Question

In about 200 words (total), answer one of the following questions:

1. Describe the two distinct obligations incurred by a corporation when issuing bonds.
2. Explain the meaning of each of the following terms as they relate to a bond issue: (a) convertible and (b) callable.
3. If bonds issued by a corporation are sold at a discount, is the market rate of interest greater or less than the contract rate?

Answer 1

Convertible bonds are the bonds which have an option to get converted into common shares as on particular date. The conversion can be done at the discretion of the shareholders. Companies issue convertible bonds to lower the coupon rate of interest .A conversion ratio is defined based on which specified number of common shares will be issued. Convertible bonds offer higher returns compared to common stock but lower returns when compared to plain corporate bonds. Companies which have high growth and want to conserve cash issue convertible bonds since the repayment is not done and equity base is increased.

A Callable bond is a redeemable bond that allows the redemption before the stated maturity of the bond. A Callable bond allows the company to pay the bond face value at an earlier date. It can be recalled at higher price than face value which is call premium. A firm may take a call to redeem the bonds if the interest rate moves in their favour. Many companies often redeem bond when it is favourable to them and borrow fresh money to ensure their finance cost is lower. Callable bonds often carry higher rates of interest compared to other types of bonds.