CFA Practice Question

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CFA Practice Question

All of the following statements about convertible bonds are true EXCEPT:

A. The yield on the convertible will typically be higher than the yield on the underlying common stock.
B. The convertible bond will likely participate in a major upward movement in the price of the underlying common stock.
C. Convertible bonds are typically secured by specific assets of the issuing company.
D. A convertible bond can be valued as a straight bond with an attached option.
Correct Answer: C

User Contributed Comments 22

User Comment
kalps A is false, the fact that there is a conversion option decreases the yield as there is more incentive for the purchaser for future gain if price of common stock rises
tinku I agree. A has call option embedded. That should cost something.
LogicMan Check the wording of A! Yields on convertible bonds are lower than those of bonds but higher than those of STOCKS (this is what A is comparing to!) So A is actually true.
morpheus918 Tru dat! The div yield on the common stock is likely much lower than the convertible bond.
mtcfa Of course A is true. Otherwise investors would just choose to buy the stock.
1sttimer think about could the yield be higher on convertible bonds, which are senior to equity??
ehc0791 if the underlying stock yield is higher than the convertable bonds, the bonds are most likely being converted. So a is true.
steved333 My understanding of B is that if there is a major upswing in the price of the stock, the bonds will be converted, thus participation. Anyone disagree?
Kaont Yield on convertible bond normally always higher than stocks - It is because in most of the case, the only reason for a company to raise capital through convertible bond is because public/instituational investors do not have enough confidence in the company itself. In order to seek for new capital, it needs to have a higher yield and some types of promising in returning of capital. Thus yield is higher than stock and it is a bond. Please refer to the 2008 capital injection events for Citigroup/MBIA/JP Morgan...
JHeld Think about A for just a minute. The callable bond give the holder the RIGHT to the yield in the stock as well as the yield on the bond...
king100 Still not sure why A would be true. I think everyone is in agreement on why the yield on a convertible is lower than for a non-convertible (the conversion option has value). Similary, I would have thought that the yield would be lower than than that of the underlying stock as the holder of the convertible benefits from an increase in the stock price but has downside protection (ie it is less risky than a stock but benefits from the upside). I would have thought this would imply a lower yield for the convertible. Can someone please explain what I am missing here?
jayj001 I'm confused also. Assuming the yield is inversely related to your height on the seniority pyramid, A is false?
michlam14 i agree with Kaont. A is initially a debt instrument with no voting rights and the yield should reflect that. unless the stock price raise sufficently, there's the risk it doesn't get converted into shares. I wish there's a "like" button so I can "like" Kaont's comment.
johntan1979 All the arguing about A... why NOT C?
jonan203 carpenter's rule:

measure twice, cut once

CFA level 1 writer's rule:

read twice, answer once
gill15 I agree with Johntan...I thought bonds were secured by Assets of issuing company....arent bonds always...
adidasler the previous question answered that geniuses ....
usually unsecured and subordinated debt ...
vadfir Convertibles have 3 basic attributes:
1) An upside potential that normally is less than that of the underlying comm. stock because convert. buyers pay premium for the conversion privilege
2)Less downside risk than the stock due to built-in price supports.
3)Yield is normally higher than that of the associated stock.
chcarnes @gill15 - an unsecured bond is a claim to cash flows of the firm. a secured bond is secured by a specific asset that will be liquidated as first priority to pay back bondholders. Key word is specific
fabsan Practitioners agree that the Return on any Asset class is 1st function or the risk. The yield or the Required rate of return on the convertible bond depends on the risk of the convertible bond. Everybody should agree that the convertible bond is less risky than the common stock of the same issuer (in any perspective). If market are efficient or even semi-efficient, the yield on the convertible cannot exceed the yield on the stock. At the same time, if th yield on the common stock is higher than the convertible bond yield we have an arbitrage condition (investors will buy the bond, convert it and sell the stock till there is no more arbitrage condition). I think the yield should relatively be the same for these 2, therefore A is not true.
sshetty2 1sttimers right, you cant compare debt to equity in terms of yield despite the convertibility factor; i messed up to i thought they were comparing convertibility to non-convertibility
curren0625 A is true, it is a common sense. In actual, coupon payment is generally higher than dividend, based on rational pricing. It's LV1, don't be complex.
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