Lesson 2.6: Paying Off the Debt Flashcards
What statements about zero-coupon bonds are true?
I. Zero-coupon bonds are sold at a deep discount from face value.
II. The owner of a zero-coupon bond receives his return only at maturity.
A zero-coupon bond is a type of debt security that pays no periodic interest payments. Instead, the investor receives his return only at maturity, when the bonds are redeemed. Zero-coupon bonds are sold at a deep discount from face value, but they are redeemed at full face value when they mature.
corporate zero-coupon bonds:
The discount is in lieu of periodic interest payments.
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 creating “phantom income.” Zero-coupon bonds have greater, not lower, price volatility.
convertible debentures:
—————————————————————————–Regarding convertible debentures, one characteristic of which your clients should be aware of is that:
When compared with similar nonconvertible debentures, convertible debentures are issued with a lower coupon rate.
they trade in line with the issuer’s common stock once the conversion price is reached.
The lower volatility of a convertible debenture stems from the fact that it has fixed interest payments and will be redeemed at maturity as any other bond or debenture would. No such guarantees apply to common stock.
An investor is considering the purchase of $100,000 maturity value of zero-coupon AAA rated corporate bonds scheduled to mature in 20 years. What are among the risks that this investor will be assuming?
I. Default risk & II. Interest rate risk
Even though these bonds are rated AAA, 20 years is a long time and it is possible that this corporation may not even exist when the maturity date arrives. Adding to the risk is the fact that there are no interest payments in the interim. That is why the most commonly recommended zero-coupon bonds are those issued or guaranteed by the U.S. Treasury. Because zero-coupon bonds have the longest duration for their maturity of any bonds, they have the greatest exposure to interest rate changes. Prepayment risk is only found with mortgage-backed securities, and one of the benefits of zeroes is that there is no reinvestment risk.
It is not uncommon to find a fixed-income security issued with a call feature. The feature is usually of most benefit to:
the issuer.
The call feature enables the issuer to redeem (call in or buy back) the security at a specified price, usually beginning with a specified number of years after the security is issued. How does this benefit the issuer? If the cost of money (interest rates) has declined since the fixed-income security was issued, the issuer can float a new issue with interest (or dividends in the case of preferred stock) based on that lower cost of funds and use the money raised to call in the existing securities currently paying a higher return. It is the same concept as refinancing a mortgage when interest rates go down.
Issuing callable bonds is advantageous to the issuer because it allows the company to:
replace a high, fixed-rate issue with a lower issue after the call date.
Callable bonds allow the company to take advantage of reduced interest rates by calling in high bonds with high interest rates and replacing them with lower ones. The marketplace requires that the company pay a higher coupon rate on callable bonds compared to ones that are not callable. This compensates the investor for taking the risk of a future call. The call price would never be less than the par value.
Which investment gives the investor the least exposure to reinvestment risk?
Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon bonds paying no interest. Thus, there is no income to reinvest during the holding period and therefore no reinvestment risk.
regarding callable bonds:
They usually provide a call risk premium.
Callable bonds are normally called only when interest rates fall. The call premium (a percentage above par value that the issuer will pay when called) helps to compensate bondholders for the lower interest rate at which they will be able to reinvest the proceeds. Callable bonds have greater risk for investors (call risk) and therefore offer higher yields than noncallable bonds.
A new convertible debt security has a provision that it cannot be called for five years after the issue date. This call protection is most valuable to a recent purchaser of the security if:
the market price of the underlying common stock is increasing.
Convertible debt securities are more sensitive to the price of the underlying common stock than they are to interest rates. Call protection would enable this investor to hold on to the debt security while the stock rises in value rather than having it called away. Although it is true that call protection protects against a potential call when interest rates decline, the protection against a call when the underlying stock is rising is considered to be more valuable.
When discussing convertible debt securities, it would be correct to state that:
A) the issuer pays a lower interest rate.
B) holders may share in the growth of the common stock.
C) holders have a fixed 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.
regarding zero-coupon bonds:
They eliminate reinvestment rate risk.
Zero-coupon bonds are sold at a deep discount from par value and have no coupon payments. Because there is nothing to reinvest, there is no reinvestment risk. That is why many investors prefer zero-coupon bonds for specific goals, such as college education for children. The tradeoff is that no coupon also means higher interest rate risk. These bonds have maximum price volatility and respond sharply to interest rate changes.
——————————————————————————–The investor has phantom income, which must be reported on an annual basis.
On a taxable zero-coupon bond, the annual imputed interest is reported for tax purposes. Because this income is not actually received annually, it is referred to as phantom income. Zero-coupon bonds always sell at a discount from their maturity value—never at a premium—and one risk that zero-coupon bonds avoid is reinvestment risk because there are no interest payments to reinvest.
The call feature available on some bonds:
allows the issuer the option to escape high interest rates if market rates decline.
Many bonds have a call feature that allows the issuer to call in the bonds, assuming the issuer has the cash available to pay them off, and escape high interest rates if market interest rates decline. If the company does not have the cash, it may issue a new bond at the lower prevailing interest rate and use that money to pay off the old bonds. This is known as refunding and, in essence, is no different from refinancing the mortgage on a home.
When it comes to issuing a debt security, which of the following features will generally enable the issuing corporation to borrow at the lowest interest rate?
Convertible
Because the convertible feature offers potential growth through the exercise of the conversion option, the interest rate on these securities is generally lower than other debt issues of the same corporation. The call feature increases the reinvestment risk and that is compensated for with a higher coupon. The descriptive adjective cumulative refers to dividend payments on preferred stock but not to bonds. Because zero-coupon bonds pay nothing until maturity, that added risk requires a higher yield to attract investors.
All of the following statements regarding bonds selling at a discount are correct:
A) they can indicate that interest rates have risen.
B) they can indicate that the issuer’s credit rating has fallen.
C) they will appreciate more than comparable bonds selling at a premium if interest rates fall.
Issuers tend to call bonds with higher coupons. Bonds trading at a premium have higher coupons than those trading at a discount (and are more likely to be called—wouldn’t you pay off your high-interest debt before the low-interest debt?). The longer the duration, the more volatile the bond’s price. Lower coupon rates mean a longer duration. If rates rise, prices fall. If a bond’s rating falls, so does its price.
If your customer wants to set aside $40,000 for when his child starts college but does not want to endanger the principal, you should recommend:
zero-coupon bonds backed by the U.S. Treasury.
Treasury STRIPS are guaranteed by the U.S. government, so there is no chance of default. They are zero-coupon bonds and offer no current income, which is appropriate for a client who wants a 100% return paid at a future date for college expenses.
