Corporate Bonds - Debt Securities

Question 0

Term Period of Bonds

Answer 0

Long-Term (usually 10-30 years)

EX: 1,000 (Par) x 6% (coupon rate)= 60.00 per year

Question 1

Promise to Pay

Answer 1

a. A corporation issues a certificate indicating that it has borrowed a fixed sum of money and that it promise to repay it at a future date. The nominal interest rate and maturity date will be on the face of the bond. The bond is the evidence of the debt and the bondholder is a creditor of the corporation.
b. Bonds have a senior claim on the assets of a corporation ahead of equity securities in event of liquidation. This means that they have less risk than options, warrants, or stocks.

Question 2

Denominations

Answer 2

a. Usually $1,000 or $5,000 although denominations may range from $50 to $10,000. Assume the denomination is $1,000 unless stated otherwise.
b. Payable at par ($1,000) at maturity

Question 3

Quotes

Answer 3

a. Corporate bonds are quoted as a percentage of par value. Paris always $1,000 for a bond. For example, a bond quoted at 97 is selling 97% of $1,000 par value or $970. 1) If a bonds sells for mor than par value, the difference is called the ‘premium.’ 2) If a bond sells for less than par value, it is at a ‘discount.’
b. One point equals $10. Fractions are quoted as 1/8 or $10. For example, $1.25 (1/8 of 10). 1/2 point equals $5.

Question 4

TRACE (Trade Reporting and Compliance Engine)

Answer 4

Engine is the FINRA developed vehicle that facilitates the mandatory reporting of over the counter secondary market transactions in eligible fixed income securities.

1) All brokers/dealers who are FINRA member firms have an obligation to report transactions in corporate bonds and assett-backed securities to TRACE under the SEC approved set of rules.
2) TRACE allows for real-time dissemination of transaction and price data for 99% of corporate bond trades.
3) Before FINRA implemented TRACE, quotes were found in daily newspaper and what was called the yellow sheets, a daily publication of the National Quotation Bureau providing wholesale prices between dealers in corporate debt securities.
4) Bond prices are not influenced by settlement date or accrued interest.

Question 5

Nominal Yield (Stated Yield/Coupon Rate)

Answer 5

1) The fixed interest rate stated on the face of the bond.
2) A 6% nominal yield would pay $60 in annual income ($1,000 par value x 6%). Payments are sem-annual, thus, $30 each pay date. Maturity date indicates the cycle. For example, a maturity date of September 1, 2020 would pay March 1st and September 1st.
b.

Question 6

Current Yield

Answer 6

1) The interest stated on the face of the bond dividend by the current market price of the bond (Interest per year / current price = CY)
2) The current yield on common and preferred stock is calculated in the same way. (Current interest Dividend / Current Price= CY)

Question 7

Yield to Maturity

Answer 7

1) Takes into account not only the price of the bond but the fact that if it is held to maturity, a bond bought at a discound will have a gain and bond bought at a premium will have a loss.
a. Also known as ‘basis price’
b. Formula: Yield to maturity = Adjusted / Average Price.

Question 8

Adjusted Interest

Answer 8

The yearly interest on the bond plus the per year gain (amortized premium) or minus the per year loss (prorated discount) in principal until maturity.

Question 9

Average Price

Answer 9

The average between the par value of $1,000 and the $1,100 paid. $1,050 + $1,100= $2,100 / 2 = $1,050. Thus, $50 divided by $1,050 equals a ‘yield to maturity’ of 4.76%.

Question 10

Yield to Call

Answer 10

1. Yield to Maturity for bonds at a premium will be lower than the nominal rate.
2. Yield to Maturity for bonds at a discount will be higher than the nominal rate.
3. Current yield and yield to maturity always move in the same direction, up or down.

Question 11

Bond Yields

Answer 11

A yield is the rate of return an investor earns from a bond.
Nominal Yield (NM):  Interest stated on bond face- DOES NOT CHANGE
Current Yield (CY): Current value varies.  The current yield equals the annual interest return divided by the current market price.

Question 12

If a Bond is

Answer 12

1. Purchased at premium, the current yield and yield to maturity will be less than nominal yield.
2. Purchased at discount, the current yield and yield to maturity will be more than nominal yield.
3. Purchased at par, the current yield, yield to maturity and nominal yield will be the same.

Question 13

Services (Bonds)

Answer 13

1. Moody’s Investor Service= Aaa (Best Quality, lowest risk), Aa (Best Quality), A (Medium Grade; favorable invest attributes), Baa (Lower Medium grade; neither highly protected nor poor), C (Lowest rated class)
2. Standard and Poor’s Corporation= AAA (Prime), AA (High Grade), A (Upper medium grade), BBB (Medium Grade), C (In default)
   b. Bonds rated in the BBB and up categories are known as bank grade or investment grade bonds.
   c. “Safe” means that the principal and interest will be paid when due.
   d. Non-rated could mean that the issuer’s total debt is relatively small.
   e. A rating of aa refers to preferred stock, not bonds
   f. Poor quality bonds have lower prices higher

Question 14

Relationships to Interest Rates

Answer 14

Bond prices move up and down in relation to current interest rate levels. As interest rates fall, bond prices rise and yields fall; as interest rates rise, bond prices fall and yields rise. The relationship between the market price and interest rate direction is inverse.

Question 15

Basis Point

Answer 15

a. The smallest measure used in quoting yields on bonds and notes.
1. One basis point= .01% of the yield (.0001) or 10 cents
2. Ten basis points= .1% of the yield (.001) or $1.00
3. 100 basis points= 1% of the yield (.01) or $10.00
b. If the yield moves down 10 basis points, it will affect the dollar price of a 15 year bond more than the dollar price of a five year bond. Longer maturities are more volatile in price.
c. If a bond has a yield of 9%, it will pay $90 a year. If another bond has a yield of 10%, it will pay $100 a year. This $10 difference in yield represents 100 basis points, since 1 basis point equals 10 cents.

Question 16

Coupon or Bearer Bonds

Answer 16

a. The interest and principal are payable to the bearer when due. The interest coupons are attached. The coupons are clipped as they become due and are presented by the holders to their banks for payment. These types of bonds are seldom issued but may be available in the secondary market.
1. The coupon rate is the rate of interest stated on the face of the certificate.

Question 17

Registered Bonds

Answer 17

a. The name of the owner is written on the face of the bond and recorded on the books of the issuing corporation; legal title may be transferred only when endorsed by the registered owner.
1. The principal is sent directly to the owner at maturity; the interest is sent directly to the owner semi-annually (no coupons)

Question 18

Registered as to Principal Only

Answer 18

a. A registered bond with the coupons attached; the principal is trated like a registered bond bu the interest is paid by the coupon

Question 19

Book Entry Bonds

Answer 19

a. Fully registered bond for which there is no actual certificate; title is via customer confirmation and owners’ names are kept in a computer listing (ledger book).
1. U.S. government bonds are frequently in book entry form
2. Ownership is transferred by instructing a clearing agency to transfer the entry on its books.

Question 20

Accrued Interest

Answer 20

1. Interest is payable semi-annually by the issuer’s paying agent.
   a. If a bond issue date is June 1, 2005 and the first coupon is dated January 1, 2006, it will pay seven months interest for the first coupon on January 1, 2006. After that, six months of interest will be paid every July 1 and January 1. This called ‘odd’ or ‘long first coupon.’
2. A buyer of a bond will pay the purchase price plus the amount of accrued interest due to the seller; the issuer’s paying agent will pay te buyer the full amount due on the next pay date. It is calculated from the morning of the last interest payment date up to but not including, the settlement date.
   Note: For new issues, it is calculated from the dated date (issued date) up to but not including the settlement date.

Question 21

Accrued Interest (2)

Answer 21

a. The settlement date is three business days (regular way) from the purchase date except for U.S. government issues (next business day settlement) and cash settlement (same day).
b. Use a 30 day month and 360 day year.
1. Exception: For government bonds, use the actual days in the month and the actual days in the year.
c. Formula: Principal x Rate x Time/ 360 = Accrued Interest!

Question 22

Trust Indenture

Answer 22

1. Describes the rights and duties of the issuing corporation, the bondholder, and the trustees. It protects bondholders.
   a. Trustee: Independent of the issuing corporation (usually a commercial bank).
   b. Required by the Trust Indenture Act of 1939.
   c. An indenture contains all of the conditions and agreements.

Question 23

Mortgage Bonds

Answer 23

a. Debt obligation secured by the pledge of the corporation’s real assets evaluated at the time of issuance
1. The original issue has priority on claims
b. Closed-End Mortgages
1. The corporation agrees to a one time issue of a stated amount of bonds. However, after these bonds have been issued, no more may be issued under the mortgage.
c. Open-End Mortgages
1. The corporation may issue additional bonds under the mortgage.
d. In analyzing a mortgage bond, the name of the trustee bank holding title is not important.
e. If the value of the real estate is not sufficient to satisfy the claims of the bondholders, they cannot attach other assets. They simply become a general creditor.

Question 24

Collateral Trust Bonds (Trust Certificate)

Answer 24

a. secured by a pledge of securities owned by the corporation as collateral with a trustee

Question 25

Equipment Trust Certificates (rolling stocks)

Answer 25

a. Bonds secured by equipment of the company, often called ‘rolling stock.’
b. Used by railroads, airlines, and trucking companies.

Question 26

Debenture Bonds (No Collateral)

Answer 26

a. Unsecured written promises of the corporation to pay principal at its due date with interest.
b. Security depends on the assets and earnings of the corporation
c. Issued on the general credit of the corporation
d. Subordinated Debentures
1. An unsecured claim; junior to prior debentures
e. Municipalities do not issue debentures

Question 27

Guaranteed Bonds

Answer 27

a. The bonds are guaranteed by an entity other than the issuing corporation.
b. Usually guaranteed by the parent company as to both principal and interest; however, the guarantee may be interest only

Question 28

Income Bonds (Adjustment Bonds/ Temporary Relief)

Answer 28

a. When a corporation goes bankrupt and reorganizes, existing debt may be replaced with this type of bond.
b. Bondholders may have greater principal than before; principal is paid at maturity.
c. Interest is paid only if earned by the corporation.
d. Trades ‘flat.’ without accrued interest.
e. Not considered safe investments

Question 29

Convertible Bonds (Debenture that pays interest)

Answer 29

a. These bonds are convertible into common stock at either a fixed ratio or a set price per share
1. Usually debenture issues
b. Advantages to issuer of convertible bonds
1. Issued at lower rate of interest than straight bonds
2. A substantial demand on the part of investors
3. Reduced interest expense upon conversion
c. A disadvantage to the issuer of convertible bonds would be the shift of ownership due to the conversion into voting stock (dilution).
d. Advantage to the investor: If the affairs of the company do not prosper, the bondholder becomes a creditor. If the affairs of the company prosper, the bondholder can convert to stock and benefit by the appreciation.
1. Has greater maketibility/liquidity

Question 30

Conversion Price

Answer 30

a. The issuer of the bond sets a price (conversion price) on the underlying stock. When the market price of the underlying stock reaches this conversion price, it is economically feasible to convert.

Question 31

Conversion Ratio

Answer 31

a. A method to determine the number of shares of stock a bondholder will receive if the decision is made to convert.
b. This number is computed by dividing the face value of the bond (par) by the conversion price. For example, $1000 (par) / $50 (conversion price) = 20 shares

Question 32

Conversion Parity

Answer 32

a. The market price at which an equal exchange value will result when the conversion privilege is exercised
b. Calculator: Market Value of Bond / Number of Shares Converted = Parity of Common

Question 33

Call Feature

Answer 33

a. A bond feature by which all of part of an issue may be redeemed by the corporation or municipality (issuer) before maturity and under certain specified conditions; it is the issuer’s choice.
b. Advantage to the issuer
1. Eliminate issues with unfavorable indenture provisions
2. Change the terms of the debt
3. Reduce the debt
4. Refund high coupon bonds with low coupon bonds
c. Call Protection
1. The investor is partially protected due to a minimum time period that must expire before the call can be invoked
2. Call Protection is an advantage for the bondholder
d. The issuing corporation often pays a call premium to the investor for the privilege of the call.
1. The premium is the amount above par that the issuer must pay
e. The investor may redeem the bond any time after it is called.
f. Interest stops accruing after the call date
g. Prior notice is required for the redemption. This is usually done by publication of a notice in the newspaper. The investors could sell their bonds on the open market if desired.
h. Bonds to be redeemed (the entire issue, series, maturity date, or a partial call) are drawn by random selection by the trustee
i. Sinking Fund
1. An annual reserve of capital set aside out of current earnings so that over a period of time, sufficient money will be available to call bonds prior to maturity or to redeem them at maturity.
j. If a premium bond is callable at par beginning on a certain date, it should be priced to the call date, not the maturity date (i.e.- yield to call)
k. If a corporation calls its bonds at 107%, it will pay $1,070 plus any interest due.

Question 34

Refunding of Bonds

Answer 34

1. The issuance of a new debt security (bond) using the proceeds to redeem older bonds at maturity or outstanding bonds issued under less favorable terms and conditions.
2. Also know as ‘refinancing’
3. One purpose would be to reduce interest expenses

Question 35

General Information Pertaining to Corporate Bonds

Answer 35

1. Traded over the counter (OTC) and on the exchanges
2. Dollar Bonds
   a. Some corporate bonds trade in currency values instead of as a percentage of face amounts because of the relatively small amounts available for each maturity in the entire issues.
3. Level Debt Service
   a. Structuring the maturities of a bond issue to provide approximately equal combined principal and interest payments
4. Both preferred stocks and bonds are senior to common stock as are fixed-income securities

Question 36

Stocks

Answer 36

a. A share of stock represents ownership in the corporation
b. An owner receives dividends when declared and earned by the corporation.
c. The lifetime of common stock is continuous with the existence of the corporation.

Question 37

Bonds

Answer 37

a. A bond certificate represents a debt of a corporation.
b. A creditor receives interest that must be paid when due.
c. The lifetime of a bond is limited to a specific maturity date when that obligation must be repaid.