FIN 330 Chapter 16 Questions

Why do bonds have sinking funds? How are they different from a call provision?

1. Because the corporation has to repay the bond in the future. By creating a sinking fund for bonds, it becomes easy for the corporation to repay the bonds. It minimizes the risk of falling short on cash at the time of maturity. 2. Sinking funds limit the number of bonds which can be bought back by the issuer early and call provisions allow the issuer to pay off all the bonds issued by him. Buyback prices of the sinking funds are lower compared to call provisions.

A convertible bond allows for a bond to be converted into what at a future date?

Stock

Initially, bond ratings were paid for by the bond purchaser. Today bonding ratings are under an "issuer pays" model. Explain how the two forms are different

Bond rating agencies used to charge the purchaser of the bond for providing financial data and advisory services. Now, these agencies charge fees from the issuer who holds the financial instruments

Shoma is thinking about buying a municipal bond. She notices some are revenue bonds, whereas others are general obligation bonds, but she does not understand what these are. How would you explain this to Shoma?

Both bonds are municipality bonds which are backed and issued by the local or state municipality. Revenue bonds are repaid from the cash obtained from the cash-generating projects. General obligation bonds do not focus on the specific projects and are issued by the government for the general expenses.

Jenny is considering purchasing a bond, but she notices that the bond has many covenants. She is unsure what they mean. How would you explain these covenants to Jenny?

Covenants are the promises in the agreement which states that certain activities can be performed while certain activities cannot be performed. Covenants in the bond guard the interest of both the parties in the bond agreement. -Expressed in terms of financial ratios -Expressed in terms of nonfinancial factors such as information provided

Sunita wants to earn the highest possible after-tax return on her savings. She has two options: a corporate bond and a tax-free government bond. The corporate bond yields 5%, and Sunita is in the 25% marginal tax bracket. What equivalent tax-free rate would a government bond need to have to make her indifferent between the corporate bond and the government bond?

Equivalent tax-free rate=Taxable interest rate * (1-Marginal tax rate) =.05 * (1-.25) =3.75%

Explain, in words and graphically, how private borrowers such as Harley-Davidson are negatively affected by a flight to quality

Flight to quality increases their costs of borrowing. A diagram shows an increase in interest rate which means borrowing costs have increased as well. There is a shift that represents a reduction in the supply of loanable funds

During times of crises, funds can flow from long-term debt markets to shorter-term debt markets. This is often referred to as a:

Flight to yield

Explain why some argue the "issuer pays" model creates a conflict of interest

The bond rating agency has the stake in how well the bonds are sold in the market. Bond rating agencies may rate the bonds higher than what they are to generate more income for themselves which will create a conflict of interest

Which of the following correctly describes the role of the bond-rating agencies in the subprime mortgage asset bubble?

The bond-rating agencies gave high ratings to assets backed by subprime mortgages, thus encouraging the growth of the asset bubble

Explain how TIPS, or Treasury inflation-protected securities, actually protect investors from inflation

The rate of the interest on the bond does not change with the TIPS but the amount of principal which is used to calculate the payment of the interest changes due to change in the consumer price index. So, at the time of the maturity of the bond, it is redeemed either at par or at the principal amount which comes after the adjustment of the inflation, whichever is more.

Explain, in words and graphically, how the financial crisis that started in the United States led to a worldwide flight to quality

There was a flight to quality across the world as well. Investors across the world were taking their funds out from the riskier debt markets to the safer debt markets. When the flight to quality is strong in the market, the funds flow out from the market of the rest of the world. The funds make their way to the market of the US Treasury which decreases the interest rate of treasuries. Borrowing costs for the rest of the world was shot up.