Chapter 6

Why would a corporation issue bonds instead of stock?

It keeps control and profits (no new owners), but must repay principal plus interest, which lowers profits

Secured vs. unsecured corporate bonds?

Secured: backed by specific assets plus full faith and credit; Unsecured: backed only by the issuer's full faith and credit

What happens to secured bonds' collateral if the issuer goes bankrupt?

A trustee takes the assets and liquidates them for the bondholders

Define: Mortgage bond

Secured by a first or second mortgage (lien) on real property; often issued serially

Define: Equipment trust certificate

Secured by equipment ("rolling stock" like rail cars, planes, trucks); trustee holds title until paid off; used by transportation companies

Define: Collateral trust bond

Secured by stocks or bonds of other issuers held in escrow

Define: Debenture

Unsecured bond backed only by the issuer's full faith and credit; holders are general creditors

Define: Subordinated debenture

Unsecured bond with a junior claim to other debentures, but still ahead of stockholders

What are Chapters 7, 11, 13, and 15 of bankruptcy?

Ch. 7: liquidation; Ch. 11: corporate reorganization; Ch. 13: individuals negotiate with creditors; Ch. 15: foreign issuers, assets, or investors

What is the order of liquidation in a Chapter 7 bankruptcy?

1) Secured creditors 2) Wages 3) Taxes 4) General creditors/debentures 5) Subordinated debentures 6) Preferred stock 7) Common stock

Define: High-yield (junk) bond

Rated below BBB (S&P) or Baa (Moody's); higher coupon for higher credit risk; suitable only for speculative investors

Define: Fallen angel

A bond originally rated investment grade that's been downgraded to junk

Define: Income (adjustment) bond

Issued in reorganization; principal promised but interest paid only if earned; trades flat at a deep discount; speculative — not for income investors

Define: Guaranteed bond

Bond whose interest and principal are also guaranteed by another company (e.g., a parent guaranteeing a subsidiary)

Define: Stepped (step-up/dual) coupon bond

Starts with a low coupon that rises at set intervals; usually callable on reset dates

Define: Zero-coupon bond

Bought at a deep discount, pays no periodic interest, matures at par; the discount is the interest

Who are zero-coupon bonds suitable for, and what are their risks?

Investors needing a future lump sum (college, retirement), not current income; high interest-rate and inflation risk, but no reinvestment risk

How is a corporate zero-coupon bond taxed?

Annual accretion is taxed as interest ("phantom income"), so it's often held in an IRA; muni zeros are tax-exempt

Define: Capital appreciation bond (CAB)

A zero-coupon-like bond with no periodic interest; basis = compound accreted value

Define: Eurodollar bond

U.S.-dollar bond issued outside the U.S.; not SEC-registered, so it can't be sold in the U.S. for 40 days

Define: Yankee bond

U.S.-dollar bond issued by a foreign entity in the U.S.; SEC-registered

Define: Eurobond

Bond issued in one country but denominated in another country's currency (foreign pay bond)

Define: Sovereign bond

Debt issued by a foreign national government; rating and yield reflect that government's credit standing

Define: Money-market securities

Short-term debt maturing in one year or less; safe, liquid "cash equivalents"

Who are money-market securities suitable for?

Investors needing safety and liquidity for short-term needs or parking cash (e.g., before a home purchase) — not long-term growth

Define: Commercial paper

Short-term unsecured corporate debt, 270 days or less; usually issued at a discount; minimum $100,000

Why is commercial paper exempt from SEC registration?

Its maturity is 270 days or less

What are the top commercial paper ratings?

S&P: A1; Fitch: F1+; Moody's: P-1 (Prime 1); speculative = NP (not prime)

Directly placed vs. dealer-placed commercial paper?

Direct: issuer sells to the public with its own sales force; Dealer-placed: sold through a commercial paper dealer

Define: Bankers' acceptance (BA)

Time draft guaranteed by a bank, used to finance foreign trade; secured by the bank and the goods

Define: Negotiable CD

Bank CD maturing in 2 weeks to 1 year; minimum $100,000 ("jumbo" $1M+); can be sold in the secondary market without penalty

How much FDIC insurance covers CDs?

$250,000 per depositor; joint accounts up to $500,000

Define: Brokered (long-term) CD

CD sold through a BD, maturing in 2–20 years; not a money-market security

What risks do brokered CDs carry that bank CDs don't?

Limited liquidity, possible loss if sold early, call features, possible lack of FDIC coverage, variable or step features

What protection applies if the broker-dealer selling a brokered CD fails?

SIPC — brokered CDs are considered securities

Step-up vs. step-down CD?

Step-up: starts below market, then rises; Step-down: starts above market, then falls (must be disclosed)

What must be disclosed for a callable brokered CD?

Issuer may call it at its discretion; investor may face reinvestment risk; return may be less than YTM; may have to hold to maturity if not called

Define: Federal funds (fed funds) rate

Rate on overnight bank-to-bank loans to meet reserve requirements; a leading indicator of interest rates (influenced, not set, by the Fed)

Define: Prime rate

The rate banks charge their most creditworthy corporate customers

Define: SOFR

Secured Overnight Financing Rate — benchmark based on overnight repo loans; used to structure bonds

Define: Repurchase agreement (repo)

Dealer sells securities (usually T-bills) and agrees to buy them back at a set price and date — a collateralized loan

Define: Reverse repo (matched sale)

Dealer buys securities and agrees to sell them back — the dealer is lending money

Define: Convertible bond

Bond exchangeable for a set number of common shares; lower coupon in exchange for growth potential

Who is a convertible bond suitable for?

Investors wanting income plus long-term growth potential — not high income or short-term needs

How is a convertible bond's conversion ratio calculated?

Par value ($1,000) ÷ conversion price (conversion price × ratio always = $1,000)

A bond is convertible at $40. What's the conversion ratio?

25 shares ($1,000 ÷ $40)

Define: Conversion value

Market value of the shares received on conversion (shares × stock price)

Define: Parity

When a convertible bond's market price equals its conversion value; most trade at a premium to parity

Conversion price $50; stock is $60. What's the bond's parity price? At a 10% premium?

Parity: $1,200 (20 shares × $60); 10% premium: $1,320

Conversion price $25; the bond trades at $1,200. What's the stock's parity price?

$30 ($1,200 ÷ 40 shares)

How do stock splits and stock dividends affect a convertible bond?

Adjusted by anti-dilution covenant: 2-for-1 split on a $40 conversion price = 50 shares at $20; 20% stock dividend = 30 shares at $33.33

What are the advantages and disadvantages of convertible bonds?

Issuer: lower coupon, deleverages if converted; Investor: bond safety with stock upside; Disadvantage: conversion dilutes EPS

Define: Forced conversion

Issuer calls a convertible when the call price is below conversion value, forcing holders to convert

Convertible at $40, stock at $50, called at 105. Convert or accept the call?

Convert — 25 shares × $50 = $1,250, more than the $1,050 call price

Define: Arbitrage (convertibles)

Profiting when a convertible trades below parity: buy the bond, convert, sell the stock

Bond with a 40-share ratio trades at $1,350; stock is $35. What's the arbitrage profit?

$50 per bond (parity is $1,400)

Is converting a bond to stock taxable?

No — the bond's cost basis carries over to the shares (e.g., $1,200 ÷ 40 shares = $30 per share)

Define: Structured product

Note combined with a derivative linked to an index, commodity, currency, or stock; not FDIC-insured or a bank deposit

Define: Exchange-traded note (ETN)

Unsecured debt tracking an index; no coupon, gains paid at maturity; trades on an exchange (can be margined or shorted); carries issuer credit risk

Define: Reverse convertible

Short-term note paying a high coupon; if the underlying falls below the knock-in level, the investor gets shares instead of cash; no upside