FINANCIAL MANAGEMENT CORPORATE BONDS- THEY ARE MORE COMPLEX THAN YOU THINK Jill Dougherty was hired as an investment analyst by A.M. Smith Inc. for the Cincinnati, Ohio office based on her sound academic credentials, which included an MBA from a top ranking university and a CFA designation. At the time of her recruitment, she was told that one of her responsibilities would be to conduct educational seminars for current and prospective clients. A.M. Smith Inc., a prestigious investment services firm, with branches in 30 major metropolitan areas, had achieved most of its success due to its excellent client relations and focus on client support. The firm ranked amounted the very best in terms of the number of successful equity underwriting deals undertaken. Recently, a large utility company had hired it as the leading investment banker for a major corporate bond issue. Since most of its real customers were more familiar with stock investments, John Sullivan, the branch manager at the Cincinnati office, asked Jill to prepare and present a seminar outlining the various implications of fixed income investments. “About 60% of our investors are in the 55+ age group, Jill, so we should not have much trouble convincing them of the benefits of investing. Your job is to convince them of the relative safety and income potential of corporate bonds,” said John. In preparation for the seminar, Jill called up a few of her best clients and queried them regarding their awareness of the risk and return potential associated with corporate bond investments. She realised that apart from a good knowledge about the current level and stability of interest rates and inflation, most customers were not very familiar about the finer aspects of bond investing. Bond features like callability, convertibility, sinking fund provision, bond rating, debentures, interest rate risk, etc. were not well understood by most of the clients she interviewed. Most of them seemed awfully interested in knowing more about the opportunities offered by bond investing and Jill knew that she would have a good turnout at the seminar. She decided to refer back to her Finance textbook and dig out some definitions and examples that she could use in her PowerPoint presentation. She downloaded current date for outstanding bonds of various maturities, ratings and coupon rates (see Table 1) and started preparing her slides. TABLE 1 COPRORATE BOND INFORMATION Issuer Face Value Coupon Rate Rating Quoted Price Years until maturity Sinking Fund Call Period ABC Energy $1,000.00 5% AAA $703.10 20 Yes 3 Years ABC Energy $1,000.00 0% AAA $208.30 20 Yes NA TransPower $1,000.00 10% AA $1,092.00 20 Yes 5 Years Telco Utilities $1,000.00 11% AA $1,206.40 30 No 5 Years FINANCIAL MANAGEMENT: QUESTIONS TO BE ANSWERED FOLLOWING DETAILS PROVIDED IN THE TOPIC''S DESCRIPTION ABOVE: 1. How should Jill go about explaining the relationship between coupon rates and bond prices? Why do the coupon rates for the various bonds vary so much? (Word Limit: 200) 2. How are the ratings of these bonds determined? What happens when the bond ratings get adjusted downwards? (Word Limit: 200) 3. During the presentation one of the clients is puzzled why some bonds sell for less than their face value while others sell for a premium. She asks whether the discount bonds are a bargain. How should Jill respond? (Word Limit: 300) 4. What does the term “yield to maturity” mean and how is it to be calculated? (Word Limit: 300) 5. What is the difference between the “nominal” and effective yields to maturity for each bond listed in Table 1? Which one should the investor use when deciding between corporate bonds and other securities of similar risk? Please explain. (Word Limit: 200) 6. Jill knows that the call period and its implications will be of particular concern to the audience. How should she go about explaining the effects of the call provision on bond risk and return potential. (Word Limit: 300) 7. How should Jill go about explaining the riskiness of each bond? Rank the bonds in terms of their relative riskiness. (Word Limit: 300) 8. One of Jill’s best clients poses the following question, “If I buy 10 of each of these bonds, reinvest any coupons received at the rate of 5% per year and hold them until they mature, what will my realised return be on each bond investment?” How should Jill respond? (Word Limit: 200)