Series 7 unit 5
A bond was issued 3 years ago with a coupon of 6%. The bond matures in 21 years and is callable at 103. Current market interest rates are 8%. Which of the following is most likely true? A) The bond is selling at a discount. B) The bond is selling at a premium. C) The coupon will be changed. D) The bond will be called.
A This question contains more information than is needed. Simply, this is a bond where interest rates have gone up since it was issued. When interest rates go up, bond prices go down. Bonds are not called when current interest rates are higher than the coupon; the reverse is true.
An investor purchases a newly issued convertible bond at par. The bond is convertible at $25. Three years later, the underlying common stock is trading at $33 per share. If the investor sells the bond at the parity price, A) there is a long-term capital gain of $320. B) the investor has no gain and no loss. C) there is a long-term capital gain of $8 per share. D) there is a long-term capital loss of $175.
A This question involves several steps. The first is to determine the conversion ratio in shares. A bond convertible at $25 per share has a share conversion rate of 40 shares ($1,000 ÷ $25). The second step is to compute the parity price. That is, what are those 40 shares worth? Multiply 40 shares by $33 per share and that equals $1,320. When the bondholder sells the bonds at parity, that $1,320 is received. The $320 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 $8 per share higher than the conversion price of $25. That represents an increase of 32% (8 ÷ 25). If the bond is at parity with the stock, its price must be 32% higher and that brings us again to the $1,320 price.
If a customer sells a zero coupon bond before maturity, gain or loss will be the difference between sales proceeds and A) accreted value. B) discounted value. C) original cost. D) par value.
A 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
An investor interested in acquiring a convertible bond as part of her investment portfolio would A) want the safety of a fixed-income investment along with potential capital appreciation. B) seek to minimize changes in the bond price during periods of steady interest rates. C) be interested in tax advantages available to convertible debt securities. D) want the assurance of a guaranteed dividend on the underlying common stock.
A An investor who wants the safety of a fixed-income investment with the potential for capital gains would be most interested in purchasing a convertible bond. However, because convertible bonds 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.
An investor purchases a bond on its initial public offering. Even though the bond has a maturity value of $1,000 in 10 years, the offering price is only $600. If the bond is held to maturity, A) $400 is reported as ordinary income. B) there are no tax consequences to report. C) there is a $400 long-term capital gain. D) there is a $360 long-term capital gain and $40 in ordinary income.
B A bond issued at a significant discount from its maturity value is known as an original issue discount bond (OID). In the case of a corporate bond, the computation is more complex than can be tested, but there are two things you need to know: A portion of the discount is taxed as ordinary income each year until maturity, even though it is not actually received. This is called phantom income. Each year's taxable amount is reported on Form 1099-OID. Because a portion of the discount has been taxed each year, at maturity there are no tax consequences—no gain, no interest
Which of the following is not a type of corporate debt instrument? A) Mortgage bond B) Revenue bond C) Income bond D) Subordinated debenture
B A revenue bond is a type of municipal bond. Income bonds are usually issued by companies coming out of a bankruptcy where the company is obligated to pay the semiannual interest only if there are sufficient earnings. Mortgage bonds are secured by real property, such as the company's physical facilities, and subordinated debentures are unsecured debt and come last in line among the creditors. The course will not describe municipal revenue bonds until the next unit. How were you supposed to know what they are? You might have a question where the correct response is something you never heard of—what do you do? Eliminating the choices you know are incorrect is an important test-taking technique. Look at this question. We covered the other three choices in our text on corporate debt issues; that should have made the correct answer obvious.
An investor is looking for a fixed-income investment that can provide a reasonable income while offering potential inflation protection. Which of the following would be the best recommendation to meet this investor's objective? A) High-yield bonds B) Convertible bonds C) Cumulative preferred stock D) Common stock
B Convertible bonds offer the best solution for this client. The bond carries a fixed interest rate, meeting the goal of reasonable income. The ability to convert the bond into common stock offers the potential to keep pace with inflation. Common stock historically has been the best inflation hedge. Why isn't it the correct answer here? Because common stock is not considered a fixed-income investment. Although the cumulative preferred stock is a fixed-income investment, there is no inflation protection (the cumulative feature only provides assurance that past dividends are likely to be paid). High-yield bonds will provide income but, once again, there is no inflation protection. What's more, these are known as junk bonds, and the steady income might be questionable due to the low quality of many of these bonds.
ABC Company has issued $20,000,000 of convertible bonds with a coupon of 5% and a current market value of 120. The conversion price is $40. If all the bonds are converted, how many additional shares of common stock will ABC have outstanding? A) 600,000 B) 500,000 C) 400,000 D) 1,000,000
B Each bond will convert to 25 shares of common stock ($1,000 ÷ $40). 20,000 bonds were issued ($20,000,000 ÷ $1,000). Therefore, 500,000 additional shares (20,000 × 25) will be outstanding if all the bonds are converted.
A customer purchases an ABC 6½% convertible preferred stock at $80. The conversion price is $20. If the common stock is trading 2 points below parity, the price of ABC common is A) $16. B) $14. C) $12. D) $18.
B 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.
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) $22.50. B) $50.00. C) $22.73. D) $45.45.
C 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.
An investor owns a convertible debenture with a conversion price of $10. If a 10% stock dividend is paid on the company's common stock, which of the following is true? A) The investor will receive 10 shares of the common stock. B) The conversion price will be adjusted to $11.00. C) The conversion price will be adjusted to $9.09. D) The investor will receive 1 share of the common stock.
C You can assume that any convertible security on the exam will have an anti-dilutive provision. That means that a stock dividend or stock split will not cause the investor's conversion privilege to be diminished. With a conversion price of $10, the investor was able to convert into 100 shares ($1,000 divided by $10). After the 10% stock dividend, the investor must be able to convert into 10% more shares (110 shares). To get 110 shares from a $1,000 principal, the price must be reduced. The computation is $1,000 divided by 110. That equals $9.09 per share.
A 7% convertible debenture is selling at 101, and it is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. What is the parity price of the debenture? A) $910 B) $850 C) $920 D) $929
C To determine the parity price of the bond, 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, multiply the current price of the common by the conversion ratio. The result is the parity price of the bond (40 shares × $23 = $920).
If a mutual fund's objective is income, it would not hold which of the following securities in its portfolio? A) Corporate bonds B) Preferred stock C) U.S. T-notes D) Income bonds
D A fund designed to generate current income for its shareholders would not hold an income bond, also known as an adjustment bond. Income bonds pay interest only if the issuer has enough earnings to do so. They are often issued by companies coming out of bankruptcy. As a result, these bonds tend to trade like zeroes
Which of the following statements regarding convertible bonds is not true? A) Convertible bondholders are creditors of the corporation. B) Coupon rates are usually lower than nonconvertible bond rates of the same issuer. C) If there is no advantage to converting the bonds into common stock, they would sell at a price based on their market value without the convertible feature. D) Coupon rates are usually higher than nonconvertible bond rates of the same issuer.
D Coupon rates are not higher; they are lower because of the value of the conversion feature. The bondholders are creditors. If the stock price falls, the conversion feature will not influence the bond's price.