Series 7: Unit 5--Corporate Bonds

In all cases on the exam, the interest paid by corporations on their debt securities is treated as ordinary income. And unlike dividends on stock, there is no category of:

"qualified" interest with a reduced tax rate.

In active trading, a bond of standard size rises in price from 98(5/8) to 101(3/4). This represents a dollar change of:

$31.25 101(3/4) - 98(5/8) = 3(1/8) 3(1/8) = $30 (3 * $10 per point) + $1.25 (1/8) = $31.25

ABC Corporation's 4% bond is currently trading at 98 (5/8). That would be the price of:

$986.25 We do this in 2 steps. First, the 98 is 98% of $1,000, or $980. Second, we add the (5/8 --> 6.25). $980 + $6.25 = $986.25

With a face value of $1,000, each percentage point of that face is equal to $10. That would mean a bond quoted at 99 is worth:

$990

If the JRP 6s of '31, currently selling at 120, were convertible at $40, how many shares would one get when one converted the bond?

25 shares $1,000 / $40 per share = 25 shares It does not matter if the bond is selling at a premium or discount.

A bond convertible at $20 per share is convertible into (assuming $1,000 par value):

50 shares ($1,000 / $20) = 50

Collateral Trust Bonds:

a corporation that has neither real estate nor equipment will deposit the marketable securities it owns into a trust to serve as collateral for the lenders. The better the quality of the deposited securities, the better the quality and rating of the bond.

If a convertible security and the common stock we would get upon conversion are worth the same, we say they are:

at parity

If a customer sells a zero coupon bond before maturity, gain or loss will be the difference between sales proceeds and:

the 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.

The return the investor receives from a zero coupon bond is the difference between:

the discounted purchase price and par value

A debenture is issued with the backing of:

the general credit of the corporation

The duration of a zero coupon bond is always equal to

the length to maturity

Why do corporations add a conversion feature to bonds or preferred stock?

to make it more marketable. Similar to the "sweetener" concept.

Income bonds, also known as adjustment bonds:

when a company is reorganizing and coming out of bankruptcy. Income bonds pay interest ONLY if the corporation has enough income to meet the interest payment and if the BOD declares a payment.

What is the appeal to zero coupon bonds?

zero coupon bonds allow an investor to lock in a yield (or rate of return) for a predetermined, investor-selected time with NO REINVESTMENT RISK

ABC Corporation has issued $100 million of convertible debentures having a nondilutive covenant. Each debenture is convertible into 40 shares of ABC's common stock. If ABC declares a 2:1 stock split, the conversion price of each debenture will be:

$12.50 per share When a debenture is convertible into 40 shares, the conversion price is $25 per share ($1,000 / $40 per share) After a 2:1 stock split, the conversion rate will now be twice as many shares. $1,000 / $80 per share = $12.50 per share

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:

$25.25 debenture is convertible (conversion ratio) = $1,000 / $25 = 40 shares $1,010 / 40 shares = $25.25 would be parity.

A customer owns a 7.5% ABC convertible bond currently trading at 11. The conversion price is $40. What is the parity price of the common?

$46.00 The bond is selling at a 15% premium. To be equal to that, the stock must be selling at a 15% premium over the conversion price. $40 * 1.15 = $46.00

A DMF convertible bond (convertible into 25 shares) has increased 20% above par in market value. Which of the following would you expect the price of the DMF's common stock to be?

$48 $1,000 par + 20% = $1,200 / 25 shares = $48

A bond convertible at $50 is selling at 105% of parity, while the common stock has a current market value of $45. What is the market value of the bond?

$945 (45 - 50) / 50 = -10%, which means the parity price of the bond must be 10% below the par value, which is $900 (assuming $1,000 is par).

Guaranteed bond:

a bond that is guaranteed as to payment of interest, or both principal and interest, by a corporate entity other than the issuer. The value of the guarantee is only as good as the strength of the company. Guaranteed bonds are popular with railroad/oil companies.

The conversion price is the stock price at which:

a convertible bond can be exchanged for shares of common stock.

Debenture:

a debt obligation backed by the issuing corporation's word and general creditworthiness. Debentures are written promises to pay the principal and interest on a specific basis. Debentures are UNSECURED and the quality of debentures depends on the overall assets and earnings.

Parity is a theoretical concept--we're looking for the price that would make the bond and stock "equal." In actuality, convertible securities almost always have a market price:

above the parity price. Convertible bonds normally sell at a premium above parity.

An investor owns 100 shares of the 4% $80 par convertible, callable, cumulative preferred stock issued by HBH Creations. With a conversion price of $20 and a current market price of $84, HBH issues a call of all of the outstanding preferred shares at $82. If HBH Creations common stock is currently selling at $18 per share, what is the likely wisest choice for the investor?

accept the call at $82 $80 par / $20 conversion price = 4 HBH shares If investor converts now, they'd receive $72: $80 / 4 HBH shares at current price = $72 ($18 * 4) If investor accepts the call, they get $82. The investor could hold onto the preferred shares but the moment the call is announced, the share price would fall since the preferred shares would stop paying dividends. Therefore, it makes sense to accept the call.

For a company who is going through a bankruptcy and does not own securities, administrative claims must be paid first. What does this mean?

attorneys, property appraisers, the courts, etc. must be paid for doing the work and therefore have first priority.

Unsecured debt securities:

backed ONLY by the reputation, credit record, and financial stability of the corporation.

Regarding a corporation's stock price, conversion does NOT have an adverse effect on the stock price because:

conversion naturally occurs over time, not all at once

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?

convert the bond into the stock Reggie will not be allowed to hold the bond to maturity because it is being called. Because the market value of the bond will fall to meet the call price at 102, Reggie should convert the bond into shares, where he would get: Redeem at call --> 1,000 * 102% = 1,020 vs Converting --> 20 shares * $57.75 = $1,155

Subordinated bonds usually refer to:

debentures

Secured debt securities:

debt backed by various kinds of assets of the issuing corporation.

Phantom income:

income that must be taxed in a year even if the income is not distributed from the company. An example is buying a 10Y zero coupon bond for $400 and getting paid $600 at maturity. The investor didn't "see" the income annually, but still has to pay taxes on it--paying $60 in interest income annually.

Convertible securities are not suitable for investors with the financial objective of:

income--convertible securities pay lower interest

Reducing corporate debt through conversion means a loss of:

leverage

An investor purchases a corporate zero coupon bond at a price of $510. The bond matures in 7 years. 4 years later, the bond is sold at a price of $690. What are the tax consequences of the sale?

loss of $100 The amount of the discount is $490 ($1,000 - $510) Annual accretion is $70 ($490 / 7 years) After 4 years, there is $280 of accretion (4 * $70) Because the annual accretion is added to the investor's cost basis, the basis is now $790 ($510 purchase price + $280 in accretion) The bond's sale price of $690 is $100 below the accredited basis. That means a loss of $100.

Do convertible securities (convertibles) sell for a lower or higher coupon rate than nonconvertibles?

lower--the conversion feature is one of the perks of owning convertible securities, which means corporations can get away with issuing convertible securities at lower fixed-rates.

Why are income bonds not suitable for investors looking for stable income?

missed interest payments do NOT accumulate for future payments and the interest paid is dependent upon the corporation's ability to generate enough income to make the payment.

Senior debt usually describes:

mortgage bonds, collateral trust bonds, equipment trust certificates Bonds with prior claim ahead of unsecured creditors.

What is the collateral of most corporates bonds?

mortgages/real estate of the corporation

The conversion ratio, also called the conversion rate, expresses the:

number of shares of stock a bond may be converted into.

A bond trading at $1,200 and a convertible security that can be converted into 20 shares if the stock is selling at $60 per share. This is an example of:

parity--equal

Corporate bonds that are guaranteed are guaranteed as to payment of:

principal and interest by ANOTHER corporation A guaranteed corporate bond is guaranteed by another corporation that typically has a higher credit rating than the issuing corporation and is in a control relationship with it.

List the priorities of a corporations liquidity:

secured bonds > unsecured bonds > subordinated bonds > preferred stock > common stock

Equipment Trust Certificates:

serial bonds issued by transportation companies that are secured by the equipment purchased with the proceeds of the loan. If the company does not make the payments on the equipment, the lender repossess the collateral and sells it for their benefit--kind of like having to personally finance a car.

In addition to federal income tax, interest paid by corporations is taxed on both a:

state and local level

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:

tender the bonds Tendering the bond for 102 is the best option. Selling the bond at its current market value of 101 is not ideal. Converting the stock would result in 25 shares ($1,000 par converted at $40 = $25) sold at $39.50 per share ($39.50 * 25 = $987.50).