Series 7 Chapter 5- Corporate Bonds

In a bond quote, each 1/8 has a value of

$1.25 (10/8)

Disadvantages of Convertible Securities to Investors (4)

- Low interest rate on convertibles - Investor's priority is lower than other debt securities -If securities are callable, there is the possibility the issuer will call it and force the investor to decide whether or not to convert - Not good income option

Disadvantages of Convertible Securities to the Issuer (4)

- When bonds are converted, shareholders' equity is diluted; that is, more shares are outstanding, so each share now represents smaller fraction fo ownership in the company - Common stockholders have a voice in the company's management, so a substantial conversion could cause a shift in the control of the company - Reducing corporate debt though conversion means a loss of leverage - The resulting decrease in deductible interest costs raises the corporation's taxable income

Convertible Debt Securities

-Can convert debt to shares of stock -Only issued by corporations -Conversion details located in the bond indenture

the downpayment of rolling stock for equipment trusts is usually

20%

A customer purchases an ABC 6.5% convertible preferred stock at $80. The conversion price is $20. If the common stock is trading two points below parity, the price of ABC common is A)$14. B)$16. C)$12. D)$18.

A

An investor seeking income combined with a conservative level of risk would purchase A) AA-rated mortgage bonds. B) AAA-rated convertible debentures. C) unrated income bonds. D) junk bonds.

A) AA-rated mortgage bonds. The conservative level of risk eliminates the income bonds and the junk bonds. Income bonds pay interest only if the issuer has the funds to do so. Junk bonds are named such because of their high risk. Even though the convertible debentures have a higher rating than the mortgage bonds, the difference is relatively insignificant at that level and either would be suitable for the conservative investor. However, because of the convertible feature, it is always true on the exam that the income return is lower than non-convertible issues. Therefore, the most suitable for this investor would be the mortgage bonds.

Which of the following corporate bonds is backed by other securities? A) Collateral trust bond B) Debenture C) Mortgage bond D) Equipment trust certificate

A) Collateral trust bond Collateral trust bonds are backed by a portfolio of other securities, while mortgage bonds are backed by real estate. Equipment trust certificates are backed by equipment, while debentures are backed only by the company's promise to pay.

Libby sees a tombstone advertisement for a new issue of Southwest Barge subordinated convertible debentures. The bonds will carry an 11¼% coupon, are convertible into common stock at $10.50, and are being issued to the public at 100. The proceeds of the issue will be used specifically for purchasing new Southwest barges. Libby's concerns about the issue could include which of the following? A)The company might demand that she accept common stock for her bond. B)The issue may have a junior claim to another security issue. C)She should not be concerned, as the bonds will be first in liquidation. D)The new barges might sink, and the collateral would be gone.

B

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.

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)$23. D)$26.

C

A convertible corporate bond with a conversion price of $20 is trading at 115. The parity price of the common stock is A) $26. B) $17. C) $23. D) $20.

C) $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.

In active trading, a bond of standard size rises in price from 98 5/8 to 101¾. This represents a dollar change of A) $0.3125. B) $3.125. C) $31.25. D) $312.50.

C) $31.25. Let's take this step by step remembering that every point in a bond quote equals $10 and every 1/8 of a point equals $1.25 ($10/8=$1.25). Method #1 1) The increase is 3 1/8 points (101 ¾ minus 98 5/8 = 101 6/8 minus 98 5/8 = 3 1/8 2) 3 1/8 = $30 (3 times $10 per point) + $1.25 which equals $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. LO 5.d

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) Hold the bond to maturity C) Convert the bond into the stock D) Redeem the bond at the call price

C) Convert the bond into the 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.

Anti-Dilutive Protection

Concern of any convertible security holder is protection against possible dilution resulting from stock split/stock dividend (if privilege is stated in conversion price, this offers protection)

If LMN, Inc., has filed for bankruptcy, in what order would interested parties be paid? Holders of secured debt Holders of subordinated debentures General creditors Preferred stockholders A) III, I, II, IV. B) I, II, III, IV. C) IV, I, II, III. D) I, III, II, IV.

D) I, III, II, IV. The liquidation order is as follows: the IRS (and other government agencies), secured debt holders, unsecured debt holders and general creditors, holders of subordinated debt, preferred stockholders, and common stockholders.

A corporation has an outstanding issue of 8% convertible debentures with a conversion price of $25. The bond indenture contains an antidilutive clause guaranteeing the debt holders the right to maintain proportionate equity conversion in the corporation. If the company pays a 10% stock dividend to its common shareholders, how will that affect the debenture holders? A) The interest rate on the debentures will increase to 8.8%. B) Each debenture holder will receive a check for $100. C) They will receive four shares of the common stock. D) The bonds will now be convertible at approximately 22.73.

D) The bonds will now be convertible at approximately 22.73. The antidilutive provision means the debenture holders will be able to convert into an equivalent share value as before. With a conversion price of $25, the bond is convertible into 40 shares ($1,000 ÷ $25). After the 10% stock dividend, they should be able to have 10% more shares, or 44 shares. That means the conversion price must be reduced. Divide $1,000 by 44 shares and the result is $22.73. Remember, anytime there is a stock dividend, prices go down.

All of the following are the advantages of a margin account except A) leveraging is possible. B) money is borrowed. C) less cash is needed. D) losses are minimized

D) losses are minimized. Any losses on a margin trade are magnified because of the leverage.

An investor owns ten ABC 6s of 2045. The debentures have a conversion price of $50 with an anti-dilution provision. After ABC distributes a 20% stock dividend, the investor's position will be A) ten ABC 6s of 2045 convertible into 16.67 shares. B) ten ABC 6s of 2045 convertible into 20 shares plus forty additional shares. C) twelve ABC 6s of 2045 with conversion price of $50. D) ten ABC 6s of 2045 with a conversion price of $41.67.

D) ten ABC 6s of 2045 with a conversion price of $41.67. This question deals with the anti-dilution provisions of a convertible security. When there is a stock dividend or a stock split, the holder of the convertible maintains the same equity proportion as before. With a conversion price of $50, the debenture is convertible into 20 shares ($1,000 ÷ $50). After a 20% stock dividend, the holder should be able to acquire 20% more shares. That makes the security convertible into 24 shares. Divide the $1,000 par value by 24 shares and the conversion price is now $41.67.

Parity Price of Stock

MV (Bond) / Conversion Ratio

Parity Price of Preferred Stock

MV (Common stock) x conversion ratio

the difference between the deep discounted purchase price and the full face value at maturity is the return the investor receives in zeroes

accretion

conversion does not have an adverse effect on

stock price

Due to a sudden drop in earnings, the board of directors of Amalgamated Metal Industries (AMI) has voted to suspend all dividend payments this year. This would have the least effect on holders of AMI's A)subordinated debentures. B)cumulative preferred stock. C)senior claim preferred stock. D)callable preferred stock.

A

KLM Company has 10 million convertible bonds outstanding that are convertible at $25. The bonds contain an antidilution feature. If KLM declares a 10% stock dividend, the new conversion price will be A)$22.73. B)$45.45. C)$50.00. D)$22.50.

A

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) 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.

With the advent of the horseless carriage (a.k.a. the automobile), the Acme Buggy Whip Corporation's revenues fell to the point where it could no longer cover expenses. This led to an involuntary bankruptcy. The priority of payout was A) senior notes, general creditors, preferred stock, common stock. B) senior notes, preferred stock, common stock, general creditors. C) general creditors, senior notes, preferred stock, common stock. D) common stock, preferred stock, general creditors, senior notes.

A) senior notes, general creditors, preferred stock, common stock. Senior debt refers to obligations that have priority in the event of default. It parallels the use of senior when comparing preferred stock to common stock, the most junior of all securities.

A customer purchases 600 shares of the $100 par ABC 6.5% convertible preferred stock at $80. The conversion price is $20. If the common stock is trading two points below parity, the price of ABC common is A) $16. B) $14. C) $12. D) $18.

B) $14. The conversion ratio is computed by dividing par value by the conversion price ($100 par / $20 = 5). Parity price of the common stock is computed by dividing the market price of the convertible by the conversion ratio ($80 / 5 = $16). $16 − 2 = $14. Alternatively, with the preferred stock selling 20% below its par value, the parity price will be 20% less than the conversion price. That would make the parity price $16 (20% of $20 = $4 and $20 minus $4 = $16). The question states that the common stock is two points below parity which would, once again, be $16 minus $2 or $14.

Rank the following from first to last in order of payment at liquidation of a corporation. General creditors Preferred stock Subordinated debentures Accrued taxes A) III, IV, II, I B) III, IV, I, II C) IV, I, III, II D) IV, III, I, II

C) IV, I, III, II The complete order of liquidation is as follows: secured debt, debentures and general creditors, subordinated debentures, preferred stock, common stock.

One of your customers owns 10 HBH Creations 4.5% convertible callable debentures. The conversion price into HBH common stock is $40. With the current market price of the HBH Creations stock at $44, the company publishes a notice that all of the debentures will be called in thirty days at a price of 104. When the customer calls for your advice, you would probably recommend A) selling the debenture. B) selling the stock. C) exercising the conversion privilege. D) accepting the call.

C) exercising the conversion privilege. Generally, a corporation exercises the call privilege when the call price is below the parity price. With a current market price of the stock at $44 per share, the parity price of the debenture is 110 ($1,100). The effect of this call is that it, in essence, forces the investors to convert, and the issuer never has to pay off the debt. Let's take a look at the math here. With a conversion price of $40, a debt security with a par value of $1,000 is convertible into 25 shares ($1,000 ÷ 40). If the stock is currently selling at $44 per share and the investor could convert into 25 shares, it makes the conversion worth $1,100 (25 shares times $44 = $1,100). In our question, the call price is 104 ($1,040) so the question becomes, "What is a better deal for your customer: exercising the conversion privilege that gives the customer stock with a value of $1,100 or accepting the call worth $1,040?" Why not just sell the debentures? Because once the call at 104 has been issued, the price of the debentures will decline to approximately that level. Why not sell the stock? The investor doesn't own any stock until conversion, so there is nothing yet to sell.

ABC Company issues a 10% bond due in 10 years. The bond is convertible into ABC common stock at a conversion price of $25 per share. The ABC bond is quoted at 90. Parity of the common stock is A) $36.00. B) $25.00. C) $100.00. D) $22.50.

D) $22.50. The bond is quoted at 90, so it is selling for $900. The parity price of the common stock is $22.50, calculated as follows: the bondholder could convert the bond into 40 shares of stock ($1,000 face amount / $25 per share = 40 shares). Because the bond has a current price of $900, divide $900 by 40 to get the underlying parity price (90% × $25 = $22.50).

In active trading, a bond of standard size rises in price from 98 5/8 to 101¾. This represents a dollar change of A) $31.25. B) $3.125. C) $0.3125. D) $312.50.

Let's take this step by step remembering that every point in a bond quote equals $10 and every 1/8 of a point equals $1.25 ($10/8=$1.25). Method #1 1) The increase is 3 1/8 points (101 ¾ minus 98 5/8 = 101 6/8 minus 98 5/8 = 3 1/8 2) 3 1/8 = $30 (3 times $10 per point) + $1.25 which equals $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.

Parity Price of Common Stock

MV (Preferred stock) / Conversion ratio (# of shares)

Parity Price of Bond

MV (Stock) x Conversion Ratio

Types of Bonds Issued by Corporations (8)

Mortgage Bonds Equipment Trust Certificates Collateral Trust Bonds Debentures Guaranteed Bonds Senior Subordinated Income Bonds

conversion price formula

Par / Conversion Ratio

Conversion Ratio Formula

Par Value / Conversion Price

Zero coupon bond

a bond that makes no coupon payments and is thus initially priced at a deep discount major attraction of this bond is that it allows an investor to lock in a yield (or rate of return) for a predetermined, investor- selected time with no reinvestment risk

attraction of a zero coupon bond:

allows investor to lock in a yield for a predetermined, investor selected time with no reinvestment risk.

the current market price of a zero coupon bond reflects the ___ for similar maturities

current interest rates

Most convertible bonds are

debentures

debt obligation of the corporation backed only by its word and general creditworthiness. written promises of the corporation to pay the principal at its due date and interest on a regular basis.

debentures

zeros are often used to fund

education and retirement

particularly railroad and airline companies finance the acquisition of their rolling stock, locomotives, or airplaines by issuing an __

equipment trust certificate

a company can eliminate a ___ as conversion takes place, thus reducing debt

fixed interest charge

bond that is guaranteed as to payment of interest, or both principal and interest, by a corporate entity other than the issuer.

guaranteed bonds

not suitable for customers seeking stable income

income bonds

used when a company is reorganizing and coming out of bankruptcy pay interest only id the corporation has enough income to meet the interest payment and if the BOD declares a payment

income bonds (or adjustment bonds)

With convertibles, the market price tends to move upward if the stock price moves up. This means there is possible ___ protection which usually isnt offered with fixed income securities

inflation

convertibles can be sold with a ___ coupon rate than nonconvertibles because of the conversion feature

lower

if a corporation develops financial problems and is unable to pay the interest on bonds, the real assets pledged as collateral are generally sold to pay off the mortgage bondholders

mortgage bonds

Advantages of Convertible Securities to the Investor (4)

- As a debt security, a convertible debenture pays interest at a fixed rate and is redeemable for its face value at maturity, provided the debenture is not converted. - If a corporation experiences financial difficulties, convertible bondholders have priority over common stockholders in the event of a corporate liquidation - In theory, a convertible debenture's market price tends to be more stable during market declines than the underlying common stock prices. If the stock price declines to a level well below the conversion price, the debenture's price will then reflect the CY competitive with other debt securities - Because convertibles can be exchanged for common stock, their market price tends to move upward if the stock price moves up. The owner of a convertible debenture has all the upside potential of the common stockholder with less downside risk -Conversion of a senior security into common stock is not considered a purchase and a sale for tax purposes. Thus, the investor incurs no tax liability on the conversion transaction.

Advantages of Convertible Securities to the Issuer (4)

- Convertibles can be sold with a lower coupon rate than non convertibles bc of the conversion feature - A company can eliminate a fixed interest charge as conversion takes place, thus reducing the debt - Bc conversion normally occurs over time, it does not have an adverse effect on the stock price, which may occur after a subsequent primary offering - At issuance, conversion price is higher than market price of the common stock

With a bearish outlook on the market, an investor would like to purchase something that will generate income now during current bearish conditions but would also be able to take advantage of capital appreciation should market sentiment turn bullish. Which of the following would be a suitable purchase recommendation that puts the investor in a position to do both? A) Convertible bonds B) Common stock C) Cumulative preferred stocks D) Nonconvertible bonds

A) Convertible bonds A convertible bond would generate income from interest payments during the bear market, but if market sentiment becomes bullish, the bond can be converted into common stock, taking advantage of the change in market conditions. None of the remaining choices could fulfill both of these investment objectives.

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? The investor is 65 years old and needs the reliability of current income. The investor is 45 years old and has purchased these in an IRA rollover account and wants the assurance of funds for retirement. The investor is 30 years old and has a newborn child and wishes to assure funds for a college education. 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.

ABC Corporation has an outstanding 8% convertible bond that is callable at 102. Currently, the bond is trading at 101. The conversion price is $40, and the common stock is currently trading at $39.50. ABC announces a call at 102. To realize the greatest profit, a bondholder should A) tender the bonds. B) continue to hold the bonds and receive interest payments. C) convert the bonds into common and sell the converted shares. D) sell the bonds at the current market price.

A) tender the bonds. The investor would realize the greatest sales proceeds by tendering the bond to the corporation for 102. Selling the bond at its current market value of 101 is not an attractive option. Converting the bond to common stock would result in 25 shares ($1,000 par converted at $40 = 25 shares) sold at $39.50 per share ($39.50 × 25 = $987.50). Once the call date passes, the issuer ceases interest payments making it unattractive to continue to hold the bonds.

KLM Company has 10 million convertible bonds outstanding that are convertible at $25. The bonds contain an antidilution feature. If KLM declares a 10% stock dividend, the new conversion price will be A) $45.45. B) $22.73. C) $22.50. D) $50.00.

B) $22.73. Before the stock dividend, an investor would have received 40 shares of stock for each $1,000 bond ($1,000 / $25). A 10% stock dividend would now give an investor 44 shares on conversion (40 shares + 10% = 4 shares more). $1,000 / 44 shares = $22.73 per share for the new conversion price.

A 7% convertible debenture is selling at 101. It is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. If the stock were trading at parity with the debenture, the price of the stock would be A) $25.00. B) $25.25. C) $43.91. D) $40.00.

B) $25.25. To determine the parity price of the common, 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, divide the current price of the bond by the conversion ratio. The result is the parity price of the common stock. (1,010 / 40 = $25.25).

A customer purchased 10 ABC 9s of 2045 convertible debentures at 99. The debentures are callable at 101. The conversion ratio is 40. Some time later, the debentures are called while the common is trading at $24 and the debenture is trading at 98. Which of the following options would be most beneficial to the customer? A) Sell the bonds B) Tender the bonds to the corporation C) Wait for a better offer from the corporation D) Convert the bonds and sell the common stock

B) Tender the bonds to the corporation First of all, recognize that the investor purchased 10 of the debentures. They have a coupon of 9% and mature in 2045. None of that is relevant to answering the question, but we want to be sure you understand the terminology.The option most beneficial to the investor is tendering the debentures to the corporation for $10,100 (10 times $1,010). If the debentures were sold on the market, the investor would receive $9,800 (10 times $980). If the debentures were converted into common, the investor would receive 400 common shares (40 shares per debenture times 10) that could be sold for their current price of $24, for a total of $9,600.

Corporate bonds that are guaranteed are A) required to maintain a self-liquidating sinking or surplus fund. B) guaranteed as to payment of principal and interest by another corporation. C) guaranteed as to payment of principal and interest by the U.S. government. D) insured by Assured Guaranty Corporation.

B) guaranteed as to payment of principal and interest by another corporation. A guaranteed corporate bond is one guaranteed by another corporation that typically has a higher credit rating than the issuing corporation and is in a control relationship with it.

A corporate bond is quoted at 102⅝. A customer buying 10 bonds would pay A) $10,258.00. B) $10,025.80. C) $10,262.50. D) $10,285.00.

C) $10,262.50. Par ($1,000) × 102% = $1,020. Five-eighths of one bond point ($10) equals 0.625 times $10 equals $6.25. Therefore, the quote reading 102⅝ equals $1,026.25 per bond ($1,020 + $6.25). Because we are told the customer is buying 10 bonds, we multiply $1,026.25 by 10 bonds, which equals the amount the customer will need to pay to make the entire purchase: $10,262.50.

A convertible debenture callable at 101 is trading at 105. The debenture carries 4% coupon and is convertible at $25. The common stock is trading at $27. If an investor bought the debenture and converted, the profit would be A) $40.term-72 B) $20. C) $30. D) $75.

C) $30. As is the case with many math questions, there is more than one way to arrive at the correct answer choice. We'll show you two of them for this question and you can use whichever method is easiest for you. First, calculate the number of shares the investor will receive upon conversion of the debenture: $1,000 (par) divided by $25 per share conversion rate equals 40 shares per debenture. With the market price at 105, each debenture costs $1,050. What is the parity price of the stock? $1,050 divided by 40 shares which equals $26.25 per share. That is, when the common stock is selling at $26.25 per share, the 40 shares received upon conversion are equal to the same $1,050 as the debenture; this is what parity is all about. If we subtract the parity price of the stock ($26.25) from the current market price of the stock ($27), we see there is a profit of $0.75 per share. Converting into 40 shares at a profit of $0.75 per share results in a total profit of $30. Alternatively, knowing that the debenture is convertible into 40 shares of common stock, with the current market price of that stock at $27 per share, those 40 shares could be sold for $1,080 (40 × $27). If the debenture can be purchased for $1,050 (105) and then converted into $1,080 worth of stock, the investor profits by $30. Please note that, as is the case with many calculation questions, there is information supplied that is totally irrelevant to solving the problem. In this question, the fact that the debenture is callable and pays interest at a rate of 4% has nothing to do with determining the investor's profit following the conditions given.

From first to last, in what order would claimants receive payment in the event of bankruptcy? Holders of secured debt Holders of subordinated debentures General creditors Preferred stockholders A) III, I, II, IV B) IV, I, II, III C) I, III, II, IV D) I, II, III, IV

C) I, III, II, IV The liquidation order is as follows: secured debt holders, unsecured debt holders (including general creditors), holders of subordinated bonds, preferred stockholders, and common stockholders.

If LMN, Inc., has filed for bankruptcy, in what order would interested parties be paid? Holders of secured debt Holders of subordinated debentures General creditors Preferred stockholders A) IV, I, II, III. B) III, I, II, IV. C) I, III, II, IV. D) I, II, III, IV.

C) I, III, II, IV. The liquidation order is as follows: the IRS (and other government agencies), secured debt holders, unsecured debt holders and general creditors, holders of subordinated debt, preferred stockholders, and common stockholders.

A corporation with an outstanding convertible debenture issue could force conversion by A) issuing new debentures with a higher coupon rate. B) soliciting proxies from the common shareholders asking them to vote for mandatory conversion. C) decreasing the coupon rate on the debenture to a level where the dividend on the common stock provides a higher return. D) publishing an announcement that the debenture holders have thirty days to tender their bonds at the call price.

D) publishing an announcement that the debenture holders have thirty days to tender their bonds at the call price. Most convertible debt securities are callable, usually at a price slightly above the par value. When the price of the underlying common stock rises to a point where the converted value of the bond is worth more than the par value, issuers will frequently exercise their call privilege. Because the call price is usually significantly less than the converted value, it is only common sense that the debenture holders will exercise their conversion privilege. For example, when the market price of the common stock is $25 per share, a $1,000 convertible debenture with a conversion ratio of 50 shares per bond, has a conversion value of $1,250 (50 shares time $25 per share). By calling the bonds at the stated call price, perhaps 102 or 103, the company can force the bond holders to convert the bonds. Using our example, why would investors hold on to the bonds knowing that, within about 30 days, they're going to get a check for $1,020 or so for each bond when they could convert and own shares worth $1,250 per bond. This is known as forced conversion. Shareholders do note vote on a management decision to call in debt. The coupon rate on the debenture is fixed; the issuer doesn't have the ability to change it. ** This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback.

backed by various kinds of assets of the issuing corporation

Secured

Liquidation Priority

Secured creditors Unsecured creditors Subordinated debt holders Preferred Stockholders Common stockholders

When a corporation wants to borrow money and has neither real estate nor equipment to use as collateral. Instead it deposits securities it owns in a trust to serve as collateral. Can be securities in that corporation or any other securities as long as the securities are readily liquidated (marketable)

collateral trust bonds

The stock price at which a convertible bond can be exchanged for shares of common stock

conversion price

expressed the number of shares of a stock a bond may be converted into

conversion rate/ratio

pays interest at a fixed rate and is redeemable for its face value at maturity, provided the debenture is not converted

convertible debenture

interest income is usually higher and surer for

convertible debentures and convertible preferred stock

interest paid by corporations on their debt securtiies is treated as

ordinary income

the investor doesnt "see" the income from zeros annually, but still has to pay taxes on it

phantom income

there is a great deal of __ in zeros

price volatility (bc duration is equal to the length of maturity)

there is no ___ liability for an investor on a conversion transaction

tax liability

backed only by the reputation, credit record, and financial stability of the corpoartion

unsecured