Ch 5

Question 1

Just as a home ordinarily would have a market value greater than the principal aount of its mortgage, the value of the real estate pledged by the corp will be…

Answer 1

in excess of the amount borrowed under that bond issue.

If corp develops fin problems and isn’t able to pay the interest on the bonds, those real asssets pledged as collateral are generally sold to payoff the mortgage bondholders.

Question 2

equipment trust certificate

Answer 2

debt secured by a specific asset

railroads and airline companies finance acq of their rolling stock, locomotives, or airplnes by issuing an equipment trust certificate.

Because the equipemtn does wear out, the railroad will pay off a portion of the loan on an annual basis.

If the co. finishes paying off the loan, the co. receives clear titlee to its equipment from the truste..

If the co. does NOT make the payments, the lendor reposesses the colalteral and sells it for her benefit.

Question 3

Collateral trust bonds

Answer 3

corporation wants to borrow money and has neither real estate (for a mortgage) nor equipment (for an equipment trust) to use as collaterla. Instead, it deposits securities it owns into a trust to serve as collateral for the leaders.

• better quality securiites deposited as collateral = better quality and rating of the bond

Question 4

debentures

Answer 4

unsecured corp bonds

debt obligation of the corp. backed ONLY by its word and general creditworthiness.

It’s a written promise to the corp. to pay the principle at its due date and interstt on a regular basis.

quality depends on the overall A and earnings of the corporation. Although debentures are unsecured, there are issuers whose credit standing is so good that their debentures are safer than mortage bonds of less creditworthy companies.

Question 5

guaranteed bond

Answer 5

bond that is guaranteed as to payment of interest, or both principal and interest, by a corp centityt other than the issuer.

value of the gauranatee is ONLY AS GOOD AS THE STRENGTH OF THE CO. MAKING THATGUANRATEE.

were popular in railroad industry

Question 6

Subordinated

Answer 6

“belonging to a lower or inferior class or rank; secondary”

also called a “debenture”

has claim that’s behind (junior to) that of any other creditor.

Question 7

income bonds

Answer 7

aka adjustment bonds

used when a co. is oreoginaizing and coming out of bankruptyc. Income bonds pay interst ONLY I the corproation has eough income to meet intnnerst paym and if the BOD declares a payment.

NOT sutiable for cusotmers seekign stable income.

Question 8

Zero coupon bond

Answer 8

don’t make any interest paym, so they’re issued/traded at a deep discount and mature at par.

difference between discounted purchase P and full face value at matuiry is the reutnr the investor receives (also called accretion).

greater deal of price volatility

Question 9

current market price of a zero coupon bond reflects…

Answer 9

the current interst rates for similar matuirtiies

Question 10

major attraction of zero coupon bonds?

Answer 10

it allows an investor to lock in a yield/ROR for a predetermined, investor-selected time with no reinvestment risk.

Question 11

LIQUIDATION PRIORITY

Answer 11

1. secred creditors (mortgage bonds, equipm trust certificates, collatral trust bonds)
2. unsecured creditors (ie. general creditors, icluding debenture holder
3. subordeirnated debt holders
4. preferred stockhodlers
5. common stockhodles

non-security priority items:

1. wages (highest priorfity, AFTER securied creditors)
2. taxes
3. unsecured (general creditors), such as debentures

Question 12

adminstirative cliams

Answer 12

in bankruptcies, admin roles (ie. attorneys, poperty appraisers, courts, etc) must be paid for doing work and therefore have 1st priority.

Question 13

convertible debt securities

Answer 13

co states that lenders (investors) may exchange (convert) debt into shares of the co’s common stock

convertible sec can ONLY be issued by corporation.

Covnerstion priviliege is exercised at the discretion of the invesotr. Thhe exact number of shares that a bond will be ocnvertible into at any point is PRINTED IN BOND INDENTURE at time of issuance

Question 14

advantages of convertible securities TO THE ISSUER

Answer 14

a corp adds a convertion feature to its bonds/perf stock to make it more marketable.

Sweenerrer:

• convertibles can be sold witht a lower coupon rrate than nonconverti les bc of the conversion feauter.
• Bc conversion normally occurs over time, an adverse effect on the stock price it’ll be $133.4
• sotkc price (which may ocrrur to do 30% rrewmarry / Omaldon
• at issuance, converrion price is ggghih err

Question 15

Disadv of cusotmer securiite TO THE ISSUER

Answer 15

potentail disadv for a corp and its stockholders:

• DILUTION? when bonds are converted, SE is DILUTED; so more shares are outstanding, so each share now reps a smaller fraction of ownership in the company
• SHIFT IN CONTROL? common stockh have a voice int he co’s mgmt, so a substantial conversion could cause a shift in the control of the co.
• LOSS OR LEV? reducing corporate debt through conversion means a loss of leverage
• RAISING CORP’S TAXABLE INCOME? resulting decrease in deductible interest costs raises the corp’s taxable income

Question 16

Adv of convertible securities TO INVESETORS

Answer 16

• HIGHER INTEREST INCOME THAN DIVIDEND INCOME. convertible debenture pays interest at a fixed rate and is redeemable for its face value at maturity, provided the debenture is not converted; as a rule, interest income is HIGHER than dividned income on the underlying common stock. similarly, preferred stock usually pays a higher dividend than does common stock
• LIQ PRIORITY OVER COMMON SHAREH. if corp experiences fin difficulties, covnertibe bondholders have prioroity over common shareholders (if corp liquiditaing)
• STABLE. convertible debenture’s market price tends to be more stable duringg market declines than the underlying common stock’s price. If stock price declines to a level well below the conversion price, the debenture’s price will then reflect a CY competitive with other debtt sec
• INFLATION PROTECTION. bc convertibles can be exchanged for common stock, their market price tends to move UP if stock price moves UP. Owner of a convertible debenture has all the upside potential of common stockh with less downrside risk. aka INFLATION PROTECTION!!! most fixed-income secuirites don’t offer this (2 yrr time horizon!)

Question 17

disadv of convertible sec to INVESTORS

Answer 17

• LOWER LIQ PRIORITY! bc most convertibles are debentures, invetor’s priority is lower than other debt sec; this COULD b e a concern if co’s fin outlook is shaky
• CALLABLE RISK = NO MORE INT PAYMENTS! if security is callable, there is the posssibility the issuer calls it early and forces investor to decide whether or not to converrt. Once converted, the semiannual interst pyaments are gone! Meaning the ivnestor is subject to all of the risks of owning common stock.

Question 18

anti-dilutive portection

Answer 18

1 of the ocncerns of any holder of a convertible security (bonnd or prreferred stock) is protection against the potential dilution resulting from a sotkc split or a stock dividend.

Question 19

corporate bond quotes

Answer 19

each 1/8

Question 20

When equity market is strong and stock pirces are rising, convertbiel’s value …

Answer 20

rises with underlying common stock’s value!

When equity prices are declining, convertible’s market price declines BUT generally levels off when its yield becomes competitie with the yield on nonconvertible bonds. TThis tends to keep it from declining as much as the common stock. Conveertbile conds normally sell at a premium abobve parity.

Question 21

corporate debt interst

Answer 21

interst paid by corporations on their debt sec is treated as ORDINARY INCOME. THere is NO category of “qulaified interst” with a reduced tax rate. In addition to fed income tax, this interest is staxable on a state and local level too.

Question 22

coroprate deb se arre subject to…

Answer 22

taxation

Question 23

holding zero bond to maturity resultts in… any gain or loss?
+ holding period details

Answer 23

NO gain or loss.

That is NOT the cae for interest-bearing bonds. There is no accretion with them. Just compare purchase and sale prices tod etermine a gain/loss. When bond his hled ot matuirty, sale price is parr. There’s no accretion with them.

When bond is held ot matuirty, sale price is par.

if holding period is 12 months or less, any ggain/loss is ST. If holding period is longer than 12 months, it’s LT. WHen computing net gains and lossses, it makes NO difference whether the transaction is in a bond or stock.
IRS is ONLY concerned about LT and ST