Practice Quiz

Financial Planner

Category - Investment Planning

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Your client wants to invest in bonds and they don’t mind high levels of risk if the payoff is worth it in the end. He has been watching a company that is looking to complete a major project in the city and is offering debentures, but there are rumors that the company may go bankrupt trying to complete the project. What should the client be told about debentures as it pertains to the current scenario?
  1. That debentures are only backed only by the company’s creditworthiness.
  2. The debentures are unsecure promissory notes.
  3. That due to the added risk of unsecure debt the yield can be higher than secure debt.
  4. All of the above.
Explanation
Answer: D - Debentures are unsecure promissory notes that are only backed by a company’s creditworthiness; however, the added risk of bonds that are unsecure debt can yield higher interest than that of secure debt. Note that during bankruptcy, debentures are redeemed only after all secured debt has been paid off. Therefore, debentures pay a higher yield than secured debt because of the added risk. Some debentures are subordinated, and these are even more risky than other debt. Subordinated debentures are paid off after all unsecured debt is paid off during bankruptcy.
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