Corporate Debt Flashcards
A corporation has issued $1,000 par, 8% convertible bonds, callable at par. The bonds are convertible into 20 shares of common stock. Currently, the bond is trading at 101 while the common stock is trading at $54. The corporation calls the bonds at par plus accrued interest of $20 per bond. A customer holds 100 bonds, purchased at par. The customer wishes to liquidate the position at the greatest profit. The BEST recommendation is to (ignoring commissions):
A. tender the bonds at the call price
B. sell the bonds at the current market price
C. sell short the common stock and convert the bonds for delivery to cover the short
D. continue to hold the bonds
The best answer is C.
If the bonds are tendered at the call price, the owner receives $1,000 per bond. If the bonds are sold at the current market price, the owner receives $1,010 per bond. Since each bond is convertible into 20 common shares, the short sale of 20 common shares will yield 20 x $54 = $1,080. The bonds can then be converted to common to cover the short position. Thus, selling short the common is the best choice. Continuing to hold the bonds does not make sense since interest payments will cease.
Corporate bonds are issued with an “anti-dilutive” covenant. If the corporation declares a 5% stock dividend, all of the following will be reduced EXCEPT the:
A. market price of the stock
B. conversion price of the stock
C. parity price of the stock
D. conversion ratio
The best answer is D.
When a senior convertible security is issued with an “anti-dilutive” covenant, should the company issue additional common shares, the terms of conversion are adjusted when the stock’s market price is reduced for the dividend. To adjust the terms of conversion, the conversion price is reduced, and the number of common shares into which the security is convertible is therefore increased. Since the parity price of the stock is: Par / Conversion Ratio, if the conversion ratio increases, the parity price of the stock will decrease as well.
A customer purchases a convertible bond at 104, convertible into the common stock at $12.50. The common stock is currently trading at $10. The company declares a 25% stock dividend. The bond trust indenture includes an anti-dilution clause. After the ex date for the stock dividend, the conversion price for this bond issue will be:
A. $8
B. $10
C. $12.50
D. $15.00
The best answer is B.
If the company issues additional shares, each of the existing shares is worth “less” since the company’s earnings are spread over a greater number of shares. Thus, the market price will adjust downward to reflect this. If a company issues 25% more shares (after the dividend, there will be 1.25 times the old number of shares), then the earnings and consequently the share price will drop by a factor of 1/1.25.
The bondholder bought the issue based on a conversion price of $12.50. The market price of the stock is being diluted by the additional shares, reducing or eliminating the value of the bondholder’s conversion feature. To protect the bondholder from this occurrence, trust indentures include an anti-dilution covenant. The conversion price of the stock is adjusted downwards by the same factor, so that the convertible bondholder experiences no loss from the issuance of the new shares.
Old Price
—————- = New Conversion Price
New Factor
$12.50
- ———- = $10 Per Share
- 25
A customer purchases a convertible bond at 90, convertible into the common stock at $40. The common stock is currently trading at $36. The company declares a 25% stock dividend. The bond trust indenture includes an anti-dilution clause. After the ex date for the stock dividend, the conversion price for this bond issue will be:
A. $30
B. $32
C. $36
D. $40
The best answer is B.
If the company issues additional shares, each of the existing shares is worth “less” since the company’s earnings are spread over a greater number of shares. Thus, the market price will adjust downward to reflect this. If a company issues 25% more shares (after the dividend, there will be 1.25 times the old number of shares), then the earnings and consequently the share price will drop by a factor of 1/1.25.
The bondholder bought the issue based on a conversion price of $40. The market price of the stock is being diluted by the additional shares, reducing or eliminating the value of the bondholder’s conversion feature. To protect the bondholder from this occurrence, trust indentures include an anti-dilution covenant. The conversion price of the stock is adjusted downwards by the same factor, so that the convertible bondholder experiences no loss from the issuance of the new shares.
Old Price
—————- = New Conversion Price
New Factor
$40
- ———- = $32 Per Share
- 25
Quotes for corporate bonds found on Bloomberg are:
A. wholesale corporate bond prices for broker/dealers
B. retail corporate bond prices for public customers
C. the dollar amount of new issue corporate bonds traded over the preceding 30 days
D. the dollar amount of new issue corporate bonds to be sold over the next 30 days
The best answer is A.
Quote providers such as Bloomberg and Reuters give dealer to dealer prices (the “wholesale” market) for corporate bonds daily.
All of the following are true statements regarding corporate obligations EXCEPT:
A. debentures are usually term issues
B. commercial paper is usually sold at a discount
C. corporate yields are higher than municipal yields
D. most corporate bonds are traded through the New York Stock Exchange
The best answer is D.
Debentures are usually term issues - all bonds having the same interest rate and maturity. Commercial paper is sold at a discount and matures at par - note that this is true for almost all money market securities. Corporate yields are higher than municipal yields because the interest income is fully taxable. Though a very small amount of corporate bonds are traded on the NYSE (in a separate trade matching computer), most of the trading volume takes place over-the-counter between corporate bond dealers such as Goldman Sachs and other firms.
Interest on a corporate bond accrues on a:
A. 30/360 basis
B. 30/actual basis
C. actual/360 basis
D. actual/actual basis
The best answer is A.
Interest on corporate bonds accrues on an arbitrary 30-day month / 360-day year basis.
A customer buys a new issue corporate bond with a dated date of January 1st, settling on January 21st. The first interest payment is due March 1st. How many days of accrued interest must the customer pay to the underwriter?
A. 20
B. 30
C. 31
D. 60
The best answer is A.
The issue is dated Jan 1st, with the first interest payment due Mar 1st (short first interest payment, also called an odd first interest payment). Since the customer bought the bonds from the underwriter, settling on Jan 21st, he or she must pay 20 days of accrued interest to the underwriter. Remember, interest accrues up to, but not including, settlement date.
A customer buys 10 Allied Corporation 8% debentures, M ‘35, at 90 on Monday, October 8th. The interest payment dates are Feb. 1st and Aug. 1st. The trade settled on Wednesday, October 10th. How many days of accrued interest will the buyer pay to the seller?
A. 62
B. 63
C. 69
D. 70
The best answer is C.
Interest accrues on a 30 day month / 360 day year basis for corporate bonds. The bonds were purchased on Monday, October 8th. Settlement takes place on Wednesday, Oct 10th. Interest accrues up to but does not include settlement date. Thus, 30 days are due for Aug; 30 for Sept; and 9 for Oct; for a total of 69 days.
A customer buys 10 Allied Corporation 8% debentures, M ‘29, at 90 on Friday, August 21st in a regular way trade. The interest payment dates are March 1st and September 1st. How many days of accrued interest will the buyer pay to the seller?
A. 82
B. 174
C. 175
D. 176
The best answer is B.
Accrued interest for corporate bonds is calculated on a 30 day month / 360 day year. Interest accrues from the morning of the last interest payment up to, but not including, settlement date. This trade settles on Tuesday the 25th. So, there are 30 days due for March, 30 days due for April, 30 days due for May, 30 days due for June, 30 days due for July, and, finally, 24 days due for August (up to but not including the settlement date of August 25th). The total is 174 days.
A customer buys 10M of Allied Corporation 8% debentures, M ‘28, at 90 on Wednesday, May 29th. The interest payment dates are Mar. 1st and Sept. 1st. The trade settled on Friday, June 1st. The customer will receive how many months of interest in the next payment?
A. 3
B. 4
C. 5
D. 6
The best answer is D.
Issuers make fixed semi-annual interest payments to bondholders covering the preceding 6-month period. If the bond is traded in between interest payment dates, the payment of accrued interest from buyer to seller ensures that each party gets the correct amount of interest.
A customer buys 10M of Allied Corporation 10% debentures, M ‘35, at 90 on Tuesday, October 9th. The interest payment dates are Feb 1st and Aug 1st. The trade settled on Thursday, October 11th. The amount of the next interest payment will be:
A. $400
B. $500
C. $900
D. $1,000
The best answer is B.
10M stands for 10 - $1,000 bonds (M is Latin for $1,000) = $10,000 face amount of bonds. The bonds pay 10% interest annually. 10% of $10,000 is $1,000 annual interest. Since payments are made twice per year, each payment will be $500.
A customer buys 10M of Allied Corporation 8 1/4% debentures, M ‘34, at 90 on Thursday, Oct 9th. The interest payment dates are Feb. 1st and Aug. 1st. The trade settled on Monday, October 13th. The amount of the next interest payment will be:
A. $412.50
B. $825.00
C. $900.00
D. $1,000.00
The best answer is A.
10M stands for 10 - $1,000 bonds (M is Latin for $1,000) = $10,000 face amount of bonds. The bonds pay 8 1/4% interest annually. 8 1/4% of $10,000 is $825 annual interest. Since payments are made semi-annually, $412.50 is amount of each payment.
What does a bond trading “flat” mean?
A. No commission is added to the price of the trade
B. The bond is trading without accrued interest
C. The dealer’s bid and ask quote for the bond are the same
D. The bond does have SIPC insurance
The best answer is B.
A bond trades flat (without accrued interest) when the issuer has defaulted on the interest payments, or if the issue is an income bond or a zero coupon bond. Therefore, a current bondholder receives no interest on bonds that trade flat. When such a bond is traded, no accrued interest is paid from buyer to seller - so the trade is being done at a “flat” amount without any accrued interest added to the price.
All of the following bonds trade “flat” EXCEPT:
A. Defaulted bonds
B. Adjustment bonds
C. Income bonds
D. Reset bonds
The best answer is D.
When a bond is trading “flat,” it is trading without accrued interest. Income bonds (a.k.a. adjustment bonds) and defaulted bonds trade flat since they do not pay current interest. Income bonds don’t pay interest unless the corporation reaches a high enough level of earnings (that is, the interest payment is dependent upon the income level of the corporation, hence the name “income bond”). Defaulted bonds are “in default” of their interest payments, and are thus not paying interest. Reset bonds establish dates when the interest rate will be reset to a given value (depending on interest rates at the time of the “reset”). They make regular semi-annual interest payments and hence trade “and interest.” They do not trade flat.
