Other Features

Several other types of bonds are used sufficiently often to warrant mention. First, convertible bonds are bonds that are convertible into shares of common stock, at a fixed price, at the option of the bondholder. Convertibles have a lower coupon rate than nonconvertible debt, but they offer investors a chance for capital gains in exchange for the lower coupon rate. Bonds issued with warrants are similar to convertibles. Warrants are options that permit the holder to buy stock for a stated price, thereby providing a capital gain if the price of the stock rises. Bonds that are issued with warrants, like convertibles, carry lower coupon rates than straight bonds.

Another type of bond is an income bond, which pays interest only if the interest is earned. These securities cannot bankrupt a company, but from an investor's standpoint they are riskier than "regular" bonds. Yet another bond is the indexed, or purchasing power, bond, which first became popular in Brazil, Israel, and a few other countries plagued by high inflation rates. The interest rate paid on these bonds is based on an inflation index such as the consumer price index, so the interest paid rises automatically when the inflation rate rises, thus protecting the bondholders against inflation. In January 1997, the U.S. Treasury began issuing indexed bonds, and they currently pay a rate that is roughly 1 to 4 percent plus the rate of inflation during the past year.

Define floating rate bonds and zero coupon bonds.

What problem was solved by the introduction of long-term floating rate debt, and how is the rate on such bonds determined?

Why is a call provision advantageous to a bond issuer? When will the issuer initiate a refunding call? Why?

What are the two ways a sinking fund can be handled? Which method will be chosen by the firm if interest rates have risen? If interest rates have fallen?

Are securities that provide for a sinking fund regarded as being riskier than those without this type of provision? Explain.

What is the difference between a call for sinking fund purposes and a refunding call?

Define convertible bonds, bonds with warrants, income bonds, and indexed bonds.

Why do bonds with warrants and convertible bonds have lower coupons than similarly rated bonds that do not have these features?

The value of any financial asset—a stock, a bond, a lease, or even a physical asset such as an apartment building or a piece of machinery—is simply the present value of the cash flows the asset is expected to produce.

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