CFA Practice Question

There are 266 practice questions for this study session.

CFA Practice Question

Which of the following statements is(are) true with respect to the debt structure of a high-yield bond issuer?

I. The firm's senior debt has absolute priority over any bank loans that may be outstanding.
II. Bank loans, in general, are floating-rate loans.
III. Payment-in-kind bonds would be regarded as a form of subordinated debt.
IV. Relative to coupon-paying bonds, zero-coupon bonds will result in much lower interest coverage ratios as the bonds approach closer to maturity.
A. II and III
B. I and II
C. III and IV
Explanation: The firm's bank loans have absolute priority over any senior debt that may be outstanding.

[IV] A zero coupon bond will always result in a much higher interest coverage ratio, since it never requires the issuer to pay interest. However, the "bullet" payment at the end for a zero-coupon bond could pose some serious risks to the issuer.

User Contributed Comments 8

User Comment
dblueroom The bullet payment at the end of a zero-coupon bond is its face value, right? What do they mean by bullet? i.e. corporate bullet bond.
Grahamite According to an accounting class I took last year, zero coupon bonds still create a periodic interest expense. I think the "implied rate" is multiplied by the principle balance. Don't quote me on this, but I don't think the interest coverage ratio would be much different than if they were coupon paying bonds.
NIKKIZ I agree with Grahamite - there is no cashflow implication for a zero-coupon bond until maturity but there certainly is a charge taken against it in the income statement (amortization). As time goes by, the combined value of principal plus accumulated (unpaid) interest increase, meaning that interest increases in the later years of the zero-coupon bond. Could it possibly be that the interest coverage ratio needs to be calculated from the cashflow and not income statement? Opinions welcome.
kazec If cash interest paid differs from interest expense signficantly, the former should be used in calculating interest coverage ratio.
rana1970 For accounting studentd, Interest expense is amortized at decreasing rate, so near the maturity date Interest will be minimum & hense coverage ratio is very high. That's why iv is incorrect.
tylaw III is wrong - just because a bond is PIK doesn't make it subordinated. There's plenty of senior unsecured PIK paper out there. A bond is only subordinated if its indenture says it is - otherwise, everything is general unsecured in the eyes of US bankruptcy law.
charliedba according to

PIK loans are typically unsecured (i.e., not backed by a pledge of assets as collateral) and/or with a deeply subordinated security structure (e.g., third lien).
alles Actually, for discount bonds, interest expense will increase over time as the bond liability increases in the balance sheet (the amortization of the discount is added to the bond liability). So near the maturity interest expense will be the highest. And this impact is larger for zero-coupon bonds because the discount is larger.
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