Question 1

Callable bonds I) normally have a call protection period
II) frequently pay one year's coupon amount as the call premium
III) tend to be called only if market interest rates rise
IV) are preferred by investors over non-callable bonds

Accepted Answer

I) Callable bonds typically have a call protection period, which is a specified amount of time during which the issuer cannot redeem the bonds before maturity. This protects the bondholder from having the bond called away too soon. II) It's not common for callable bonds to pay one year's coupon amount as the call premium; the call premium varies and is specified in the bond's terms. III) Issuers tend to call bonds when market interest rates fall, not rise, so they can refinance at a lower interest rate. IV) Investors generally prefer non-callable bonds over callable bonds because they offer more certainty regarding cash flows and return, as they cannot be called away before maturity.

Question 2

Which of the following are negative protective covenants that can be found in a bond indenture?
I. Bond proceeds must be used to finance fixed assets
II. Bonds with senior status cannot be issued while this bond issue is outstanding
III. The issuer is prohibited from guaranteeing debt of another firm
IV. The issuer must furnish audited financial statements on an annual basis

Accepted Answer

Negative protective covenants are restrictions on the actions of the issuer that aim at protecting the bondholders. Choice I is a positive protective covenant because it requires the issuer to use the bond proceeds in a specific way that can reduce the risk of default. Choice IV is a routine requirement for most bond issues, which is aimed at giving transparency to the bondholders. On the other hand, Choices II and III are negative covenants because they restrict the issuer from taking certain actions that may increase its risk of default or affect the bondholders' interests. Bonds with senior status may have priority over this bond issue in terms of claims on assets in case of default, which can decrease the bondholders' recovery rate. By prohibiting the issuer from guaranteeing the debt of another firm, the bondholders' exposure to the counterparty risk of other borrowers is reduced.

Question 3

The primary purpose of protective covenants is to

Accepted Answer

Protective covenants are designed to safeguard bondholders' investments by minimizing the risk of default. Protective covenants limit the actions of bond issuers, protecting bondholders from actions that may lower their credit quality or default risk. They are included in bond indentures and outline the issuer's commitments as well as the rights and responsibilities of bondholders. Though some covenants may allow the issuer to call the bond or reduce price volatility, their primary purpose is to protect bondholders against actions that impede their ability to receive the principal and the interest payments that they are entitled to.

Question 4

Which of the following is true about the make-whole call provision?

Accepted Answer

The make-whole call provision allows issuers to pay off debt early but at a cost that ensures bondholders are compensated for their loss of future interest payments, effectively making them whole. This provision also results in a call price that changes over time, as it is typically based on a formula that takes into account the present value of the bond's remaining interest payments.

Question 5

Collateral trust bonds are commonly issued by

Accepted Answer

Collateral trust bonds are commonly issued by holding companies. These bonds are backed by assets such as stocks or bonds owned by the holding company, which serve as collateral for the bondholders. The holding company uses the funds raised from issuing bonds for various purposes such as financing acquisitions, paying off debt or funding expansion projects.

Question 6

A convertible bond

Accepted Answer

A convertible bond has limited downside risk since it can always be redeemed at its face value upon maturity. However, it also has unlimited upside potential since it can be converted into equity of the issuing company, which can appreciate in value indefinitely. Thus, choice B is the correct answer.

Question 7

A disadvantage to the bondholder of a traditional fixed-price call provision is:

Accepted Answer

If interest rates decline after the issuance of the bond, the issuer can recall the bonds and reissue new bonds at a lower coupon rate, leaving the bondholder with a lower rate of return than the current coupon rate. Thus, the bondholder might be forced to invest at a rate lower than the current coupon rate.

Question 8

Bonds are traded in the

Accepted Answer

Bonds are traded in primary markets when they are first issued, in secondary markets where investors buy and sell bonds from each other, and in over-the-counter (OTC) markets, which is a decentralized market where participants trade directly between two parties without a central exchange or broker.

Question 9

The put feature of a bond is valuable because it

Accepted Answer

The put feature of a bond is valuable because it effectively sets a price floor for the bond. This means that the bondholder can sell the bond back to the issuer at a predetermined price if the bond price falls below a certain level. This gives the bondholder some protection against a decline in the price of the bond.

Question 10

If you own a bond that is called under a make-whole call provision, you will be paid a call price which is

Accepted Answer

A make-whole call provision allows the issuer to pay the bondholder a price that is approximately equal to the present value of the remaining interest payments and principal, discounted at a rate specified in the bond's indenture, which is typically close to the bond's current market value.

Question 11

How much will you be paid if you own a bond that is called under a make-whole call provision?

Accepted Answer

Under a make-whole call provision, the bond issuer must compensate the bondholder for all remaining interest payments that would have been received if the bond had not been called. Therefore, the bondholder will receive the present value of all future bond payments that will not be paid because of the call. This compensation is designed to ensure the bond issuer does not benefit from lower interest rates at the expense of the bondholder.

Question 12

Investing heavily in a firm's bonds, you are concerned about the future bond issues being granted seniority over your issue. Your fear will be gone if you find that your bonds are

Accepted Answer

A negative pledge clause prevents the issuer from issuing new debt that would be senior to existing debt, thus protecting the seniority of your bonds.

Question 13

Which one of the following is a positive protective covenant that might be found in a bond indenture?

Accepted Answer

A positive protective covenant is a clause in a bond indenture that benefits the bondholders by protecting their interests. Option A and D do not provide protection to bondholders, while option B merely outlines responsibilities without providing any specific protection. Option C, on the other hand, specifically protects bondholders from actions that may damage credit quality, making it the correct answer. Option E is incorrect as it includes options that do not qualify as positive protective covenants.

Question 14

The yield-to-maturity of a bond is equal to the bond's

Accepted Answer

The yield-to-maturity of a bond is the total return anticipated on a bond if the bond is held until it matures. It is the internal rate of return of an investment in a bond if all future interest payments are reinvested at the bond's yield-to-maturity rate. Therefore, option A is the correct choice.

Question 15

Which one of the following is the clause which prevents a bond issuer from issuing new debt that has seniority over current debt?

Accepted Answer

The clause which prevents a bond issuer from issuing new debt that has seniority over current debt is called a negative pledge. This clause is included in the bond indenture and prohibits the issuer from pledging any assets to another party that would rank higher in priority than the existing bondholders' claims.

Question 16

Callable bonds usually are sold at _________ prices than comparable non-callable bonds.

Accepted Answer

Callable bonds are usually sold at lower prices than comparable non-callable bonds because they carry the risk of being called away by the issuer, which is a disadvantage to the bondholder.

Question 17

In general, a bondholder should convert a convertible bond:

Accepted Answer

The answer of In general, a bondholder should convert a...

Question 18

Which of the following is not a common feature associated with a bond's call provision?

Accepted Answer

The bondholder does not have the discretion to refuse the call, as the call provision gives the issuer the right to call (redeem) the bond. The other features listed, such as call deferral, payment of a premium, and possible prohibition on calling to issue new debt with a lower coupon, are all common features associated with a bond's call provision.

Question 19

A call provision associated with a preferred stock issue

Accepted Answer

A call provision allows the issuer to repurchase the preferred stock at a predetermined price, often when interest rates decline, forcing investors to reinvest at lower rates.

Question 20

Par value is important in preferred stock because

Accepted Answer

Par value is important in preferred stock because the dividend is often stated as a percentage of par value. This means that the amount of dividend payment is calculated based on the par value of the stock.

Quiz 18: Corporate Bonds

Callable bonds I) normally have a call protection period II) frequently pay one year's coupon amount as the call premium III) tend to be called only if market interest rates rise IV) are preferred by investors over non-callable bonds