Question

Suppose that Ford Motor Company issues two types of bonds. One is a standard bond. The second is a special bond which is identical to the standard bond but also gives the bond holder an ownership share in Ford. Which bond will have a higher price? Which bond will have a higher yield? Why?

Answer 1

The bond prices are not decided one way- that is, both supply as welll as demand determine it. However, Ford Motors is a huge company and we shall assume that there is enough demand for its bonds- we will consider only the supply side economics.

A standard bond just means that the company is taking a loan with a promise to pay it back. Theoretically, the special bond which gives ownership should be priced higher than a standard bond. This is because of the additional service being provided (the special bond involves selling and buying of ownership). However, it will have a lower rate of return than the standard bond- this is because bond prices and rate of interest are inversely related (Keynesian theory).

Say that the special bond is priced at $50 and the special one at $70. Typically, if a company increases in value at year end, the profits must be shared by all the bond holders. This means that each bond will receive a $5 hike in price at the end of the year (say). Now, rate of return on on the $50 bond becomes 10% whereas that on the 70$ bond becomes 7.14%.