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Corporate Bonds vs Preferred Stocks

1. Although corporate bonds have lower total annual returns per year than common stocks, corporate bonds are not risk free. For example, Enron's filing for bankruptcy in December 2001 was one of the largest bankruptcy filings in the U.S. The creditors received less than twenty cents on the dollar for their investments. Similarly, when WorldCom declared bankruptcy, its creditors received less than forty cents on the dollar for their investments. Bond investors who were just seeking income from their bond investments experienced significant principal losses.
What are some of the risks of investing in corporate bonds? Despite these risks, why do investors still invest in corporate bonds?

2. Corporations can finance themselves through many ways such as common stock, corporate debt, and preferred stock. The cost of common stock can be determined using the capital asset pricing model (CAPM). Not all common stocks pay a common stock cash dividend; however, it is quite common for a bond to pay interest. This bond interest payment is a major reason bond investors buy coupon-paying corporate bonds. The preferred stock financing option, however, is used less frequently by corporations compared to corporate debt and common stock financing options.
How does a corporate bond compare with preferred stock? How does the valuation of a corporate bond compare with the valuation of preferred stock?

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1. Although corporate bonds have lower total annual returns per year than common stocks, corporate bonds are not risk free. For example, Enron's filing for bankruptcy in December 2001 was one of the largest bankruptcy filings in the U.S. The creditors received less than twenty cents on the dollar for their investments. Similarly, when WorldCom declared bankruptcy, its creditors received less than forty cents on the dollar for their investments. Bond investors who were just seeking income from their bond investments experienced significant principal losses.
What are some of the risks of investing in corporate bonds?

As we know interest rates fluctuate over time, and an increase in rates leads to a decline in the value of an outstanding bond; this is the interest rate risk. Interest rates can and do rise, and rising rates cause a loss of value for bondholders. Thus, people or firms who invest in bonds are exposed to risk from increasing interest rates. Interest rate risk is higher on bonds with long maturities than on those maturing in the near future. This is because the longer the maturity, the longer before it is paid off and the bondholder can replace it with one with a higher coupon. The longer its maturity, the more its price changes in response to a given change in interest rate.

Potential default is another risk faced by bondholders. If the issuer defaults, investors will receive less than the promised return. The ...

Solution Summary

This solution provides detailed explanations to the following questions:
What are some of the risks of investing in corporate bonds? Despite these risks, why do investors still invest in corporate bonds?
How does a corporate bond compare with preferred stock? How does the valuation of a corporate bond compare with the valuation of preferred stock?

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