bond with a conversion price of $20 is trading at 115. The parity price of the common stock is A)$20. B)$17. C)$26. D)$23.
D) $23 A conversion price of $20 means the conversion ratio is 50 (i.e., each bond can be converted into 50 shares of common stock). $1,150 / 50 = $23 parity price.
A 7% convertible debenture is selling at 101, and it is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. What is the parity price of the debenture? A)$910 B)$850 C)$929 D)$920
D) $920 Conversion ratio = par value / conversion price then times the conversion ratio by the current market value its trading at To determine the parity price of the bond, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, multiply the current price of the common by the conversion ratio. The result is the parity price of the bond (40 shares × $23 = $920).
In active trading, a bond of standard size rises in price from 98 5/8 to 101¾. This represents a dollar change of A)$312.50. B)$3.125. C)$0.3125. D)$31.25.
$) 31.25 Method #2 1) 101 3/4 = 101 x $10 = $1,010 + 3/4 of $10 = $7.50, total price is $1,017.50. 2) 98 5/8 = 98 x $10 = $980 + 5/8 of $10 = $6.25. total price is $986.25. 3) The difference between the two prices is $1,017.50 minus $986.25 which = $31.25.
An investor purchases zero-coupon bonds issued by the U.S. Treasury due to mature in 18 years at $100,000. Which of the following might describe the primary reason for selecting that investment vehicle? I. The investor is 65 years old and needs the reliability of current income. II. The investor is 45 years old and has purchased these in an IRA rollover account and wants the assurance of funds for retirement. III. The investor is 30 years old and has a newborn child and wishes to assure funds for a college education. IV. The investor is 20 years old, has just received an inheritance, and wishes to shelter income for as long as possible. A) II and III B)I and IV C)I and II D)III and IV
A) II and III Zero-coupon bonds maturing in 18 years would assure the 45-year-old of the face value at age 63. Being in an IRA, there would be no current taxation, and upon maturity, if desired, the funds could be distributed without the 10% penalty. Zero-coupon bonds are one way to guarantee funds for college education. However, with no current income, they would not be suitable for the 65-year-old and would not offer any tax shelter to the 20-year-old.
An investor purchases a newly issued convertible bond at par. The bond is convertible at $40. Three years later, the underlying common stock is trading at $50 per share. If the investor sells the bond at a $50 premium over the parity price, there is A)a long-term capital gain of $300. B)a long-term capital gain of $1,050. C)a long-term capital gain of $200. D)a long-term capital gain of $10 per share.
A) long term capital gain of $300 This question involves several steps. The first is to determine the conversion ratio in shares. A bond convertible at $40 per share has a share conversion rate of 25 shares ($1,000 ÷ $40). The second step is to compute the parity price. That is, what are those 25 shares worth? Multiply 25 shares times $50 per share and that equals $1,250. When the bondholder sells the bonds at parity plus a $50 premium, $1,300 is received. The $300 profit over the $1,000 initial cost is a long-term capital gain. An alternative that might be easier for some is to look at the appreciation of the stock. It is $10 per share higher than the conversion price of $40. That represents an increase of 25% (10 ÷ 40). If the bond is at parity with the stock, its price must be 25% higher and that brings us again to the $1,250 parity price. Add the $50 premium to get to $1,300, $300 above the initial cost.
DMF Company has $50 million of convertible bonds (convertible at $50) outstanding. The current market value of DMF's stock is $42. The bond indenture contains a nondilution feature. If DMF declares a 10% stock dividend, the new conversion price will be A)lower than $50. B)higher than $50. C)$50. D)the stock's current market price.
A) lower than $50 With an antidilution feature, the issuer will increase the number of shares available upon conversion if the company declares a stock split or stock dividend. This means the bondholder must be able to convert it to more shares, which requires a lower conversion price.
An investor purchases a PQR convertible bond at 98 on June 18, 1994. The bond is convertible at $25, and on June 19, 1995, when the common stock is trading at $26 per share, the investor converts his bond into the stock. For tax purposes, these transactions will result in A)neither gain nor loss. B)a $40 capital gain. C)a $40 capital loss. D)a $60 capital gain.
A) neither a gain nor loss The process of converting a convertible bond into common stock is NOT a taxable event. ONLY WHEN THE STOCKS SOLD, the taxable event occurs.
Your new client lists income as the primary investment objective for an account with your broker-dealer. Which of the following investments would not be suitable? A)Zero-coupon bonds B)Ginnie Mae government securities C)Corporate debt securities D)Corporate preferred shares
A) zero coupon bonds Zero-coupon bonds make no payments until maturity, and therefore, would not be suitable investments for those with an income objective. Typically, preferred shares (because of the fixed dividend they pay) and corporate or government securities, which make interest payments, would be suitable investments to meet an income objective.
One of your customers owns five JLO 5s of 2042. The debentures have a conversion price of $15. When the market price of the convertible is 80, the parity price of the stock is A)$18.00. B)$12.00. C)$15.00. D)$5.33.
B) $12.00 A debenture with a conversion price of $15 is convertible into 66.66 shares ($1,000 ÷ $15). It is always the par value that is used, not the market price. To determine the parity price of the stock, divide the current market price of $800 by 66.66 and the answer rounds off to $12. Some students find it easier to recognize that the bond is 20% below its par value. To be equal (and that is what parity means), the stock must be 20% below the $15 conversion price (or 80% of it). Reducing $15 by 20% is a $3 reduction to $12 or taking 80% of $15 equals $12
Investors placing zero-coupon bonds in their portfolios are most likely to be looking to provide I.accumulation of capital. II. current income. III. protection against reinvestment risk. IV. tax deferral. A)II and III only B)I and III only C)II and IV only D)I and IV only
B) I and III only Zero-coupon bonds are always purchased at a discount because they pay no interest. At maturity, the bondholders receive the maturity value. That represents the initial investment plus interest. Therefore, the investors are receiving more capital than invested (capital accumulation). Zero-coupon securities avoid reinvestment risk because there are no periodic interest payments to be reinvested. When you purchase one of these securities, the quoted yield to maturity is exactly what you will earn if you hold it to the end. With no interest payments, there is no current income. There is no tax deferral with a zero. In fact, unless it is a zero coupon municipal bond, there is phantom income; income not currently received but currently taxable.
If a customer sells a zero coupon bond before maturity, gain or loss will be the difference between sales proceeds and A)discounted value. B)accreted value. C)par value. D)original cost.
B) accreted value Zero coupon bonds must be accreted for tax purposes. Each year, the annual accretion is taxable to the holder. In addition, the customer may adjust the cost basis of the zero upward by the amount of the annual accretion.
Bondholders may not take action against the corporation if it fails to make interest payments for A)subordinated debentures. B)income bonds. C)convertible bonds. D)debentures.
B) income bonds Income bonds pay interest only if earnings are sufficient and declared by the board of directors. This is not true of any of the other fixed-income securities listed (debentures, subordinated debentures, or convertible bonds).
Which of the following statements regarding corporate zero coupon bonds are true? I.Interest is paid semiannually. II. The discount is in lieu of periodic interest payments. III. The discount must be accreted and is taxed annually. IV. The discount must be accreted annually with taxation deferred until maturity. A)I and III B)II and IV C)II and III D)I and IV
C) II and III The investor in a corporate zero coupon bond receives the return in the form of growth of the principal amount over the bond's life. The bond is purchased at a deep discount and redeemed at par at maturity. That discount from par represents the interest that will be earned at maturity date. However, the discount is accreted annually, and the investor pays taxes yearly on the imputed interest.
Which of the following would be most likely to issue an equipment trust certificate? A)A company using specialized equipment on an oil drilling rig B)A user of farming equipment C)An airline company D)A social media company installing new servers
C) an airline company When you see "equipment trust certificate," think transportation companies such as airlines and railroads.
Which of the following best describes a debenture? A)A corporate debt obligation that allows the holder to purchase shares of the company's common stock at specified dates before maturity B)An investment in the debt of another corporate party C)Unsecured corporate debt D)A long-term corporate debt obligation with a claim against securities rather than against physical assets
C) unsecured corporate debt debenture is a debt obligation of the corporation backed only by its word and general creditworthiness. Debentures are written promises of the corporation to pay the principal at its due date and interest on a regular basis. Although this promise is as binding as a promise for a mortgage bond, debentures are not secured by any pledge of property. They are sold on the general credit of the company. The quality depends on the overall assets and earnings of the corporation. Although debentures are unsecured, there are issuers whose credit standing is so good that their debentures are safer than mortgage bonds of less creditworthy companies
Convertible debentures offer which of the following benefits to investors? A)Highest priority in the event of dissolution B)A higher coupon rate than comparable non-convertible debt C)The upside potential of a common stockholder with less downside risk D)Forced conversion when the underlying stock price increases
C) upside potential of common stockholder with less downside risk If the price of the underlying stock increases, the holder of the debenture can exercise the conversion privilege and capture that growth. Unlike the stock, as a debt security, the regular periodic interest payments tend to provide a floor below which the price of the debenture will not fall. In exchange for this benefit, the coupon rate is lower than a comparable non-convertible security. Many of these convertibles have a call feature. If the price of the stock rises, the issuer may decide to call it in and the investor's best option is to convert. This is known as forced conversion and forces the investor in a debt security to own an equity security. Debentures have a lower priority in dissolution than secured bonds
Reggie owns a convertible bond that converts into 20 shares of common stock. The current market value of the bond was 118½ at the close on Friday, April 1. A 30-day call is announced before the opening on Monday, April 4, at a price of 102. The stock is trading at $57.75. What should Reggie do? A)Sell the bond B)Redeem the bond at the call price C)Hold the bond to maturity D)Convert the bond into the stock
D) convert the bond into stock Reggie will not be allowed to hold the bond to maturity because it is being called. The real question is whether he should sell the bond, allow it to be called, or convert it to the underlying stock. Now that the call has been announced, the market value of the bond will fall to meet the call price. This occurs as a result of declining demand. (Who wants to buy a bond that is about to be called at a lower price?) Thus, redeeming the bond at the call price and selling the bond would both yield the same results: $1,000 times 102% equals $1,020. If he converts the bond, he will get the following results: 20 shares times $57.75 equals $1,155. Therefore, it makes the most sense to convert the bond.
Equipment trust certificates are commonly issued by A)utilities. B)political subdivisions. C)the U.S. government. D)transportation companies
D) transportation companies Equipment trust certificates are corporate bonds commonly issued by transportation companies such as railroads and airlines. These bonds are backed by equipment (e.g., aircraft) the issuer uses in their business.
Which of the following would be the most likely unsuitable recommendation for a client whose objective is steady income? A)An income bond B)A bank CD C)A U.S. Treasury bond D)A subordinated debenture
Income (or adjustment) bonds carry the unique characteristic of requiring payment of interest only when the issuer's income is sufficient. They are used primarily for companies undergoing a financial restructuring, usually after a bankruptcy filing. Don't be fooled by the subordinated debenture. Although it stands last in line of the creditors in the event of a liquidation, that does not mean the investor is not going to get regular interest payments, especially when the debenture is investment grade. Bank CDs typically pay interest quarterly.
What are income bonds
Income bonds, also known as adjustment bonds, are issued when a company is reorganizing and coming out of bankruptcy. Income bonds pay interest only if the company has enough income to meet the interest payment. As a result, these bonds normally trade flat without accrued interest. Therefore, they are not suitable for customers seeking income.
