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P1.T3. Markets & Products

Bionic Turtle FRM Practice Questions

Chapter 17. Corporate Bonds

By David Harper, CFA FRM CIPM

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Chapter 17. Corporate Bonds

P1.T3.504. BOND INDENTURE AND INTEREST PAYMENTS............................................................ 3
P1.T3.507. HIGH-YIELD CORPORATE BONDS ............................................................................. 6
P1.T3.195. CORPORATE BOND INDENTURES ............................................................................. 8
P1.T3.196. BOND MATURITY AND RETIREMENT .........................................................................10
P1.T3.198. FABOZZI’S CORPORATE BONDS ..............................................................................14

Appendix (OPTIONAL)
P1.T3.505. BOND INTEREST PAYMENTS AND ZERO-COUPON BONDS ..........................................16
P1.T3.506. BOND SECURITY AND RANK ....................................................................................20
P1.T3.197. CORPORATE BOND SECURITY ................................................................................23

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Chapter 17. Corporate Bonds

P1.T3.504. Bond indenture and interest payments
P1.T3.507. High-yield corporate bonds
P1.T3.195. Corporate Bond Indentures
P1.T3.196. Bond Maturity and Retirement
P1.T3.198. Fabozzi’s Corporate Bonds

P1.T3.504. Bond indenture and interest payments

Learning objectives: Describe a bond indenture and explain the role of the corporate
trustee in a bond indenture. Explain a bond’s maturity date and how it impacts bond
retirements.

504.1. Which of the following elements is the LEAST likely to be explicitly specified in the bond
indenture?
a) Negative covenants
b) Principal value of bond (aka, par value)
c) Yield to maturity (aka, yield)
d) Legal identity of bond issuer

504.2. Four years ago, Acme Corporation issued a bond with a fixed-rate coupon and an
original maturity of seven years; that is, the tenor (term to maturity) is three years. In the
meantime, market interest rates have declined and the issuer wants to extinguish (retire) the
bond's principal which is obviously before the stated maturity date. Among the following
methods, which is the following is the MOST likely to make it possible for the issuer to retire the
date before the maturity date?
a) Execute an appealing tender offer to the bond holders
b) Exercise of a put provision that was included in the indenture
c) Exercise of a call provision that was inadvertently omitted from the indenture at issuance
d) None of the above: unless there is a call provision in the indenture, the issuer has no
legal way to extinguish debt prior to the stated maturity date

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504.3. On Jan 1st, 2010, Acme Corporation (a U.S. corporation) issued a zero-coupon bond
with an original maturity of ten (10) years on Jan 1st, 2020. The original yield to maturity (YTM,
yield) was 6.0% with semi-annual compounding. In 2015, Amce filed for bankruptcy with a
bankruptcy filing date of September 1st, 2015 (which becomes the settlement date). The
bankruptcy court determines that the original yield is a valid market yield assumption for
purposes of unpaid interest. Which of the following is represents the bondholder's claim at
settlement?
a) $55.37 (day count is not relevant)
b) $77.40 based on 30/360 day count
c) $83.81 based on act/act day count
d) $100.00 (day count is not relevant)

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Answers:

504.1. C. Yield to maturity (aka, yield). Yield is a function of price paid which will vary
with market conditions. In addition to legal identity of bond issuer and its legal form, the
indenture will specify key financial terms including: principal (par), coupon rates and dates, and
maturity date. The indenture will also specify covenants (affirmative and negative), funding
sources, credit enhancements and collaterals.

504.2. A. Execute a tender offer to the bond holders

 In regard to false (B), a put provision (put option) would give the bondholder (aka,
lender)--not the issuer (aka, borrower)--the right, but not the obligation to demand early
repayment.
 In regard to false (C), the call provision would need to be specified in the indenture;
e.g., Fabozzi: "An indenture is a contract that defines the legal rights and obligations of
the issuer and the bondholders, represented through the trustee, with respect to a bond
issue. The indenture establishes fundamental rules for three primary investor concerns:
(1) payments by the issuer to bondholders; (2) limits on the kinds of issuer behavior that
may harm bondholders’ prospects for repayment; and (3) the enforcement mechanisms
available to bondholders if issuers do not fulfill their obligations."1

504.3. B. $77.40 based on 30/360 day count; the 30/360 is not essential, it is really
included as a reminder than US corporate bonds use a 30/360 day count convention.

The owner (aka, creditor) of a zero-coupon bond in bankruptcy can make a claim for the original
bond price plus the accrued (and unpaid) interest up to the date of the bankruptcy filing. The
owner would not be entitled to the full principal amount.

 In this case, under a 30/360 day count convention, settlement on 9/1/2015 with original
issuance maturity on 1/1/2010 represents 5.6677 years since issuance and 4.3333 years
until maturity. Assuming 6.0% yield, the current value of the bond = -PV(6%/2, 4.333 * 2,
0, 100) = $77.40.
 We can retrieve the same value with the calculator by pricing the bond as of 7/1/2015
(because that is exactly 4.5 years until maturity, such that 9.0 semesters is an integer).
Specifically, on 7/1/2015, the bond's value was 9 N, 3 I/Y, 0 PMT, 100 FV and CPT PV =
$76.64167 then compound the value forward at the 6.0% yield such that $76.64167 *
1.03^(2/12*2) = $77.40.

Forum discussion at: [Link]

and-interest-payments.8831/

1
Frank Fabozzi (editor), The Handbook of Fixed Income Securities, 8th Edition (New York: McGraw-Hill,
2012).

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P1.T3.507. High-yield corporate bonds

Learning objectives: Differentiate between credit default risk and credit spread risk.
Describe event risk and explain what may cause it in corporate bonds. Define high-yield
bonds, and describe types of high-yield bond issuers and some of the payment features
unique to high-yield bonds. Define and differentiate between an issuer default rate and a
dollar default rate. Define recovery rates and describe the relationship between recovery
rates and seniority.

507.1. On a single day the price of a corporate bond with a modified duration of 4.52 years
drops from $87.20 to $85.65. If the benchmark yield increases by 10 basis points during the
day, which is nearest to the approximate change in the bond's credit spread?

a) Increase of 29 bps
b) Increase of 19 bps
c) Approximately unchanged
d) Decrease of 15 bps

507.2. In regard to event risk, Fabozzi writes "In recent years, one of the more talked-about
topics among corporate bond investors is event risk. Over the last couple of decades, corporate
bond indentures have become less restrictive, and corporate managements have been given a
free rein to do as they please without regard to bondholders".

If included in the bond indenture, each of the following will mitigate event risk EXCEPT which
is LEAST likely to mitigate (minimize) event risk?

a) Poison put provision

b) Maintenance of net worth clause
c) Restriction on asset divestitures, mergers and (asset) acquisitions
d) Affirmative covenant that requires issuer to comply with all laws and regulations

507.3. Keedsler Motors issued a bond five years ago which is currently a high-yield bond. Each
of the following is not necessarily true, except which of the following MUST be true about this
bond?

a) It is not investment-grade
b) It was never investment-grade
c) It is subordinated and/or unsecured
d) It has a yield at least 100 basis points above the benchmark and offers more interest
rate risk than credit risk

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Answers:

507.1. A. Increase of 29 bps

The linear estimate of price change (in percentage terms) equals (1) multiplied by modified
duration (D) multiplied by yield change: %ΔP ~= -%Δy*D.

Therefore, %Δy ~= -%ΔP/D ~= (85.65/87.20 - 1)/4.52 = 0.00393257 = 39.326 basis points.

If the benchmark index increased by 10 basis points, then the credit spread increased by about
39.326 - 10.0 = 29.326 bps.

507.2. D. False: events are legal activities--and further generally required Board/shareholder
approval--such as (but not limited to) decapitalizations, restructurings, recapitalizations,
mergers, acquisitions, leveraged buyouts, and share repurchases, but are nonetheless risks to
bondholders. As implied by Fabozzi, event risk includes events that are advantageous to
shareholders or managers but unfavorable to bond holders.

Fabozzi also writes, "It is important to keep in mind the distinction between event risk and
headline risk. Headline risk is the uncertainty engendered by the firm’s media coverage that
causes investors to alter their perception of the firm’s prospects. Headline risk is present
regardless of the veracity of the media coverage."2

507.3. A. It is not investment grade. "High-yield" is a ratings-based distinction. Bonds are

either investment grade or high-yield (aka, speculative, junk);
see [Link]

Forum discussion at: [Link]

corporate-bonds.8854/

2
Frank Fabozzi (editor), The Handbook of Fixed Income Securities, 8th Edition (new York: McGraw-Hill,
2012).

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P1.T3.195. Corporate bond indentures

AIMs: Describe a bond indenture and explain the role of the corporate trustee. Describe
the main types of interest payment classifications.

195.1. Each of the following is true about a bond indenture EXCEPT:

a) A bond indenture is a legal contract that details the obligations (promises) of the bond
issuer and the rights of investors
b) A bond indenture is a corporate bond that is unsecured by collateral
c) Bond indenture terms are a compromise between issuer (wants to pay lowest rate;
prefers fewer covenants) and bond holders (want to earn highest possible rate; prefer
more covenants)
d) The Trust Indenture Act requires a corporate trustee for all corporate bond offerings in
the amount of more than $5 million sold in interstate commerce

195.2. Each of the following is true about the corporate trustee in a corporate bond issuance
EXCEPT:

a) The trustee is paid by bondholders

b) The trustee acts in a fiduciary capacity for investors who own the bond issue
c) The trustee must, at the time of issue, authenticate the bonds issued (i.e., keep track of
all the bonds sold) and make sure that they do not exceed the principal amount
authorized by the indenture
d) If a corporate issuer fails to pay interest or principal, the trustee may declare a default
and take such action as may be necessary to protect the rights of bondholders

195.3. Each of the following is true about corporate bond interest payments EXCEPT:

a) The three main interest payment classifications of domestically issued corporate bonds
are straight-coupon bonds (aka, fixed-rate) , zero-coupon bonds, and floating-rate (aka,
variable-rate) bonds
b) Two variations on the zero-coupon bond are deferred-interest bonds (DIB) and pay-in-
kind (PIK) bonds
c) The day count convention (a.k.a.) day count basis for corporate bonds issued in the
United States is 30/360
d) A floating-rate bond tends to have a higher duration than a straight-coupon bond with an
equivalent current yield

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Answers:

195.1. B. A debenture (not an indenture!) is an unsecured corporate bond.

In regard to (A), (C) and (D), each is true.

195.2. A. “It must be emphasized that the trustee is paid by the debt issuer and can only
do what the indenture provides.”

In regard to (B), (C), and (D), each is true.

195.3. D. False, a floating rate bond has a (Macaulay) duration equal approximately to the
time to next coupon; in practice, often rounded down to zero.

In regard to (A), (B) and (C), each is true.

Forum discussion at [Link]

indentures-fabozzi.4715/

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P1.T3.196. Bond maturity and retirement

AIMs: Explain a bond’s maturity date and how it impacts bond retirements. Describe the
mechanisms by which corporate bonds can be retired before maturity, including: Call
provisions; Sinking-fund provisions; Maintenance and replacement funds; Tender offers

196.1. Consider the following statements with respect to a corporate bond’s maturity
I. A bond’s maturity is the date on which the issuer’s obligation to satisfy the terms of the
indenture is fulfilled
II. On the bond’s maturity date, the principal is repaid with any premium and accrued
interest that may be due
III. Neither the issuer nor the bondholder may alter the bond’s term to maturity; i.e., neither
may alter the date when the indenture (contract) terminates

Which of the above statements is (are) TRUE?

a) I. only
b) I. and II.
c) II. and III.
d) All three

196.2. As a zero-coupon bond approaches its maturity date (i.e., as the term to maturity
decreases) EACH of the following is necessarily true EXCEPT:

a) The price increases

b) The price volatility decreases
c) The Macaulay duration decreases
d) The dollar value of an ‘01 (DV01) decreases

196.3. Each of the following is true about a corporate bond with a fixed-price call provision (i.e.,
embedded call option) EXCEPT:

a) The price of the callable bond must be less than the price of an otherwise identical non-
callable bond
b) The callable bond will exhibit negative convexity at low yields
c) The optionality is appealing to bondholders because they can refinance if market interest
rates increase
d) The optionality is appealing to the issuer because the issuer can refinance if market
interest rates decline

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196.4. Consider two statements about a corporate bond with a make-whole call provision:
I. The make-whole call price floats inversely with the level of Treasury (interest) rates
II. Compared to a similar bond but with a fixed-price call provision, the make-whole call
provision increases the upfront compensation required by bondholders

Which of the statements is (are) TRUE?

a) Neither
b) I. only
c) II. Only
d) Both

196.5. What is (are) the advantage(s) of a sinking-fund bond provision?

a) Default risk is reduced

b) Possible price support if interest rates increase
c) Both (a) and (b)
d) Neither (a) nor (b)

196.6 Which of the following is true about a maintenance and replacement fund (M&R) provision
in a corporate utility bond?

a) M&R provision only maintains the value of the security backing the debt, but investors
should be aware that M&R might be used to retire debt
b) M&R provision only maintains the value of the security backing the debt and cannot be
used to retire debt
c) M&R provision improves the value of the security backing the debt, but investors should
be aware that M&R might be used to retire debt
d) M&R provision improves the value of the security backing the debt and cannot be used
to retire debt

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196.7. Each of the following is true about a tender offer by the issuer of a corporate bond
EXCEPT:

a) The tender offer provision must be specified in the indenture, otherwise it is considered
“hostile” and subject to legal challenge
b) Firms tend to employ tender offers to eliminate restrictive covenants or to refund debt
c) A tender offer is a means to extinguishing debt prior to its stated maturity
d) If the issuer (firm) perceives that participation is too low, the issuer can increase the
tender offer price and extend the tender offer window

196.8. What is an advantage of a fixed-spread tender offer over a fixed-price tender offer?

a) No significant advantage
b) It is easier for bondholders to assess the value of a fixed-spread tender offer
c) Significantly less counterparty credit risk to bondholders in a fixed-spread tender offer
d) Fixed-spread tender offers eliminate the exposure to interest-rate risk for both
bondholders and the issuer during the tender offer window

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Answers:

196.1. B. I. and II. (III. is false as often the issuer/bondholder can change the term to
maturity)

196.2. D. As DV01 = P*D/10,000, price (P) is increasing but (D) is decreases with mixed
influence.

In regard to (A), (B), and (C), each is TRUE.

196.3. C. This would refer to a put option

In regard to (A), (B) and (D), each is TRUE.

 In regard to (A), recall: value of call option = value of option-free bond - value of callable
bond

196.4. B. I. only

196.5. C. Both (a) and (b)

196.6. A. M&R provision only maintains the value of the security backing the debt, but
investors should be aware that M&R might be used to retire debt

196.7. A. A tender offer mechanism is not required to be included in the bond indenture,
in CONTRAST to call and refunding provisions, sinking funds, main-tenance and
replacement funds, and redemption through sale of assets.

In regard to (B), (C), and (D), each is true.

196.8. d. Fixed-spread tender offers eliminate the exposure to interest-rate risk for both
bondholders and the issuer during the tender offer window

Forum discussion at [Link]

retirement.4722/

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P1.T3.198. Fabozzi’s corporate bonds

AIMs: Describe and differentiate between credit default risk and credit spread risk. Define
high-yield bonds, describe types of high-yield bond issuers and some of the payment
features peculiar to high yield bonds. Define and differentiate between an issuer default
rate and a dollar default rate. Define recovery rates and describe the relationship
between recovery rates and seniority.

198.1. Which of the following is most likely to cause an increase (i.e., widening) in a corporate
bond credit spread?

a) Economic expansion in the business cycle

b) Increase in the bond’s liquidity
c) Flight to quality
d) Addition of embedded put option feature to the bond

198.2. Each of the following is an example of a high-yield bond issuer EXCEPT:

a) Issuer with a credit rating of “BBB-”

b) Original issuer
c) Fallen angel
d) Leveraged buyout

198.3. In a given credit rating category, there were 100 corporate bonds outstanding during the
year with a total par value of $1.0 billion and a market value of $800 million. Among the group,
only one of the bonds defaulted; its par value was $10.0 million and its trading price at the time
of default was $4.0 million. What was the DOLLAR DEFAULT RATE for the rating category
during the year?

a) 0.40%
b) 0.50%
c) 1.00%
d) 1.25%

198.4. According to Fabozzi, each of the following is true about corporate bond recovery rates
EXCEPT:

a) Measuring recovery rates is not a simple task

b) In one possible method, recovery rate measure = credit spread divided by hazard rate
c) In one possible method, recovery rate measure = trading price at time of default divided
by the par value
d) The higher the level of seniority, in general the greater is the recovery rate

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Answers:

198.1. C. Flight to quality is selling of corporates and buying of Treasury securities.

 In regard to (A), economic expansion—> narrower credit spread
 In regard to (B), increase in bond liquidity—> narrower credit spread (i.e., illiquidity
discount implies lower price implies higher yield)
 In regard to (D), a put option is favorable to the investor—> narrower credit spread (in
contrast, a call option is favorable to the issuer—> wider credit spread)

The credit spread is the difference between the yield of the corporate bond and the yield of a
comparable risk-free benchmark (e.g., Treasury). Presumably most of the credit spread is due
to exposure to credit risk, in particular default risk. The credit spread is NOT only a function of
default risk; it is a function of other issuer and non-issuer (e.g., systemic, technical) factors.

198.2. A. “BBB-” is the lowest S&P Investment Grade rating; BB+ is the highest
Speculative Grade (aka, high-yield, junk)

In regard to (A), (B), and (C), each are an example, given by Fabozzi, of high-yield bond
issuers.

198.3. C. 1.00%
 Issuer default rate = (number of issuers that default) divided by (total number of issuers
at the beginning of the year); In this case, issuer default rate = 1/100 = 1.0%.
 Dollar default rate = (par value of all bonds that defaulted in a given calendar year)
divided by (the total par value of all bonds outstanding during the year). In this case,
dollar default rate = $10 million / $1.0 billion = 1.0% also.

198.4. B. False. There is an approximation for the hazard rate = spread / (1 - recovery rate)
= spread /LGD, such that LGD = spread / hazard rate.

In regard to (A), (C) and (D), each is true.

Forum discussion at [Link]

bonds.4735/

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Appendix (OPTIONAL)
This Appendix contains Practice Questions that were written for an earlier iteration of the FRM syllabus.
As such, they are decidedly optional and not necessary to your current preparation. They are included
merely as a supplemental resource in case you want to give additional practice to this topic. Why might
previous questions remain relevant? Because, in general, the FRM exam has a loose rather than tight
linkage to Learning Objectives (LOs); this has been argued as both a strength (i.e., less opportunity to
"game" the exam via rote memorization) or a weakness (i.e., less clarity on exactly what will be asked on
exam day) of the exam. GARP's approach is not necessarily identical to other certification exams whose
LOs might be a specific map to the actual questions. As the 2020 Learning Objectives document itself
advises, "The FRM is a comprehensive exam and you are expected to be familiar with a broad range of
risk management concepts and techniques. Key concepts appear in the Study Guide as bullet points at
the beginning of each section to help you identify the major themes and knowledge domains associated
with the readings listed under each section." Notice how the emphasis is on the broad range of concepts
and the broad knowledge points; in fact they are called "broad knowledge points." For this reason,
engaging with Practice Questions that we have relegated to the Appendix is certainly optional, but at the
same time is unlikely to be a waste of time if you want to drill down further on a particular topic.

P1.T3.505. Bond interest payments and zero-coupon bonds

P1.T3.506. Bond security and rank
P1.T3.197. Corporate bond security

P1.T3.505. Bond interest payments and zero-coupon bonds

Learning objectives: Describe the main types of interest payment classifications.
Describe zero-coupon bonds and explain the relationship between original-issue
discount and reinvestment risk.

505.1. A US corporate bond that matures on October 1st, 2017 with a par value of $100.00 pays
a semi-annual coupon with a coupon rate of 9.0% per annum. It pays coupons on April and
October 1st and it offers a yield to maturity (yield) of 4.0% per annum. If it settles on September
1st 2015, which is nearest to the bond's flat (aka, quoted or clean) price?
a) $109. 89
b) $111.78
c) $113.64
d) $115.53

505.2. Three months ago, a US corporation issued a floating-rate note (FRN) that pays its first
coupon in three months and matures in five years. The index (aka, reference rate; eg, six-month
LIBOR) was 1.20% at the time of issuance but has dropped to its current level of 0.50%. The
index is quoted per annum with semiannual compounding. The quoted margin on the note is
200 basis points, such that the first coupon pays 3.20% = 1.20% reference + 2.00% margin.
Assume three months equals 0.25 years and assume the quoted margin equals the required
margin; i.e., the margin is appropriate compensation for credit risk. Which is nearest to the
note's current value?
a) $97.35
b) $99.13
c) $100.00
d) $100.97

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505.3. Six months ago Brian Smith purchased a zero-coupon bond with a face value of $100.00
and a remaining term to maturity of seven (7.0) years. When he purchased the bond, the yield
curve was flat at 3.0% per annum with semi-annual compounding. While today the yield curve
remains flat, it has shifted up by 40 basis points. If Brian sells the bond today, what is his per
annum return with semi-annual compounding and approximately how much of the return is due
to reinvestment risk?

a) -6.70% with about 30% due reinvestment risk

b) -4.54% with about 50% due reinvestment risk
c) -2.13% with no reinvestment risk
d) +0.40% with no reinvestment risk

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Answers:

505.1. A. $109. 89

On the April 1st, 2015, the bond's full (aka, invoice or dirty) price = $111.78365 = PV(Rate =
0.04/2, Nper = 2.5*2, Pmt = $100*0.90/2, Fv = $100).

As a US corporate bond, it has a 30/360 day count convention with 150 days since last coupon.
This bond's full price on the settlement date = $111.78365 * 1.02^(150/180) = $113.64363. The
bond's flat price = $113.64363 - ($4.50*150/80) = $109.89363.
 In regard to (B), this is the bond's full price at the last coupon date.
 In regard to (C), this is the bond's full price on the settlement date.
 In regard to (D), this adds the bond's full price at the last coupon date to the accrued
interest which overstates the bond's full price at settlement as the bond's yield is less
than its coupon rate.

505.2. D. $100.97

The key assumption is that, given the quoted margin equals the required margin (a fine
default assumption in any case), the floating-rate note prices exactly to par immediately
after (upon) each coupon payment.
 Therefore, we only need to value a single cash flow. In this case, as the coupon equals
$1.60 = $3.20%/2 * $100.00, the cash flow is $101.60 in three months.
 Therefore, the current value equals $101.60*(1+0.250/2)^-(0.25*2) = $100.97089. The
assumption given ("Assume three months equals 0.25 years") was to avoid confusions
due to day count convention; while fixed-rate US corporate bonds always use 30/360,
floating-rate notes (FRN) tend to use act/act or act/360.
 Also, intuitively, the floating rate note was priced at par (i.e., $100.00) immediately at
issuance, just like it prices to par immediately after each coupon. The floating rate
subsequently dropped such that the not price shifts above par, pricing at a premium; if
the floating rate had increased, the note would subsequently price at a discount.

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505.3. C. -2.13% with no reinvestment risk

 At purchase, the bond price was =-PV(Rate = 0.0300/2 = 0.150, NPer = 7 * 2 = 14, Pmt
= 0, Fv = 100) = $81.185;
The same result but with calculator: 14 N, 1.5 I/Y, 0 PMT, 100 FV and CPT PV =
$81.185.
 Today, the bond price = -PV(Rate = 0.0340/2 = 0.170, NPer = 6.5 * 2 = 13, Pmt = 0, Fv
= 100) = $80.3207;
Please note the calculator only requires you to input the changed TVM values!
In this case, 13 N, 1.7 I/Y and CPT PV = $80.3207.
 The per annum return with semi-annual compounding equals 2*(80.3207/81.185 - 1) = -
0.02129 = -2.129%.

Please note:
 A zero-coupon bond has no reinvestment risk; it is entirely interest rate risk (aka,
duration risk)
 If the yield did not change, the return would equal the yield of 3.0% and, further, the
bond price would increase as it "pulls to par."

Forum discussion at: [Link]

payments-and-zero-coupon-bonds.8837/

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P1.T3.506. Bond security and rank

Learning objectives: Distinguish among the following security types relevant for
corporate bonds: mortgage bonds, collateral trust bonds, equipment trust certificates,
subordinated and convertible debenture bonds, and guaranteed bonds.

506.1. In 2014, General Products Incorporated issues a mortgage bond to investor John Smith.
The bond's indenture authorized the issuance of an additional bonds, in the future, with the
same mortgage lien as already issued to John Smith. In 2015, General Products issued a
subordinated debenture to Investor Sally Miller. In regard to John Smith's mortgage bond, which
of the following is the LEAST plausible?

a) John Smith was granted a security interest in real property

b) The bond issued to Sally Miller carries a higher coupon rate than Investor ABC's
mortgage bond
c) John Smith's indenture imposed conditions in an after-acquired clause
d) The bond issued to Sally Miller was a violation of the after-acquired clause in John
Smith's indenture

506.2. Galaxy Corporation has issued a senior debenture to investor Barry Brown. Which of the
following is most likely to be TRUE about this debenture?

a) Investor ABC has no claim on the property of Acme

b) Because it is a debenture, an indenture is not required
c) The bond's indenture contains a negative-pledge clause
d) Due to its seniority, this debenture could also be called a "covered bond"

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506.3. Virtucon Corporation recently issued the following four bonds:

I. a senior secured bond

II. a subordinate debenture
III. a subordinate convertible debenture with a par value of $1,000 and a conversion ratio of
20
IV. a subordinate callable debenture

Further please note:

 The three subordinate bonds rank pari passu (see
[Link] with each other.
 The first two bonds (Bonds I and II) contain no embedded options; i.e., Bonds I and II
are non-callable and non-putable

About Virtuocon's capital structure, each of the following is true EXCEPT which is false?

a) The subordinate callable debenture (Bond IV) exhibits negative convexity at low yields
b) The subordinate callable debenture (Bond IV) has a higher price than the non-callable
subordinate debenture (Bond II)
c) The conversion price of the convertible bond (Bond III) is $50.00
d) The yield on the convertible bond (Bond III) is lower than the yield on the subordinate
debenture (Bond II)

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Answers:

506.1. D. False: An after-acquired clause provides that any additional property acquired by the
borrower after the mortgage or security agreement is signed will be additional collateral for the
obligation. Further, the subordinated debenture is unsecured, it does not impact the collateral
pledged to John Smith.
 In regard to (A), (B) and (C), each is plausible or likely.
 In regard to true (C), see [Link]

506.2. C. True: The bond's indenture contains a negative-pledge clause.

In regard to (A), (B) and (D), each is FALSE.

506.3. B. False: The subordinate callable debenture (Bond IV) has a LOWER price than
the non-callable subordinate debenture.

The call option is valuable to the issuer (Virtucon Corporation) such that it must accept a lower
price. Here are two useful equations:
 value of a callable bond = value of an option-free bond - value of call option; i.e., the call
is valuable to the issuer and lowers the price
 value of a putable bond = value of an option-free bond + value of put option; i.e., the put
is valuable to the investor and increases the price

In regard to (A), (C) and (D), each is TRUE.

Forum discussion at: [Link]

rank.8848/

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P1.T3.197. Corporate bond security

AIMs: Describe zero-coupon bonds, the relationship between original-issue-discount and
reinvestment risk, and the treatment of zeroes in bankruptcy.
Describe the various security types relevant for corporate bonds, including: Mortgage
bonds; Collateral trust bonds; Equipment trust certificates; Debenture bonds (including
subordinated and convertible debentures); Guaranteed bonds

197.1. A corporate zero-coupon bond with a face value of $1,000 was issued in January 2010
with an original maturity of five (5) years. The offering price was $708.92 based on semi-annual
discounting of a 7.0% yield. In July 2011, 1.5 years after issuance, the issuer files for
bankruptcy. If the yield is unchanged, which of the following is nearest to the amount that can be
claimed by the bond creditor?

a) $709
b) $759
c) $786
d) $1,000

197.2. Consider the following statements about bond reinvestment risk and bond duration
(interest rate risk):
I. Lower bond reinvestment implies higher interest rate risk (duration), ceteris paribus
II. Due to reinvestment risk, the yield-to-maturity on a bond is unlikely to equal the bond’s
realized return
III. Reinvestment risk is eliminated in a zero-coupon bond

Which of the above statements is (are) TRUE?

a) I. only
b) I and II.
c) II and III.
d) All three

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197.3. Each of the following is true about a corporate mortgage bond EXCEPT:

a) A mortgage bond grants the bondholders a first-mortgage lien on substantially all its
properties
b) A lien is a legal right to sell mortgaged property to satisfy unpaid obligations to
bondholders
c) As a result of a first-mortgage lien, which provides additional security for the bondholder,
the issuer is able to borrow at a lower rate of interest than if the debt were unsecured.
d) In a corporate mortgage bond, the lien tends to create negative convexity at lower yields

197.4. Each of the following is generally true about a collateral trust bond EXCEPT:

a) Collateral trust bond are secured by assets, referred to as collateral, which are pledged
to bondholders as security
b) The collateral in a collateral trust bond might include stocks, securities in the issuer’s
subsidiary(ies), notes, bonds, or whatever other kinds of obligations owned by the issuer
c) The issuer delivers to a corporate trustee under a bond indenture the securities pledged,
and the trustee holds them for the benefit of the bondholders
d) When voting common stocks are included in the collateral, the indenture permits the
bondholders to vote the stocks

197.5. Which of the following is TRUE of a corporate debenture bond?

a) Debentures are unsecured bonds; i.e., they are not secured by a specific pledge of
designated property
b) Debenture bondholders have no claim(s) on the property of the the issuer (or its
earnings)
c) Very few (“almost none”) corporate bonds are debentures
d) Debentures are bonds that lack provisions designed to afford protection to bondholders

197.6. Which of the following is TRUE about a Guaranteed Corporate Bond?

a) Guaranteed bonds are free of default risk

b) The safety of a guaranteed bond depends on the financial capability of the guarantor
AND the financial capability of the issuer.
c) A guaranteed bond may not have more than one corporate guarantor
d) A guarantee may call for the guarantor to guarantee the repayment of principal, but is
NOT permitted to call for the guarantor to guarantee the payment of interest

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Answers:

197.1. C. $786
The bond has 3.5 years remaining such that PV = $1,000 / [(1 + 7%/2)^(3.5*2)] = $785.99

197.2. D. All three

197.3. D. False: the lien is a security feature. Rather, it is the embedded prepayment (call)
option typical of a homeowner mortgage (and MBS). But the security, in a corporate bond, does
not tend to or necessarily imply the existence of an embedded option feature with creates the
negative convexity.
 In regard to (A), (B) and (C), each is true.

197.4. D. When voting common stocks are included in the collateral, the indenture
permits the issuer to vote the stocks so long as there is no default on its bonds. This is
important to issuers of such bonds because usually the stocks are those of subsidiaries, and the
issuer depends on the exercise of voting rights to control the subsidiaries.

197.5. A. Debentures are unsecured bonds; i.e., they are not secured by a specific pledge
of designated property
 In regard to (B), (C) and (D), each is FALSE.

197.6. B. The safety of a guaranteed bond depends on the financial capability of the
guarantor AND the financial capability of the issuer.

Forum discussion at [Link]

security.4730/

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