CHAPTER 13
THE BOND MARKET
Teaching Guides for Questions and Problems in the Text
QUESTIONS
13-1. a. The indenture is the legal document that specifies the terms of the bond (e.g.,
maturity date, sinking fund, call penalty, and other constraints specific in the loan). Since
b. The coupon is the specified rate of interest, usually expressed as a percentage of the
principal (e.g., 5.3% per $1,000). The current rate of interest is the rate on comparable debt
c. Debentures are unsecured; they have no collateral to support the bond. Secured bonds
d. A sinking fund is a mandatory payment that facilitates retiring a bond. A call feature
e. Mortgage bonds and equipment trust certificates are both secured bonds. The difference
is the collateral. Mortgage bonds are secured by property (i.e., real estate). Equipment trust
f. A serial bond has a specified amount of debt maturing each year (e.g., Exhibit 13.5). A
term bond matures at a specified date. Term bonds often have a sinking fund, which
periodically retires a proportion of the debt issue. From the investor’s viewpoint the
g. Coupon bonds pay interest periodically (usually every six months) while a zero coupon
h. Bonds rated triple-B or better are investment grade. High-yield bonds (also referred to as
13-2. Generally the longer the term to maturity, the greater the yield to maturity. (Refer to
13-3. Sources of risk to investors in bonds are (1) default, which is the failure of the firm
to meet the terms of the debt’s indenture; (2) fluctuations in interest rates, which cause the
market price of the bond to fluctuate; (3) reinvestment rate risk, which results when
interest rates decline and the investor has to accept a lower return when interest and
principal repayments are reinvested at the lower rate, and (4) inflation, which reduces the
purchasing power of interest and principal repayments.
Default risk is a form of unsystematic risk the impact of which may be reduced through
diversification. Interest rate risk, reinvestment rate risk, and purchasing power risk are
forms of systematic (i.e., non-diversifiable) risk.
13-4. Bonds may be purchased like stocks through brokerage firms. Some bonds (e.g.,
13-5. Interest on a bond is earned (“accrues”) daily but is distributed periodically, usually
13-6. A call feature favors the company. If interest rates decline, the bonds may be called
prior to maturity. New bonds may be issued at the lower rate which saves the firms interest
A call penalty protects the bondholder from early retirement of the bond by the firm, which
may occur after interest rates have fallen. The firm could issue new bonds at the lower (i.e.,
PROBLEMS
13-1. This problem illustrates the accrual of interest on a zero coupon bond. The bond sells
for $713 with an annual rate of interest of 7 percent for five years. The annual accrued
interest is NOT ($1,000 – 287)/5 = $57.40. Instead the 7 percent is added on each year:
Year 1 $713.00 x 0.07 = $49.91
Year 2 $762.91 x 0.07 = $53.40
13-2. The periodic interest payment is $300, and the buyer paid $156 accrued interest to
the seller. The actual interest earned is $300-156 = $144. The tax owed is $144 x 0.2 =
$28.80.
13-3. This is the same as problem #2 but seen from the perspective of the seller. The
accrued interest received is $156, so the tax owed is $156 x 0.2 = $31.20
13-4. a. This problem essentially repeats #1 but adds the tax on the accrued interest. The
accrued interest each year is
The tax each year is
In years 4 through 7 the tax is $80 x 0.3 = $24
b. If the interest accrues in an IRA account, there is no tax in the current year. Instead the
Teaching Guides for the Financial Advisor’s Case: Corporate Bonds as a Viable Investment
Vehicle
1. The primary difference between bonds and stocks is related to the creditor position
versus ownership. Bondholders are creditors who own a fixed obligation, the terms of
which the debtor must meet. Certainly one of the most important terms is the payment of
Stock represents ownership. There are no fixed obligations such as dividends that the firm
must meet. Since the firm may grow, investments in common stock offer potential growth
that is not available to bondholders. Stockholders, however, must bear the risk associated
2. Interest is a fixed, legal obligation of the issuer. This does suggest that bondholders have
less risk exposure than stockholders. (Bondholders do, of course, bear risk from the
3. Bonds are purchased through brokerage firms in the same manner that stocks are
acquired. After the purchase, the investor receives a confirmation statement, which
includes the price of the bond, accrued interest owed the seller, and the brokerage
4. The investor may hold a bond to maturity or sell it in the secondary markets. There is
good reason to anticipate that a bond will not be in existence until maturity since many
5. Studies of returns (covered in Chapter 10) indicate that historical returns on stocks have
exceeded returns on bonds. This result is not surprising since stocks are riskier than bonds.
6. High yield securities may be an acceptable investment for individual members of an
investment club, especially if they are able to bear the additional risk. For the investment
7. From a tax perspective, interest on a bond is subject to federal income tax while price
appreciation on a stock may be a tax shelter. The gain is only taxed if realized and may be
8. Diversification requires acquiring different types of assets issued by a variety of firms
and governments. Acquiring both stocks and bonds is investing across types, which will
9. An investor constructs a diversified bond portfolio by acquiring bonds issued by firms
in different industries and with different maturity dates. In addition, various types of
For bonds to diversify the total portfolio, the investor needs debt instruments whose returns
are not highly correlated with the returns on the other assets in the portfolio. Once again