Lesson 2.6: Paying Off the Debt

An investor purchases a 30-year zero-coupon corporate bond. The bond was issued by a Fortune 500 company. Her investment is subject to all of the following risks except A)reinvestment risk. B)default risk. C)interest rate risk. D)purchasing power risk.

A)reinvestment risk. Explanation Zero-coupon bonds are not subject to reinvestment risk because there is nothing to reinvest. However, they are subject to purchasing power, interest rate, and default risk.

Investors interested in acquiring convertible debentures as part of their investment portfolio would A)want the safety of a fixed-income investment along with potential capital appreciation. B)be interested in tax advantages available to convertible debt securities. C)want the assurance of a guaranteed dividend on the underlying common stock. D)seek to minimize changes in the bond price during periods of steady interest rates.

A)want the safety of a fixed-income investment along with potential capital appreciation. Explanation Investors who want the safety of a fixed-income investment with the potential for capital gains would be most interested in purchasing a convertible debenture. However, because convertible debentures can be exchanged for common stock, their market price tends to be more volatile during times of steady interest rates than other fixed-income securities.

A new client is looking for a recommendation. The client is 72 years old, has sufficient income from Social Security, and has a pension plan to cover all of her living expenses. She has just inherited $100,000. She wants to invest this money to have a bit more income so she can spoil her grandchildren. Which of the following would be antipodal to her wishes? A)Jumbo CDs B)Treasury bonds C)Public utility stock D)Treasury STRIPS

D)Treasury STRIPS Explanation If she wants additional income, she cannot get that from Treasury STRIPS. They are zero-coupon bonds and pay nothing until maturity.

Which of the following statements regarding corporate zero-coupon bonds is true? A)They have lower price volatility than other bonds. B)The discount is in lieu of periodic interest payments. C)Interest is paid semiannually. D)They are beneficial for investors in higher tax brackets.

B)The discount is in lieu of periodic interest payments. Explanation 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 creating "phantom income." Zero-coupon bonds have greater, not lower, price volatility.

Of the following securities, which is most commonly recommended to fund a child's college education? A)Zero-coupon Treasury bonds B)Municipal bonds C)Treasury bills D)Investment-grade corporate bonds

A)Zero-coupon Treasury bonds Explanation Zero-coupon bonds, particularly those carrying the guarantee of the U.S. Treasury, are a favored investment vehicle for saving for a child's higher education. They have the advantage of providing a certain, quantifiable sum at a certain date in the future.

A bond, preferred stock, or debenture exchangeable at the option of the holder (for common stock of the issuing corporation) is A)a nondilutive stock. B)a convertible security. C)a collateral-backed equity security. D)a synthetic security.

B)a convertible security. Explanation A bond, preferred stock, or debenture exchangeable at the option of the holder for common stock of the issuing corporation is a convertible security.

Which of the following statements is true if a corporate bond is callable? A)The owner of the bond may demand that the issuing corporation redeem the bond before it matures. B)The issuing corporation may change the coupon rate at any time by giving the owner of the bond written notice. C)The owner of the bond may exchange it for shares of stock. D)The issuing corporation has the option to redeem the bond before it matures

D)The issuing corporation has the option to redeem the bond before it matures. Explanation A callable bond is one that may be redeemed by the issuing corporation before it matures. One reason a corporation might call a bond is to sell new bonds with a lower interest rate.

The call feature available on some bonds A)allows the issuer the option to escape high interest rates if market rates decline. B)allows bond issuers to extend the life of the bond. C)may be used to convert the bond into preferred shares. D)allows the issuer to refinance the debt if interest rates rise above the call rate.

A)allows the issuer the option to escape high interest rates if market rates decline. Explanation Many bonds have a call feature that allows the issuer to call in the bonds, assuming the issuer has the cash available to pay them off, and escape high interest rates if market interest rates decline. If the company does not have the cash, it may issue a new bond at the lower prevailing interest rate and use that money to pay off the old bonds. This is known as refunding and, in essence, is no different from refinancing the mortgage on a home.

Which of the following statements regarding a zero-coupon corporate bond is true? A)The investor has phantom income, which must be reported on an annual basis. B)The investor reports the difference between the purchase price and maturity value as ordinary income at maturity. C)These bonds have higher reinvestment risk as to interest than bonds paying semiannual interest. D)Bonds selling at a premium have a yield lower than the coupon rate.

A)The investor has phantom income, which must be reported on an annual basis. Explanation On a taxable zero-coupon bond, the annual imputed interest is reported for tax purposes. Because this income is not actually received annually, it is referred to as phantom income. Zero-coupon bonds always sell at a discount from their maturity value—never at a premium—and one risk that zero-coupon bonds avoid is reinvestment risk because there are no interest payments to reinvest.

Which of the following statements regarding convertible debentures is true? A)When compared with similar nonconvertible debentures, convertible debentures are issued with a lower coupon rate. B)The issuer pays a higher rate of interest compared with a comparable nonconvertible debenture. C)The debenture holders receive a variable rate of interest. D)The issuer has the right to convert the debentures during the time period specified in the indenture.

A)When compared with similar nonconvertible debentures, convertible debentures are issued with a lower coupon rate. Explanation A conversion feature is a benefit to the debtholder. It allows the debtholder a choice to either continue holding the debt represented by the debenture or to convert it into shares of common stock of the underlying issuer. Everything that is done in the securities industry has to be a win-win situation. The win for the debtholder in this instance is the ability to take advantage of the capital appreciation potential the common stock may offer, and the win for the issuer is that by offering something extra to the debenture purchaser, that purchaser is willing to accept a lower interest rate on the debt (as compared to a nonconvertible debenture), therefore giving the issuer a lower cost of capital. It is the debtholder, not the issuer, who determines when and if to convert.

Regarding convertible debentures, one characteristic of which your clients should be aware of is that A)they trade in line with the issuer's common stock once the conversion price is reached. B)they generally pay a higher interest rate than nonconvertible debentures. C)the conversion feature protects against an early call. D)it is generally best to convert when the common stock is selling below its parity price.

A)they trade in line with the issuer's common stock once the conversion price is reached. Explanation The lower volatility of a convertible debenture stems from the fact that it has fixed interest payments and will be redeemed at maturity as any other bond or debenture would. No such guarantees apply to common stock.

An investor is considering the purchase of $100,000 maturity value of zero-coupon AAA rated corporate bonds scheduled to mature in 20 years. Which of these are among the risks that this investor will be assuming? Default risk Interest rate risk Prepayment risk Reinvestment risk A)I and IV B)I and II C)II and III D)III and IV

B)I and II Explanation Even though these bonds are rated AAA, 20 years is a long time and it is possible that this corporation may not even exist when the maturity date arrives. Adding to the risk is the fact that there are no interest payments in the interim. That is why the most commonly recommended zero-coupon bonds are those issued or guaranteed by the U.S. Treasury. Because zero-coupon bonds have the longest duration for their maturity of any bonds, they have the greatest exposure to interest rate changes. Prepayment risk is only found with mortgage-backed securities, and one of the benefits of zeroes is that there is no reinvestment risk.

Which of the following investments gives the investor the least exposure to reinvestment risk? A)Common stock in an electric utility B)Treasury notes C)Treasury STRIPS/zero-coupon bonds D)Preferred stock in a growth company

C)Treasury STRIPS/zero-coupon bonds Explanation Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon bonds paying no interest. Thus, there is no income to reinvest during the holding period and therefore no reinvestment risk.

Which of the following statements about zero-coupon bonds are true? Zero-coupon bonds are sold at a deep discount from face value. Zero-coupon bonds pay periodic interest payments. The owner of a zero-coupon bond receives his return only at maturity. A)I and III B)I, II, and III C)II and III D)I and II

A)I and III Explanation A zero-coupon bond is a type of debt security that pays no periodic interest payments. Instead, the investor receives his return only at maturity, when the bonds are redeemed. Zero-coupon bonds are sold at a deep discount from face value, but they are redeemed at full face value when they mature.

It is not uncommon to find a fixed-income security issued with a call feature. The feature is usually of most benefit to A)the issuer. B)the investor. C)the transfer agent. D)the underwriter.

A)the issuer. Explanation The call feature enables the issuer to redeem (call in or buy back) the security at a specified price, usually beginning with a specified number of years after the security is issued. How does this benefit the issuer? If the cost of money (interest rates) has declined since the fixed-income security was issued, the issuer can float a new issue with interest (or dividends in the case of preferred stock) based on that lower cost of funds and use the money raised to call in the existing securities currently paying a higher return. It is the same concept as refinancing a mortgage when interest rates go down.

Which of the following is true of a zero-coupon bond? The rate of return is locked in. There is no reinvestment risk. The imputed interest is taxed as ordinary income on an annual basis. A check for the interest is paid at maturity. A)I only B)I, II, and III C)I, III, and IV D)I and IV

B)I, II, and III Explanation Zero-coupon bonds pay no periodic interest and are always issued at a discount from par. The appreciation of the zero from its discounted purchase price to its face value is thought of as interest to the bondholder, but this annual "phantom income," so named because you don't receive it, is taxed as ordinary income on an annual basis. When the bond is purchased, the investor locks in that yield, and with nothing to reinvest, there is no reinvestment risk. At maturity, the investor receives the face value ($1,000) rather than a check for the interest.

If your customer wants to set aside $40,000 for when his child starts college but does not want to endanger the principal, you should recommend A)common stock. B)zero-coupon bonds backed by the U.S. Treasury. C)municipal bonds for their tax benefits. D)corporate bonds with high rates of interest.

B)zero-coupon bonds backed by the U.S. Treasury. Explanation Treasury STRIPS are guaranteed by the U.S. government, so there is no chance of default. They are zero-coupon bonds and offer no current income, which is appropriate for a client who wants a 100% return paid at a future date for college expenses.

Which of the following statements regarding callable bonds is correct? A)They are only issued by government entities. B)They offer lower yields than comparable noncallable bonds. C)They usually provide a call risk premium. D)They are unaffected by changes in market yields.

C)They usually provide a call risk premium. Explanation Callable bonds are normally called only when interest rates fall. The call premium (a percentage above par value that the issuer will pay when called) helps to compensate bondholders for the lower interest rate at which they will be able to reinvest the proceeds. Callable bonds have greater risk for investors (call risk) and therefore offer higher yields than noncallable bonds.

A new convertible debt security has a provision that it cannot be called for five years after the issue date. This call protection is most valuable to a recent purchaser of the security if A)interest rates are stable. B)interest rates are rising. C)the market price of the underlying common stock is increasing. D)interest rates are falling.

C)the market price of the underlying common stock is increasing. Explanation Convertible debt securities are more sensitive to the price of the underlying common stock than they are to interest rates. Call protection would enable this investor to hold on to the debt security while the stock rises in value rather than having it called away. Although it is true that call protection protects against a potential call when interest rates decline, the protection against a call when the underlying stock is rising is considered to be more valuable.

When it comes to issuing a debt security, which of the following features will generally enable the issuing corporation to borrow at the lowest interest rate? A)Callable B)Zero-coupon C)Cumulative D)Convertible

D)Convertible Explanation Because the convertible feature offers potential growth through the exercise of the conversion option, the interest rate on these securities is generally lower than other debt issues of the same corporation. The call feature increases the reinvestment risk and that is compensated for with a higher coupon. The descriptive adjective cumulative refers to dividend payments on preferred stock but not to bonds. Because zero-coupon bonds pay nothing until maturity, that added risk requires a higher yield to attract investors.

A corporation is likely to call eligible debt when interest rates are A)volatile. B)rising. C)stable. D)declining.

D)declining. Explanation A corporation generally calls in its debt when interest rates are declining, in order to replace old, higher interest rate debt with new, lower interest rate issues.