Chapter 12 Part 4 Flashcards Preview

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Flashcards in Chapter 12 Part 4 Deck (20):

Mortgage bonds are secured by

a first or second mortgage on real property (either land or buildings). The bondholders have a lien on the property. The first mortgage bondholders have a first (senior) lien on the property. The second mortgage bondholders have the second (junior) lien. To protect the bondholders, the total par value of all the outstanding mortgage bonds should be less than the value of the property


Equipment Trust Certificates

These bonds are secured by a piece of equipment. They are usually issued by transportation companies (railroads, airlines, and shipping companies). Historically, equipment trust certificates have been very safe investments, since the equipment is usually worth more than the bonds


Collateral trust bonds

are secured by the stock or bonds of another company (not the issuer). Usually, the other corporation is an affiliate or a subsidiary of the issuing corporation


Most corporate bonds are secured only by the

corporation's promise to pay (good faith). not by a specific piece of corporate properly.



Unsecured bonds are called debentures. If the issuer defaults, the owners of debentures have the same claim on the company's assets as any other general creditor-before the stockholders, but after any secured bondholders


subordinated debentures

Sometimes companies issue unsecured bonds that have a junior claim on their assets, compared to the bonds that they have already issued. These are called subordinated debentures. The claims of these new bondholders on the company's assets are subordinated to those of the existing bondholders. In case the company goes bankrupt, the owners of the subordinated debentures will be paid after the other bondholders but before the stockholders


Since convertible bonds are generally unsecured, they are actually a type of

debenture or subordinated debenture


Convertible bonds are similar to

convertible preferred stock. (See Chapter 11.) They allow investors to convert their bonds into shares of the company's common stock at a predetermined ratio. Since convertible bonds have this extra feature, companies can issue them at a lower interest rate than they would normally need to pay to attract investors


Converting Bonds to Stock

The conversion price is set at the time the bonds are issued. To determine the number of shares of stock that a bondholder will receive if she converts her bonds, divide the par value of the bond ($1,000) by the conversion price. This becomes the conversion ratio


For example, if an investor purchases 10% convertible subordinate debentures issued with a conversion price of $40, the conversion ratio is

25 shares for each bond


Convertible bonds offer investors a greater degree of safety than preferred or common stock, but they also offer them the potential for greater

capital appreciation than nonconvertible bonds if the underlying stock does well


A disadvantage of convertible bonds is that if all the bonds are converted into stock, the number of shares that the company has outstanding may

increase dramatically. This may cause dilution, a decrease in the value of the stockholder's investment. In addition, the convertible bond pays a lower interest rate than comparable nonconvertible bonds


The prices of corporate bonds are quoted as a

percentage of par value. The prices may be broken down into fractions such as 85 1/2 or 103 5/8


To determine the dollar price of a corporate bond, you first

convert any fractions into decimals. Then multiply the percentage by the bond's par value ($1,000).


dollar cost of A corporate bond selling at 80 = 80%

Step 1: Convert 80% to a decimal = .80. Step 2: .80 x $1,000= $800. Step 2: .80 x$1,000= $800


dollar cost of A corporate bond selling at 85 1/2

Step I: Convert 1/2 into a decimal by dividing 2 into 1. 1/2 = .5 Step 2: Convert 85.5% to a decimal = .855. Step 3: .855 x $1,000 = $855


dollar cost of A corporate bond selling at 103 3/8

Step I: Convert 3/8 into a decimal. 3/8 = .375. Step 2: Convert 103.375% to a decimal= 1.03375 Step3: 1.03375 x $1,000=$1,033.75


accrued interest

If a bondholder sells her bond before she receives her next interest payment, she is still entitled to the interest earned up until the time she sold the bond. The person who buys her bond will need to add the amount that the bondholder would have received to the price paid for the bond


the interest on corporate bonds accrues on the basis of a

30-day month and a 360-day year


The IRS treats the interest on corporate bonds the same way as dividends. Interest payments on corporate bonds are subject to

federal, state, and local inco1ne taxes as ordinary income. This means it is taxed in the year received at the investor's tax bracket. Bond interest must be included on the investor's tax returns the same year that it is received

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