4.1 Bonds Flashcards
Advantages of bonds
Issuer’s perspective
* Interest is tax deductible
* No control given up
Disadvantages of bonds
- Payment of interest and principal is legal obligation
- Increased risk
- Amount of debt financing is limited.
The call provision in some bond indentures allows
A. The issuer to exercise an option to redeem the bonds.
B. The bondholder to exchange the bond, at no additional cost, for common shares.
C. The bondholder to redeem the bond early by paying a call premium.
D. The issuer to pay a premium in order to prevent bondholders from redeeming bonds.
A. The issuer to exercise an option to redeem the bonds.
Serial bonds are attractive to investors because
A. All bonds in the issue mature on the same date.
B. The yield to maturity is the same for all bonds in the issue.
C. Investors can choose the maturity that suits their financial needs.
D. The coupon rate on these bonds is adjusted to the maturity date.
C. Investors can choose the maturity that suits their financial needs.
Serial bonds have staggered maturities; that is, they mature over a period (series) of years. Thus, investors can choose the maturity date that meets their investment needs. For example, an investor who will have a child starting college in 16 years can choose bonds that mature in 16 years.
Short-term interest rates are
A. Usually lower than long-term rates.
B. Usually higher than long-term rates.
C. Lower than long-term rates during periods of high inflation only.
D. Not significantly related to long-term rates.
A. Usually lower than long-term rates.
Historically, one facet of the term structure of interest rates (the relationship of yield and time to maturity) is that short-term interest rates have ordinarily been lower than long-term rates. One reason is that less risk is involved in the short run. Moreover, future expectations concerning interest rates affect the term structure. Most economists believe that a long-term interest rate is an average of future expected short-term interest rates. For this reason, the yield curve will slope upward if future rates are expected to rise, downward if interest rates are anticipated to fall, and remain flat if investors think the rate is stable. Future inflation is incorporated into this relationship. Another consideration is liquidity preference: Investors in an uncertain world will accept lower rates on short-term investments because of their greater liquidity, whereas business debtors often prefer to pay higher rates on long-term debt to avoid the hazards of short-term maturities.
All of the following may reduce the coupon rate on a bond issued at par except a
A. Sinking fund.
B. Call provision.
C. Change in rating from AA to AAA.
D. Conversion option.
B. Call provision.
A bond issued at par may carry a lower coupon rate than other similar bonds in the market if it has some feature that makes it more attractive to investors. For example, a sinking fund reduces default risk. Hence, investors may require a lower risk premium and be willing to accept a lower coupon rate. Other features attractive to investors include covenants in the bond indenture that restrict risky undertakings by the issuer and an option to convert the debt instruments to equity securities. The opportunity to profit from appreciation of the firm’s stock justifies a lower coupon rate. An improvement in a bond’s rating from AA to AAA (the highest possible) also justifies reduction in the risk premium and a lower coupon rate. However, a call provision is usually undesirable to investors. The issuer may take advantage of a decline in interest rates to recall the bond and stop paying interest before maturity.
Which one of the following characteristics distinguishes income bonds from other bonds?
A. The bondholder is guaranteed an income over the life of the security.
B. By promising a return to the bondholder, an income bond is junior to preferred and common stock.
C. Income bonds are junior to subordinated debt but senior to preferred and common stock.
D. Income bonds pay interest only if the issuing company has earned the interest.
D. Income bonds pay interest only if the issuing company has earned the interest.
An income bond is one that pays interest only if the issuing company has earned the interest, although the principal must still be paid on the due date. Such bonds are riskier than normal bonds.
If a corporation’s bonds are currently yielding 8% in the marketplace, why is the firm’s cost of debt lower?
A. Market interest rates have increased.
B. Additional debt can be issued more cheaply than the original debt.
C. There should be no difference; cost of debt is the same as the bonds’ market yield.
D. Interest is deductible for tax purposes.
D. Interest is deductible for tax purposes.
Because interest is deductible for tax purposes, the actual cost of debt capital is the net effect of the interest payment and the offsetting tax deduction. The actual cost of debt equals the interest rate times (1 – the marginal tax rate). Thus, if a firm with an 8% market rate is in a 40% tax bracket, the net cost of the debt capital is 4.8% [8% × (1.0 – .40)].
Debentures are
A. Income bonds that require interest payments only when earnings permit.
B. Subordinated debt and rank behind convertible bonds.
C. Bonds secured by the full faith and credit of the issuing firm.
D. A form of lease financing similar to equipment trust certificates.
C. Bonds secured by the full faith and credit of the issuing firm.
Debentures are unsecured bonds. Although no assets are mortgaged as security for the bonds, debentures are secured by the full faith and credit of the issuing firm. Debentures are a general obligation of the borrower. Only companies with the best credit ratings can issue debentures because only the company’s credit rating and reputation secure the bonds.
Young Co. issues $800,000 of 10% bonds dated January 1, Year 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in 5 years. The current market rate for similar bonds is 8%. The entire issue is sold on the date of issue. The following values are given:
Present Value of Ordinary Annuity / Present value of $1
(N=10; i=0.04) 8.11090 / 0.67556
(N=10; i=0.05) 7.72173 / 0.61391
What amount of proceeds on the sale of bonds should Young report?
A. $799,997
B. $815,564
C. $849,317
D, $864,884
D, $864,884
The proceeds received from the issuance of bonds equal the sum of the present value of the cash flows associated with the bonds (both the face amount and interest payments) discounted at the interest rate prevailing in the market at the time. The present value of the $800,000 face amount discounted at the market interest rate of 8% is equal to $540,448 ($800,000 × .67556). The present value of the semiannual interest payments of $40,000 [$800,000 × 10% × (6 months ÷ 12 months)] discounted at the market interest rate of 8% is equal to $324,436 ($40,000 × 8.11090). Thus, the proceeds on the sale of the bonds equal $864,884 ($540,448 + $324,436).
If a $1,000 bond sells for $1,125, which of the following statements are true?
I. The market rate of interest is greater than the coupon rate on the bond.
II. The coupon rate on the bond is greater than the market rate of interest.
III. The coupon rate and market rate are equal.
IV. The bond sells at a premium.
V. The bond sells at a discount.
A. I and IV.
B. I and V.
C. II and IV.
D. II and V.
C. II and IV.
The excess of the price over the face value is a premium. A premium is paid because the coupon rate on the bond is greater than the market rate of interest. In other words, because the bond is paying a higher rate than other similar bonds, its price is bid up by investors.
Which one of the following would be the most appropriate discount rate for an investment deemed to have moderate risk?
A. Projected return on S&P 500 equities
B. Yield on U.S. Treasury obligations
C. Yield on investment grade bonds
D. Projected return on global equities
C. Yield on investment grade bonds
Investment grade bonds are considered safe investments with moderate risk.
A firm plans to issue mortgage bonds subject to an indenture. Which of the following restrictions or requirements are likely to be contained in the indenture?
I. Receiving the trustee’s permission prior to selling the property.
II. Maintain the property in good operating condition.
III. Insuring plant and equipment at certain minimum levels.
IV. Including a negative pledge clause.
A. I, II, III, and IV.
B. II and III only.
C. I and IV only.
D. I, III, and IV only.
A. I, II, III, and IV.
Mortgage bonds are pledges of certain assets for a loan. They are usually secured by real property. The bond issuer would usually (i) not be allowed to sell the secured property without receiving permission from the bond trustee, (ii) be required to maintain the property in good operating condition, (iii) insure the property against loss, and (iv) not be allowed to pledge the property as security for any other loan.
What is the price of a 10-year, 10% coupon bond with a $1,000 face value if investors require a 12% return? Assume annual coupon payments.
A. $887.00
B. $565.00
C. $604.50
D. $322.00
A. $887.00
The price of the bond is equal to the sum of present value of the face value of the bond and the present value of the interest payment. Thus, the price is $887.00 [($1,000 x 0.322 PV factor) + ($100 x 5.65 PV factor)].
Which one of the following statements is true when comparing bond financing alternatives?
A. A call premium requires the investor to pay an amount greater than par at the time of purchase.
B. A bond with a call provision typically has a lower yield to maturity than a similar bond without a call provision.
C. A call provision is generally considered detrimental to the investor.
D. A convertible bond must be converted to common stock prior to its maturity.
C. A call provision is generally considered detrimental to the investor.
A callable bond can be recalled by the issuer prior to maturity. A call provision is detrimental to the investor because the issuer can recall the bond when market interest rates decline. It is usually exercised only when a company wishes to refinance high-interest debt.
A corporation issued convertible bonds with a par value of $1,000. The corporation’s stock is selling at $38.00 per share, and the current market price of the convertible bonds is $1,050. If the conversion ratio is 25, what will be the conversion price?
A. $40.00
B. $27.63
C. $38.00
D. $42.00
A. $40.00
The formula for conversion ratio is the par value of the convertible bond divided by the conversion price. Therefore, the conversion price can be calculated as follows:
Conversion ratio = par value of the convertible bond / conversion price
25 = 1,000 / conversion price
conversion price = 1,000 / 25 = 40
Which one of the following provides the best measure of interest rate risk for a corporate bond?
A. Yield to maturity
B. Bond rating
C. Maturity
D. Duration
D. Duration
The longer a bond’s term, the more sensitive is its price to interest rate changes
Junk bonds are
A. Securities rated at less than investment grade.
B. Securities that are highly risky but offer only low yields.
C. Worthless securities.
D. Considered illegal since the collapse of the Drexel Burnham Lambert firm.
A. Securities rated at less than investment grade.
Junk bonds are high-risk and therefore high-yield securities that are normally issued when the debt ratio is very high. Thus, the bondholders have as much risk as the holders of equity securities. Such bonds are not highly rated by credit evaluation companies. Junk bonds become accepted because of the tax deductibility of the interest paid.
Protective clauses set forth in an indenture are known as
A. Addenda.
B. Covenants.
C. Provisions.
D. Requirements.
B. Covenants.
Restrictive covenants, also known as protective clauses, in bond indentures are intended to prevent the issuer from taking actions not in the bondholders’ best interest. A trustee may be appointed to monitor compliance.
A yield curve shows the relationship between bond yields that differ by the
A. Credit risk of the issuer of the bonds.
B. Years to maturity of the bonds.
C. Par value of the bonds.
D. Dividend yield of the issuer of the bonds.
B. Years to maturity of the bonds.
A yield curve shows the relationship between interest rates and a bond’s years to maturity.
If the interest rate on newly issued bonds increases due to expected inflation, which one of the following will most likely occur?
A. The required rate on common stocks will decrease.
B. The price of existing bonds will likely increase.
C. The price of preferred shares will likely increase.
D. The price of common stocks will fall.
D. The price of common stocks will fall.
Higher interest rates on bonds will lead to an increased demand for bond investments, which subsequently decreases the demand for common stock. Also, companies will pay more in interest and will thus have less money for dividends. Both of these factors cause the price of the common stocks to fall.
