Fixed-Income Securities Flashcards

Fixed-Income Securities: Features and Types

Chapter Overview

• This chapter covers the fixed-income marketplace and the rationale for using fixed-income securities.
• It familiarizes you with the terminology used to discuss bonds, debentures, and other types of fixed-income securities.
• It helps distinguish among the different types used by governments and corporations.
• Finally, it teaches you how to read bond quotes and ratings.

Learning Objectives

• Describe the fixed-income marketplace and the rationale for issuing debt securities.
• Define the terminology, main features, and characteristics of the various fixed-income securities.
• Summarize the features and characteristics of Government of Canada securities.
• Summarize the features and characteristics of provincial and municipal government securities.
• Summarize the features and characteristics of corporate bonds.
• Summarize the features and characteristics of other fixed-income securities.
• Interpret bond quotes and ratings.

Key Terms

• Fixed-income securities: Debt instruments that promise fixed payments, such as bonds and debentures.
• Bond: A long-term, fixed-obligation debt security secured by physical assets.
• Debenture: A type of bond secured by the general creditworthiness of the issuer rather than specific assets; also known as an unsecured bond.
• Trust deed: A legal document outlining the details of a bond issue.
• Par value (Face value): The principal amount the bond issuer contracts to pay at maturity to the bondholder.
• Coupon rate: The interest rate paid by the bond issuer relative to the bond’s par value.
• Maturity date: The date at which a bond matures, when the principal amount of the loan is paid back to the investor holding the bond.
• Term to maturity: The time that remains before a bond matures.
• Bond price: The present discounted value of all the future payments that the bond issuer is obligated to pay the investor.
• Yield to maturity: The annual return on a bond that is held to maturity.
• Floating-rate securities (Variable-rate securities): Bonds with coupon rates that adjust to changing interest rates.
• Strip bond (Zero-coupon bond): A bond created when a dealer separates the individual, future-dated interest coupons from the rest of the bond (known as the underlying bond residue) and sells each coupon, as well as the residue, separately at significant discounts to their face value.
• Callable bond (Redeemable bond): A bond that the issuer has the right, but not the obligation, to pay off before maturity.
• Call protection period: The period before the first possible call date during which a callable bond cannot be called.
• Extendible bond: A bond issued with a short maturity term but with an option to extend the investment for a longer term.
• Retractable bond: A bond issued with a long maturity term but with the option to redeem early.
• Election period: A specific time during which the decision to exercise the maturity option must be made for extendible and retractable bonds.
• Convertible bond (Convertible debenture): A bond that can be exchanged for common shares of the issuing company.
• Conversion price: The specific price at which a convertible bond can be exchanged for common shares.
• Conversion privilege: The right to exchange a bond for common shares on specifically determined terms.
• Forced conversion: A provision that allows the issuing company to call in the debt for redemption, forcing bondholders to convert the bonds into a predetermined number of common shares.
• Sinking fund: Sums of money that are set aside out of earnings each year to provide for the repayment of all or part of a debt issue by maturity.
• Purchase fund: A fund set up to retire a specified amount of outstanding bonds or debentures through purchases in the market at or below a stipulated price.
• Protective provisions: Covenant clauses in the bond contract designed to guard against any weakening in the security holder’s position.
• Treasury bills (T-bills): Short-term government obligations sold at a discount and maturing at par.
• Real return bonds: Bonds with coupon payments and principal repayment adjusted for inflation.
• Instalment debenture (Serial bond): A bond where part of it matures in each year of its term.
• First mortgage bonds: Senior securities of a company that constitute a first charge on the company’s assets, earnings, and undertakings.
• After-acquired clause: A clause in a mortgage bond stating that all assets can be used to secure the loan, even those acquired after the bonds were issued.
• Domestic bonds: Bonds issued in the currency and country of the issuer.
• Foreign bonds: Bonds issued outside of the issuer’s country and denominated in the currency of the country in which they are issued.
• Eurobonds: International bonds issued in a currency other than the currency of the country where the bond is issued.
• Collateral trust bonds: Bonds secured by a pledge of securities or collateral.
• Equipment trust certificates: Bonds that pledge equipment as security.
• Subordinated debentures: Debentures that are junior to other securities issued by the company or other debts assumed by the company.
• High-yield bonds (Speculative bonds): Lower credit-quality bonds with a higher risk of default.
• Commercial paper: An unsecured promissory note issued by a corporation or an asset-backed security backed by a pool of underlying financial assets.
• Term deposits: An offer a guaranteed rate for a short-term deposit (usually up to one year).
• Guaranteed investment certificates (GIC): An offer fixed rates of interest for a specific term.

Introduction

• Governments, corporations, and other entities borrow funds to finance and expand their operations.
• They issue fixed-income securities in financial markets.
• Purchasing a fixed-income security represents the decision to lend money to the issuer.
• Investors become creditors but do not gain ownership rights like with equity investments.
• The fixed-income market is often overlooked, but trading activity is significant.
• The dollar amount traded on Canada’s bond markets consistently averages about 10 times that of total equity trading in any given year.
• Understanding the features, characteristics, and terminology of the fixed-income market is important.

The Fixed-Income Marketplace

• Fixed-income securities represent debt of the entity that issues them; called debt securities.
• Terms include a promise to repay the maturity value (principal) on the maturity date, and to pay interest at stated intervals or at maturity.
• If held to maturity, the rate of return is fairly certain.
• Interest payments are taxed as ordinary income.
• Fixed-income securities include bonds, debentures, money market instruments, mortgages, and preferred shares.
• Issuers can modify terms to suit needs and costs and to provide acceptable terms to various lenders.

The Rationale for Issuing Fixed-Income Securities

• Corporations and governments raise money to finance their operations by issuing fixed-income securities.
• Governments fund programs through tax revenue but borrow when spending exceeds revenue.
• Companies can also sell assets, borrow from a bank, or issue equity securities.
• The financing method depends on the cost; companies prefer the cheapest means possible.
• Two common reasons for issuing fixed-income securities:
  • To finance operations or growth
  • To take advantage of financial leverage

Examples of Financing Operations or Growth:

• A company wants to invest and expand its current operations so that it can meet the increasing demand for its product lines.
• The company decides to announce a new bond issue for “general corporate purposes”.
• A corporation is interested in purchasing a company that specializes in making paper bags for grocery store chains.
• The cost of the purchase is $3$ million. The corporation does not want to spend any of its available cash on the purchase, so instead it issues $3$ million in bonds.
• The proceeds from the bond issue are used to complete the purchase, and the borrowing costs are paid out from the corporation’s revenue stream.

Example of Taking Advantage of Financial Leverage:

• Financial leverage refers to using borrowed funds to seek magnified percentage returns on an investment.
• Consider a company that wants to open a new plant to increase its production capacity.
• The company issues $1$ million in bonds at $10\%$ interest, at a cost of $50,000$ a year after tax.
• The expanded capacity is expected to increase after-tax profits by more than $100,000$ a year.
• The company proceeds with the project because it can increase the return on shareholders’ equity by borrowing the money.
• In other words, the expected return from investing the borrowed funds is greater than the cost of borrowing.
• When the return from borrowing is higher than the borrowing cost, the result is the successful use of financial leverage.

The Basic Features and Terminology of Fixed-Income Securities

• In most cases, when people speak of fixed-income securities, they are referring to bonds.
• However, other types of fixed-income securities also exist, which we will discuss later in this chapter.
• A bond is a long-term, fixed-obligation debt security that is secured by physical assets—such as a building or a railway car—owned by the issuing company.
• Bonds are considered fixed-income securities because they impose fixed financial obligations on issuers—that is, the payment of regular interest payments and the return of principal on the date of maturity.
• The details of a bond issue are outlined in a legal document called the trust deed and written into a bond contract.
• If the issuer can no longer meet the fixed obligations, the bond goes into default.
• When that happens, the provisions of the trust deed allow the bondholders to seize specified physical assets and sell them to recover their investment.
• A debenture is a type of bond that is secured by something other than a specified physical asset, typically by a general claim on residual assets.
• Therefore, the debenture is backed by the general creditworthiness of the issuer.
• For this reason, debentures are also referred to as unsecured bonds.
• Aside from this difference, debentures are similar to bonds, and as such, they promise the payment of regular interest and the repayment of principal at maturity.
• In this chapter, we follow the industry practice of referring to both bonds and debentures as bonds, unless the difference is important.
• For example, government bonds are never secured by physical assets, and so technically they are debentures; in practice, however, they are always referred to as bonds.

Bond Terminology

Characteristics of a Bond

• Par Value:
  • The principal amount the bond issuer contracts to pay at maturity.
  • A bond is issued and matures at its par value.
• Coupon Rate:
  • The interest rate paid by the bond issuer relative to the bond’s par or face value over the term of the bond.
  • The coupon represents the regular interest the bond issuer is obliged to pay to the bondholders.
  • Most bonds are coupon bonds, paying fixed coupon rates.
  • Most bonds make semi-annual coupon payments; some bonds pay coupons on an annual basis.
  • The coupon rate is set at the time of issue and typically does not change over the term of the bond.
  • The bondholders receive a fixed-income stream of payments based on that coupon rate.
  • Changes in market interest rates impact the value and price of a bond.
• Maturity Date:
  • The date at which a bond matures, when the principal amount of the loan is paid back to the investor holding the bond.
  • Upon maturity, the final interest payment is also made.
• Term to Maturity:
  • The time that remains before a bond matures.
• Bond Price:
  • The present discounted value of all the future payments that the bond issuer is obligated to pay the investor.
  • Specifically, the bond price is the sum of the present value of all future interest payments plus the present value of the future repayment of the loan upon maturity.
  • Alternatively, you can think of it as the price you would pay today to earn interest every six months and receive the principal repayment upon maturity.
  • Once a bond is issued, it can trade at a value that is equal to, above, or below its par value depending on the direction of market interest rates.
  • The price of a bond is quoted using an index with a base value of $100$.
  • For example, $1,000$ par value with a price quoted at $97$ refers to a price of $97$ for each $100$ of face value.
  • Since there are $10$ units of $100$ face value in a $1,000$ bond, the price of a bond with a $1,000$ face value and a price quote of $97$ would be $970$.
• Yield to Maturity:
  • The annual return on a bond that is held to maturity.

Example:

A $1,000$, $6\%$, semi-annual coupon bond due January $10$, $2037$ will pay $30$ to the bondholder on January $10$ and on July $10$ of each year until maturity.

The semi-annual payment of $30$ represents the fixed obligation that the issuer is required to make for the life of the bond.

The yield to maturity on the bond on January $10$, $2024$ is $5.2\%$ and trades at a price of $107.491$ for a total cost of $1,074.91$.

The characteristics of this bond are summarized as follows:

• $1,000$: Upon maturity, the issuer will pay back to the bondholder the principal amount of $1,000$, which represents par value, or the face value, of the bond.
• $6\%$: The issuer pays the bondholder a coupon rate of $6\%$, which is paid in amounts of $30$ twice a year.
• January $10$, $2037$: The maturity date of the bond is January $10$, $2037$.
• $13$ years: The term to maturity of the bond is $13$ years (January $10$, $2024$ to January $10$, $2037$).
• $107.491$: The bond price is $107.491$, which means each $100$ of face value will cost $107.491$ to purchase.
• Based on the quoted price of $107.491$, the price of a $1,000$ face value bond is currently $107.491\%$ of its face value, or $1,074.91$ (calculated as $107.491 / 100 × 1,000$).
• In other words, the $1,000$ face value bond has $10$ units of $100$ face value and therefore costs $10 × 107.491$.
• $5.2\%$: The yield to maturity on the bond (the annual return if purchased on January $10$, $2024$, and held to maturity) is $5.2\%$.

Bond Features

• Bonds come in many varieties, but most bonds have certain features in common, including those described below.

Interest on Bonds

• A bond’s coupon indicates the income the bondholder will receive.
• Therefore, the coupon is also referred to as interest income, bond income, or coupon income.
• Most bonds pay a fixed coupon rate, although some bonds have variable rates (referred to as floating-rate securities).
• Interest payments can take the following forms:
  • Coupon rates can change over time, according to a specific schedule, as with step-up bonds, and most types of savings bonds.
  • Interest can be compounded over time and paid at maturity, rather than periodically, as with strip bonds (coupons and residuals).
  • A rate of interest does not have to be applied; the loan can be compensated in the form of a return based on future factors, such as the change in the level of an equity index. These types of securities are called index-linked notes.
• In North America, the majority of bonds pay interest twice a year, at six-month intervals.

Denominations

• Bonds can be purchased only in specific denominations.
• Normally, an issue designed for a broad retail market is issued in smaller denominations, the most common being $1,000$ and $10,000$.
• Larger denominations may be issued to suit the preference of investing institutions, such as banks and life insurance companies.
• These denominations may be worth millions of dollars.

Bond Pricing

• A bond trading at a quoted price of $100$ is said to be trading at par (i.e., at face value).
• A bond trading below par—at a price of $98$, for example—is said to be trading at a discount (i.e., based on the index of $100$, the bond is trading at $98\%$ of face value).
• A bond trading above par—at a price of $104$, for example—is said to be trading at a premium.
• Market interest rates, relative to the coupon on a bond, are a key determinant of the price of a bond.

Bond Yields

• A bond yield, also referred to as what a bond is yielding, represents the amount of return on the bond.
• There are several types of yields, including yield to maturity which we mentioned above.
• The interest income that you earn on a bond divided by its face value is another type of yield.
• We can also determine the current yield on a bond by dividing the coupon income by the current market price.
• As you will learn in the chapter on bond pricing and trading, while the coupon income on a bond stays constant over its term, yield and price fluctuate day to day.

Term to Maturity

• Bonds can be grouped into three categories according to their term to maturity:
  • Short-term bonds have more than one year but less than five years remaining in their term.
  • Medium-term bonds have terms of five to $10$ years.
  • Long-term bonds have terms greater than $10$ years.
• Certain bonds that have a term to maturity of up to one year trade as money market securities.
• Money market securities are a special type of short-term, fixed-income security, generally with a term of one year or less.
• These securities include T-bills and commercial paper, but some high-grade bonds also qualify when their terms are reduced below the one-year mark.

Liquidity, Negotiability, and Marketability

• Liquidity, negotiability, and marketability all refer to the ease with which bonds can be traded.
• Liquid bonds trade in significant volumes.
• Medium and large trades can be made quickly without a significant sacrifice on the price.
• For example, Government of Canada bonds have very good liquidity given that there is an active market for these bonds, i.e., they are generally in high demand by both domestic and international investors.
• Negotiable bonds can be transferred because they are in good delivery form.
• Marketable bonds have a ready market.
• For example, a private placement or other new issue may have clients willing to buy it because its price and features are attractive.
• However, marketable bonds are not necessarily liquid because most private placements do not have an active secondary market.

Strip Bonds

• A strip bond (also called a zero-coupon bond) is created when a dealer acquires a block of high-quality bonds and separates the individual, future-dated interest coupons from the rest of the bond (known as the underlying bond residue).
• The dealer then sells each coupon, as well as the residue, separately at significant discounts to their face value.
• Holders of strip bonds receive no interest payments.
• Instead, the strips are purchased at a price that provides a certain compounded rate of return when they mature at par.
• Strip bonds typically trade at a discount to their par value.
• The income on strip bonds is considered interest income rather than a capital gain.
• Tax must be paid annually on the interest income, even though that income is not received until the bond matures.
• Therefore, it is often recommended that strip bonds be held in a tax-deferred plan such as a registered retirement savings plan.

Example:

• An investment dealer buys $10$ million face value of a five-year, semi-annual pay Government of Canada bond with a coupon of $5.50\%$, intending to strip the bond for sale to clients.
• With this bond, the dealer can create $10$ different strip coupons, each with a face value of $275,000$ (calculated as $10$ million × $0.055$ × $0.5$).
• Each coupon will have its own maturity date. The face value of each strip coupon is equal to the dollar value of each interest payment on the regular bond.
• The bond’s principal repayment can be sold as a residual with a face value of $10$ million.
• The strip coupons are then sold at a discount to the $275,000$ face value.
• For this example, let’s assume that the coupon payable in three years sells today for $233,690$.
• If you were buying this strip bond today and holding it until the coupon’s payment date, you would receive $275,000$ in three years.
• The strip bond does not generate any other regular income for the investor during the three-year period.

Callable Bonds

• Bond issuers often reserve the right, but not the obligation, to pay off the bond before maturity, either to take advantage of lower interest rates or simply to reduce their debt when they have the excess cash to do so.
• This privilege is known as a call or redemption feature.
• A bond bearing this clause is known as a callable bond or redeemable bond.
• As a rule, the issuer agrees to give notice of $10$ to $30$ days that the bond is being called or redeemed.
• In Canada, most corporate and provincial bond issues are callable.
• However, Government of Canada bonds and municipal debentures are usually non-callable.

Standard Call Features

• A standard call feature allows the issuer to call bonds for redemption at a specified price on either specific dates or specific intervals over the life of the bond.
• The call price is usually set higher than the par value of the bond, which provides a premium payment for the holder.
• The premium is a compensation to the investor, who no longer has an investment that was expected to receive a stated income for a certain number of years.
• The closer the bond is to its maturity date before it is redeemed, the less the hardship for the investor.
• Therefore, the redemption price is often set on a graduated scale, with the premium payment becoming lower as the bond approaches its maturity date.
• Provincial bonds are usually callable at $100$ plus accrued interest (i.e., interest that has accumulated since the last interest payment date).
• Accrued interest belongs to the holder of the bond.
• The period before the first possible call date (during which a callable bond cannot be called) is known as the call protection period.

Example:

• DEF Corporation’s $7.375\%$ debentures are due May $1$, $2029$.
• They are not redeemable before May $1$, $2025$.
• Starting May $1$, $2025$, they are redeemable according to the following payment schedule on $30$ days’ notice, up to the $12$ months ending April $30$ of each year:
  • From May $1$, $2025$ to April $30$, $2026$ at $103.68$
  • From May $1$, $2026$ to April $30$, $2027$ at $102.46$
  • From May $1$, $2027$ to April $30$, $2028$ at $101.23$
  • From May $1$, $2028$ and thereafter at $100.00$ (at par to maturity)
• Suppose you own a $1,000$ debenture of this issue and the debenture is called.
• The following are examples of payment received, depending on what date it is called:
  • Called on January $31$, $2026$: $1,036.80$ plus accrued interest.
  • Called on August $15$, $2026$: $1,024.60$ plus accrued interest.
  • Called on March $20$, $2028$: $1,012.30$ plus accrued interest.
  • Called on December $1$, $2028$: $1,000.00$ plus accrued interest.

Extendible and Retractable Bonds

• Some corporate bonds are issued with extendible or retractable features.
• Extendible bonds and debentures are usually issued with a short maturity term (typically five years), but with an option to extend the investment.
• This option means that the investor can exchange the debt for an identical amount of longer-term debt (typically $10$ years) at the same rate or a slightly higher rate of interest.
• In effect, the maturity date of the bond can be extended so that the bond changes from a short-term bond to a long-term bond.

Example:

• GHI International Inc. $7\%$ Extendible Junior Bonds, Series B$2.1$, due July $26$, $2025$, are extendible to July $26$, $2030$ from July $26$, $2025$ at a rate of $7.125\%$.
• Retractable bonds are the opposite of extendible bonds.
• They are issued with a long maturity term but with the option to redeem early.
• The maturity date is usually at least $10$ years, but investors have the right to redeem the bonds at par by a retraction date (which is typically five years earlier than the maturity date).

Example:

• JKL Inc. $4\%$ bonds are due on June $30$, $2030$ and are retractable at par on June $30$, $2025$.
• With both extendible and retractable bonds, the decision to exercise the maturity option must be made during a specific time called the election period.
• In the case of an extendible bond, the election period may last from a few days to six months, or more, before the short maturity date.
• During the election period, the holder must notify the appropriate trustee or an agent of the debt issuer to either extend the term of the bond or allow it to mature on the earlier date.
• If the holder takes no action, the bond automatically matures on the earlier date and interest payments cease.
• In the case of a retractable bond, if the holder does not notify the trustee or agent before the retraction date of his or her decision to shorten the term of the bond, the debt remains a longer-term issue.

Convertible Bonds and Debentures

• Convertible bonds and convertible debentures (often called convertibles) combine certain advantages of a bond with the option of exchanging the bond for common shares.
• In effect, a convertible security allows an investor to lock in a specific price (called the conversion price) for the common shares of the company.
• The right to exchange a bond for common shares on specifically determined terms is called the conversion privilege.
• Convertible bonds are like regular bonds; they have a fixed interest rate and a definite date on which the principal must be repaid.
• However, they offer the possibility of capital appreciation through the right to convert the bonds into common shares at the holder’s option, at stated prices over stated periods.
• Convertible bonds therefore offer the investor the potential to share in the company’s growth.
• The conversion privilege makes a bond more attractive to investors, and thus more saleable.
• It not only tends to lower the cost of the money borrowed; it may also enable a company to raise equity capital indirectly on terms that are more favourable than the terms for the sale of common shares.

Characteristics of Convertible Bonds

• The conversion price of most convertible bonds goes up gradually over time to encourage early conversion.
• Convertible bonds may normally be converted into stock at any time before the conversion privilege expires.
• However, some convertible debenture issues have a clause in their trust deeds that stipulates “no adjustment for interest or dividends”.
• This clause excuses the issuing company from having to pay any accrued interest on the convertible bond that has built up since the last designated interest payment date.
• Similarly, any common stock received by the bondholder from the conversion normally entitles the holder only to those dividends declared and paid after the conversion takes place.
• Some convertibles will also have a protection against dilution clause, where if the common shares of the company are split the conversion privilege will be adjusted accordingly.
• Convertibles are normally callable, usually at a small premium and after reasonable notice.

Forced Conversion

• Forced conversion is an innovation built into certain convertible debt issues to give the issuing company more control in calling in the debt for redemption.
• The conversion forces bondholders to convert the company’s bonds into a predetermined number of common shares.
• The issuing company will typically be interested in forcing a conversion when market interest rates fall below the bond’s coupon rate, or if the price of the underlying common shares begins to trade above the conversion price.
• This redemption provision usually states that, once the market price of the common stock involved in the conversion rises above a specified level and trades at or above this level for a specific number of consecutive trading days, the company can call the bonds for redemption at a stipulated price.
• The price at which the company calls the bonds back is much lower than the level at which the convertible debt would otherwise be trading because of the rise in the price of the common stock.
• A forced conversion is an advantage to the issuing company, rather than to the debt holder, for several reasons:
  • It relieves the issuer of the obligation to make interest payments on debt once investors convert their debt into equities.
  • It can free up room for new debt financing if needed.
• However, a forced conversion is not so disadvantageous to the bondholder that it detracts from an issue when it is first sold.
• Once the price of the convertible debt rises above par, subsequent prospective buyers should check the spread between the prevailing purchase price and the possible forced conversion level.

Example:

Assume that you own $7\%$ convertible bonds of RFC Inc. that are due February $1$, $2029$.

• Before February $1$, $2026$, the bonds are convertible into $44.033$ common shares for each $1,000$ of face value.
• Each common share under this arrangement has a conversion price of $22.71$ (calculated as $1,000 ÷ 44.033$).
• The bonds are not redeemable by the company before February $1$, $2024$.
• The company has the option to pay you the principal amount on redemption or maturity, or to pay you in common shares.
• The number of common shares is obtained by dividing $1,000$ by $95\%$ of the weighted average trading price for $20$ consecutive trading days on the TSX, ending five days before maturity or the date fixed for redemption.
• This provision is considered to be a forced conversion clause because you must choose whether to convert the bond into common shares at $22.71$ a share or accept the company’s redemption offer.
• The second option could force you to pay a considerably higher price per share.
• For example, if the weighted average price was $27$, the company would divide $1,000$ by $25.64$ (calculated as $95\% × 27$) to arrive at $39$ shares.
• You would receive $39$ shares, compared to $44.033$ shares if you had chosen to convert before the forced conversion was imposed by the issuer.

Market Behaviour of Convertibles

• The market price of convertible bonds and debentures is influenced by their investment value as a fixed-income security and by the price of the common shares into which they can be converted.
• When the stock price of the issuing company is below the conversion price, the convertible behaves like any other straight fixed-income security with the same features.
• However, because these bonds can be converted into common shares, their price behaves differently than comparable straight fixed-income securities.
• When the price of the underlying stock rises above the conversion price (the bond price divided by the number of shares that the bond can be converted into), the bond price rises accordingly.
• Conversely, even if interest rates rise sharply, the bond price will not drop below the conversion price.

Example:

Assume you own an ABC $6\%$ convertible bond that trades at $980$ and can be converted into $40$ ABC common shares that currently trade at $22$ a share.

• Even if interest rates rise sharply and comparable bonds that are not convertible fall in price, the ABC bond will have a conversion value of at least $880$ because it can be converted into $40$ common shares that trade at $22$ (calculated as $40$ shares × $22 = 880$).
• If the common shares now trade at $27$, the price of the bond will rise accordingly to at least $1,080$, even if the comparable bonds that are not convertible still trade at $980$.
• The reason is simple: the investor holds a security that can be sold today for $1,080$ (calculated as $40$ shares × $27$) if converted.
• In this example, the conversion price of the ABC convertible is $24.50$, which is the bond price divided by the number of shares that the bond can be converted into (calculated as $980 ÷ 40$).
• You can think of the price of $24.50$ as the price per share to buy the common stock if the investor purchased those shares by first buying the convertible bond for $980$ and then converting the bonds into shares.

Sinking Funds and Purchase Funds

• Some issuers must repay portions of their bonds for redemption before maturity.
• They fulfil this obligation in one of