Bonds

Question 1

What is the concept of terms structure of interest rates?

Answer 1

The term structure of interest rates is the relationship between yield to maturity and time to maturity

It is important to corporate treasures who must decide whether to issue short or long-term debt and to investors who must decide whether to buy short or long-term debt

The graph has 4 yield curves:

1. Upward sloping
2. Flat
3. Downward sloping
4. Humped

Note: In recent years, long-term rates have been higher than short-term rates, so the yield curve is usually upward sloping

Question 2

When plotting a yield curve, what factors are held constant?

Answer 2

When plotting a yield curve, several factors are held constant:

1. Default risk of instruments
2. Taxability of the instruments
3. Callability of the instruments
4. Sinking fund provisions

Question 3

What are the advantages of bonds to an issuer?

Answer 3

The following are advantages of issuing bonds:

1. Interest paid on debt it tax deductible. This is by far the most significant advantage of debt. For a corporation facing a 40% - 50% marginal tax rate, the tax savings produced by the deduction of interest can be substantial
2. Basic control of the firm is NOT shared with debt holders

Question 4

What are the disadvantages of bonds to an issuer?

Answer 4

The following are disadvantages of issuing bonds:

1. Unlike returns on equity investments, the payment of interest and principal on debt is a legal obligation. If cash flow is insufficient to service debt, the firm could become insolvent
2. The legal requirement to pay debt service raises a firm’s risk level. Shareholders will consequently demand higher capitalization rates on retained earnings, which may result in a decline in the market price of the stock
3. The long-term nature of bond debt also affects risk profiles. Debt originally appearing to be profitable may become a burden if interest rates fall and the firm is unable to refinance
4. Certain managerial prerogatives are usually given up in the contractual relationship outlined in the bond’s indenture contract (i.e. specific ratios must be kept above a certain level during the term of the loan)
5. The amount of debt financing available to the individual firm is limited. Generally accepted standards of the investment community will usually dictate a certain debt-equity ratio for an individual firm. Beyond this limit, the cost of debt may rise rapidly or debt may not be available

Question 5

What is a Term bond?

Answer 5

A term bond has a single maturity date at the end of its term

Question 6

What is a Serial bond?

Answer 6

A serial bond matures in stated amounts at regular intervals

Question 7

What are Variable rate bonds?

Answer 7

Variable rate bonds pay interest that is dependent on market conditions

Question 8

What are Zero-coupon (Deep-discount bonds)?

Answer 8

Zero-coupon or deep-discounted bonds bear no stated rate of interest and thus involve no periodic cash payments; the interest component consists entirely of the bond’s discount

Question 9

What are Commodity-backed bonds?

Answer 9

Commodity-backed bonds are payable at prices related to a commodity such as gold

Question 10

What are Callable bonds?

Answer 10

Callable bonds may be repurchased by the issuer at a specified price before maturity

Question 11

What are Convertible bonds?

Answer 11

Convertible bonds may be converted into equity securities of the issuer at the option of the holder under certain conditions

Question 12

What are Mortgage bonds?

Answer 12

Mortgage bonds are backed by specific assets (usually real estate)

Question 13

What are Debentures?

Answer 13

Debentures are backed by the borrower’s general credit but not by specific collateral. Thus, debentures are risker to investors than secured bonds

Question 14

What are Registered bonds?

Answer 14

Registered bonds are issued in the name of the holder. Only the registered holder may receive interest and principal payments

Question 15

What are Bearer bonds?

Answer 15

Bearer bonds are not individually registered. Interest and principal are paid to whomever present the bond

Question 16

What are Subordinated debentures (second mortgage bonds)?

Answer 16

Subordinated debentures and second mortgage bonds are junior securities with claims inferior to those of senior bonds

Question 17

What are Income bonds?

Answer 17

Income bonds pay interest contingent on the issuer’s profitability

Question 18

What are Revenue bonds?

Answer 18

Revenue bonds are issued by governmental units and are payable from specific revenue sources

Question 19

What are Investment-grade bonds?

Answer 19

Investment-grade bonds are considered safe investments and thus have the lowest yields. The highest rating assigned is “triple-A”

Some fiduciary organizations (such as banks and insurance companies) are only allowed to invest in investment-grade bonds

Question 20

What are Non-investment grade bonds?

Answer 20

Non-investment grade bonds (also called speculative-grade bonds, high-yield bond or junk bonds) carry high risk

They exploit the tax deductibility of their large interest payments. They are often used to finance leveraged buyouts and mergers