Question

Bill and Edna had been married two years and had just reached the point where they

had enough savings to start investing. Bill’s uncle Dave told them that he had recently

inherited some very rare railroad bonds from his grandmother’s estate. He wanted

to help Bill and Edna get a start in the world and would sell them 50 of the bonds at

\(100 each. The bonds were dated 1873, beautifully engraved, showing a face value of

\)1,000 each. Uncle Dave pointed out that “United States of America” was printed

prominently at the top and that the U.S. government had established a sinking fund to

retire the old railroad bonds. A sinking fund is a fund established for the purpose of

repaying the debt. It allows the organization (the U.S. government, in this example)

to set aside money over time to retire the bonds. All Bill and Edna needed to do was

hold on to them until the government contacted them, and they would eventually get

the full \(1,000 for each bond. Bill and Edna were overjoyed—until a year later when

they saw the exact same bonds for sale at a coin and stamp shop priced as “collectors’

items” for \)9.95 each!

Requirements

1. If a company goes bankrupt, what happens to the bonds it issued and the investorswho bought the bonds?

2. When investing in bonds, how can you tell whether the bond issue is a legitimatetransaction?

3. Is there a way to determine the relative risk of corporate bonds?

Short answer

Settlement process performed between the investor and company at time of bankruptcy. Risk of corporate bond measured by credit rating. Some of the credit ratings-giving agencies are Moody and Fitch.

Step-by-step solution

Definition of bankrupt

Bankruptcy is when the borrower fails to pay back the money of lenders.

When the company goes bankrupt

When a company goes bankrupt, there is a settlement in the court between the company and the investors. The company’s assets are divided between the investors and creditors. The equity investors get their money at the end of the distribution only if the assets are remaining. If the assets do not remain at the end, then the equity investors do not get anything. On the other hand, the bondholder receives the amount based on the portion of their investment.

Step 3:Bond issue is a legitimate

The purchase of the stocks and bonds is only made through the registered securities dealer. The investor gets a statement of brokerage containing their name.

Way to determine the risk of corporate bonds

The relative risks of the corporate bonds can be measured by using the credit ratings given by the credit service agencies. The ratings of the bonds are shown in the term alphabet. The top rating of the bonds is AAA. The lower grade of the credit rating is C.