I was reading Security Analysis by Benjamin Graham (Sixth Edition). Page 63, last paragraph says:

A third kind of analytical conclusion may be illustrated by a comparison of Interborough RapidTransit Company First and Refunding 5s with the same company’s Collateral 7% Notes, when both issues were selling at the same price (say 62) in 1933.

The 7% notes were clearly worth considerably more than the 5s. Each \$1,000 note was secured by deposit of \$1,736 face amount of 5s; the principal of the notes had matured; they were entitled either to be paid off in full or to a sale of the collateral for their benefit. The annual interest received on the collateral was equal to about $87 on each 7% note (which amount was actually being distributed to the note holders), so that the current income on the 7s was considerably greater than that on the 5s. Whatever technicalities might be invoked to prevent the note holders from asserting their con- tractual rights promptly and completely, it was difficult to imagine conditions under which the 7s would not be intrinsically worth consid- erably more than the 5s.

The 1,736 statement puzzled me. Is it a statement or a quick calculation? I assume that 5% and 7% is referring to the annual yield rate. Thus, if the latter is bought for $\$1000$, then after a year it will grow to $\$1070$. To have the same result, the former should be bought as $\$1070\div 1.05\approx\$1019 $, which is nowhere near the value in the statement.

  • $\begingroup$ In bond jargon "5s" refers to bonds with a 5% coupon not yield. $\endgroup$
    – Alex C
    Mar 11 '19 at 1:00
  • $\begingroup$ Note that he is comparing (his opinion of) "intrinsic value" not market value. He does not assume that they are necessarily the same. He believes the 7% have better instrinsic value because of their collateral. $\endgroup$
    – Alex C
    Mar 11 '19 at 1:24
  • $\begingroup$ I see. Thus, the statement '$\$1000$ notes against $\$1736$' is not calculated from 5% and 7% coupon, right? $\endgroup$ Mar 11 '19 at 2:04
  • $\begingroup$ Right. He got that figure from some other source, perhaps the bond prospectus or company reports. $\endgroup$
    – Alex C
    Mar 11 '19 at 2:06
  • $\begingroup$ I see. Thanks a lot! :) $\endgroup$ Mar 11 '19 at 2:07

A &5 note of worth \$1000, is issued against a collateral of 5% bond of worth \$1736. Now yearly interest of \$1736 at a rate of 5% comes \$87. This interest is distributed among note holders. So note holder effective get a interest of 8.7% (=87/1000 x 100) which is much better than 7% as per contract. This is the advantage note holders were getting

------I think this will clarify your query : Kashinath


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