PartFour

InvestinginFixedIncomeSecurities

PartFourIncludes
Chapter10 FixedIncomeSecurities
Chapter11 BondValuation
177Gitman/JoehnkFundamentalsofInvesting,TenthEdition

Chapter10
FixedIncomeSecurities

Outline
Learning Goals
I. WhyInvestinBonds?
A. PuttingBondMarketPerformanceinPerspective
1. HistoricalReturns
2. BondsversusStocks
B. ExposuretoRisk
1. InterestRateRisk
2. PurchasingPowerRisk
3. Business/FinancialRisk
4. LiquidityRisk
5. CallRisk
ConceptsinReview

II. EssentialFeaturesofBonds
A. BondInterestandPrincipal
B. MaturityDate
C. PrinciplesofBondPriceBehavior
D. PricingaBond
E. CallFeaturesLettheBuyerBeware!
F. SinkingFunds
G. SecuredorUnsecuredDebt
H. BondRatings
1. HowRatingsWork
2. WhatRatingsMean
ConceptsinReview
III. TheMarketforDebtSecurities
179Gitman/JoehnkFundamentalsofInvesting,TenthEdition
A. MajorMarketSegments
1. TreasuryBonds
2. AgencyBonds
3. MunicipalBonds
a. TaxAdvantages
b. TaxableEquivalentYields
4. CorporateBonds
B. SpecialtyIssues
1. ZeroCouponBonds
2. MortgageBackedSecurities
3. CollateralizedMortgageObligations
4. AssetBackedSecurities
5. JunkBonds
C) AGlobalViewoftheBondMarket
1. U.S.PayversusForeignPayBonds
a. DollarDenominatedBonds
b. ForeignPayBonds
ConceptsinReview

IV. ConvertibleSecurities
A. ConvertiblesasInvestmentOutlets
1. ConvertibleNotesandBonds
2. ConversionPrivilege
3. Lyons
B. SourcesofValue
C. MeasuringtheValueofaConvertible
1. ConversionValue
a. ConversionPremium
b. PaybackPeriod
2. InvestmentValue
ConceptsinReview

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
10.1. MaxandVeronicaDevelopaBondInvestmentProgram
10.2. TheCaseoftheMissingBondRatings
ExcelwithSpreadsheets
TradingOnlinewithOTIS
 Chapter10FixedIncomeSecurities180

Key Concepts
181Gitman/JoehnkFundamentalsofInvesting,TenthEdition
1. Historicalreturnsinthebondmarketandcomparisontostockreturns

2. Currentincomeandcapitalgainscomponentsofbondreturns,includingthefixednatureofcoupon
paymentsandinverserelationshipbetweenbondreturnsandinterestrates

3. Thetypesofriskstowhichbondinvestorsareexposed;callfeaturesmayresultintheearlyexercise
ofbondswithrelativelyhighcouponpaymentstreams

4. Thebasicfeaturesofbondsandtheprinciplesofbondpricebehavior,includingtheimpactofcoupon
paymentsandbondmaturityontheinverserelationshipbetweeninterestratesandbondprices

5. Themanytypesofbondvehiclescurrentlyavailableandthewidearrayofinvestmentobjectivesthey
canfulfill;treasurybonds,agencybonds,municipalbonds,andcorporatebondsareexamined

6. Aglobalviewofthebondmarket,includingdollardenominatedandforeignpaybonds

7. Bondratingsandthewaytheywork

8. Basicfeaturesandcharacteristicsofconvertiblesecuritiesarepresented;conversionvaluesand
investmentvaluesarecompared

Overview
Bondsareanimportanttypeofinvestmentvehicleduetotheattractiveinvestmentopportunitiestheyoffer
toinvestorsandthesizeofthebondmarket.Thischapterexaminesvariousfeaturesofbondsandbond
ratings.

1. Whyinvestinbonds?Investorschoosebondsbecausetheyprovideinterestincomeandan
opportunityforcapitalgains.Theinstructorshouldindicatetotheclassthat,duetothecertaintyof
interestincomefrombonds,manyinvestorsperceivegreatersafetyinbondinvestmentsthaninstock
investments.This,however,isnottheonlyreasonforinvestinginbonds.

2. Toputbondreturnsintoperspective(andtoclearuppossiblemisconceptionsalongtheway),some
timeshouldbespentreviewingthehistoricalperformanceofbondyieldsandbondreturns;Table10.1
canbeusedforthispurposeasitshowsyieldsandreturnsforthefortyfiveyearperiodfrom1961to
2005.Takesometimetocontrastbondyieldswithbondreturns.Inthisregard,itsimportanttodrive
homethepointthatbondyieldisnotthesamethingasbondreturn.Whiletheformerisameasureof
theyieldpromisedonabond,thelatterisameasureofthereturnactuallyrealizedoveragivenholding
period,anditincludesbothinterestincomeandcapitalgains(orloss).Finally,youmightwanttoclose
thisdiscussionbycontrastingstockreturns(Table6.1)withbondreturns(Table10.1),emphasizingnot
onlydifferencesinreturns,butalsodifferencesinrisk.TheMarketsDiarysectionofTheWallStreet
Journalorsimilarpublicationwillhelpupdatethevaluesfoundinthetext.

3. Fixedincomesecuritiesarealsoexposedtovarioustypesofrisks.Theinstructorshouldoutlinethe
fivemajortypesofriskstowhichbondsareexposed:Interestraterisk,purchasingpowerrisk,
business/financialrisk,liquidityrisk,andcallrisk.Itshouldbeemphasizedthateventhough
TreasuryBondsareissuedbytheU.S.governmentandarefreeofdefaultrisk,theyareverymuch
subjecttointerestraterisk,thesinglemostimportantforceinthebondmarket.
 Chapter10FixedIncomeSecurities182
4. Featuresthatcharacterizebondsincludeprincipal,interest,maturitydate,andcallandsinkingfund
provisions.Itmightbehelpfultomakethefollowingdistinctionbetweenbondsandstocksinclass:
owningacompanysbondsdoesnotconstituteanownershipinthecompany,whereasowningstock
inacompanyliterallymeansowningpartofthefirm.Buyingacompanysbondsislikemakinga
loantoacompany,exceptthatbondsmaybetradedinthemarketandtheirvaluesfluctuate.Itmay
alsobepointedoutthatbondholdershaveclaimsthattakepriorityovertheclaimsofthestockholders
ontheassetsofthecompany.

5. AninterestingdifferencebetweencorporateandTreasurybondsisthattheformeristradedasa
percentageofparouttothreedecimalplaces.Treasuryquotesdividepercentageintothirtyseconds
ofapoint.Bringingrecentquotestotheclassroomwillhelpstudentsunderstandthedifference.

6. Bondratingsarepresentednext.Differentbondratingsshouldbementioned.Adetailedexplanation
ofwhattheseratingsimplytotheinvestormightalsobeexplored:Alowerbondratingmeansthata
particularbondisriskierthanahigherratedbond,sotheinvestorrequiresagreaterreturn(yield)
fromalowerratedbond(foragiventype,maturity,andcoupon).

7. BondtradingtakesplacemainlyintheOTCmarket.BondsissuedbytheU.S.Treasury,agenciesof
theU.S.government,anddifferentmunicipalitiesusuallyhaveeithertaxfreeorsometaxexempt
status.Corporatebondsarenottaxexempt.Thebenefitsoftaxfreeandtaxexemptbonds
(calculatingtaxableequivalentyields)fordifferentinvestorsshouldbediscussed.

8. Likethestockmarket,thebondmarketisalsoglobalized.ThishelpsU.S.investorsincreasetherisk
diversificationoftheirbondportfolios.Whenexplainingtheforeignbondmarket,theinstructor
shoulddifferentiatebetweenU.S.payandforeignpaybonds.

9. Convertiblespossessfeaturesofbothfixedincomesecuritiesandequity.Studentsshouldbemade
awarethateitherbondsorpreferredstockscanbeissuedasconvertiblesecurities.Thenextsection
dealswithvaluingconvertibles.Itshouldbeemphasizedhowconversionvalueandconversion
premiumareimportantinaffectingthepriceandreturnperformanceofaconvertible.

10. Investmentstrategiesrelatedtoconvertiblesarediscussednext.Studentsshouldunderstandthat
convertiblesprovidegoodupsidepotentialthroughtheirequityfeatureanddownsideprotection
throughtheirfixedincomeproperties.Additionally,itshouldalsobeshownthatconvertiblesmaybe
usedforeithercapitalgainsorcurrentincome.Theinstructormightpointoutthatconvertiblesare
popularasinvestmentvehiclesbecausetheyincludethefeaturesofbothstocksandbonds.
Presentationofthepaybackperiodprovidesclarityregardingconversionpremiumdisadvantagesand
comparativecurrentcashflowadvantagesofconvertiblesecurities.

Answers to Concepts in Review

1. Bondsareappealingtoindividualinvestorsbecausetheyprovideagenerousamountofcurrent
incomeandtheycanoftengeneratelargecapitalgains.Thesetwosourcesofincometogethercan
leadtoattractiveandhighlycompetitiveinvestorreturns.
183Gitman/JoehnkFundamentalsofInvesting,TenthEdition
Bondsmakeanattractiveinvestmentoutletbecauseoftheirversatility.Theycanprovidea
conservativeinvestorwithhighcurrentincomeortheycanbeusedaggressivelybyinvestorswho
prefercapitalgains.Giventhewideandfrequentswingsininterestrates,investorscanfindavariety
ofinvestmentopportunities.Inadditiontotheirversatility,certaintypesofbondscanbeusedto
shelterincomefromtaxes.Whilemunicipalbondsareperhapsthebestknowntaxshelters,some
Treasuryandfederalagencybondsalsogiveinvestorssometaxadvantages.
2. Table10.1showsthatoverthepastfortyfiveyearsbondreturnsandmarketinvestmentratesmove
inoppositedirection.Forexample,1987bondyieldsrosefrom9.02to10.33.Thetotalrateofreturn
during1987was1.47percent,duetothedeclineinbondprices.

Swingsinmarketinterestrateshaveadefiniteimpactonannualbondreturns,asshowninTable
10.1.Inparticular,wheninterestratesrise,bondpricesfall,andsuchcapitallossesdragbondreturns
down(unlikemarket,orpromisedyields,bond/totalreturnsaremadeupofbothinterestincomeand
capitalgainsorlosses).Whenmarketinterestratesfall,justtheoppositeoccurs:i.e.,bondpricesrise
andsodobondreturns.

3. Bondsareexposedtothefollowingfivemajortypesofrisk:
(1) Interestraterisk:Thisaffectsthemarketasawholeandthereforetranslatesintomarketrisk.
Whenmarketinterestratesrise,bondpricesfall,andviceversa.
(2) Purchasingpowerrisk:Thisistheriskcausedbyinflation.Wheninflationheatsup,bondyields
lagbehindinflationrates.Abondinvestorislockedintoafixedcouponbondeventhough
marketyieldsarerisingwithinflation.
(3) Business/financialrisk:Thisreferstotheriskthattheissuerwilldefaultoninterestand/or
principalpayments.Businessriskisrelatedtothequalityandintegrityoftheissuer,whereas
financialriskrelatestotheamountoftheissuersleverage.Treasurysecuritiesarefreeofthis
risk,althoughitisanimportantconsiderationforcorporateandmunicipalbonds.
(4) Liquidityrisk:Thisistheriskthatabondwillbedifficulttoselliftheinvestorwishestodoso.
Thebondmarketisprimarilyoverthecounterinnature,andmuchoftheactivityoccursinthe
primary/newissuemarket.WiththeexceptionoftheTreasurymarketandmostoftheagency
market,thereisnotmuchofasecondarymarketformostbonds.
(5) Callrisk:Thisreferstotheriskthatabondwillberetiredbeforeitsscheduledmaturitydate.
Whenabondiscalled,thebondholdersarecashedoutoftheirinvestmentandmustthenfind
alternativeinvestmentoutletsthatmayhaveloweryields.
Themostimportantsourceofriskforbondsingeneralisinterestraterisk.Itisthemajorcauseof
pricevolatilityinthebondmarket.Asinterestratesbecomemorevolatile,sodobondprices.

4. Issuecharacteristics(suchascallfeatureandcoupon)doindeedaffecttheyieldandpricebehavior
ofabond.Forexample,highcouponbondshavehigheryieldsthanlowcouponbonds;bondsthat
arefreelycallableprovidehigheryieldsthanbondsthatarenoncallable;usually(althoughnot
always)longmaturitiesyieldmorethanshortmaturities.Withrespecttopricevolatility,bondswith
lowercouponsand/orlongermaturitieswillrespondmorevigorouslytochangesinmarketinterest
ratesandthereforehavegreaterpricevolatilitythanshortmaturityand/orhighcouponbonds.

5. Withacallfeature,theissuerpaysacallpremiumgenerallyequaltooneyearsinterestattheearliest
dateofcall.Ontheotherhand,sinkingfundsisaprovisionthatstipulatestheamountofprincipalthat
willberetiredannuallyoverthelifeofabond.Therearenocallpremiumswithsinkingfund
provisions.

Thethreedifferenttypesofcallfeaturesare:
 Chapter10FixedIncomeSecurities184
(1) Freelycallable:Theissuecanbeprematurelyretiredatanytime.
(2) Noncallable:Theissuerisprohibitedfromretiringthebondissuepriortomaturity.
(3) Deferredcallable:Theissuecannotbecalleduntilafteracertainlengthoftimehaspassedfrom
thedateofissue.
Abondcanbefreelycallablebutnonrefundableforacertainnumberofyears.Inthiscase,a
nonrefundingoradeferredrefundingissuecanstillbecalledandprematurelyretiredforanyreason
otherthanrefunding.

6. Thedifferencebetweenapremiumandadiscountbondillustratestheinverserelationshipbetween
bondpricesandmarketinterestrates.Apremiumbondsellsformorethanitsparvalue,whichoccurs
whenmarketinterestratesdropbelowthebondscouponrate.Incontrast,adiscountbondsellsfor
lessthanparandistheresultofmarketratesrisingabovethecouponrate.

Thefactorsthataffectabondsprice,volatilityareinterestrates,couponandmaturityoftheissue.
Thegreaterthemovesininterestrates,thegreatertheswingsinbondprices.Bondswithlower
couponsand/orlongermaturitiesrespondmorevigorouslytochangesinmarketratesandtherefore
undergosharperpriceswings.

7. Apercentofparquotationindicatesthattheissueistradingatthequotedpercentoftheparvalueof
theobligation.Forexample,apercentofparquotationof98ona$1,000parvalueobligationmeans
thebondistradingat98%of$1,000$980.

Corporatebondquotesareinthousandthsofapercentage,whichessentiallyresultsincorporatebond
pricesbeinginpennies.Forinstance,aquoteof98.167wouldbeapriceof$981.67.

Governmentbondsarequotedin32ndsofapoint,whichisonepercentofparvalue.Hence,abond
quotedat102:8ispricedat102percentand8/32ofapercent,or102.25percent.Agovernmentbond
withaparvalueof$1,000wouldcost$1,022.50(e.g.,1.0225$1,000)plustransactioncosts.

8. Bondratingsaregradesthatareassignedtobondissuesonthebasisofextensive,professionally
conductedfinancialanalysistodesignateinvestmentquality.Ratingsbasicallypointtothedefault
riskofanissue.Higherratingsmeanthatissuesareinvestmentgrade.Lowerratingsmeanthatissues
areinthejunkcategoryandmorespeculative.Thehighertherating,thelowerthedefaultriskand,
hence,thelowertheyieldofanobligation.Alowerratingmeansthattheinvestormustassumemore
ofthedefaultriskandhastobecompensatedwithahigheryield.Further,investmentgradesecurities
arefarmoreinterestsensitiveandtendtoexhibitmoreuniformpricebehaviorthanjunkbondsand
otherlowerratedissues.

Foraparticularbondissue,ifMergentandS&Passigndifferentratings(calledsplitratings)theissue
isthensaidtobesplitrated.

9. Fromanindividualinvestorperspective,bondratingsrelievethedrudgeryofevaluatingthequalityof
thebond.Individualscandependonagencyratingsasaviablemeasureofthecreditworthinessofthe
issuerandtheissuersdefaultrisk.Overtime,theratingagencieshavedoneanexcellentjobof
assessingbondquality;hence,theseratingsareobjectiveandreliable.

Bondratingsareintendedtoonlymeasureanissuersdefaultrisk,andassuch,ratingsprovideno
indicationoftheamountofmarketriskimbeddedinabond.Eventhehighestqualityissueswillgo
downinpricewheninterestratesincrease,subjectinginvestorstocapitallossandmarketrisk.
185Gitman/JoehnkFundamentalsofInvesting,TenthEdition
10. Bondsaresecuritiesthatpromisetopayastatedamountofannualinterestoverthelifeofanissue,
andthenrepaytheprincipalvalueofthebondatmaturity.Bondissueshavecertainadvantagesand
disadvantages,someofwhichdependontheissuingentity.
(a) TreasurybondsaredebtsecuritiesissuedbytheU.S.federalgovernmenttomeettheever
increasingneedsofthefederalbudget.Advantages:Highqualityorlowdefaultrisk(backedby
thefullfaithandcreditoftheU.S.government);verypopularinstrumentsthathaveawell
developedsecondarymarket;exemptfromstateandlocaltaxes;manycouponsandmaturities
available;someautomaticallyadjusttheirpar(maturity)valuetoprotectinvestorsfromthe
impactofinflation(TIPS).Disadvantages:Duetotheirlowrisk,theseissuesbearlowyields;
makeapoorinflationhedge;andmanyhavelongmaturitiesandthereforearesubjecttowide
priceswings.
(b) AgencybondsaredebtsecuritiesissuedbyvariousagenciesandorganizationsoftheU.S.
governmentliketheGovernmentNationalMortgageAssociation(GNMA).Typically,agency
bondsofferyieldsabovethemarketratesforTreasuries.Advantages:Lowrisk(whilenotapart
oftheU.S.Governmentthemarketexpectsthefederalgovernmenttosupportitsindependent
agencies);manyareexemptfromstateandlocaltaxes;somepayinterestmonthly.
Disadvantages:Thesecondarymarketisnotwelldevelopedforallagencyissues;lowyielddue
tolowrisk(thoughtheiryieldisabovethatofTreasurybonds);somehaveveryhighunitcosts
(likeGNMApassthroughs:$25,000).
(c) Municipalbondsaredebtsecuritiesissuedbystates,counties,cities,andotherpolitical
subdivisionslikeschooldistrictsandwaterandsewerdistricts.Advantages:Interestonmost
municipalsisexemptfromfederalincometaxandusuallythestateorlocaltaxoftheissuing
governmentbody;manycarryamunicipalbondguaranteethatlowersrisk;ratedbyMoodys
andS&P.Disadvantages:Lowyieldforindividualsinlowtaxbrackets;mostissuesarenot
widelytradedandsohavepoorliquidity;requireslargecapitalinvestment($5,000).
(d) Corporatebondsaredebtsecuritiesissuedbycorporations.Thecorporatebondmarketis
customarilysubdividedintotheindustrial,publicutility,transportation,andfinancialbond
segments.Advantages:Widevarietyofissues;relativelyattractiveyields;ratedbyMoodys
andS&Prelativelygoodliquidityinthesecondarymarket.Disadvantages:
Higherriskthangovernmentbackedbonds;longlifetomaturity.

11. (a) Zerocouponbondshavenointerest,orcoupon,payments.Theyaresoldatadeepdiscountfrom

theirparvalues,andthentheyincreaseinvalueovertimeatacompoundrateofreturnsothatat
maturitytheirvalueisequaltopar.Thereisnoreinvestmentriskofcouponpaymentswiththese
bonds.However,theIRSdoesrequirethatinterestbereportedonanaccrualbasis.Thismakes
thesebondsmostattractiveforuseintaxshelterinvestmentslikeIRAs.
(b) CMOs,orcollateralizedmortgageobligations,areobligationsdesignedtoreducetheproblems
causedbythepassthroughofprincipalpaymentsonmortgagebackedbonds.Normally,all
bondholdersreceiveaproratedportionoftheprincipalpayments,butwithCMOsinvestors
selectashortterm,intermediate,orlongtermposition.Allprincipalpaymentsarethenmadeto
theshortterminvestorsfirst.Oncetheyarepaid,thenextgroupbeginsreceivingprincipal
payments.Suchissuesareusedbyinvestorsseekingthehigheryieldsofmortgagebackedissues.
(c) Junkbondsarelowrated,highyielding,speculativevehiclesissuedprimarilybycorporations
(theresalsoasmaller,butstillsizable,marketforhighyieldjunkmunicipals).Inthepast
theseissueswereinitiallyofhighqualitybutdeterioratedasthecompanyfacedtroubledtimes.
Today,thetermappliestoyoung,rapidlygrowingfirmsthatusesuchissuesforcapitalgrowth
and/ortofinancemergersandtakeovers.Theseissuesshouldonlybeusedbyinvestorswhocan
accepthighlevelsofrisk.Theirhighyieldsandhighriskmaketheminappropriatefor
conservativeinvestors.
 Chapter10FixedIncomeSecurities186
(d) Yankeebondsarebondsissuedbyforeigngovernmentsorcorporationsorbysocalled
supranationalagenciesliketheWorldBankandtheInternationalMonetaryFund.Thesebonds
aredenominatedindollarsandregisteredwiththeSEC.Thebondsareissuedandtradedinthe
UnitedStates(onU.S.exchangesandtheOTCmarket).AlltransactionsareinU.S.dollars,
eliminatinganycurrencyexchangerisk.Thesebondsaregenerallyveryhighinqualityandoffer
competitiveyieldstoinvestors.

12. Bondholdersdislikeinflationasincreasesininflationincreasenominalinterestrates,thusreducing
bondprices.So,theU.S.governmentissuedbonds(i.e.TIPS)thatareprotectedagainstunexpected
inflation,thusmakingthemmoreattractivetoinvestors.TheU.S.governmentlikesthesesecurities
becauseitneednotcompensateinvestorsforinflation.Henceitsborrowingcostsarelower.
ThebiggestadvantageofTIPSforinvestorsistheprotectionagainstunexpectedchangesininflation.
Iftheinvestorisriskaverse,hemightpreferTIPSoverconventionalbonds,whicharenotprotected
againstinflation.ButTIPSarenotveryusefulduringperiodswheninflationstaysdormantasinterest
ratesonTIPSaremuchlowerthanconventionalbonds.AnotherbigdisadvantageofTIPSisthat
investorshavetopayataxontheincreasingfacevalueoftheirbondseachyear,whiletheyget
compensatedforinflationatmaturity.Hencetheyenduppayinginterestonincometheydonthave
onhand.
Thetaximplicationsofvariousgovernmentbondsdiffer.Treasuryissuesaresubjecttofederal
incometax,butexemptfromstateandlocaltaxes.Agencyissuesareallsubjecttofederaltax.Some,
however,areexemptfromstatetaxes.Theinterestonmostmunicipalissues,ontheotherhand,is
exemptfromfederalincometaxesand,usually,thestateandlocaltaxesofthegovernmentalunit
issuingthem;capitalgainsonmunicipalbondsaresubjecttonormalfederal,state,andlocaltaxrates
andmustbepaidonanysuchprofitsearned.

13. Assetbackedsecurities(ABS)aredebtissuessecuredbyapoolofbankloans,leases,andother
assets.Theseotherassetsincludecreditcardbills,computerleases,truckrentals,androyaltyfees.
Whereasthefederalgovernmentcreatedthreeprimaryagenciestohandlemortgagebackedsecurities
(MBS),assetbackedsecuritiesarecreatedbyinvestmentbankersassistingcorporations.ABSshave
shortermaturitiesthanMBSs.BothABSsandMBSsprovidemonthlyinterestpayments.
Securitization(i.e.formingMBSandABS)istheprocesswherebymanylendingvehiclesare
transformedintomarketablesecurities.Anindividualcreditcardloanmightbeveryriskybutapool
ofsimilarloanshasamuchlowerriskofdefaultbecauseitisquiteimprobablethatallloansinthe
poolwoulddefaultatthesametime.Hencetheconceptofsecuritizationissimilartothetraditional
conceptofriskdiversificationofaportfolio.

14. Dollardenominatedbondshavetheircashflows(interestpaymentandprincipalrepayments)
denominatedindollars.Ontheotherhand,foreignpaybondshavetheircashflowsdenominatedin
someforeigncurrency.
Thetwomajortypesofforeign,U.S.paybondsareYankeebondsandEurodollarbonds:
Yankeebondsareissuedbyforeigngovernmentsorcorporations,registeredwiththeSEC,andissued
andtradedintheUnitedStates.AlltransactionsareinUnitedStatedollars.Theyaregenerallyvery
highinqualityandofferinvestorsverycompetitiveyields.
EurodollarbondsareissuedandtradedoutsidetheUnitedStates.Theyaredollardenominatedbut
arenotregisteredwiththeSEC.ThismeansthatunderwriterscannotsellnewissuestoU.S.
investors.OnlyseasonedEurodollarissuescanbesoldinthiscountry.
187Gitman/JoehnkFundamentalsofInvesting,TenthEdition
BecauseU.S.paybondsaredollardenominated,thereisnocurrencyexchangeriskforanU.S.
investor.Butforeignpaybondsaredenominatedinsomecurrencyotherthandollars,traded
overseas,andnotregisteredwiththeSEC.Thesebondsarethereforesubjecttochangesincurrency
exchangerates,whichinturncandramaticallyaffecttotalreturnstoU.S.investors.Therearealso
positivediversificationadvantagesarisingfromholdingbothdomesticbondsandforeignpay
foreignbonds.

15. Aconvertibledebentureisalongterm,unsecuredcorporatebondcarryingtheprovisionthatwithina
stipulatedtimeperiod,thebondmaybeconvertedintoacertainnumberofsharesoftheissuing
corporationscommonstock.Aconvertiblepreferredisverysimilartoaconvertiblebondexceptthat
itisinitiallyissuedasapreferredstockandthenisconvertibleintocommonshares.Thus,a
debentureisabondandapreferredisastock;anotherdifferencebetweenaconvertibledebentureand
convertiblepreferredisthatwhiletheconversionratioofthedebenturegenerallydealswithlarge
multiplesofcommonstock,theconversionratioofapreferredisgenerallyverysmall.Thisis
becausecorporatebondsaresoldin$1,000increments,whilepreferredssellfor$25to$100.

16. Theequitykickerfeatureofaconvertiblesecuritygivestheinvestoranopportunitytoparticipatein
thepotentialpriceperformanceoftheunderlyingcommonstock.Whenthemarketpriceofthe
commonisequaltoorgreaterthanthestatedconversionprice,theequitykickerhasvaluetothe
investorandthepriceoftheconvertiblewillmovewiththecommon.Whenthepriceofthestock
goesup,thepriceoftheconvertiblewillincreasebyamultiplethatapproximatesitsconversionratio;
likewise,ifthepriceofthestockfalls,theconvertiblewilldeclinebythesamemultiple.(Subjectto
theconversionpricebeinglessthanthestockprice.)

17. Theconvertiblereceivesvaluefrombothitsbondandstockproperties.Attheminimum,thesecurity
isworthwhatitearnsasafixedincomesecurity(presentvalueofinterestandfacevalueatmaturity).
Thisisitsbond(orinvestment)value,anditsetsthepricefloorfortheconvertible.Inaddition,the
securityhasthepotentialtoearnacapitalgainbasedonthefactthatitcanbetradedforafixed
numberofsharesofcommonstock(asspecifiedbytheconversionratio).If,forexample,a$1,000
bondcanbeconvertedinto50sharesofcommonstock,thenasthestockbeginstosellformorethan
$20pershare(theconversionprice),thereisapotentialcapitalgain,andthevalueoftheconvertible
willreflectthis(i.e.,thebehavioroftheunderlyingcommonstock).

18. Conversionvalueisanindicationofwhataconvertibleissuewouldtradeforifitspricewerebased
onitsstockvalue.Itisequaltotheconversionratiotimesthecurrentstockprice.Conversionparity
indicatesthepricethecommonstockshouldsellforinordertomaketheconvertibleworthitspresent
marketprice.Itisequaltothecurrentpriceoftheconvertibledividedbytheconversionratio.

Paybackperiodisagoodtooltoassesstheconversionpremiumonconvertibles.Thepaybackperiod
isameasureofthelengthoftimeittakesforthebuyerofaconvertibletorecovertheconversion
premiumfromtheextrainterestincomeearnedontheconvertible.Asaninvestmentrule,everything
elsebeingequal,theshorterthepaybackperiod,thebetter.

Thebondinvestmentvalueofaconvertibleisapriceatwhichthebondwouldtradeifitwere
nonconvertibleandifitwerepricedatorneartheprevailingmarketyieldsofcomparableissues.
Thisfigureindicateshowfartheconvertiblewillhavetofallbeforeithitsitspricefloorandbegins
tradingasastraightdebtinstrument.

Suggested Answers to Investing in Action Questions

 Chapter10FixedIncomeSecurities188
Some Tips on TIPS (in Textbook)
(a) WhywouldinvestorsandtheTreasurybeinterestedinTIPS?
(b) WhatistheprimaryadvantageanddisadvantageofTIPS?
Answers:
(a) TIPSareTreasuryinflationprotectedsecurities,whichadjusttheirparvaluetocompensate
bondholdersforthedeclineintheirpurchasingpower.Hence,theTIPSvaluewillnotdeclineas
inflationheatsup.TheTreasuryDepartmentiswillingtoissueinstrumentswhereittakestheinflation
raterisk,becauseitisabletoissueTIPSwithinterestratesthatarehalfthoseofnormalTreasury
bonds.Thefederalgovernmentalsocollectstaxontheincreaseinparvalue,eventhoughthegainwill
notbeactuallyrealizeduntilmaturity.

(b) InvestorsinTIPSdonothavetoworryaboutinflationbutearnareturnthatisonlyabouthalfofthe
yieldonotherTreasurybonds.
189Gitman/JoehnkFundamentalsofInvesting,TenthEdition

Suggested Answers to Discussion Questions

1. (a) Thedifferencebetweenthetwodecadesisduetotheriseintheinterestratesduringtheearly
1980s,whichinturnincreasedtheyieldsforbonds.
(b) Duringthe1990s,interestratesfelltolevelsnotseeninoverthirtyyears.Byearly1999,long
termTbondswereyieldinglessthan5percent.Themarketwasconsideredbullishascompared
tothebearishmarketsofthe1970sand1980s.
(c) Sinceitishighlyunlikelythatthehighinterestratesofthe1980swillreturninthenextdecade,it
wouldappearthatafairrateofreturntoexpectfrombondsisverycomparabletothelate1990s.
Infact,inlate2006,theyieldontenyearTreasurynoteswas4.64percent.
(d) Answerswillvarywiththestudentsdegreeofriskaversion.Whenstudentsfirstgraduatethey
arefortyyearsfromretirement.Overthistimeperiod,extremelygoodyearsinthestockmarket
willoffsetlosses.Hence,investmentadvisorswilltypicallysuggestthattheyhaveasmall
fractionoftheirwealth(perhaps20percent)inbonds.Astimeprogresses,theirbondproportion
willrise.Giveninflationaryrisks,thoseinretirementwillstillholdsomestockintheirportfiolio.

2. (a) Agencybonds:bondsissuedbygovernmentagenciesthatarehighqualitysecurities.
(b) Municipalbonds:bondsthataretheissuesofstates,counties,citiesandotherpolitical
subdivisions.
(c) Zerocouponbonds:bondsthatpaythecouponatthetimeofmaturity.
(d) Junkbonds:highyieldbondsthathavereceivedlow,subinvestmentgraderatings,usually
BaorB.
(e) Foreignbonds:bondsthatareissuedinaforeigncountryandpricedinthatcountryscurrency.
(f) Collateralizedmortgageobligations:paymentsarebasedontranchesthatareshort,mediumor
longtermandarederivativesecuritiescreatedfromtraditionalmortgagebackedbonds,which
areplacedintrust.

3. Therearenoinvestmentproductsintheworldthatarepurelyriskfree,yetthemarketsliketothink
ofariskfreeassetforcomparisonpurposes,especiallytodeterminetheriskpremiumforrisky
assets.TheclosestthingthemarketshavetoapurelyriskfreeassetarethedebtsecuritiesoftheU.S.
federalgovernment,whichhavenevermissedacouponpaymentoramaturitydateinhistory.Given
thishistoricalrecordofzerovariance,theguaranteeoftheU.S.governmenthasagreatdealof
credibilityinthefinancialmarkets.Noonecanpredictthefuture,butthereappearstobenothingin
theshorttermthatindicatesthegovernmentwillnotliveuptoitsguarantee.

4. (1) f (6) c
(2) b (7) g
(3) a (8) i
(4) d (9) h
(5) e

5. Convertiblesecuritiesstartoutasbonds(orevenpreferredstock)andendupassharesofcommon
stock.Beforeconversion,thebondsareusuallyunsecureddebtobligationsandsubordinatedtoother
formsofdebt.Corporationscanforceconversionbycallingthebondsandgivingtheconvertible
bondholdersthechoicebetweencashorsharesofthecompanyscommonstock.Aslongastheshare
priceissufficientlyhigh,bondholderswilllogicallyexchangetheirlendingpositionforthatoffirm
ownership.Throughtheconvertiblesecurityroute,companiesobtainequityinvestmentdollarsfrom
individualsyouwouldnormallyinvestinthefirmscommonstock.
 Chapter10FixedIncomeSecurities190
6. LYONs,orliquidyieldoptionnotes,combineaddaconversionfeatureandputoptiontoazero
coupon.Investorscanconvertthebondsforsharesthroughtheconversionfeature.Theycansellthe
bondbacktotheissuerforprespecifiedamountsthroughtheconversionfeature.However,thesales
pricemaybeinstocksandbonds,aswellascash.Althoughtherearenocouponpayments,youalso
donothavetoreinvestcouponpayments.Likeallzeros,aLYONprovidesareturnthroughprice
appreciation.Unlesstheunderlyingstocksvaluerisesat,atleastthesamerate,investorsmayfind
thattheconversionfeatureislosingitsvalue.

7. Answerswillbedependentuponthedebenturesandpreferredstockchosen.Itmaybeadvantageous
fortheinstructortoselectsecuritiesasusethisquestionaspartofalecture.

Solutions to Problems
Annualinterestincome
1. Currentyield
Currentmarketpriceofbond
$60
Currentyield 7.06%
$850
Note:Anissuescallfeaturedoesnotaffectitscurrentorpromisedyield.

2. Annualinterest$120
Currentyield $120/$1,2500.096or9.6%

3. Interest 0.1$1,000$100
$100/Price0.06$100/0.06Price$1,666.67

4. Aninvestor,comparingmunicipalstocorporates,mustconvertthemunicipalyieldtoitsfullytaxable
equivalent:
Yieldonmunicipalbond
Fullytaxableequivalentyield
(FTEY) 1 - federaltaxrate
0.0525
7.29%
1 - 0.28
Sincethefullytaxableequivalentyieldof7.29percentislessthanthe7.5percentreturnonthe
corporatebond,thecorporateissueoffersahigherreturnandisthebetterbuy.
Yes,thedecisionverylikelywouldchangeifthiswasaninstatebondandtheinvestorlivedina
statewithhighincometaxes.Thisbondwouldnotonlyshieldtheinvestorfromfederaltaxesbutalso
fromhighstateincometaxes.Sincethefullytaxableequivalentyieldformula(atleasttheone
presentedinthetext,whichisthemostwidelycitedversionoftheFTEY)considersonlyfederal
taxes,theresultinganswermustberaisedsomewhattoaccountforthestatetaxshield.Usingthehigh
endofthe1/4to1/2percentrangecitedinthetext(sincethisissupposedtobeahightaxstate),the
netresultisaFTEYofaround7percentforthemuni(i.e.,7.29%0.50%)versus7percentforthe
corporateissue.Underthesecircumstances,themunicipalbondisthehigheryieldinginvestment.

5. Aftertaxyieldbeforetaxyield[1{ftrstr(1ftr)}]
Where:ftrfederaltaxrateandstrstatetaxrate
0.07[1{0.330.08(10.33)}]0.07[1(0.330.0536)]
191Gitman/JoehnkFundamentalsofInvesting,TenthEdition
0.07[10.3836]0.07[0.6164]0.043or4.3%

6. BondA: AArated,instatemuniwith6.375percentcoupon;exemptfrombothfederalandstate
incometaxes
BondB: AAratedoutofstatemuniwith7.125percentcoupon;exemptfromfederalincometaxes
BondC: Corporatebondyielding9.75percent;notaxadvantages
BondD: LongtermTreasurybondyielding9percent;exemptfromstateincometaxesonly
(a) Calculationsforfullytaxableequivalentyields(FTEY):

BondA
BondYield
FTEY
1 - [Federaltaxrate - Statetaxrate(1 - FTR)]
6.375 6.375

1 - [0.35 0.115(1 - 0.35)] 1 - (0.35 0.0748)
11.08%
BondB
BondYield 7.125
FTEY 10.96%
1 - (Federaltaxrate) 1 - 0.35
BondC
TheFTEYisthesameasthestatedyield:9.75%
BondD
BondYield 9.00
FTEY 10.17%
1 - (Statetaxrate) 1 - 0.115

Note:BecausetheTreasurybondisexemptfromstatetaxesonly,theyieldisadjustedto
calculatethefullytaxableequivalentyieldusingtheaboveformula.
SheshouldbuyBondA,theAAratedinstatemunicipalbond;itsaftertaxreturnishighest.
(b) Rankingonthebasisoffullytaxableequivalentyield,besttoworst:

Bond Coupon FTEY

1. AAratedinstatemunicipal 63/8 % 11.08%
2. AAratedoutofstatemunicipal 77/8 10.96
3. LongtermTreasurybond 9 10.17
4. Corporatebond 9 /4
3 9.75

7. TreasurytaxableequivalentyieldTreasuryyield/(1Statetaxrate)
0.05/(10.08)0.05/0.920.05435.43%

MunicipaltaxableequivalentyieldMunirate/[1(FTRSTR(1FTR))]
0.04/[1{0.330.08(10.33)}]0.04/[1{0.330.08(0.67)}]
0.04/[1(0.330.0536)0.04/[10.3836]0.04/0.61640.0649or6.49%.
Robshouldpurchasethemunicipalbondasthetaxadjustedyieldis6.49percent,whichisbetterthan
thetaxadjustedyieldof5.43percentontheTreasurybond.
 Chapter10FixedIncomeSecurities192
Annualinterestincome
8. Currentyield
Currentmarketpriceofbond
Coupon Interest MarketPrice CurrentYield
95
a. 91/2 % $95.00 973/4 97.75%1,000 9.72%
977.50
160
b.16 160.00 1645/8 164.625%1,000 9.72%
1, 646.25
52.50
c. 51/4 52.50 5454%1,000 9.72%
540
Alloftheabovebondshaveacurrentyieldof9.72percentand,assuch,areidentical.

9. (a)
Coupon Interest MarketPrice CurrentYield
$75
Beginningofyear 71/2 % $75 $850.00 8.82%
$850
$75
Endofyear 71/2 75 $962.50 7.79%
$962.50

Asthepriceofthebondwentup,thecurrentyielddroppedto7.79percent.
Annualinterestincome Capitalgains
(b) HPR
Purchaseprice
$75 $962.50 - $850 $75 $112.50

$850.00 $850.00
$187.50
22.06%
$850.00

10. Priceat7%yield($100/0.07)$1,428.57
Priceat6%yield($100/0.06)1,666.67
Lossonsale 238.10
InterestIncome 100.00
NetLoss $138.10
Colwynlost$138.30onthisinvestmentbecauseinterestrateswentup.
Annualinterestincome+Capitalgains
11. (a) HPR
Priceatbeginningofyear

(1) (2) (3) (4) (5) (6)

Capital Total
Ending Beginning Gain Annual Return HPR
Year Price Price (1)(2) Income (3)(4) (5)(2)
2001 $1,006.25 $941.25 $65 $88.75 $153.75 16.33%
2002 1,020.00 1006.25 13.75 88.75 102.50 10.19
2003 1,046.25 1020.00 26.25 88.75 115.00 11.28
2004 1,101.25 1,046.25 55.00 88.75 143.75 13.74
2005 1,212.50 1,101.25 111.25 88.75 200.00 18.16
193Gitman/JoehnkFundamentalsofInvesting,TenthEdition
(b) Evaluationofreturnperformance:

AnnualHPR(%)
Year ARatedCorporate BondMarket
2001 16.33% 9.16%
2002 10.19 -5.76
2003 11.28 9.18
2004 13.74 12.16
2005 18.16 11.95
Average 13.94 7.34

LookingattheaverageHPRsoverthefiveyearperiod,wecanconcludethattheArated
corporatebondhasoutperformedthemarket:13.94percentversus7.34percent.Alsonotethat
theAratedcorporatebondreturnswerelessvolatile(Minimum10.19%&Maximum
18.16%)comparedtothevolatilityofthebondmarket(Minimum5.76%&Maximum
12.16%).

12. $20,000.Azerocouponbondtradesatadiscounttofacevalueandpaysnointerestduringits
lifetime.Atmaturity,itpaysfacevalue,whichrepresentstheprincipalandaccruedinterestonthe
bondduringitslifetime.

13. Brandonprobablypurchasedanassetbackedsecurity.Thesesecuritiespayaportionofprincipal
withtheinterestpaymentsastheunderlyingcollateralisrepaid.

14. (a) TotalReturninSwissFrancs:

EndingValueofBondinCHF+DividendsinCHF
TotalReturn -1
BeginningValueofBondinCHF
11,750CHF+950CHF
-1
11,000CHF
15.45%
(b) TotalReturninU.S.Dollars:
EndingValueofBondinCHF+DividendsinCHF
TotalReturn
BeginningValueofBondinCHF
ExchangeRateatEndofHoldingPeriod
-1
ExchangeRateatBeginningofPeriod

(11,750CHF+950CHF) 0.8000
TotalReturn -1
11,000CHF 0.6329
1.4594 - 1
45.94%

15 (a) Ifyoubuyeachfor$10,000andselleachfor$10,000,theprofitwillbetheinterestyouearn,
whichisequalto$600ontheEurobondand$500ontheU.S.bond.
 Chapter10FixedIncomeSecurities194
(b) Theoriginalpurchasewillbe$10,000/1.119,009euros.
9,0091.069,549.5euros.
9,549.50.98(thenewexchangerate)$9,358.51.
$10,600$9,358.51$1,241.49isthecurrencyimpact.
Ratherthanmakingmoneyonthisinvestment,theinvestorwouldlosemoney.Thelosswouldbe
equalto$10,000$9,358.51$641.49.
Alternativemethod:
Thecurrencychangeis0.98/1.110.882883.
$10,6000.882883$9,358.56

16. ConversionEquivalentConversionratioMarketprice21$40$840.

17. Commonstock:$850/$2534shares
Commonstockprofit($35$25)34shares$340
Convertibleprofit(($50(34$35))850$1240850$390
Buytheconvertiblebond.

18. Convertiblebond:$1,000facevalue,6percentcoupon,20-yearmaturity,convertible
into20shares;currentpriceoftheconvertibleis$800,currentstockpriceis$35.
195Gitman/JoehnkFundamentalsofInvesting,TenthEdition
(a) Conversionprice Parvalue/Conversionratio
$1,000/20$50/share
(b) Conversionratio Statednumberofsharesthebondcanbeconvertedinto
20shares
(c) Conversionvalue ConversionratioMarketpriceofthestock
20$35$700
Conversionparity Marketpriceoftheconvertible

Conversionratio
$800/20$40
(d) Conversionpremium CurrentmarketpriceofconvertibleConversionvalue
$800$700$100
Conversionpremium $100/$70014.29%
(e) PaybackPeriod Conversionpremium(in$)

Annualinterest Annualdividend
incomefrom-incomefrom
convertiblebondunderlyingCS
$100 $100

$60 - (20 0.75) $60 - $15
2.2years
(g) InvestmentvalueValueasastraight(nonconvertible)bond
$60PVIFA8%,20yrs.$1,000PVIF8%,20yrs.
$609.818$1,0000.215
$589.08$215$804.08
Sotheconvertibleissellingnearitsfloororitsvalueasabond.
 Chapter10FixedIncomeSecurities196
19. Priceofconvertibleinoneyearwillbe10percentovertheconversionvalue.
Conversionvalue PriceofstockConversionratio
$7520$1,500
Priceofconvertible $1,50010%of$1,500
$1,500$150$1,650(in1yr)
Now,with$5,000aninvestorcanbuyfivebondspricedat$1,000each.Therefore:
Interest(coupon)income ($1,0000.08)5
$80perbond5$400
Capitalgains ($1,650$1,000)5
$650perbond5$3,250
Totalincome $400$3,250$3,650
1yearholdingperiodreturn$3,650/$5,00073%
Giventheconvertibleissellingatapriceof$1,000,whichincludesa25percentconversion
premium:

Conversionvalueofthesecurity$1,000/1.25$800
(Afactorof1.25isusedinthisformulasince,witha25percentconversionpremium,thepriceofthe
convertiblewillbeequalto125percentoftheconversionvalue.)
Conversionvalue
Priceofunderlyingcommonstock
Security'sconversionratio
$800/20 $40/share
Note:Thisproblemshowsthat,whilethepriceoftheconvertiblewentupby65percentoverthe
courseoftheyear(from$1,000to$1,650),thepriceoftheunderlyingcommonstockwentupeven
more:87.5percent(from$40to$75).Thereasonforthis,ofcourse,isthedropintheconversion
premium(from25percentto10percent)i.e.,thisrepresentslostprofits,whichacttoreducethe
rateofpriceappreciationoftheconvertibleissue(apointofwhichstudentsshouldbemadewell
aware,sincethismajordrawbackisacommonfeatureofconvertiblesecurities).

20. Theinvestmentvalueofaconvertiblebondisdonebypricingthebondatarateequal(orclose)to
theprevailingmarketyieldforcomparablenonconvertibleissues.Inthiscase:
InvestmentValue InterestincomePVIFAk%,nyrs.MaturitypaymentPVIFk%,nyrs.
$75PVIFA9%,15yrs.$1,000PVIF9%,15yrs.
$75(8.061)$1,000(0.275) $879.58

21. Conversionvalue ConversionratioPriceofcommonstock

1.8$40$72
Conversionpremium MarketpriceConversionvalue
$90$72$18
Sothereisaconversionpremiumof$18or25%($18/$72).
Marketpriceofconvertible
Conversionparity
Conversionratio
$90
$50
1.8
197Gitman/JoehnkFundamentalsofInvesting,TenthEdition
Conversionparityisthepricethecommonstockwouldhavetosellforinordertomakethe
convertiblesecurityworthitspresentmarketvalue.Thedifferencebetweentheconversionparity
andtheactualmarketpriceofthecommon($40)isthecurrentconversionpremiumpershareof
$10($50$40)or25percent($10/$40).

Solutions to Case Problems

Case 10.1Max & Veronica Develop a Bond Investment Program
Thissimplecaserequiresthestudenttochooseafixedincomeinvestmentstrategyforacouplewhohope
toinvestonalongtermbasis.Inparticular,thestudentmustreviewandconsidertheapplicabilityof
severalkindsofissuesastheyrelatetotheinvestmentneedsofthiscouple.

(a) MaxandVeronicadontrelyontheincomefromtheirinvestmentsfortheirdaytodayneeds.They
haveanadequateincome,sotheirbondportfoliocanbeusedprimarilytomaximizetotalincomeona
longer termbasis(capitalappreciationandhighcurrentincome).Theyshouldinvestwithaview
towardmaximizingthetotalreturnovertheirholdingperiod,ratherthaneitherinterestorcapital
gainsalone.Thisimpliesamiddleoftheroadapproachthatinvolvessomecurrentincome(thatcan
bereinvested)andsomecapitalgains.

(b) MaxandVeronicacouldconsideravarietyofissues.Forexample,Treasuryobligationsmaturingin
twentyyearsormorewouldbeoneoption.Treasuryobligationshavelowrisk,arenoncallableor
haveverylongcalldefermentperiods,andareexemptfromstateandlocaltaxes.Agencyissuesare
anothergoodchoiceforthem,sincemosthavelowriskbutofferhigheryieldsthanTreasuries.Many
agencyissuesarealsoexemptfromstateandlocaltaxes.Mostmunicipalbondsareexemptfrom
federalincometaxes,providingahighfullytaxableequivalentyieldgiventhePeterstaxbracket.
Corporatebondsmayalsobeattractivebecauseoftheirhighyields.Also,theymightgiveserious
considerationtodeepdiscountedbondsfortheircapitalgainspotential;thelowcouponsalsoreduce
reinvestmentproblems.

(c) Studentsanswerswillvary.

(d) Studentsanswerswillvary.

(e) Studentsanswerswillvary.

Case 10.2The Case of the Missing Bond Ratings

Inthiscase,thestudentrelatesvariousfinancialratiostobondratingsinordertoassignabondratingtoa
particularissue.ThestudentshouldreviewthefinancialratiospresentedinChapter6beforesolvingthis
case.

(a) BondsissuedbyCompanies2,3,and6areinvestmentgradeissues.Thebondsissuedbytheother
three(1,4,and5)areinthejunkbondcategory.Comparingthevariousfinancialratios,weseethat
Company3ranksatthetopinmostratios.Companies2,3,and6havefairlygoodliquiditypositions,
rankwellintermsofprofitability,andhavesufficientcashflowtocoverinterestandprincipal.Also,
theirdebttototalcapitalratioislowercomparedtotheotherthreefirms.Companies1,4,and5have
poorliquidityratiosandverylowinterestcoverage.Thehigherleverageatthesecompaniesmakes
theirbondsveryspeculative.
 Chapter10FixedIncomeSecurities198
(b) AAAisthehighestratingforabond,whileBisthelowestratingforspeculative
(noninvestment)gradeissues.Company3easilyhasthebestratiosandshouldbetheAAArated
firm.Company4,ontheotherhand,hasthepoorestratiosandshouldreceivetheBrating.

(c) Company6rankssecondintermsoffinancialratios;itscurrentratioisslightlybetterthanCompany2
buthasalowerquickratio.ItsreturnontotalcapitalishigherthanCompany2,andithaslower
leverageandbetterinterestcoverage.Therefore,onthebasisoffinancialratiosCompany6shouldbe
ratedAAandCompany2,A.

Companies1and5arefairlysimilarwithrespecttothefinancialratios.EventhoughCompany5has
abetterprofitabilitymargin,itisalsoveryhighlyleveragedcomparedtoCompany1.These
companiesshouldbeassignedBBratings.