Chapter 5

Question 1

Which of the following statements regarding corporate zero coupon bonds are true?

• Interest is paid semiannually.
• The discount is in lieu of periodic interest payments.
• The discount must be accreted and is taxed annually.
• The discount must be accreted annually with taxation deferred until maturity.

Answer 1

• II and III
• The investor in a corporate zero coupon bond receives the return in the form of growth of the principal amount over the bond’s life. The bond is purchased at a deep discount and redeemed at par at maturity. That discount from par represents the interest that will be earned at maturity date. However, the discount is accreted annually, and the investor pays taxes yearly on the imputed interest.

Question 2

Which of the following would be most likely to issue an equipment trust certificate?

Answer 2

• An airline company

- When you see “equipment trust certificate,” think transportation companies such as airlines and railroads.

Question 3

A 7% convertible debenture is selling at 101. It is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. If the stock were trading at parity with the debenture, the price of the stock would be

Answer 3

• $25.25
• To determine the parity price of the common, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, divide the current price of the bond by the conversion ratio. The result is the parity price of the common stock. (1,010 / 40 = $25.25).

Question 4

All of the following statements regarding convertible bonds are true except

Answer 4

• holders receive a higher interest rate.
• Because of the possibility of participating in the growth of the common stock through an increase in the market price of the common, the convertible can be issued with a lower interest rate. The interest rate on a convertible, just as with any other fixed-income security, does not change.

Question 5

All of the following statements regarding convertible bonds are true except

Answer 5

• holders receive a higher interest rate.
• Because of the possibility of participating in the growth of the common stock through an increase in the market price of the common, the convertible can be issued with a lower interest rate. The interest rate on a convertible, just as with any other fixed-income security, does not change.

Question 6

Libby sees a tombstone advertisement for a new issue of Southwest Barge subordinated convertible debentures. The bonds will carry an 11¼% coupon, are convertible into common stock at $10.50, and are being issued to the public at 100. The proceeds of the issue will be used specifically for purchasing new Southwest barges. Libby’s concerns about the issue could include which of the following?

Answer 6

• The issue may have a junior claim to another security issue.
• The word subordinated is the key to the question. A subordinated bond has other debt holders ahead of it in the event of liquidation. The barges do not serve as collateral, as the bonds are identified as debentures, and having to convert to common stock is not a threat because she is the one that will, if she desires, exercise the conversion privilege.

Question 7

An investor purchased a new issue corporate zero-coupon bond for $600. The bond has a maturity of 20 years. Six years later, the investor sells the bond for $740. For tax purposes, this would result in

Answer 7

• a capital gain of $20.
• The $400 discount is accreted over the 20 years to maturity. That is an annual accretion of $20. After 6 years, that is $120, making the tax basis of the bond $720. Because the sale at $740 is $20 more than the basis, the investor has a long-term capital gain.

Question 8

A convertible debenture has a conversion price of $40 per share. If the market value of the debenture rises to a 12.5-point premium over par, which of the following are true?

• Conversion ratio is 25:1
• Conversion ratio is 28:1
• Parity price of the common stock is $42
• Parity price of the common stock is $45

Answer 8

• I and IV
• The conversion ratio is computed by dividing par value by the conversion price ($1,000 par ÷ $40 = 25). The next step is calculating the market price of the debenture. A 12.5% premium to par means the market price is 112.5% of the $1,000 par. That computes to $1,125.00. Parity price of the common stock is computed by dividing the market price of the convertible debenture by the conversion ratio ($1,125 ÷ 25 = $45). Alternatively, if the debenture is at a 12.5% premium, the common stock will be at parity (equal) when it is selling at 112.5% of the $40 conversion price. Or, 112.5% × $40 = $45.

Question 9

ABC Corporation has issued a convertible preferred stock with a par value of $100. The stock is convertible at $40. The current market price of the preferred stock is $80. It would be correct to state that the conversion ratio is

Answer 9

• 2.5:1
• When a $100 par preferred has a conversion price of $40, the stockholder can convert into 2.5 shares. That is a 2.5:1 ratio. The current market price of the stock is only relevant if the question asks about the parity price (which is $32). As a refresher, the parity price is that market price where the value of the shares received on conversion is equal to (at parity with) the market price of the convertible security. With the preferred stock selling at $80 per share and being convertible into 2.5 common shares, when the market price of the common is $32 ($80 ÷ 2.5) we have parity because 2.5 times $32 = $80.

Question 10

A bond convertible at $50 is selling at 105% of parity, while the common stock has a current market value of $45. What is the market value of the bond?

Answer 10

• $945
• When a bond is convertible at $50, it means the holder can exchange each $1,000 par value bond for the company’s common stock at a rate of $50 per share. Dividing $1,000 (always use the par value, not the market value) by $50 results in a conversion rate of 20 shares per bond. With the bond convertible into 20 shares and the market price of each share currently $45, the parity price, the price at which the value of the stock and the bond are the same, is $900, (20 x $45). The question tells us that the bond is selling for 105% of the parity price. That would be $900 x 105% = $945.

An alternative method is to recognize that the stock is selling for 10% below its conversion price ($45 is $5 less than $50 and $5 ÷ $50 = 10%). That means the parity price of the bond must be 10% below the par value, or $900 (which is 10% less than $1,000). Once you have the $900, multiply by 105% to arrive at the correct answer of $945.

Question 11

Phantom income is a characteristic of

Answer 11

• zero-coupon bonds
• Phantom income is the term describing income that is not received, but it is taxed. With zero-coupon bonds, the principal payoff at maturity represents receipt of the discount in lieu of periodic interest. However, each year, a portion of that discount is reported to the IRS on Form 1099 OID and is taxed as ordinary income unless the security is a municipal bond.

Question 12

With a bearish outlook on the market, an investor would like to purchase something that will generate income now during current bearish conditions but would also be able to take advantage of capital appreciation should market sentiment turn bullish. Which of the following would be a suitable purchase recommendation that puts the investor in a position to do both?

Answer 12

• Convertible bonds
• A convertible bond would generate income from interest payments during the bear market, but if market sentiment becomes bullish, the bond can be converted into common stock, taking advantage of the change in market conditions. None of the remaining choices could fulfill both of these investment objectives.

Question 13

Due to a sudden drop in earnings, the board of directors of Amalgamated Metal Industries (AMI) has voted to suspend all dividend payments this year. This would have the least effect on holders of AMI’s

Answer 13

• subordinated debentures
• Regardless of the level of seniority of a preferred stock, it comes behind any debt security. More importantly, interest on a debenture, subordinated or not, is a contractual obligation. Unlike the dividends on stock, the decision to pay or not to pay interest is not an optional one. Failure to pay interest on a debt security can lead to foreclosure and bankruptcy proceedings.

Question 14

An investor purchases a PQR convertible bond at 98 on June 18, 1994. The bond is convertible at $25, and on June 19, 1995, when the common stock is trading at $26 per share, the investor converts his bond into the stock. For tax purposes, these transactions will result in

Answer 14

• neither gain nor loss
• The process of converting a convertible bond into common stock is not a taxable event. When the stock is sold, the taxable event occurs.

Question 15

An investor viewing a stock market video is particularly interested in the discussion of convertible debt securities. Those are issued by

Answer 15

• corporations
• Convertible securities (debt or preferred stock) are always convertible into common stock. Therefore, they can be issued only by an entity that also issues common stock: a corporation.

Question 16

ABC Corporation has outstanding a 7.75% convertible debenture currently trading at 102. The bond is convertible into common stock at $40. ABC stock is trading $45 per share. Which of the following statements is true?

Answer 16

• To profit in this situation, the investor should buy the bonds and short the stock.
• With a conversion price of $40, the bond is convertible into 25 shares of ABC common stock ($1,000 / $40 = 25 shares). As the common stock is currently trading at $45 per share, the value of the stock as converted would be $1,125 (25 shares × $45 = $1,125), which is greater than the current price of the bond ($1,020). Therefore, the bond and the stock are not at parity. An investor could profit in this situation by shorting the stock and buying an equivalent number of bonds. A bond could be purchased for $1,020 and immediately converted into stock worth $1,125—a risk-free profit opportunity.

Question 17

A corporation has an outstanding issue of 8% convertible debentures with a conversion price of $25. The bond indenture contains an antidilutive clause guaranteeing the debt holders the right to maintain proportionate equity conversion in the corporation. If the company pays a 10% stock dividend to its common shareholders, how will that affect the debenture holders?

Answer 17

• The bonds will now be convertible at approximately 22.73.
• The antidilutive provision means the debenture holders will be able to convert into an equivalent share value as before. With a conversion price of $25, the bond is convertible into 40 shares ($1,000 ÷ $25). After the 10% stock dividend, they should be able to have 10% more shares, or 44 shares. That means the conversion price must be reduced. Divide $1,000 by 44 shares and the result is $22.73. Remember, anytime there is a stock dividend, prices go down.

Question 18

A convertible debenture callable at 101 is trading at 105. The debenture carries 4% coupon and is convertible at $25. The common stock is trading at $27. If an investor bought the debenture and converted, the profit would be

Answer 18

• $30
• As is the case with many math questions, there is more than one way to arrive at the correct answer choice. We’ll show you two of them for this question and you can use whichever method is easiest for you. First, calculate the number of shares the investor will receive upon conversion of the debenture: $1,000 (par) divided by $25 per share conversion rate equals 40 shares per debenture. With the market price at 105, each debenture costs $1,050. What is the parity price of the stock? $1,050 divided by 40 shares which equals $26.25 per share. That is, when the common stock is selling at $26.25 per share, the 40 shares received upon conversion are equal to the same $1,050 as the debenture; this is what parity is all about. If we subtract the parity price of the stock ($26.25) from the current market price of the stock ($27), we see there is a profit of $0.75 per share. Converting into 40 shares at a profit of $0.75 per share results in a total profit of $30. Alternatively, knowing that the debenture is convertible into 40 shares of common stock, with the current market price of that stock at $27 per share, those 40 shares could be sold for $1,080 (40 × $27). If the debenture can be purchased for $1,050 (105) and then converted into $1,080 worth of stock, the investor profits by $30. Please note that, as is the case with many calculation questions, there is information supplied that is totally irrelevant to solving the problem. In this question, the fact that the debenture is callable and pays interest at a rate of 4% has nothing to do with determining the investor’s profit following the conditions given.

Question 19

Your new client lists income as the primary investment objective for an account with your broker-dealer. Which of the following investments would not be suitable?

Answer 19

• Zero-coupon bonds
• Zero-coupon bonds make no payments until maturity, and therefore, would not be suitable investments for those with an income objective. Typically, preferred shares (because of the fixed dividend they pay) and corporate or government securities, which make interest payments, would be suitable investments to meet an income objective.

Question 20

A customer owns a 7.5% ABC convertible bond currently trading at 115. The conversion price is $40. What is the parity price of the common?

Answer 20

• $46.00
• What does parity price mean? Here is what it says in the LEM:

Calculating Conversion Parity

Parity means that two securities are of equal dollar value (in this case, a convertible bond and the common stock into which it can be converted). The question is looking for the parity price of the common stock. That is the market price per share, where the total value of the stock received upon conversion equals the market price of the bond. There are two ways to do this. The first is generally the easiest to understand.
We are told that the bond has a conversion price of $40. That means you can get 25 shares if you wish to convert. That is because the issuer is basically saying, “We owe you $1,000 and will let you spend it on our stock at $40 per share.”
Now that we know we can get 25 shares, what does each share have to be worth to equal $1,150? If you divide $1,150 by 25 shares, the result is $46.
The other method to do this is as follows: The bond is selling at a 15% premium. To be equal to that, the stock must be selling at a 15% premium over the conversion price. $40 times 115% equals $46. If that makes sense to you, it is much faster than the first method.

Question 21

Equipment trust certificates are commonly issued by

Answer 21

• transportation companies
• Equipment trust certificates are corporate bonds commonly issued by transportation companies such as railroads and airlines. These bonds are backed by equipment (e.g., aircraft) the issuer uses in their business.

Question 22

ABC Company issues a 10% bond due in 10 years. The bond is convertible into ABC common stock at a conversion price of $25 per share. The ABC bond is quoted at 90. Parity of the common stock is

Answer 22

• $22.50
• The bond is quoted at 90, so it is selling for $900. The parity price of the common stock is $22.50, calculated as follows: the bondholder could convert the bond into 40 shares of stock ($1,000 face amount / $25 per share = 40 shares). Because the bond has a current price of $900, divide $900 by 40 to get the underlying parity price (90% × $25 = $22.50)

Question 23

An investor purchases zero-coupon bonds issued by the U.S. Treasury due to mature in 18 years at $100,000. Which of the following might describe the primary reason for selecting that investment vehicle?

• The investor is 65 years old and needs the reliability of current income.
• The investor is 45 years old and has purchased these in an IRA rollover account and wants the assurance of funds for retirement.
• The investor is 30 years old and has a newborn child and wishes to assure funds for a college education.
• The investor is 20 years old, has just received an inheritance, and wishes to shelter income for as long as possible.

Answer 23

• II and III
• Zero-coupon bonds maturing in 18 years would assure the 45-year-old of the face value at age 63. Being in an IRA, there would be no current taxation, and upon maturity, if desired, the funds could be distributed without the 10% penalty. Zero-coupon bonds are one way to guarantee funds for college education. However, with no current income, they would not be suitable for the 65-year-old and would not offer any tax shelter to the 20-year-old.

Question 24

PDQ Corporation has a 6.25% $100 par value convertible preferred stock (conversion ratio of 4) outstanding. The stock has an antidilution covenant. If PDQ declares a 10% stock dividend, the antidilution covenant will adjust

Answer 24

-the conversion price to approximately $22.73.

Question 25

The purchaser of a general obligation (GO) municipal bond should be concerned with - property tax assessments. - the maintenance covenant. - market risk. - feasibility studies

Answer 25

- I and III - GO bonds are issued by municipalities and, like all debt instruments, are subject to interest rate changes (market risk). Ad valorem (property taxes) are the primary source of debt funding for municipal GO bonds and are based on property assessments. Feasibility studies and maintenance covenants are associated with municipal revenue bonds where user fees from municipal projects and facilities are used to fund the debt.

Question 26

Which of the following would be considered in analyzing the credit worthiness of a revenue bond issuer? - Per capita debt - Debt service coverage - Management - Debt to assessed valuation

Answer 26

- II and III - Revenue bonds are paid out of revenues from a particular project or facility, not from tax revenue. Therefore, debt service coverage and the personnel in charge of managing the facility are important. Overall debt of the issuer would be important in analyzing a general obligation bond backed by the issuer's full faith and credit.

Question 27

Purchasers of municipal revenue bonds are interested in knowing the priority of their claim on the revenues generated by the project. In general, the most senior position is held by

Answer 27

- a gross revenue pledge - The simplest way to think about this question is to look at our paycheck. What is the higher number – your gross pay or your net (take-home) pay? You could also say, "Who has the first claim on my earnings?" The government and that is why the taxes come out of your gross paycheck rather than your net check. The concept is the same here. In a gross revenue pledge, interest to the bondholders is paid out of the gross revenues before any other deductions. In a net revenue pledge, certain expenses are paid first, and then, from what remains, the bondholders receive their due.

Question 28

If a customer buys a new issue municipal bond at a discount in the primary market, which of the following statements are true? - The discount must be accreted. - The discount may not be accreted. - At maturity, there is a capital gain. - At maturity, there is no capital gain.

Answer 28

- I and IV - If a new issue municipal bond is bought at a discount in the primary market, the discount must be accreted. The accretion is considered interest income, and, as an original issue discount bond, is not taxable.

Question 29

All of the following statements regarding a municipality's debt limit are true except

Answer 29

- that the debt limit is the maximum amount a municipality can borrow in any one year. - The debt limit is the maximum amount of debt a municipality can have.

Question 30

One of the benefits of adding a sinking fund provision to a municipal bond issue is that the bond will generally

Answer 30

- be issued with an interest rate lower than without the sinking fund - Adding a sinking fund provision to a bond issue invariably results in a higher rating for the security. The fact that money is put aside to repay the principal on a regular basis offers greater safety. A higher rating results in a lower coupon, not a higher one. After all, the higher the rating, the lower the risk, and that means the issuer is able to borrow at a lower cost. Although the sinking fund itself does not change the maturity date, having a sinking fund enables the issuer to use partial calls to redeem the bond ahead of the final maturity date. A sinking fund has nothing to do with tax treatment.

Question 31

Net overall debt of a municipality is

Answer 31

- net direct debt plus overlapping debt. | - Net overall debt of a municipality is defined as net direct debt plus overlapping debt

Question 32

Which of the following statements about municipal brokers' brokers is not true?

Answer 32

- They perform trades on a principal basis only - A broker's broker does not maintain an inventory of bonds. Therefore, they do not act as principals; they act as agents only in trades between dealers or institutions. They do not do retail business.

Question 33

A municipal bond is purchased at a discount in the secondary market at 90. The face amount is $10,000, and the bond has 10 years to maturity. If the bond is sold for 97 after five years, what is the taxable gain?

Answer 33

- $200 - When a municipal bond is bought at a discount in the secondary market, the discount is accreted and taxable as ordinary income. Accretion increases cost basis. Therefore, five years later, the bond's cost basis is 95. At that point, the customer has a two-point capital gain. Had the bond been bought as an original issue discount, the annual accretion is considered interest income and is not taxable.

Question 34

All of the following would be considered when evaluating a municipal revenue bond's creditworthiness except

Answer 34

- collection ratio - The collection ratio shows the percentage of property taxes that are collected. This would be relevant in evaluating general obligation bonds, which are backed by the taxing authority of the issuer. Revenue bonds, however, are backed by user fees, not taxes.

Question 35

Which of the following is limited in the case of a limited tax municipal bond?

Answer 35

- The type of tax that can be used to service the debt - A general obligation (GO) bond may be backed by a specific tax. For example, a limited tax GO may be serviced only from sales tax revenue, not income tax revenue. As the source of debt service is limited (it is not backed by the full taxing authority of the issuer), these bonds are sold with higher yields than conventional GOs.

Question 36

Expressed as a percentage of par, one basis point equals

Answer 36

- one-one hundredth of 1%. - One basis point equals one-one hundredth of 1% of par. One percent of par ($1,000) equals $10; therefore, 1 basis point equals one-one hundredth of $10, or $0.10 (10 cents).

Question 37

debt capital

Answer 37

- money loaned to a corporation by investors who buy the issuer's debt securities - corporation is obligated to pay back the principal at maturity with a stated rate of interest

Question 38

types of bonds issued by corporation

Answer 38

- mortgage bonds: corporations borrow money backed by real estate of the corporation - equipment trust certificates: railroads and airlines finance the acquisition of their rolling stock, locomotives, or airplanes by issuing equipment trust certificate - collateral trust bonds: when a corporation wants to borrow money without any real estate nor equipment to use as collateral for the lenders - debentures: a debt obligation of the corporation backed by its own word and general creditworthiness aka written promises of the corporation to pay the principal at its due date and interest on a regular basis - guaranteed bonds: a bond that is guaranteed as to payment of interest or both principal and interest by a corporate interest other than the issuer

Question 39

subordinated debenture

Answer 39

-belonging to a lower or inferior class or rank; secondary. It is usually describing a debenture. A claim that is behind that of any other creditor

Question 40

income/adjustment bonds

Answer 40

- used when a company is reorganizing and coming out of bankruptcy - pay interest only if the corporation has enough income to meet the interest payments & if the BOD declares a payment

Question 41

zero coupon bond

Answer 41

- debt obligations that are debt obligations that do not make any interest payments - zeroes are issued at a deep discount and mature at par ($1000) - the difference between the discounted purchase price and the full face value at maturity is the return to investor (accretion) - current market price reflects current interest rates for similar maturities - corporations, state & local governments, as well as the U.S. Treasury can issue zero coupon bonds

Question 42

zero coupon bond benefits

Answer 42

- allows an investor to lock in a yield (or rate of return) for a predetermined, investor-selected time with no reinvestment risk - usually used to future education or retirement needs - sold at discounts and have no current return, with a great deal of price volatility - duration is always equal to the length to maturity - shorter duration = less volatility

Question 43

liquidation priority

Answer 43

-secured creditors, unsecured creditors, subordinated debt holders, preferred stockholders, common stockholders

Question 44

convertible debt securities

Answer 44

- investors may exchange (convert) the debt shares of the company's common stock - can only be issued by corporations - exercised at the investors discretion

Question 45

conversion ratio

Answer 45

- conversion price is the stock price at which a convertible bond can be exchanged for shares of common stock - conversion ratio/conversion rate expresses the number of shares of a stock a bond may be converted into - the indenture tells you the number of shares into which the bond is convertible (the bond is convertible into 50 shares or 50:1)

Question 46

conversion price

Answer 46

- instead of telling the number of shares into which the bond is convertible, the indenture will give the conversion price - the price per share that the corporation will sell their stock in exchange for the bond one is holding - despite the current market price, the bond always represents a debt of the corporation of $1000 - always divide the par value $1000 by the conversion price

Question 47

advantages of convertible securities

Answer 47

- can be sold with a lower coupon rate because of conversion features - a company can eliminate a fixed interest charge as conversion takes place, thus reducing debt - at issuance, conversion price is higher than market price of common stock