Question

In 1936, the Canadian government raised $55 million by issuing bonds at a 3 percent annual rate of interest. Unlike most bonds issued today, which have a specific maturity date, these bonds can remain outstanding forever; they are, in fact, perpetual.
At the time of issue, the Canadian government stated in the bond indenture that cash redemption was possible at face value ($100) on or after September 1966; in other words, the bonds were callable at par after September 1966. Believing that the bonds would actually be called, many investors purchased these bonds in 1965 with the expectation of receiving $100 in 1966 for each perpetual bond they had. In 1965, the bonds sold for $55. A rush of buyers, however, drove the price to slightly less than the $100 par value by 1966, but prices fell dramatically when the Canadian government announced that these perpetual bonds were indeed perpetual and would not be paid off. The bonds’ market price declined to $42 in December 1966. Because of their severe losses, hundreds of Canadian bondholders formed the Perpetual Bond Association to lobby for face value redemption of the bonds, claiming that the government had reneged on an implied promise to redeem the bonds. Government officials in Ottawa insisted that claims for face value payment were nonsense—that the bonds were and always had been clearly identified as perpetuals. One Ottawa official stated, “Our job is to protect the taxpayer. Why should we pay $55 million for less than $25 million worth of bonds?”
The following questions relating to the Canadian issue will test your understanding of bonds in general:
a. Do you think it would it make sense for a business firm to issue bonds like the Canadian government bonds described here? Explain.
b. Suppose the U.S. government today sold $100 billion each of four types of bonds: five-year bonds, 50-year bonds, “regular” perpetual bonds, and Canadian-type perpetual bonds. Rank the bonds from the one with the lowest to the one with the highest expected interest rate. Explain your answer.
c. Do you think the Canadian government would have taken the same action with regard to retiring the bonds if the interest rate had fallen rather than risen after they were issued?
d. Do you think the Canadian government was fair or unfair in its actions? Give the pros and cons of its decision, and justify your reason for thinking that one outweighs the other. Would it matter if the bonds had been sold to “sophisticated” as opposed to “naive” purchasers (investors)?



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  • CreatedNovember 24, 2014
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