Unit 4

Reggie owns a convertible bond that converts into 20 shares of common stock. The current market value of the bond was 118½ at the close on Friday, April 1. A 30-day call is announced before the opening on Monday, April 4, at a price of 102. The stock is trading at $57.75. What should Reggie do? A) Convert the bond into the stock B) Redeem the bond at the call price C) Sell the bond D) Hold the bond to maturity

A) Convert the bond into the stock Reggie will not be allowed to hold the bond to maturity because it is being called. The real question is whether he should sell the bond, allow it to be called, or convert it to the underlying stock. Now that the call has been announced, the market value of the bond will fall to meet the call price. This occurs as a result of declining demand. (Who wants to buy a bond that is about to be called at a lower price?) Thus, redeeming the bond at the call price and selling the bond would both yield the same results: $1,000 × 102% = $1,020. If he converts the bond, he will get the following results: 20 shares × $57.75 = $1,155. Therefore, it makes the most sense to convert the bond.

Phantom income is a characteristic of: A) Zero-coupon bonds B) American depositary receipts C) Convertible bonds D) Preferred stock

A) Zero-coupon bonds Phantom income is the term used to describe income that is not received but is taxed. With zero-coupon bonds, the principal payoff at maturity represents receipt of the discount in lieu of periodic interest. However, each year, a portion of that discount is reported to the IRS on Form 1099 OID and is taxed as ordinary income unless the security is a municipal bond.

Rank the following from first to last in order of payment at liquidation of a corporation: General creditors Preferred stock Subordinated debentures Accrued taxes

Accrued taxes General creditors Subordinated debentures Preferred stock

If a mutual fund's objective is income, it would not hold which of the following securities in its portfolio? A) Corporate bonds B) Income bonds C) Preferred stock D) U.S. T-notes

B) Income bonds 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.

Regarding convertible debentures, one characteristic of which your clients should be aware of is that: A) They generally pay a higher interest rate than nonconvertible debentures B) They trade in line with the issuer's common stock once the conversion price is reached C) It is generally best to convert when the common stock is selling below its parity price D) The conversion feature protects against an early call

B) They trade in line with the issuer's common stock once the conversion price is reached The lower volatility of a convertible debenture stems from the fact that it has fixed interest payments and will be redeemed at maturity as any other bond or debenture would. No such guarantees apply to common stock.

An investor viewing a stock market video is particularly interested in the discussion of convertible debt securities. Those are issued by: A) Foreign governments B) The U.S. Treasury C) Corporations D) Municipalities

C) Corporations Convertible securities (debt or preferred stock) are always convertible into common stock. Therefore, they can only be issued by an entity that also issued common stock: a corporation.

An investor needing current income should not receive a recommendation to purchase: A) Convertible bonds B) Income (adjustment) bonds C) Zero-coupon bonds D) Callable bonds

C) Zero-coupon bonds Yes, income bonds only pay interest if the company earns enough to pay it. And yes, convertible bonds pay less than nonconvertible bonds. And the callable bond can be called away when interest rates fall. Nevertheless, the investor does expect some income. When it comes to the zero-coupon bond, there is absolutely no current interest paid, so that would be the least likely reccommendation here.

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

C) 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, the bondholder receives $1,300, a $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.

XYZ Corporation has outstanding a 7% convertible bond currently trading at 102. The bond, which has a conversion price of $50, was issued with an antidilution covenant. If XYZ declares a 10% stock dividend, the new conversion price, as of the ex-date, will be: A) $55.00 B) $55.55 C) $45.00 D) $45.45

D) $45.45 To compute a new conversion price, divide the current conversion price by 100% plus the percent increase in shares. $50 ÷ 110% = $45.45.D) $45.45

Which of the following would be the most likely unsuitable recommendation for a client whose objective is steady income? A) A bank CD B) A subordinated debenture C) A U.S. Treasury bond D) An income bond

D) An income bond

A 30-year corporate bond is quoted as QRS Zr 39. This quote tells an investor that the bond: A) Is backed by the U.S. government B) Pays interest annually C) Pays interest semiannually D) Pays no interest until maturity

D) Pays no interest until maturity The initials Zr in the bond quote indicate that this is a zero-coupon bond. Zero-coupon bonds pay all interest at maturity even though the investor is taxed annually as if he had been receiving interest over the life of the bond.

From first to last, in what order would claimants receive payment in the event of corporate bankruptcy? Holders of secured debt Holders of subordinated debentures General creditors Preferred stockholders

Holders of secured debt General creditors Holders of subordinated debentures Preferred stockholders

If LMN, Inc., files for bankruptcy, in what order would interested parties below be paid? Holders of secured debt Holders of subordinated debentures General creditors Preferred stockholders

Holders of secured debt General creditors Holders of subordinated debentures Preferred stockholders

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) $22.50 C) $45.45 D) $50.00

A) $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.

An investor purchased five bonds at 97⁵⁄₈ and sold them two years later at 102¼. This resulted in a gain of: A) $231.25 B) $248.13 C) $49.63 D) $46.25

A) $231.25 97 5/8 = $976.25 per bond (97 x 10 = 970) (5/8 = 6.25) (970 + 6.25 = 976.25) With FIVE bonds, that is a total of $4,881.25 (976.25 x 5 = 4,881.25) 102 1/4 = $1,022.50 per bond (102 x 10 = 1,020) (1/4 = $2.50) (1,020 + 2.50 = 1,022.50) With FIVE bonds, that is a total of $5,112.50 (1,022.50 x 5) $5,112.50 - $4,881.25 = $231.25

A convertible debenture callable at 101 is trading at 105. The debenture carries 4% coupon and is convertible at $25. The common stock is trading at $27. If an investor bought the debenture and converted, the profit would be: A) $30 B) $20 C) $40 D) $75

A) $30 Knowing that the debenture is convertible into 40 shares of common stock, with the current market price of that stock at $27 per share, those 40 shares could be sold for $1,080 (40 × $27). If the debenture can be purchased for $1,050 (105) and then converted into $1,080 worth of stock, the investor profits by $30. Please note that, as is the case with many calculation questions, there is information supplied that is totally irrelevant to solving the problem. In this question, the fact that the debenture is callable and pays interest at a rate of 4% has nothing to do with determining the investor's profit following the conditions given.

A corporation coming out of a bankruptcy proceeding would probably find it most attractive to issue: A) An income bond B) A subordinated debenture C) A promissory note D) A collateral trust certificate

A) An income bond Income (or adjustment) bonds carry the unique characteristic of requiring payment of interest only when the issuer's income is sufficient. They are used primarily for companies undergoing a financial restructuring, usually after a bankruptcy filing. Each of the other choices would require timely payment, and failure to do so could result in the company's failure.

There are many reasons to invest in a convertible bond. Which of the following is a reason to invest in a convertible bond? A) In a bearish equity market, convertible bonds would at least provide income and allow you to benefit from upside market movement if the equity market turns bullish later B) In a bearish equity market, convertible bonds provide growth potential in the underlying stock, and it might actually be cheaper to obtain the stock by converting the bond into stock rather than paying commissions when buying the common stock in the market C) Convertible bonds can be called in early if interest rates fall, allowing you to receive your principal back faster than waiting for the bond to mature D) Convertible bonds provide interest income that is stable, and the bonds are more marketable than nonconvertible bonds of the company that pay higher stated yields if you are seeking income

A) In a bearish equity market, convertible bonds would at least provide income and allow you to benefit from upside market movement if the equity market turns bullish later The chief benefit of convertible bonds is that they pay interest even when the underlying stock is down. But you can benefit from growth if the stock turns bullish later. Having bonds called in early is not a benefit because you will have reinvestment risk and have to reinvest the principal in a lower interest rate environment. Even though you would not pay commissions on the conversion of the bond into the stock, the conversion price is usually set higher than the market value of the stock and that worsens in a bearish market. Convertible bonds are more marketable, but if you are looking for income rather than trading the bonds, the yields are lower than the nonconvertible bonds, making them less attractive from an income viewpoint.

A large grocery chain owns smaller markets. A regional chain is experiencing hardship, and gets its debt downgraded by S&P's. The chain needs to raise capital to deal with a lack of cash flow. What method would be the best? A) regional chain should seek to get their parent company to support them through the issuance of guaranteed bonds which although unsecured would be safer than direct debenture of the struggling chain B) regional chain should issue high-yield corporate bonds to attract investors because they are safer than issuing stock to the investors if the company defaults C) regional chain should issue secured mortgage bonds to investors because the investors would be guaranteed to get their money back even if the regional chain defaults D) regional chain should issue preferred stock to the investors letting them know that preferred shareholders have a preference in liquidation above general creditors

A) regional chain should seek to get their parent company to support them through the issuance of guaranteed bonds which although unsecured would be safer than direct debenture of the struggling chain Although it is true that high yield (junk) bonds have a higher priority than stockholders in a default, it is not the best answer. Due to the fact the regional chain has a larger parent company, it would be more likely to raise capital through the parent company by the issuance of guaranteed debt which is actually unsecured but would normally have a higher credit rating than the distressed smaller company. Mortgage bonds, although secured, do not guarantee that investors would get back all their money as the underlying property might be distressed and be of lower value when liquidated.

ABC Company issued $20 million 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) 1,000,000 B) 500,000 C) 400,000 D) 600,000

B) 500,000 Each bond will convert to 25 shares of common stock ($1,000 ÷ $40). The company issued 20,000 bonds ($20,000,000 ÷ $1,000). Therefore, 500,000 additional shares (20,000 × 25) will be outstanding if all the bonds are converted.

A couple with a child who is six years away from entering college has saved $150,000 for that child's college tuition. Which of the following portfolio mixes would be the most suitable for meeting the investment objective? A) 20% T-bills, 10% corporate bonds, 70% equities and equity funds B) 70% Treasury STRIPS, 20% equities, 10% cash equivalents C) 85% corporate bonds, 15% Treasury STRIPS D) 30% investment grade corporate bonds, 70% equities

B) 70% Treasury STRIPS, 20% equities, 10% cash equivalents Treasury STRIPS - zero coupon bonds that are purchased at a discount and mature at face value - are a suitable investment for future, anticipated expenses such as college tuition when there is a relatively short time horizon. The equities are included to provide some inflation protection. The cash equivalents (money market instruments) add stability. The two choices with 70% equities are taking too much market risk, and the choice with only debt securities is subject to inflation risk.

Which of the following investments would be most likely to react to market events in a manner similar to common stock? A) Commercial paper B) A convertible debenture C) A preferred stock D) An income bond

B) A convertible debenture Because convertible securities (debentures or preferred stock) are convertible into common stock, it is typical for their price fluctuations to be similar to those of the underlying stock. In fact, some portfolio managers consider convertible debentures to be part of their allocation to equity rather than fixed income.

An investor wants to maximize income using debt securities. Which of the following lists rank securities from the least suitable to the most suitable recommendation if income is the investment objective? A) Treasury bills, convertible bond, income bond B) Income bond, convertible bond, nonconvertible bond C) Nonconvertible bond, convertible bond, income bond D) Convertible bond, income bond, nonconvertible bond

B) Income bond, convertible bond, nonconvertible bond Income/adjustment bond is least suitable because it is issued by companies coming out of bankruptcy with interest payable only if the money is available. A convertible bond has a lower coupon than a nonconvertible bond b/c of the convertibility feature. Therefore, if seeking to maximize income, the corporate bond would be the most suitable of the 3 choices.

A bond was issued three years ago with a coupon of 8%. The bond matures in four years and is callable at 108. Current market interest rates are 6%. Which of the following is true? A) The bond is selling at a discount B) The bond is selling at a premium C) The bond will be called D) The coupon will be adjusted

B) The bond is selling at a premium Simply, this is a bond where interest rates have gone down since it was issued. When interest rates go down, bond prices go up. Although the call feature can be beneficial when money is available to borrow at lower rates, the combination of the short term to maturity and the relatively high call price are unlikely to make it worth the underwriting expense. In any event, that is only a possibility, while the fact that the bond will be selling at a discount is a virtual certainty.

PDQ Corporation has a 6.25% $100 par value convertible preferred stock (conversion ratio of 4) outstanding. The stock has an antidilution covenant. If PDQ declares a 10% stock dividend, the antidilution covenant will adjust: A) the par to $110 B) the conversion price to approximately $22.73 C) the par to $90 D) the conversion price to approximately $27.50

B) the conversion price to approximately $22.73 When a $100 par value preferred stock is convertible into 4 shares of common stock, the conversion price is $25 per share ($100 ÷ 4 = $25). The antidilution covenant means the investors will have the same conversion rights after a stock split or stock dividend as they had before. After a 10% stock dividend, each share of preferred stock will be convertible into 4.4 shares (4 shares × 110% = 4.4). The par value of the preferred stock does not change. Divide that $100 par value by the new number of shares to get the new conversion price. It looks like this: $100 ÷ 4.4 = 22.73. Alternatively, you can divide the original conversion price of $25 by 110% arrive at the same answer.

Your recently retired client is looking to diversify a largely growth-oriented portfolio to create income to replace salary. Which of following would be the least suitable security to place into the portfolio? A) AA-rated public utility common stock B) AA-rated preferred stock C) AAA-rated zero-coupon corporate bonds D) A-rated mortgage bonds

C) AAA-rated zero-coupon corporate bonds Although the zero-coupon bonds have the highest rating of all, they are unsuitable for this investor because they provide no income; that is what the zero coupon means. Bonds, especially those with an A rating, will provide steady income, as will high-quality preferred stock and public utility common stock.

Which of the following debt instruments is unsecured? A) Collateral trust certificates B) Junior lien mortgage bonds C) AAA/AAA-rated debentures D) Equipment trust certificates

C) AAA/AAA-rated debentures Corporate debentures are unsecured bonds backed by the credit of the issuing corporation: they are not secured by underlying collateral.

If ABC Corporation reports a loss for the year, it is obligated to pay interest on all of the following except: A) Convertible bonds B) Variable-rate bonds C) Adjustment bonds D) Nonconvertible bonds

C) Adjustment bonds Even if a corporation reports a loss, the corporation is obligated to pay interest on all of its outstanding debt except for income (adjustment) bonds. Income/adjustment bonds require interest to be paid only if declared by the BOD.

If ABC Corporation reports a loss for the year, it is obligated to pay interest on all of the following debt securities except: A) Debentures B) Convertible bonds C) Income bonds D) Cumulative preferred stock

C) Income bonds Even if a corporation reports a loss, the corporation is obligated to pay interest on all its outstanding debt except for income (adjustment) bonds. Income bonds require payment of interest only if ABC has sufficient earnings, and the board of directors declares payment of the interest. Preferred stock is not a debt security.

For an investor concerned about loss of capital, one of the benefits of investing in a subordinated debenture is that, in the event of the issuer's bankruptcy, the investor: A) Has a claim behind preferred stockholders but ahead of common stockholders B) Is treated as a general creditor of the corporation C) Is treated as a creditor of the corporation D) Is considered a holder of senior debt

C) Is treated as a creditor of the corporation Subordinated debenture holders are the last in line of the creditors. Being subordinate to debentures, they follow the general creditors and are ahead of all equity (stock) holders. In a bankruptcy, secured creditors (senior debt), such as those with a mortgage against real property, have the first priority. They are followed by unsecured creditors, such as holders of debentures, with stockholders coming last.

An investor purchased a PQR convertible bond at 98 on June 18, 2023. The bond is convertible at $25 (40:1) on January 1, 2024. On June 20, 2024, when the common stock is trading at around $26 per share, the investor converted the bond into the company's common shares. For tax purposes, these transactions would most likely result in: A) Approximately a $40 capital gain B) Approximately a $60 capital gain C) Neither gain nor loss D) Approximately a $40 capital loss

C) Neither gain nor loss Converting a convertible bond into common stock is not a taxable event. When the stock is sold, the taxable event occurs.

Due to a sudden drop in earnings, the board of directors of Amalgamated Metal Industries (AMI) has voted to suspend all dividend payments this year. This would have the least effect on holders of AMI's: A) Callable preferred stock B) Cumulative preferred stock C) Subordinated debentures D) Senior claim preferred stock

C) Subordinated debentures Regardless of the level of seniority of a preferred stock, it comes behind any debt security. More importantly, interest on a debenture, subordinated or not, is a contractual obligation. Unlike the dividends on stock, the decision to pay or not to pay interest is not an optional one. Failure to pay interest on a debt security can lead to foreclosure and bankruptcy proceedings.

Convertible debentures offer which of the following benefits to investors? A) Highest priority in the event of dissolution B) Forced conversion when the underlying stock price increases C) The upside potential of a common stockholder with less downside risk D) A higher coupon rate than comparable non-convertible debt

C) 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. Many of these convertibles have a call feature. 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 a forced conversion and forces the investor in a debt security to own an equity security. Debentures have lower priority in dissolution than secured bonds.

A commonly used investment to provide a defined sum in the future, such as for college education or retirement, is: A) Common stock B) Convertible bonds C) Zero-coupon bonds D) Warrants

C) Zero-coupon bonds The key to this question is the defined sum. Zero-coupon bonds are usually purchased at a deep discount, which helps a small initial deposit grow into a substantial sum at maturity. Common stocks can't promise a specific sum when it is time for college. Warrants simply give the holder an opportunity to purchase the specified stock in the future; they have no defined value. Although convertible bonds with a maturity at the target date will provide the defined sum, the internal compounding of the zero-coupon bond will generally provide a higher return.

One of your customers owns 10 HBH Creations 4.5% convertible callable debentures. The conversion price into HBH common stock is $40. With the current market price of the HBH Creations stock at $44, the company publishes a notice that all of the debentures will be called in thirty days at a price of 104. When the customer calls for your advice, you would probably recommend: A) Selling the debenture B) Selling the stock C) Accepting the call D) Exercising the conversion privilege

D) Exercising the conversion privilege Generally, a corporation exercises the call privilege when the call price is below the parity price. With a current market price of the stock at $44 per share, the parity price of the debenture is 110 ($1,100). The effect of this call is that it, in essence, forces the investors to convert, and the issuer never has to pay off the debt. Let's take a look at the math here. With a conversion price of $40, a debt security with a par value of $1,000 is convertible into 25 shares ($1,000 ÷ 40). If the stock is currently selling at $44 per share and the investor could convert into 25 shares, it makes the conversion worth $1,100 (25 shares × $44 = $1,100). In our question, the call price is 104 ($1,040) so the question becomes, "What is a better deal for your customer: exercising the conversion privilege that gives the customer stock with a value of $1,100 or accepting the call worth $1,040?" Why not just sell the debentures? Because once the call at 104 has been issued, the price of the debentures will decline to approximately that level. Why not sell the stock? The investor doesn't own any stock until conversion, so there is nothing yet to sell.

Bondholders may not take action against the corporation if it fails to make interest payments for: A) Debentures B) Subordinated debentures C) Convertible bonds D) Income bonds

D) Income bonds Income bonds pay interest only if earnings are sufficient and declared by the board of directors. This is not true of any of the other fixed-income securities listed (debentures, subordinated debentures, or convertible bonds).

The market price of a convertible bond depends on all of the following except: A) The rating of the bond B) The value of the underlying stock into which the bond can be converted C) Current interest rates D) The conversion prices of bonds from similar companies

D) The conversion prices of bonds from similar companies A convertible bond's current market price will be impacted by the value of the underlying stock into which the bond can be converted, current interest rates, and the rating of the bond. Conversion prices are not set in competition; therefore, the conversion prices of similar bonds would be of no concern regarding price.

A convertible bond has a conversion price of $50 per share. If the market value of the bond rises to a 10-point premium over par, which of the following statements is true? A) The conversion ratio is 20:1 with parity price of the common stock at $60 B) The conversion ratio is 22:1 with parity price of the common stock at $55 C) The conversion ratio is 22:1 with parity price of the common stock at $60 D) The conversion ratio is 20:1 with parity price of the common stock at $55

D) The conversion ratio is 20:1 with parity price of the common stock at $55 Regardless of the price of the bond, the conversion ratio will always be 20:1 because $1,000 divided by $50 is 20. Parity means equal. Therefore if the bond is at a 10% premium ($1,100), the parity value of the stock will be $55 ($1,100 ÷ 20).

In active trading, a bond of standard size rises in price from 98 5/8 to 101¾. This represents a dollar change of: A) $31.25 B) $312.50 C) $3.125 D) $0.3125

A) $31.25 Remember that every point in a bond quote equals $10 and every 1/8 of a point equals $1.25 (10 / 8 = 1.25) Method 1: The increase is 3 1/8 points (101 3/4 - 98 5/8 = 3 1/8) 3 1/8 = $30 (3 x $10 per point) + $1.25 = 31.25 Method 2: 101 3/4 = 101 x $10 = $1,010 + 3/4 of $10 = $7.50, $1,017.50 total 98 5/8 = 98 x $10 = $980 + 5/8 of $10 = $6.25, $986.25 total $1,017.50 - $986.25 = $31.25

A customer owns a 7.5% ABC convertible bond currently trading at 115. The conversion price is $40. What is the parity price of the common? A) $46.00 B) $28.75 C) $44.00 D) $34.00

A) $46.00 What does parity price mean? Parity means that two securities are of equal dollar value (in this case, a convertible bond and the common stock into which it can be converted). The question is looking for the parity price of the common stock. That is the market price per share, where the total value of the stock received upon conversion equals the market price of the bond. There are two ways to do this. The first is generally the easiest to understand. We are told that the bond has a conversion price of $40. That means you can get 25 shares if you wish to convert. That is because the issuer is basically saying, "We owe you $1,000 and will let you spend it on our stock at $40 per share." Now that we know we can get 25 shares, what does each share have to be worth to equal $1,150? If you divide $1,150 by 25 shares, the result is $46. The other method to do this is as follows: The bond is selling at a 15% premium. To be equal to that, the stock must be selling at a 15% premium over the conversion price. $40 times 115% equals $46. If that makes sense to you, it is much faster than the first method

A customer purchased an ABC $3 convertible preferred stock at $60. The par value is $50 and the conversion price is $5. If the common stock is trading a half point below parity, the price of ABC common is: A) $5.50 B) $2.50 C) $4.50 D) $9.50

A) $5.50 The conversion ratio is computed by dividing par value by the conversion price ($50 par ÷ $5 = 10). Parity price of the common stock is computed by dividing the market price of the convertible by the conversion ratio ($60 ÷ 10 = $6). $6 − 0.50 = $5.50.

An investor seeking income combined with a conservative level of risk would purchase: A) AA-rated mortgage bonds B) Junk bonds C) Unrated income bonds D AAA-rated convertible debentures

A) AA-rated mortgage bonds The conservative level of risk eliminates the income bonds and the junk bonds. Income bonds pay interest only if the issuer has the funds to do so. Junk bonds are named such because of their high risk. Even though the convertible debentures have a higher rating than the mortgage bonds, the difference is relatively insignificant at that level and either would be suitable for the conservative investor. However, because of the convertible feature, it is always true on the exam that the income return is lower than non-convertible issues. Therefore, the most suitable for this investor would be the mortgage bonds.

Investors placing zero-coupon bonds in their portfolios are most likely to be looking to provide: (2 answers) A) Accumulation of capital B) Current income C) Protection against reinvestment risk D) Tax deferral

A) Accumulation of capital C) Protection against reinvestment risk Zero-coupon bonds are always purchased at a discount because they pay no interest. At maturity, the bondholders receive the maturity value. That represents the initial investment plus interest. Therefore, the investors are receiving more capital than invested (capital accumulation). They also avoid reinvestment risk because there are no periodic interest payments to be reinvested. When you purchase one of these securities, the quoted yield to maturity is exactly what you will earn if you hold it to the end. With no interest payments, there is no current income. There is no tax deferral with a zero. In fact, unless it is a zero-coupon municipal bond, there in phantom income: income not currently received but taxable.

A new technology company plans to raise capital and seeks the advice of V Investment Bank. Economic conditions are worsening, interest rates are rising, and the markets are bearish. According to the managing underwriter, the best strategy would be to: A) Issue convertible bonds to reduce the financing costs to the corporation but also attract investors who might see the possibility of getting growth when the equity markets rebound B) Issue corporate zero-coupon bonds at a discount because there would be no interest payments that need to be made, saving the corporation from paying interest on their debt C) Issue common stock because they would be attractive to investors in a bear market because of the value they represent D) Issue only preferred stock because investors would be attracted to the higher potential for dividends than are offered by common stock

A) Issue convertible bonds to reduce the financing costs to the corporation but also attract investors who might see the possibility of getting growth when the equity markets rebound First, we should look at this scenario from the perspective of the issuer and not the investors. Due to the high interest rate environment and the bearish sentiment of the equities market, it would be more difficult to raise capital by issuing equity securities. This is why in down markets offerings of equity securities get delayed or postponed. It would be easier to attract investor money by issuing debt because of the possibility of income for the investors. Zero coupon bonds would bot be a good choice b/c the new company would not raise as much capital b/c the bonds would be sold at a deep discount but the total debt liability of paying all the debt would remain on the balance sheet. Convertible bonds could be sold for par value, but the attractive feature of conversion to stock also reduced the interest financing costs to the new corporation as well while making them more marketable. Additionally, if the bonds eventually get converted to stock, the debt burden of the new and growing company would also be reduced. In theory, because the conversion price would also have been higher than the potential market price of the stock, the issuer would ultimately have sold the converted stock for more than what the stock would have been sold for in the bearish market.

An investor purchased 20 XYZ Corporation 6s convertible bonds for 97 that mature in 20 years. The bonds are convertible into 40 shares. However, three years after the purchase, the corporation declared a 20% stock dividend when the bond was trading for 105. Then six months later, the investor decided to convert the bonds which were then trading at 104 into stock and sell the common shares which are trading were parity. What is the capital gain or loss on the bonds and the conversion price of the shares? A) Long term capital gain of $1,400 and conversion price of $20.83 B) Short term capital gain of $1,400 and conversion price of $21.875 C) Short term capital loss of $2,000 and conversion price of $25.00 D) Long term capital gain of $2,000 and conversion price of $26.00

A) Long term capital gain of $1,400 and conversion price of $20.83 Holding periods of convertible securities are based on the original investment and not on when they get converted. The converted stock would have the same holding period as the original convertible bonds which is more than 3 years so the capital gain would be long term. The original conversion price of the bond was $25 because the conversion ratio was 40 shares ($1,000 par / 40 shares = $25). However, the original cost basis per share was based on the price paid for the bond, $970. Dividing by the 40 shares makes the original cost basis $25.24 per share (970 / 40 = 25.24). The 20% stock dividend increased the number of shares from 40 to 48 shares (40 x .20 = 8 + 40 = 48), but then the cost basis must be adjusted as well: $970 + 48 shares = $20.21 adjusted cost basis. The conversion price would be based upon par $1000 ÷ 48 shares = $20.83 conversion price. When the investor converted the bonds into stock, the market value of the bond was $1,040. To get the parity value of the common shares, divide the market value of the bond by the new conversion ratio: $1040 ÷ 48 shares = parity price per share of $21.67. Thus, the gain per share is $1.46 ($21.67 − $20.21). Multiply by the 48 shares per bond and then the 20 bonds so 960 × $1.46 is approximately $1,400.

DMF Company has $50 million of convertible bonds (convertible at $50) outstanding. The current market value of DMF's stock is $42. The bond indenture contains a nondilution feature. If DMF declares a 10% stock dividend, the new conversion price will be: A) Lower than $50 B) The stock's current market price C) Higher than $50 D) $50

A) Lower than $50 With an antidilution feature, the issuer will the issuer will increase the number of shares available upon conversion if the company declares a stock split or stock dividend. This means the bondholder must be able to convert it to more shares, which requires a lower conversion price.

ABC Corporation has an outstanding 8% convertible bond that is callable at 102. Currently, the bond is trading at 101. The conversion price is $40, and the common stock is currently trading at $39.50. ABC announces a call at 102. To realize the greatest profit, a bondholder should: A) Tender the bonds B) Sell the bonds at the current market price C) Continue to hold the bonds and receive interest payments D) Convert the bonds into common and sell the converted shares

A) Tender the bonds Selling the bond at its CMV of 101 is not an attractive option compared to the call price of 102. Converting the bond to common stock would result in 25 shares (1,000 par / 40 = 25 shares) sold at $39.50 per share would get the investor $987.50 (39.50 x 25 = 987.50). Tendering the bonds yields the most profit.

A customer purchased 10 ABC 9s of 2045 convertible debentures at 99. The debentures are callable at 101. The conversion ratio is 40. Some time later, the debentures are called while the common is trading at $24 and the debenture is trading at 98. Which of the following options would be most beneficial to the customer? A) Tender the bonds to the corporation B) Wait for a better offer from the corporation C) Sell the bonds D) Convert the bonds and sell the common stock

A) Tender the bonds to the corporation First of all, recognize that the investor purchased 10 of the debentures. They have a coupon of 9% and mature in 2045. None of that is relevant to answering the question, but we want to be sure you understand the terminology.The option most beneficial to the investor is tendering the debentures to the corporation for $10,100 (10 × $1,010). If the debentures were sold on the market, the investor would receive $9,800 (10 × $980). If the debentures were converted into common, the investor would receive 400 common shares (40 shares per debenture × 10) that could be sold for their current price of $24, for a total of $9,600.

A corporation has an outstanding issue of 8% convertible debentures with a conversion price of $25. The bond indenture contains an antidilutive clause guaranteeing the debt holders the right to maintain proportionate equity conversion in the corporation. If the company pays a 10% stock dividend to its common shareholders, how will that affect the debenture holders? A) The bonds will now be convertible at approximately 22.73 B) The interest rate on the debentures will increase to 8.8% C) They will receive four shares of the common stock D) Each debenture holder will receive a check for $100

A) The bonds will now be convertible at approximately 22.73 The antidilutive provision means the debenture holders will be able to convert into an equivalent share value as before. With a conversion price of $25, the bond is convertible into 40 shares ($1,000 ÷ $25 =40). After the 10% stock dividend, they should be able to have 10% more shares, or 44 shares. That means the conversion price must be reduced. Divide $1,000 by 44 shares and the result is $22.73. Remember, anytime there is a stock dividend, prices go down.

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 conversion price will be adjusted to $9.09 B) The investor will receive 1 share of the common stock C) The investor will receive 10 shares of the common stock D) The conversion price will be adjusted to $11.00

A) The conversion price will be adjusted to $9.09 You can assume that any convertible security on the exam will have an anti-dilutive provision. That means that a stock dividend or a 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 / $10 = 100). 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 / 110 = $9.09 per share.

Libby sees a tombstone advertisement for a new issue of Southwest Barge subordinated convertible debentures. The bonds will carry an 7¼% coupon, are convertible into common stock at $10.50, and are being issued to the public at 100. The proceeds of the issue will be used specifically for purchasing new Southwest barges. Libby's concerns about the issue could include which of the following? A) The issue may have a junior claim to another security issue B) The company might demand that she accept common stock for her bond C) She should not be concerned, as the bonds will be first in liquidation D) The new barges might sink, and the collateral would be gone

A) The issue may have a junior claim to another security issue The word subordinated is the key to the question. A subordinated bond has other debt holders ahead of it in the event of liquidation. The barges do not serve as collateral, as the bonds are identified as debentures, and having to convert to common stock is not a threat because she is the one that will, if she desires, exercise the conversion privilege.

Which of the following statements regarding corporate debentures are true? (2 answers) A) They are certificates of indebtedness B) They give the bondholder ownership in the corporation C) They are unsecured bonds issued to finance capital expenditures or raise working capital D) They are the most senior security a corporation can issue

A) They are certificates of indebtedness C) They are unsecured bonds issued to finance capital expenditures or raise working capital Debentures are debt securities that represent unsecured loans of the issuer. They are senior to common and preferred stock in claims against an issuer. They are used to finance capital expenditures or raise working capital.

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) Want the assurance of a guaranteed dividend on the underlying common stock C) Seek to minimize changes in the bond price during periods of steady interest rates D) Be interested in tax advantages available to convertible debt securities

A) Want the safety of a fixed-income investment along with potential capital appreciation 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 purchased a zero-coupon corporate bond on the offering. The price was $520, and the bond matures in 12 years. Ten years after the purchase, the investor sold the bond for $945. For tax purposes, the investor will report: A) a $25 long-term capital gain B) a $425 long-term capital gain C) $425 in ordinary income D) a $55 long-term capital loss

A) a $25 long-term capital gain The discount on zero-coupon bonds must be amortized over the life of the bond. In this question, the $480 discount ($1,000 minus the purchase price of $520) is amortized at a rate of $40 per year ($480 divided by 12 years). That $40 per year is reported as ordinary income even though nothing was received by the investor. That is why it is called phantom income. If the bond is sold before maturity, the accreted value is compared with the sale price. If the sale price is higher, the difference is capital gain. If it is lower, it is capital loss. After 10 years, the accreted value is $920 ($40 per year times 10 years = $400 added to the initial $520). The sale price of $945 exceeds the cost basis of $920 by $25, and that is a long-term capital gain.

One of your customers owns five JLO 5s of 2042. The debentures have a conversion price of $15. When the market price of the convertible is 80, the parity price of the stock is: A) $15.00 B) $12.00 C) $18.00 D) $5.33

B) $12.00 A debenture with a conversion price of $15 is convertible into 66.66 shares ($1,000 ÷ $15). It is always the par value that is used, not the market price. To determine the parity price of the stock, divide the current market price of $800 by 66.66 and the answer rounds off to $12. Some students find it easier to recognize that the bond is 20% below its par value. To be equal (and that is what parity means), the stock must be 20% below the $15 conversion price (or 80% of it). Reducing $15 by 20% is a $3 reduction to $12 or taking 80% of $15 equals $12.

A customer purchased 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: A) $18 B) $14 C) $16 D) $12

B) $14 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 again be $16 minus $2 or $14.

A convertible corporate bond with a conversion price of $20 is trading at 115. The parity price of the common stock is: A) $26 B) $23 C) $17 D) $20

B) $23 A conversion price of $20 means the conversion ratio is 50 (i.e., each bond can be converted into 50 shares of common stock). $1,150 ÷ 50 = $23 parity price.

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: A) $40.00 B) $25.25 C) $25.00 D) $43.91

B) $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).

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) $40 B) $48 C) $32 D) $42

B) $48 The math is as follows: $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 ÷ 25 shares = $40 + 20% = $48.

A bond convertible at $50 is selling at 105% of parity, while the common stock has a current market value of $45. What is the market value of the bond? A) $1,045 B) $945 C) $900 D) $1,000

B) $945 When a bond is convertible at $50, it means the holder can exchange each $1,000 par value bond for the company's common stock at a rate of $50 per share. Dividing $1,000 (always use the par value, not the market value) by $50 results in a conversion rate of 20 shares per bond. With the bond convertible into 20 shares and the market price of each share currently $45, the parity price, the price at which the value of the stock and the bond are the same, is $900, (20 × $45). The question tells us that the bond is selling for 105% of the parity price. That would be $900 × 105% = $945. An alternative method is to recognize that the stock is selling for 10% below its conversion price ($45 is $5 less than $50 and $5 ÷ $50 = 10%). That means the parity price of the bond must be 10% below the par value, or $900 (which is 10% less than $1,000). Once you have the $900, multiply by 105% to arrive at the correct answer of $945.

An investor owns 10 ABC 6s of 2045. The debentures have a conversion price of $50 with an anti-dilution provision. After ABC distributes a 20% stock dividend, the investor's position will be: A) 12 ABC 6s of 2045 with conversion price of $50 B) 10 ABC 6s of 2045 with a conversion price of $41.67 C) 10 ABC 6s of 2045 convertible into 16.67 shares D) 10 ABC 6s of 2045 convertible into 20 shares plus forty additional shares

B) 10 ABC 6s of 2045 with a conversion price of $41.67 This question deals with the anti-dilution provisions of a convertible security. When there is a stock dividend or stock split, the holder of the convertible stock maintains the same equity proportion as before. With a conversion price of $50, the debenture is convertible into 20 shares ($1,000 / $50). After a 20% stock dividend, the holder should be able to acquire 20% more shares. That makes the security convertible into 24 shares (20 shares x .20 = 4 more shares). Divide the $1,000 par value by 24 shares and the conversion price is now $41.67 (1,000 / 24 = 41.67).

Which of the following quotes would not be considered a corporate bond quote? A) A bond is quoted at 96 ¾ maturing in 2029 B) A bond is quoted at 104 3/32 maturing in 2037 C) A bond is quoted at 103.16 zr maturing in 2040 D) A bond is quoted at 103 8s maturing in 2034

B) A bond is quoted at 104 3/32 maturing in 2037 Corporate bonds can be quoted in decimals or fractions. However, both corporate and municipal bonds would use fractions based upon eighths. Direct debt of the U.S. government can also use fractions. The difference is that U.S. government debt is based upon 32nds. Also note that when you see what looks like a decimal notation in U.S. government debt, it is actually based upon 32nds as well.

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? A) Convert the preferred into the common at the stated conversion rate B) Accept the call at $82 C) Sell the preferred stock D) Hold on to the preferred stock

B) Accept the call at $82 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 worth $18 each or a total of $72 for each share of preferred converted. That being the case, the investor's decision is to convert and have stock worth $7,200 (remember, there are 100 shares of the preferred, each convertible into 4 shares of the common) or 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.

Which of the following would be most likely to issue an equipment trust certificate? A) A company using specialized equipment on an oil drilling rig B) An airline company C) A social media company installing new servers D) A user of farming equipment

B) An airline company When you see "equipment trust certificate," think transportation companies such as airlines and railroads.

Which of the following corporate bonds is backed by other securities? A) Mortgage bond B) Collateral trust bond C) Equipment trust certificate D) Debenture

B) Collateral trust bond Collateral trust bonds are backed by a portfolio of other securities, while mortgage bonds are backed by real estate. Equipment trust certificates are backed by equipment, while debentures are backed only by the company's promise to pay.

Betco Corporation had insufficient liquidity to meet its outstanding debt and was subsequently forced into bankruptcy. There were numerous lawsuits from all of the various creditors and investors against the corporation. Finally, a court settlement was reached to dissolve the company and use the remaining assets to pay off the creditors. Who most likely has the highest priority of getting paid? A) The secured creditors because secured debt is always the most senior security B) The attorneys representing the plaintiffs in the lawsuits against the bankrupt company C) Investors holding guaranteed bonds because guaranteed bonds provide an ironclad guarantee that the investors always get back the principal amount invested D) The senior executives of the corporation because being senior executives gives them the most senior claim to corporate assets

B) The attorneys representing the plaintiffs in the lawsuits against the bankrupt company Normally, secured debt would have the highest claim. However, when legal issues involve judicial suits, those involved in resolving the bankruptcy would not work on the case unless they would get paid. As a result, the courts usually require administrative expenses to be paid prior to even the secured creditors. Guaranteed bonds are still a form of unsecured debt and would not have seniority over secured debt. Executives of the company would only have claims based upon unpaid compensation and in most cases, they would tend to fall under general creditor status.

Which of the following statements regarding corporate zero coupon bonds are true? (2 answers) A) Interest is paid semiannually B) The discount is in lieu of periodic interest payments C) The discount must be accreted and is taxed annually D) The discount must be accreted annually with taxation deferred until maturity

B) The discount is in lieu of periodic interest payments C) The discount must be accreted and is taxed annually 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.

An investor purchases zero-coupon bonds issued by the U.S. Treasury due to mature in 18 years at $100,000. Which of the following might describe the primary reason for selecting that investment vehicle? (2 answers) A) The investor is 65 years old and needs the reliability of current income B) The investor is 45 years old and has purchased these in an IRA rollover account and wants the assurance of funds for retirement C) The investor is 30 years old and has a newborn child and wishes to assure funds for a college education D) The investor is 20 years old, has just received an inheritance, and wishes to shelter income for as long as possible

B) The investor is 45 years old and has purchased these in an IRA rollover account and wants the assurance of funds for retirement C) The investor is 30 years old and has a newborn child and wishes to assure funds for a college education Zero-coupon bonds maturing in 18 years would assure the 45 year old of the face value at age 63. Being in an IRA, there would be no current taxation, and upon maturity, if desired, the funds could be distributed without the 10% penalty. Zero-coupon bonds are one way to guarantee funds for college education. However, with no current income, they would not be suitable for the 65 year old and would not offer any tax shelter to the 20 year old.

All the following statements concerning zero-coupon bonds are true except: A) Zero-coupon bonds pay no interest during the life of the bond B) Zero-coupon bond prices are more stable than other types of bonds C) Zero coupon bonds are most often issued with long-term maturities D) Zero-coupon bonds may be issued by the U.S. Treasury, corporations, and state and local governments

B) Zero-coupon bond prices are more stable than other types of bonds Zero-coupon bonds pay no interest during the life of the bond. Rather, investors purchase zeroes at a deep discount from par. The difference between the discounted price and the maturity value is the interest the investor receives from the bond. In other words, zeros pay no interest until maturity. The effect of this is that their prices fluctuate more than other types of bonds when traded on the secondary market. Investors typically pay income tax on the phantom interest as it accrues each year.

ABC Corporation has issued a convertible preferred stock with a par value of $100. The stock is convertible at $40. The current market price of the preferred stock is $80. It would be correct to state that the conversion ratio is: A) 4:10 B) 2:1 C) 2.5:1 D) 4:5

C) 2.5:1 When a $100 par preferred has a conversion price of $40, the stockholder can convert into 2.5 shares. That is a 2.5:1 ratio. The current market price of the stock is only relevant if the question asks about the parity price (which is $32). As a refresher, the parity price is that market price where the value of the shares received on conversion is equal to (at parity with) the market price of the convertible security. With the preferred stock selling at $80 per share and being convertible into 2.5 common shares, when the market price of the common is $32 ($80 ÷ 2.5) we have parity because 2.5 times $32 = $80.

Under what circumstances will a dilution of equity occur? A) Issue of mortgage bonds to replace debentures B) Stock dividend C) Conversion of convertible bonds into common stocks D) Stock split

C) 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.

With a bearish outlook on the market, an investor would like to purchase something that will generate income now during current bearish conditions but would also be able to take advantage of capital appreciation should market sentiment turn bullish. Which of the following would be a suitable purchase recommendation that puts the investor in a position to do both? A) Nonconvertible bonds B) Common stock C) Convertible bonds D) Cumulative preferred stocks

C) Convertible bonds A convertible bond would generate income from interest payments during the bear market, but if market sentiment becomes bullish, the bond can be converted into common stock, taking advantage of the change in market conditions. None of the other choices could fulfill both of these investment objectives.

Which of the following statements regarding convertible bonds is not true? A) 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 B) Coupon rates are usually lower than nonconvertible bond rates of the same issuer C) Coupon rates are usually higher than nonconvertible bond rates of the same issuer D) Convertible bondholders are creditors of the corporation

C) 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.

Incandescent Bulb, Inc., recently suffered significant operating losses and is planning a bankruptcy filing. Which of the following debt issues have the most junior claim? A) Common stock B) Mortgage bonds C) Debentures D) Senior notes

C) Debentures Although the most junior claim of all is that of the common stockholder (equity), this question is about the priority of debt issues. In that case, the most junior (last in line) of the creditors are the holders of the company's debentures

What action could a corporation take that would result in the forced conversion of an outstanding convertible debt security? A) Reduce the coupon rate below the dividend rate on the common stock B) Exercise the conversion feature when the debt security's conversion value exceeds the call price C) Exercise the call feature when the debt security's conversion value exceeds the call price D) Reduce the dividends on the common stock to a rate lower than the interest on the debt security

C) Exercise the call feature when the debt security's conversion value exceeds the call price

An investor purchased a corporate zero-coupon bond on the offering at a price of 51. The bond matures in 17 years and has a yield to maturity of 4.04%. Seven years later, the bond is sold at a price of 73 ¾. What are the tax consequences of the sale? A) No gain or loss until maturity B) Loss of $262.50 C) Gain of $25.76 D) Gain of 227.50

C) Gain of $25.76 The amount of the discount is $490 ($1,000 - $510). This must be accreted over the 17 years until maturity. The annual accretion is $28.82 ($490 / 17 years). After 7 years, there is $201.74 of accretion (7 years x $28.82 = $201.74). Because the annual accretion is added to the investor's cost basis, the basis is now $711.74 ($510 + $201.74). The bond's sale price of $737.50 is $25.76 above the accreted basis (737.50 - 25.76), so the investor realized a gain of $25.76 from the sale. YTM has nothing to do with the question.

Corporate bonds that are guaranteed are: A) Insured by Assured Guaranty Corporation B) Required to maintain a self-liquidating sinking or surplus fund C) Guaranteed as to payment of principal and interest by another corporation D) Guaranteed as to payment of principal and interest by the U.S. government

C) Guaranteed as to payment of principal and interest by another corporation A guaranteed corporate bond is one guaranteed by another corporation that typically has a higher credit rating than the issuing corporation and is in a control relationship with it.

All of the following statements regarding convertible bonds are true except: A) Holders receive a fixed interest rate B) Holders may share in the growth of the common stock C) Holders receive a higher interest rate D) The issuer pays a lower interest rate

C) Holders receive a higher interest rate Because of the possibility of participating in the growth of the common stock through an increase in the market price of the common, the convertible can be issued with a lower interest rate. The interest rate on a convertible, just as with any other fixed income security, does not change.

You have a client who is about to retire and wants to rearrange his portfolio to have predictable income. Which of the following would not be a good investment vehicle? A) U.S. Treasury note B) AA-rated IDB C) Income bonds D) AA-rated debenture

C) Income bonds Income bonds, also known as adjustment bonds, are issued when a company is reorganizing and coming out of bankruptcy. Income bonds pay interest only if the company has enough income to meet the interest payment. As a result, these bonds normally trade flat without accrued interest. Therefore, they are not suitable for customers seeking income.

Which the following statements concerning taxes on corporate bonds is true? A) Bonds held to maturity can only have long-term capital gains B) Bonds are always considered long term so it is impossible to have short term capital gains when purchasing bonds C) Interest income from a corporate bond is taxed based upon ordinary income rates only D) Short term capital gains on bonds derive from the interest income because the interest is always paid out twice in a year

C) 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 purchased a zero-coupon corporate bond on the initial offering. The price was 50. The bond's maturity date is in 10 years. At maturity, this investor will have: A) $500 in taxable income and no capital gain B) A combination of taxable income and capital gain based on IRS tables C) No taxable capital gain D) No taxable income and a $500 long-term capital gain

C) No taxable capital gain On a corporate zero-coupon bond, investors must accrete the interest on an annual basis. Investors receive a form 1099-OID indicating the amount of taxable accretion earned for the year. This is known as phantom income because it is taxed, but not received. This phantom income is one of the reasons why these bonds are favored for tax-sheltered accounts, such as IRAs. Because all the interest has been accreted, when the bond matures, there is no capital gain or loss.

A corporation with an outstanding convertible debenture issue could force conversion by: A) Soliciting proxies from the common shareholders asking them to vote for mandatory conversion B) Decreasing the coupon rate on the debenture to a level where the dividend on the common stock provides a higher return C) Publishing an announcement that the debenture holders have thirty days to tender their bonds at the call price D) Issuing new debentures with a higher coupon rate

C) Publishing an announcement that the debenture holders have thirty days to tender their bonds at the call price Most convertible debt securities are callable, usually at a price slightly above the par value. When the price of the underlying common stock rises to a point where the converted value of the bond is worth more than the par value, issuers will frequently exercise their call privilege. Because the call price is usually significantly less than the converted value, it is only common sense that the debenture holders will exercise their conversion privilege. 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 x $25 per share). By calling the bonds at the stated call price, perhaps 102 or 103, the company can force the bondholders to convert the bonds. Using our example, why would investors hold on to 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 a forced conversion. Shareholders do not vote on a management decision to call in debt. The coupon rate on the debenture is fixed, the issuer does not have the ability to change it.

Joe Johnson is a founding partner of Ground Break Realty. The company was impacted negatively by rising interest rates and falling property values. There was concern that the firm needed an injection of liquidity to prevent failure, and Johnson lent the company funds to forestall bankruptcy. If the company goes bankrupt, Johnson will: A) Receive his money after the secured creditors but before the holders of standard debentures B) Not receive any money back because he is an owner of the company, and the loaned money is considered equity (the money represents an equity interest in the company) C) Receive his loaned money before any of the equity investors in the company D) Receive his loaned money first over any other investor because he is a founder of the company

C) Receive his loaned money before any of the equity investors in the company It is not uncommon for founders of companies to lend money to the business the keep the company going. However, this is typically subordinated debt. Subordinated debt has priority over equity investors but goes behind all other creditors including unsecured debt such as debentures.

With the advent of the horseless carriage (a.k.a. the automobile), the Acme Buggy Whip Corporation's revenues fell to the point where it could no longer cover expenses. This led to an involuntary bankruptcy. The priority of payout was: A) Common stock, preferred stock, general creditors, senior notes B) Senior notes, preferred stock, common stock, general creditors C) Senior notes, general creditors, preferred stock, common stock D) General creditors, senior notes, preferred stock, common stock

C) Senior notes, general creditors, preferred stock, common stock Senior debt refers to obligations that have priority in the event of default. It parallels the use of senior when comparing preferred stock to common stock, the most junior of all the 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 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 a $400 long-term capital gain C) There is no reported capital gain D) $400 is reported as ordinary income

C) There is no reported capital gain

An investor interested in acquiring a convertible bond as part of her investment portfolio would: A) Want the assurance of a guaranteed dividend on the underlying common stock B) Seek to minimize changes in the bond price during periods of steady interest rates C) Want the safety of a fixed-income investment along with potential capital appreciation D) Be interested in tax advantages available to convertible debt securities

C) Want the safety of a fixed-income investment along with potential capital appreciation 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 calls an agent at New England Investment Brokers and Advisors and asks about the tax implications of various bond choices. The investor has a long-term objective and wants steady income but does not want to pay taxes on the income. The investor heard that zero-coupon bonds have no taxable income. The agent may tell the investor all the following except: A) The client should consider municipal bonds if they are in a high tax bracket B) Zero-coupon bonds are not a good choice because they have phantom income which accretes the value of the bond but does not actually get distributed to the investor as income every year C) Zero-coupon bonds are not a good choice because they are taxed on a large capital gain at maturity D) Zero-coupon bonds have no income payment but are actually taxable every year

C) Zero-coupon bonds are not a good choice because they are taxed on a large capital gain at maturity This is a false statement. Zero-coupon bonds accrete in value every year. The accretion does not get paid out as actual income. However, this phantom income is actually taxed every year as ordinary income. Zero coupons held to maturity have no capital gains because the bond was not traded.

An investor purchased a new issue corporate zero-coupon bond for $600. The bond has a maturity of 20 years. Six years later, the investor sells the bond for $700. For tax purposes, this would result in: A) a capital gain of $20 B) a capital gain of $100 C) a capital loss of $20 D) a capital loss of $280

C) a capital loss of $20 The $400 discount is accreted over the 20 years to maturity. That is an annual accretion of $20. After 6 years, that is $120, making the tax basis of the bond $720. Because the sale at $700 is $20 less than the basis, the investor has a long-term capital loss.

When analyzing a convertible debt security, it is most likely the issue is: A) a convertible preferred stock B) a zero-coupon security C) a debenture D) a bond

C) a debenture We are being very picky with the wording here. The most specific response is a debenture. In most cases, convertible debt issues are unsecured. That defines them as debentures. Note that preferred stock is not a debt security; it is equity.

A convertible debenture has a conversion price of $40 per share. If the market value of the debenture rises to a 12.5-point premium over par, which of the following are true? (2 answers) Conversion ratio is 25:1 Conversion ratio is 28:1 Parity price of the common stock is $42 Parity price of the common stock is $45

Conversion ratio is 25:1 Parity price of the common stock is $45 The conversion ratio is computed by dividing par value by the conversion price ($1,000 par / $40 = 25). The next step is calculating the market price of the debenture. A 12.5% premium to par means the market price is 112.5% of the $1,000 par. That computes to $1,125 (1,000 x 0.125 = 125 +1,000 = $1,125). Parity price of the common stock is computed by dividing the market price of the convertible debenture by the conversion ratio ($1,125 / 25 = $45).

Which of the following is not considered a debt security? A) Promissory note B) Equipment trust certificate C) Debenture D) Prior lien preferred stock

D) Prior lien preferred stock Stock, whether preferred or common, represents equity (ownership) and is never considered a debt security. The most common example of a promissory note on the exam is commercial paper, a money market instrument. Debentures represent an unsecured debt of the issuer. Equipment trust certificates represent debt secured by specific equipment, typically rolling stock.

A company was unable to keep up with modern times and has not been profitable for many years, which led to the company defaulting on their debt. The company negotiated to restructure their debt as an income bond to relieve them of paying interest until the company can become profitable again. Bondholders of the income bond would: A) Be guaranteed that the company will pay back the entire principal at maturity but not the missed interest payments while they were not profitable B) Finally receive interest income only when the company is profitable and has net income that can meet the interest payments C) Receive all past interest payments that were not paid while the company struggled to return to profitability D) Receive interest payments when the board of directors declares a payment after the company has income that can meet the interest payment

D) Receive interest payments when the board of directors declares a payment after the company has income that can meet the interest payment Income bonds are received after the company has suffered severe financial reverses so that they need to restructure the debt. To prevent the company from failing, the creditors will not receive interest on the debt while the company is not profitable. Hopefully the company will return to profitability. When it does have enough income to pay the interest, it will start paying interest, but first the board of directors must declare that it will pay. Profitability alone does not determine that the company will pay the interest. Additionally, all the past missed payments will not be paid back because these bonds trade flat, without the accrued interest payments. Furthermore, there is no guarantee the company will ever survive to pay back the principal.

AmpVolt, Inc., is facing competition in the EV transportation sector as the larger automobile companies develop attractive products that greatly dilute the market share of AmpVolt common stock. AmpVolt files for bankruptcy. As a result: A) Preferred stock shareholders have priority above all other investments B) The company's common shareholders would be guaranteed the par value of the shares C) The company's mezzanine financing has the highest priority in the liquidation of assets D) The company's collateral trust certificates would have a higher claim on residual assets at the liquidation of the company than the common stock shareholder

D) The company's collateral trust certificates would have a higher claim on residual assets at the liquidation of the company than the common stock shareholder Collateral trust certificates are a type of secured debt and would have priority over other equity securities. The par value of common stock is never guaranteed.

ABC Corporation has outstanding a 7.75% convertible debenture currently trading at 102. The bond is convertible into common stock at $40. ABC stock is trading $45 per share. Which of the following statements is true? A) The bond is at parity with the stock B) To profit in this situation, the investor should buy the stock and short the bonds C) An arbitrage opportunity does not exist in this situation D) To profit in this situation, the investor should buy the bonds and short the stock

D) To profit in this situation, the investor should buy the bonds and short the stock With a conversion price of $40, the bond is convertible into 25 shares of ABC common stock ($1,000 ÷ $40 = 25 shares). As the common stock is currently trading at $45 per share, the value of the stock as converted would be $1,125 (25 shares × $45 = $1,125), which is greater than the current price of the bond ($1,020). Therefore, the bond and the stock are not at parity. An investor could profit in this situation by shorting the stock and buying an equivalent number of bonds. A bond could be purchased for $1,020 and immediately converted into stock worth $1,125, a risk-free profit opportunity.

Equipment trust certificates are commonly issued by: A) The U.S. government B) Political subdivisions C) Utilities D) Transportation companies

D) Transportation companies Equipment trust certificates are corporate bonds commonly issued by transportation companies such as railroads and airlines. These bonds are backed by equipment (ex: aircraft) the issuer uses in their business.

Which of the following best describes a debenture? A) A long-term corporate debt obligation with a claim against securities rather than against physical assets B) An investment in the debt of another corporate party C) A corporate debt obligation that allows the holder to purchase shares of the company's common stock at specified dates before maturity D) Unsecured corporate debt

D) Unsecured corporate debt

Zero-coupon bonds are most commonly used: A) To provide a defined income B) To defer taxes C) When low volatility is the objective D) When a stated sum is required at a future date

D) When a stated sum is required at a future date Zero-coupon bonds are usually purchased at a deep discount. This means that a small initial deposit grows into a substantial sum at maturity. This is an advantage for those with a specific target amount at a specific date. Examples would be saving for higher education or a condo in retirement. There is no deferral of taxes. Worse than that, unless the bonds are held in a tax-qualified account, there is phantom income. Phantom income is the annual accrued income that is taxable, but is not received. It is the principal that is defined, not the income. All other things being equal, zero-coupon bonds have the highest volatility.

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

D) Zero-coupon bonds Zero-coupon bonds make no payment until maturity, and therefore, would not be suitable investments for those with an income objective. Typically, preferred shares (because of the fixed dividend they pay) and corporate or government securities, which make interest payments, would be suitable investments to meet an income objective.

An investor purchased a new issue corporate zero-coupon bond for $600. The bond has a maturity of 20 years. Six years later, the investor sells the bond for $740. For tax purposes, this would result in: A) a capital loss of $280 B) a capital gain of $100 C) a capital loss of $20 D) a capital gain of $20

D) a capital gain of $20 The $400 discount is accreted over the 20 years to maturity. That is an annual accretion of $20. After 6 years, that is $120, making the tax basis of the bond $720. Because the sale at $740 is $20 more than the basis, the investor has a long-term capital gain.

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) a long-term capital gain of $160 B) no gain and no loss C) a long-term capital loss of $200 D) a long-term capital loss of $40

D) a long-term capital loss of $40 This question deals with accretion of the discount. The discount here is $360 ($1,000 maturity - $640 paid = $360). With 9 years until maturity, the annual accretion is $360 / 9, which is $40 per year. After 5 years, the bond's basis has increased by $200 (40 x 5 = 200) ($640 paid + $200 = 840). The sale at $800 represents a long-term loss of $40.