Series 7: Part 2 Unit 5 Corporate Debt

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

$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.

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) Corporate debt securities B) Corporate preferred shares C) Zero-coupon bonds D) Ginnie Mae government securities

C.) Zero Coupon Bonds

Forced Conversion

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.

Conversion Price Formula

Par / Conversion Ratio

Conversion Ratio Formula

Par Value / Conversion Price

Phantom income is a characteristic of

zero-coupon bonds. Phantom income is the term describing income that is not received, but it is taxed.

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 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).

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 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 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 the HBH Creations common stock is currently selling at $18 per share, what is likely the wisest choice for the investor?

Although issuers generally exercise the call privilege when the common stock's price is above the conversion price, there are cases when the call is exercised with the hope of eliminating some of the preferred shares with their preferred dividend payout. Let's go through the math of this question. With a par value of $80 and a conversion price of $20, each share of the preferred stock is convertible into 4 shares of the HBH Creations common stock. If the investor converts, those 4 shares are currently worth $18 each or a total of $72 for each share of preferred converted. That being the case, the investor's decision is, "Do I convert and have stock worth $7,200 (remember, there are 100 shares of the preferred, each convertible into 4 shares of the common), or do I accept the call at $82 per share of preferred totaling $8,200?" Why not sell the preferred stock at $84? Because the moment the call is announced, the price of the preferred will fall. Holding on to the preferred stock doesn't make sense because after the call date, the preferred will no longer receive dividends.

What action could a corporation take that would result in the forced conversion of an outstanding convertible debt security?

Exercise the call feature when the debt security's conversion value exceeds the call price One of the investor benefits of a convertible security is that an increase in the market price of the underlying common stock will lead to a comparable increase in the price of the convertible. 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). Because most convertibles are also callable, 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 onto 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. The coupon rate is fixed, and an investor would not want to convert to the stock just because the dividends on the stock are lower than the interest on the bond

Under what circumstances will a dilution of equity occur?

The conversion of convertible bonds into common stocks Dilution of equity occurs when stockholders experience a reduction in their percentage ownership of the company. If bonds are converted, more common shares are issued, and the shareholder's equity is diluted. A stock dividend or stock split does not change a stockholder's percentage of ownership. Refunding debts has no effect on stockholders.

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

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.

Which of the following statements regarding corporate zero coupon bonds are true? Interest is paid semiannually. The discount is in lieu of periodic interest payments. The discount must be accreted and is taxed annually. The discount must be accreted annually with taxation deferred until maturity.

The discount is in lieu of periodic interest payments, and the discount must be accreted annually with taxation deferred until maturity. 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.

Convertible debentures offer which of the following benefits to investors?

The upside potential of a 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.

An investor purchases a zero coupon bond at a price of 64. The bond matures in nine years. Five years later, the investor sells the bond at a price of 80. This would result in

a long-term capital loss of $40. This question deals with accretion of the discount. The discount here is $360 (the difference between the $640 paid and the $1,000 maturity value). With nine years until maturity, the annual accretion is $360 divided by nine, or $40 per year. After five years, the bond's basis has increased by $200 ($40 times 5 years) to $840. The sale at $800 represents a long-term loss of $40.

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

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.