Question 5.3: Explain the nature of the following items and state the circ...
Explain the nature of the following items and state the circumstances under which their issue would be beneficial to (i) lenders and (ii) borrowers:
(a) deep discount bonds;
(b) zero coupon bonds;
(c) warrants;
(d) convertible bonds.
(a) Deep discount bonds are bonds issued at a large discount to nominal value, which will be redeemed at or above nominal value on maturity. They may be attractive to companies which need a low servicing cost during the life of the bond and which will be able to meet the high cost of redemption at maturity. Investors might be attracted to the large capital gain on offer, which will have tax advantages for some.
(b) Zero coupon bonds are bonds issued at a large discount to nominal value which pay no interest. The investor obtains a capital gain from the difference between the issue price and the redemption value, which is usually nominal value. Attractions for companies are similar to those for deep discount bonds.
(c) A warrant is a right to buy new shares at a future date at a fixed, predetermined price. Warrants are usually issued as part of a package with unsecured loan notes in order to make them more attractive. They are detachable from the loan notes and can be sold and bought separately. Investors may find them attractive because they offer potentially high gains compared with investing in the underlying shares.
(d) Convertible bonds are bonds which can be converted into ordinary shares at the option of the holder. The interest rate on convertibles is therefore lower, since the holder has the option to participate in the growth of the company, unlike the holder of ordinary bonds.