Reflective Questions

1. Why would an issuer consider issuing a debt instrument?

To finance operations or growth and to take advantage of financial leverage.
Corporations and governments regularly raise money to finance their operations by
issuing fixed-income securities. Governments fund their programs and other
obligations largely through tax revenue. However, when a government spends more
on those obligations than it receives in tax revenue, it must make up the difference
by borrowing money. Most governments borrow by issuing fixed-income securities.
Unlike governments, companies have various choices available when their expenses
outweigh their revenue; issuing fixed-income securities is one option. They can also
raise cash by selling assets, borrowing from a bank, or issuing equity securities. The
choice of financing method depends on the cost, given that companies generally
prefer to raise money by the cheapest means possible.
2. What does the par value of a bond refer to?
The par value of a bond (also called face value) is the principal amount the bond
issuer contracts to pay at maturity to the bondholder. A bond is issued and matures
at its par value.
3. Can you describe the difference between the coupon rate and the
yield?
The coupon rate is the interest or 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.
As you will learn in the chapter on bond pricing, changes in market interest rates
impact the value and price of a bond. As interest rates rise and fall, relative to the
coupon rate, the price or value of a bond will also rise and fall accordingly. However,
the coupon payments are not impacted by changes in interest rates.
The yield to maturity is the annual return on a bond that is held to maturity. You
will learn more about this concept in the chapter on bond pricing and trading. 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.
4. What is the primary difference between a bond and a debenture?
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. 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.
5. How is a strip bond created?
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.
6. How does a strip bond differ from a regular bond?
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.
7. What is the difference between a callable bond and a convertible
bond?
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.
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
overstated 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.
8. Can you compare sinking funds with purchase funds?
Sinking funds are 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. Sinking fund
provisions are as binding on the issuer as any mortgage provision. Some corporate
bonds have a mandatory call feature for sinking fund purposes. The issuer will
attempt to buy the debt in the secondary market when the price is at or below a
specified price. If it is unable to purchase the required amount, it will resort to
calling the debt in order to meet its obligations.
Some companies have a purchase fund instead of a sinking fund, whereby a fund is
set up to retire a specified amount of the outstanding bonds or debentures through
purchases in the market. The purchases must be available at or below a stipulated
price.
9. Can you describe five protective covenants?
 Security: In the case of a mortgage or an asset-backed or secured debt, this
clause includes details of the assets that support the debt.
 Negative pledge: This clause provides that the borrower will not pledge any
assets if the pledge results in less security for the debt holder.
 Limitation on sale and leaseback transactions: This clause protects the
debt holder against the firm selling and leasing back assets that provide
security for the debt.
 Sale of assets or merger: This clause protects the debt holder in the event
that all of the firm’s assets are sold or that the company is merged with
another company, forcing either the retiring of the debt or its assumption by
the newly-merged company.
 Dividend test: This provision establishes the rules for the payment of
dividends by the firm and ensures equity will not be drained by excessive
dividend payments.
 Debt test: This provision limits the amount of additional debt that a firm
may issue by establishing a maximum debt-to-asset ratio.
 Additional bond provisions: This clause states which financial tests and
other circumstances allow the firm to issue additional debt.
 Sinking or purchase fund and call provisions: This clause outlines the
provisions of the sinking or purchase fund and the specific dates and price at
which the firm can call the debt.
 10. What is a treasury bill?
Treasury bills (T-bills) are short-term government obligations offered in
denominations from as low as $1,000. These securities appeal to a broad range of
investors, including large institutional investors such as banks, insurance
companies, and trust and loan companies, as well as to retail investors. T-bills do
not pay interest; instead, they are sold at a discount (below par) and mature at 100.
The difference between the issue price and par at maturity represents the return on
the investment. Under the Income Tax Act, this return is taxable as income, not as a
capital gain. Every two weeks, regular T-bills are sold at auction by the Ministry of
Finance through the Bank of Canada. These bills have original terms to maturity of
approximately three months, six months, and one year.
11. How do federal, provincial and municipal bonds compare to
each other?
FEDERAL: The Government of Canada issues marketable bonds in its own name. It
also allows Crown corporations to issue debt that has a direct call on the
Government of Canada. Government of Canada bonds have a specific maturity date
and a specified coupon or interest rate. They are also transferable, which means
that they can be traded in the market. All Government of Canada bonds are
noncallable; therefore, the government cannot call them for redemption before
maturity. When comparing the bonds issued by Canadian issuers (including
corporations as well as federal, provincial, and municipal governments), investors
assign the highest quality rating to federal government bonds. (T-BILLS, REASL
RETURN BONDS)
Provincial bonds: like Government of Canada bonds, are actually debentures,
which means that they are simply promises to pay. Their value depends upon the
province’s ability to pay interest and repay principal. No provincial assets are
pledged as security. All provinces have statutes governing the use of funds obtained
through the issue of bonds. Provincial bonds are second in quality only to
Government of Canada direct and guaranteed bonds because most provinces have
taxation powers second only to the federal government. However, different
provinces’ direct and guaranteed bonds trade at differing prices and yields. Bond
quality is determined by two primary factors: credit quality and market conditions.
The credit quality of a province—that is, the degree of certainty that both principal
and interest will be paid when due—depends on such factors as the amount of
existing debt in the province per capita, the level of federal transfer payments, the
stability of the provincial government, and the wealth of the province in terms of
natural resources, industrial development, and agricultural production.
(GUARANTEED BONDS, PROVINCIAL SECURITIES)
MUNICIPAL: Today, the instrument that most municipalities use to raise capital
from market sources is the instalment debenture (also called a serial bond). Part of
this bond matures in each year of its term. Instalment debentures are usually non-
callable, which means that the investor purchases them knowing beforehand how
long the funds are expected to remain invested. Also, if the money is needed at
future specific dates, it can be invested in an instalment debenture so that it will be
available when it is needed. Generally, a municipality’s credit rating depends upon
its taxation resources. All else being equal, the municipality with a diversified
industrial sector is a better investment risk than a municipality built around one
major industry.
12. Can you describe a first mortgage bond?
There is no fundamental difference between a mortgage and a mortgage bond
except in form. Both are issued to allow the lender to secure property if the
borrower fails to repay the loan. First mortgage bonds are the senior securities of a
company. They are so named because they constitute a first charge on the
company’s assets, earnings, and undertakings before unsecured current liabilities
are paid. In analyzing a company’s financial position, you must study each first
mortgage issue to determine exactly what properties are covered by the mortgage.
First mortgage bonds are generally regarded as the best security a company can
issue, particularly if the mortgage applies to “all fixed assets of the company now
and hereafter acquired”. This last phrase, called the after-acquired clause, means
that all assets can be used to secure the loan, even those acquired after the bonds
were issued.
13. Can you describe a collateral trust bond?
Collateral trust bonds are secured by a pledge of securities, or collateral. They differ
from mortgage bonds that are secured by a pledge of real property. Collateral trust
bonds are issued by companies, such as holding companies, that own few, if any,
fixed assets on which they can offer a mortgage. However, they normally own
securities of subsidiaries.
14. What is an equipment trust certificate?
Equipment trust certificates pledge equipment as security instead of real property.
For example, a railway company may issue these kinds of bonds, using its
locomotives and train cars (called rolling stock) as security. These certificates are
usually issued in serial form, with a set amount that matures each year.
15. How do floating-rate bonds differ from regular bonds?
Floating-rate securities (also called variable-rate securities) are a type of corporate
issue that automatically adjusts to changing interest rates. These securities can be
issued with longer terms than more conventional issues. Floating-rate securities
have proved popular because they offer an advantage to investors during periods of
rising interest rates. For example, when interest rates are rising, the interest paid on
floating-rate debentures is adjusted upwards at regular intervals of six months,
which improves the price and yield of the debentures. The disadvantage of these
bonds is that when interest rates fall, the interest payable on them is adjusted
downwards at six-month intervals. A minimum rate on the bonds can provide some
protection, although the minimum rate is normally relatively low.
16. Can you describe a corporate note?
A corporate note is a short-term unsecured promise made by a corporation to pay
interest and repay the funds borrowed at a specific date, or specific dates.
17. Can you explain the difference between a domestic bond, a
foreign bond and a Eurobond?
 Domestic bonds are issued in the currency and country of the issuer.
Therefore, bonds issued by a Canadian corporation or by the Canadian
government, in Canadian dollars, in the Canadian market are domestic bonds.
These bonds are the most common type.
 Foreign bonds are issued outside of the issuer’s country and denominated in
the currency of the country in which they are issued. Foreign bonds give the
issuers access to sources of capital in other countries. Some bonds offer the
investor a choice of interest payments in either of two currencies; other
bonds pay interest in one currency and the principal in another. These so-
called foreign pay bonds offer investors increased opportunity for portfolio
diversification while providing the issuer with cost-effective access to capital
in other countries.
 Eurobonds are international bonds issued in a currency other than the
currency of the country where the bond is issued. The Eurobond market is a
large international market with issues in many currencies, including Canadian
dollars. This market attracts both international and domestic investors
looking for alternative investments. If a Canadian corporation or government
issues Eurobonds denominated in Canadian dollars, the bonds are called
EuroCanadian bonds. Eurobonds denominated in U.S. dollars are called
Eurodollar bonds.
18. What is a non-redeemable GIC?
Non-redeemable GICs cannot be cashed before maturity, except in the event of the
depositor’s death or extreme financial hardship. Interest rates on redeemable GICs
are lower than non-redeemable GICs of the same term, given that they can be
cashed before maturity.
19. What role does DBRS, Moody’s Canada and Standard & Poor’s
play in the bond market?
In Canada, DBRS, Moody’s Canada Inc. (Moody’s), and the Standard & Poor’s Bond
Rating Service (S&P) provide independent rating services for many fixed-income
securities. These ratings can help investors assess the quality of their debt holdings
and confirm or challenge conclusions based on their own research and experience.
Table 6.5 provides an overview of the Moody’s global long-term rating scale. The
definitions indicate the general attributes of debt bearing any of these ratings. They
do not constitute a comprehensive description of all the characteristics of each
category.

THE FIXED-INCOME MARKETPLACE

1. Could you please explain financial leverage?
Imagine if you borrowed money from your bank to invest in your business. Let’s say
it costs you $20,000 a year to pay for the loan, but the money you borrowed helps
you to make $80,000 per year. It would be good for you to go ahead and borrow the
required funds, because you are making more money than you have to pay for the
loan. Notice that the loan is paid for by the return, which means you are making
money without using much of your own resources. Companies do the same thing,
and the money they earn helps to increase profits and ultimately the shareholder
equity (for a definition of equity, please see Equity in the CSC interactive glossary)
THE BASIC FEATURES AND TERMINOLOGY OF FIXED-INCOME SECURITIES
2. Who is the bondholder? Is it the company that issues the bond or is it the
investor?
A bond issuer ‘issues’ a bond to the investor who ‘holds’ the bond. The investor is
the bondholder.
3. How are debentures secured?
Debentures are generally secured by residual assets (i.e., a pool of assets left over
after other assets used specifically for security are claimed by bond holders) or by
the general credit of the firm in question. However, in some cases such as a
negative pledge provision, further security may have to be provided to debenture
holders if the issuer is considering a new issue. This is a consideration the issuer
would have to keep in mind if they decide to raise more money through the
issuance of debt.
4. What does it mean to say that a debenture is secured by the issuer’s
creditworthiness?
The higher the creditworthiness of the issuer, the more likely it is that there will be
assets left over upon the dissolution of the company and all secured debt holders
are paid. Essentially, all secured debt holders claim their specific assets. Once that
is completed all other assets are liquidated and the debenture holders are paid from
what remains. The better the credit, the more likely that the debenture holder won’t
even have to worry about bankruptcy. But if bankruptcy does occur, there is a better
chance for the debenture holder to collect on something, rather than nothing at all.
5. What is the face value of a bond and what role does it play in the purchase price
of the bond?
Imagine the bond you buy as a piece of paper with 3 important pieces of
information on it. First, you see the coupon rate, which is the amount of interest the
issuer promises to pay you each year. The second is the face value. The face value
of the bond is the amount of money the issuer will pay you when the bond matures.
The interest they pay you is always calculated against the face value. Third, you’ll
see the date to maturity.
When you purchase a bond with a coupon rate of 7% with a face value of $100,000,
how much would you pay if it were trading in the market at par?
Excluding accrued interest, you would pay $100,000. To calculate this, think of the
quoted bond price as a percentage of the face value. A price of par or 100 means
you must pay 100% of the face value to purchase the bond: $100,000 x 100% =
$100,000.
What if the price of the bond was trading below par at 96.50?
You would pay 96.50% of the face value to purchase the bond (excluding accrued
interest). So the purchase price would be $100,000 x 96.50% = $96,500.
What if the price of the bond was trading above par at 104.20?
You would pay 104.20% of the face value to purchase the bond (excluding accrued
interest). So the purchase price would be $100,000 x 104.2% = $104,200 no matter
what the purchase price, purchasing this bond gives you the opportunity to own a
security that pays you 7% interest per year (i.e., 7% x $100,000 = $7,000 per year)
until it matures, and then at maturity you receive $100,000 from the issuer.
6. Could you please explain the difference between yield and coupon rate?
The coupon rate is usually fixed and represents the interest payment the issuer
makes to the investor each year until the bond matures. The coupon rate is always
calculated against the face value of a bond. For example, if the bond has a face
value of $100, then the interest payment each year would total $11.50. Usually,
bonds make semi-annual payments. As such, every 6 months, the issuer in this case
would pay the investor $5.75 until the bond matures. The yield is the return on the
bond based on two factors: the interest received each year, and the theoretical gain
or loss on the bond based on the difference between today’s purchase price and the
maturity price of the bond. If interest rates go up, the price of bonds go down. If you
buy a bond where the price is lower than the maturity value, you would have a
capital gain over time if you held the bond to maturity. When you factor in this
capital gain with the interest income, you end up with a yield that is higher than the
coupon rate. If interest rates go down, the price of the bond goes up. If you buy a
bond where the price is higher than the maturity value, you would have a capital
loss over time if you held the bond to maturity. When you factor in this capital loss
with the interest income, you end up with a yield that is lower than the coupon rate.
7. Are annual coupons quoted on an annual basis and semi-annual coupons quoted
on a semi-annual basis?
Coupon rates are always quoted on an annualized basis. A 6% coupon bond paid
semi-annually means the issuer pays 3% in the first 6 months and 3% in the second
6 months to the investor.
8. When we see a bond price of 92, for example, what does that number mean?
I like to think of the bond price as a percentage of the face value. If the quoted price
for the bond is 92 and the face value is $1,000, the price would be 92% of $1,000
($1,000 x 92% = $920).
9. What is the money market?
The money market is that part of the capital market in which short-term financial
obligations are bought and sold. These include treasury bills and other federal
government securities maturing in three years or less and commercial paper, trust
company guaranteed investment certificates, and other instruments with a year or
less left to maturity. Longer-term securities, when their term shortens to the limits
mentioned, are also traded in the money market.
10. What is the difference between a marketable issue and a liquid issue?
A marketable bond means there is a market willing to purchase the securities. A
liquid market means one can make purchases and sales of the security easily
without much of a sacrifice in price, since the securities trade abundantly.
Example: An issuer has securities to sell and there are only a few willing buyers but
they will snap up the entire issue. In this case the securities are marketable (since
there is a ready market to buy the shares) but the issue probably won’t be very
liquid (since only a few people are interested, it isn’t likely that there will be a lot of
trading. That means when someone goes to sell his or her shares, they may not get
a great price for the sale since so few people are trading in the issue).
Example: An issuer has securities to sell and thousands of investors are interested
in the issue and there will be much competition to own the shares. This issue would
be marketable (since there is a ready and willing market to buy the shares) and will
likely be very liquid (since so many people will likely be trading the shares back and
forth each day, it will be easy for a buyer or seller to place his or her order and get
something close to the desired price).
11. It seems that the term “marketable” has more than one meaning. Could you
please explain?
The government distinguishes between marketable and non-marketable bonds,
which conflicts with the second definition of marketable. When the government of
Canada talks about their marketable bonds, they are talking about bonds that can
be sold between investors. When the government talks about non-marketable
bonds, they are talking about bonds that cannot be sold between investors. This
conflicts with the standard investment definition of marketable (i.e., ready market).
This is one of the double meanings you have to live with in the marketplace. This
double meaning will not affect you on an exam.
12. What is the purpose of a graduated scale for callable bonds? Why pay more to
the investor if the bonds get called early versus paying less when the bonds are
called late?
Example: If an investor’s bond gets called a year after investment when he or she
was expecting to hold the investment for 10 years, the circumstance can be
aggravating. Not only is it a hassle to have to go out and replace that investment,
yields may also have changed and the investor will also have to pay a commission
to replace the investment. This is seen as a lot more trouble one year into the life of
a 10-year investment rather than 9 years into the life of a 10-year investment. As
such, the issuer may have a graduated scale that compensates investors when the
issuer calls back the bonds. The closer to the maturity date, the lower the
compensation the investor will receive if the bond is called because the investor is
closer to the investment objective of holding the bond to maturity. Consider that a
person who holds the bond for 9 years received 9 years' worth of interest payments
while a person who only had the bond for one year received a lot less from their
investment.
13. How does the sinking fund work?
With a sinking fund, the issuer is obligated to retire a specific amount of securities
each year. They can do so in several ways. In the case of bonds, first, the issuer can
call the bonds back. By calling the bonds, the investor has no choice but to give up
his or her investment and receive cash based on some formula stipulated in the
terms of the issuer. This is a real inconvenience since someone is basically ending
the investor’s investment when he or she didn’t expect it. Second, the issuer could
buy the bonds from interested sellers in the open market. This choice is easier on
investors because those that are interested in selling can sell them to the issuer,
while those who are not interested in selling are left alone.
More recently, issuers make attempts to retire debt by purchasing the securities
from willing sellers. And since the company is making this attempt to buy a lot of
their securities back, this additional buying in the market means more participation
in the buying/selling process. This means a more liquid market, based on the
explanation of liquidity above.
14. With a sinking fund clause, how are the bonds called? What is the method the
issuer uses to call the bonds?
The trustee acting on behalf of the issuer may call the bonds by lot for redemption.
Bonds have serial numbers, and numbers may be randomly selected for
redemption. Owners of bonds turn them in for redemption; interest payments stop
at the redemption date. Alternatively, the issuer can deliver to the trustee bonds
with a total face value equal to the amount that must be retired. The issuer in the
open market purchases the bonds. The issuer elects this option when the bonds are
selling below par.
15. Can you describe what a purchase fund is?
A purchase fund is money set aside to purchase the company’s own debt back from
investors in order to reduce the outstanding debt. Attempts to purchase debt are
made only under certain market conditions. If the market conditions do not arise,
then no purchases are made.
16. What is the major difference between a sinking fund and purchase fund?
Here is a brief summary:
Sinking funds use two methods of fulfilling the obligation to retire securities:
1. Buy securities from interested sellers based on a specific price formula; or,
2. Call securities from investors, whether investors wanted to give up their
securities or not.
Purchase funds have only one way of retiring securities: buy securities from
interested sellers based on a specific price formula. From the above information,
you can see that if the sinking fund does not purchase enough securities from
interested sellers, they are then obligated to call back the rest of the securities
needed. The same is not the case for the purchase fund. A purchase fund attempts
to make purchases from interested sellers, but if no one wants to sell or the price
isn’t right, the purchase fund will fall short of the intended target.
17. Why is holding a bond with a sinking fund obligation a disadvantage to
investors?
If Westcoast Energy buys back any of its debentures, as an example, and the
purchase is not done through the sinking fund, the company can turn over those
debentures to the trustee. When the trustee receives those debentures, they reduce
the overall obligation of debt that must be retired, thereby reducing their sinking
fund requirement. The debentures must be of the same issue in order to retire
them.
Imagine you and your friend each invested in Westcoast Energy, and the company
was trying to retire the debt. And imagine that you didn’t want to sell your
debentures but your friend did. If Westcoast Energy chose to buy debentures in the
market, they could buy your friends but not yours. Your friend sells and you hold on
to your investment and everyone is happy. But what if, rather than buy the
debentures in the market from interested sellers, Westcoast Energy decided to call
the debentures. Both you and your friend could lose your investments. Your friend
wouldn’t be unhappy because he or she wanted to sell anyway. But you didn’t want
to lose your investment. Unfortunately, when your debentures are called, you don’t
have a choice but to give them up. That’s a disadvantage to you as an investor.
18. Why would we assume that a bond would be called if trading at a significant
premium?
A callable bond means the issuer can call the bond back from the investor. If a
callable bond is trading at a significant premium (i.e., the price of the bond is
currently well above par or 100), that means interest rates must have dropped since
the date of issue. If that’s the case, the issuer will probably call the bond back at the
first available opportunity and refinance the debt. This allows the issuer to lower the
payments they make on the money they borrow.
19. Why do issuers reward investors with a premium when bonds are called?
The premium is not a reward, as you suggested, but a method of compensation for
inconvenience. Issuers may find that they have to offer slightly higher coupon rates
versus regular bonds to attract investors to a callable bond, whether a premium is
offered upon redemption or not.
20. When do you pay the premium when you buy a convertible bond?
You already paid a premium when you purchased the convertible bond. In the
context of convertible securities, the premium refers to the extra money you
theoretically paid to purchase the common shares. For example, if you paid $100 for
a bond that allows you to convert into two common shares, you have technically
paid $50 per common share. But at the time you paid $100 for the bond, what if the
common shares were trading at $45 per share? You could have purchased two
shares directly in the market by handing over $90 to your broker ($45 x 2 shares =
$90), but instead you purchased the common shares in the roundabout way of first
buying a convertible bond for $100. So instead of paying $90 for two common
shares, you ended up paying $100. Since each share was worth $45 at the time of
your bond purchased, you ended up paying a premium of 11.11% ($5/$45 =
11.11%). I figured this out by identifying that the convertible bond purchase led to a
common share purchase price of $50, even though the shares were currently
trading at $45. So you paid $5 more for each share than was necessary. This Extra
cost you paid is known as the premium.
21. What is the point of a forced conversion?
The whole point of a “forced conversion” is to give the investor the opportunity or
incentive to convert into common shares. If the investor knows what the redemption
price will be a few days before the redemption date, the investor will likely convert
the debenture into common shares. It’s either convert, or accept the offer from the
issuer. And since the offer won’t be as good as converting, the investor converts the
debenture. In a sense, the investor is forced to convert.
22. Why does a forced conversion work?
Essentially, the redemption price would be 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. This is where the force in “forced conversion” comes from. If you
knew your debentures were going to be redeemed by the company at a much lower
price than the current level of the debenture, you would feel compelled to convert
your debenture into common stock.
23. Can you give me an example of how the negative pledge provision works?
NPP example: A debenture is issued with a negative pledge provision. The provision
ensures that if the company issues any subsequent mortgage bond, then the
company must allow for the debenture with the NPP to also be equally secured. This
provides a measure of safety to the debenture holder. The last thing the debenture
holder wants is to buy the security and then have the company issue more
mortgage bonds that will rank ahead of the debenture, weakening the debentures
claim to assets. The NPP prevents this from happening. When debentures are
issued, a common provision states that no subsequent mortgage bond issue may be
secured by all or part of the company’s properties, unless at the same time the
debentures are similarly secured by the mortgage.
24. What is a sale and leaseback agreement?
Sale and leaseback is an arrangement in which one party sells a property to a buyer
and the buyer immediately leases the property back to the seller. This arrangement
allows the initial buyer to make full use of the asset while not having capital tied up
in the asset. Leasebacks may also provide tax benefits.
GOVERNMENT OF CANADA SECURITIES
25. How are T-bills taxed?
The government deems that the difference between your purchase price and
maturity price is considered interest income, and is taxed at your regular income
tax rate.
TYPES OF CORPORATE BONDS
26. What’s the difference between a regular mortgage and a mortgage bond?
A mortgage is usually a loan offered by one institution to a borrower in exchange for
a claim on assets if default occurs. As the text stated, the mortgage bond was
created when the capital requirements of corporations became too large to be
financed by the resources of any one individual lender. So there is no fundamental
difference between the two except for the reasons why they might be offered. You
should also keep in mind that only portions of a pledged asset might be covered by
a bond issue, allowing more than one type of issue to be secured by a similar asset.
And if two issues are secured by the identical asset for equal value, the lenders are
taking the risk that they won’t be able to recover the full amount of the loan that
was offered – something that the lender would have to think long and hard about
before offering funds to the borrower.
27. What does real property refer to?
Real property refers to real estate.
28. What is a corporate note?
Corporate note is an unsecured promise made by the borrower to pay interest and
repay principal at a specific day.
29. Are debentures and corporate notes the same thing?
They are similar. However, debentures are more like bonds and their protective
provisions, with the exception that the debenture is not secured by any specific
assets, but rather residual assets that are left over after bond holders are paid out
from the sale of specific assets. A corporate note is similar to a debenture in the
sense that it is an unsecured promise to pay back the investor. The major difference
is that debentures rank ahead of corporate notes in claims on assets and while
some notes may mature at a fixed date in the future, others may be structured so
they are payable upon demand.
30. How are strip bonds taxed?
There is a special circumstance where a capital gain can arise: when the sale of the
strip bond is at a price that exceeds the initial investment cost plus accrued interest
to date. That excess amount would be taxed as a capital gain. But for the most part,
strip bonds are considered taxable as regular income.
31. Could you please distinguish between foreign bonds and Eurobonds?
A foreign bond is issued outside the issuer’s country, and issued inside another
country using that country’s currency. For example, a Canadian issuing a bond in US
dollars inside the U.S. is a foreign bond. If a Canadian issuer issued bonds in France
using US dollars, this would be a Eurobond because the currency does not match
the country in which the bond is issued. Or if the bond is issued in the Euromarket
then this is a clear sign you are dealing with a Eurobond.
32. What is the purpose of issuing a Eurobond?
The purpose of a Eurobond is for the issuer to access capital markets in other
countries or jurisdictions around the world. This allows the issuer more options and
greater access for raising funds. Whether you as a Canadian decide to purchase a
Eurobond isn’t really a concern for a Canadian issuer of Eurobonds. And if the
investment doesn’t make sense for your portfolio, then there’s no sense in pursuing
the investment. I’m not clear on the current definition as it relates to countries that
use the Euro as their currency. The subject is not raised in the text, and will not form
part of your exam.
HOW TO READ BOND QUOTES AND RATINGS
33. How do we know if we should use the bid or ask price when calculating the price
of a bond in this course?
If I told you that you had to buy a bond right now, and the bid was 99.25 and the
ask was 99.75, how much would you have to pay? To answer this question, you
need to figure out who is going to sell you a bond. If the bid represents the highest
amount someone is willing to pay to buy a bond, and the ask is the lowest price
someone is willing to accept to sell their bond, which price are you going to use?
You’ll have to use the ask price. You’ll have to pay the lowest price someone is
willing to accept in selling the bond. If you use the bid price, what you are saying is
that you are buying your bond from someone who is willing to pay 99.25 to buy a
bond. But we know from the bid and ask that the absolute lowest price anyone is
willing to sell the bonds they own is at a price of 99.75. The opposite holds true if I
told you that you had to sell your bonds right now. To figure out the price, you would
need to know what the highest price someone is willing to pay for the bonds right
now. That would be the bid price of 99.25.