Unit 4 Checkpoint Exam
An investor whose primary objective is a steady income flow would probably be best served by building a portfolio of A) cumulative common stock. B) preferred stock. C) income bonds. D) investment-grade debentures.
D) investment-grade debentures. The trick here is to remember that income bonds are issued during a corporate reorganization and only pay interest when and if the company has sufficient earnings. When a bond or debenture is investment grade, the likelihood of receiving timely interest payment is high. Preferred stock is generally a good source of income, but, because the dividends are not an obligation in the way that interest is, the stability of the income is less assured. There is no such thing as cumulative common stock, only preferred.
Which of the following statements regarding convertible bonds is not true? A) Coupon rates are usually higher than nonconvertible bond rates of the same issuer. B) Coupon rates are usually lower than nonconvertible bond rates of the same issuer. C) Convertible bondholders are creditors of the corporation. D) 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.
A) Coupon rates are usually higher than nonconvertible bond rates of the same issuer. 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.
Which the following statements concerning taxes on corporate bonds is true? A) Short term capital gains on bonds derive from the interest income because the interest is always paid out twice in a year. B) Interest income from a corporate bond is taxed based upon ordinary income rates only. C) Bonds are always considered long term so it is impossible to have short term capital gains when purchasing bonds. D) Bonds held to maturity can only have long-term capital gains.
B) Interest income from a corporate bond is taxed based upon ordinary income rates only. Interest income from corporate bonds is just income, so it is taxed as ordinary income. Capital gains and losses come from trading the security. If a bond has been held to maturity, it was not traded and therefore cannot be a capital gain. Short term capital gain never applies to interest income.
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 this investor holds the bond until it matures, A) there is a $360 long-term capital gain and $40 in ordinary income. B) there is no reported capital gain. C) there is a $400 long-term capital gain. D) $400 is reported as ordinary income.
B) there is no reported capital gain. 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 all $400 of the discount has been accreted. This results in no reported capital gain
Which of the following debt securities would be most likely to offer a conversion feature into common stock? A) A mortgage bond B) Commercial paper C) A debenture D) Preferred stock
C) A debenture Invariably, when it comes to convertible debt securities, they are debentures rather than secured bonds. The conversion concept makes no sense with money market securities—they mature in one year or less. Preferred stock is often convertible, but it is an equity security, not a debt security.
