DISCUSSION QUESTIONS

1. A sinking fund can be set up in one of two ways:

  • a. The corporation makes annual payments to the trustee, who invests the proceeds in securities (frequently government bonds) and uses the accumulated total to retire the bond issue at maturity.
  • b. The trustee uses the annual payments to retire a portion of the issue each year, either calling a given percentage of the issue by a lottery and paying a specified price per bond or buying bonds on the open market, whichever is cheaper.
    What are the advantages and disadvantages of each procedure from the viewpoint of (a) the firm and (b) the bondholders?

2 Is it true that the following equation can be used to find the value of a bond with N years to maturity that pays interest once a year? Assume that the bond was issued several years ago.

3 “The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices.” Is this statement true or false? Explain. (Hint: Make up a “reasonable” example based on a 1-year and a 20-year bond to help answer the question.)

4 If interest rates rise after a bond issue, what will happen to the bond’s price and YTM? Does the time to maturity affect the extent to which interest rate changes affect the bond’s price? (Again, an example might help you answer this question.)

5 If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.

6 Assume that you have a short investment horizon (less than 1 year). You are considering two investments: a 1-year Treasury security and a 20-year Treasury security. Which of the two investments would you view as being more risky? Explain.

7 Indicate whether each of the following actions will increase or decrease a bond’s yield to maturity:

  • a. The bond’s price increases.
  • b. The bond is downgraded by the rating agencies.
  • c. A change in the bankruptcy code makes it more difficult for bondholders to receive payments in the event the firm declares bankruptcy.
  • d. The economy seems to be shifting from a boom to a recession. Discuss the effects of the firm’s credit strength in your answer.
  • e. Investors learn that these bonds are subordinated to another debt issue.

8 Why is a call provision advantageous to a bond issuer? When would the issuer be likely to initiate a refunding call?

9 Are securities that provide for a sinking fund more or less risky from the bondholder’s perspective than those without this type of provision? Explain.

10 What’s the difference between a call for sinking fund purposes and a refunding call?

11 Why are convertibles and bonds with warrants typically offered with lower coupons than similarly rated straight bonds?

12 Explain whether the following statement is true or false: “Only weak companies issue debentures.”

13 Would the yield spread on a corporate bond over a Treasury bond with the same maturity tend to become wider or narrower if the economy appeared to be heading into a recession? Would the change in the spread for a given company be affected by the firm’s credit strength?

14 A bond’s expected return is sometimes estimated by its YTM and sometimes by its YTC. Under what conditions would the YTM provide a better estimate, and when would the YTC be better?