Unit 5 - Corporate Bonds

Conversion Price

Par Value / Conversion Ratio

Corporate Debt: Taxation

- Interest is taxed as ordinary income (Federal, state, municipal)

Zero Coupon Bonds

- Issued or traded at a deep discount and mature at par ($1,000). - Interest paid at maturity, but taxed annually as phantom or imputed income. - The difference between purchase price and full face value is called accretion. - Suitable for investor looking for lump sum payment to cover some type of targeted cost (college education, etc.)

Income (Adjustment) Bonds

- Used when a company is reorganizing and coming out of bankruptcy - Interest must be declared by BoD - Not suitable for customers seeking stable income

Parity

- Values of bond and converted shares are equal - No advantage to converting at parity - Bond needs to be under parity price or the stock needs to be above parity price for opportunity to convert

Corporate Bond Quotes

1/8 = $1.25 1/4 = $2.50 3/8 = $3.75 1/2 = $5.00 5/8 = $6.25 3/4 = $7.50 7/8 = $8.75

Mortgage Bond

A bond backed by fixed assets (e.g. Real estate)

Debentures

A debt obligation backed by the issuing corporation's general credit. Syn. unsecured bond.

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) $50.00 C) $45.45 D) $22.50 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 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?

A) $48 B) $40 C) $42 D) $32 $1,000 (par) + 20% = $1,200 / 25 shares = $48. Alternatively, it is ordinarily the 20% increase in the value of the common stock that has caused the bond to increase 20% in value. $1,000 divided by 25 shares equals $40 plus 20% equals $48.

A convertible bond callable at 101 is trading at 105. The bond is a 4% bond convertible at $25. The common stock is trading at $27. If an investor bought the bond and converted, her profit would be

A) $75 B) $40 C) $30 D) $20 First, calculate the number of shares each bond will convert to: $1,000 (par) divided by $25 per share equals 40 shares per bond. With market value at 105, each bond costs $1,050. What is the stock parity price? $1,050 divided by 40 shares equals $26.25 per share. Current market value of the stock minus stock parity price equals profit (or loss). $27.00 − $26.25 = $0.75 per share × 40 shares = $30.

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 $1,050. B) a long-term capital gain of $300. C) a long-term capital gain of $10 per share. D) a long-term capital gain of $200 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.

Guaranteed Bonds

Backed by a company other than the issuer, such as a parent company

Collateral Trust Bonds

Bonds backed by financial assets. Deposited securities into a trust to serve as collateral.

Equipment Trust Certificates

Bonds secured by specific types of equipment or physical assets.

Conversion Ratio

Par Value / Conversion Price

Senior

Describes the relative priority of claim of a security.

Parity Price

Market Price / Conversion Ratio

Subordinated

Usually describing a debenture; a claim that is behind (junior to) that of any other creditor. *No matter how junior, it is still senior to any stockholder.