I came across this question in the Wiley Series 7 2020 book:
An investor holding an 8% subordinated debenture will receive how much at maturity?
a. $1,000
b. $1,080
c. $1,040
d. Depends on the purchase price
The answer is c. The stated reason is: "at maturity receive principal payment plus last semi interest payment", but I still do not get it. Can you explain?
The principal amount of a debenture is usually $1000. Since this is a 8% subordinated debenture, the annual coupon will be 8% of the principal. In other words, the investor will be paid a total of $80 every year.
In the US bond market, the convention is that unless you are explicitly told otherwise, the coupons are assumed to be paid semi-annually (i.e. every six months).
In your question, this means that the bondholder will get paid $40 every six months. At maturity, the last coupon ($40) is paid along with the principal ($1000). Therefore, at maturity, the bondholder will receive $1000 + $40 = $1040. The answer is (c).
The answer is not (a), because a payment of only $1000 (principal) is missing the last semi-annual interest payment ($40).
The answer is not (b). Semi-annual coupons (coupons paid every 6 months) mean that each coupon payment is $40. Annual coupons (coupons paid every 12 months) mean that each coupon is $80. In this case, the coupons are paid semi-annually, so the last interest payment should be $40, and not $80.
The answer is not (d), because the amount of principal and coupons that the debtor has to repay is fixed. In other words, it doesn't matter what price you paid for the debenture on the primary or secondary market. The debtor has to pay what it owes (principal + coupons) regardless of the price you paid for the debenture.
