Chapter Case of chapter 6
1. The security of the bond, that is, whether the bond has collateral. Effect on the coupon rate of the bond issue: Bond’s with collateral will have lower coupon rate as bondholders have claim on collateral no matter what.
Advantage: It provides an asset which lower default risk.
Disadvantage: Companies cannot sell this collateral as an asset and need to maintain it.
2. The seniority of the bond
Effect on the coupon rate of the bond issue: The more senior the bond, the lower the coupon rate. Senior notes have a lower coupon rate because they have less “default risk”. If the company defaults, they are more likely to recover assets so the senior notes get discounted slightly. The junior notes would likely get not as much so they have a higher risk and pay a higher rate.
Advantages: If an official creditor holds a bond that has a seniority or preferred creditor status, this creditor will get repaid on its loan first before other bond nonofficial holders in case the company would be unable to pay back its debt. Seniority makes it less risky for the companies to extend loans to countries that require aid, and thus it becomes politically easier to implement such actions.
Disadvantages: If official institutions provide financial assistance to a country in need, the other investors that hold bonds of the respective country run a larger risk of repayment. The country must first repay the larger loans to the official creditors before the private bond holders get repaid.
3. The presence of a sinking fund
Effect on the coupon rate of the bond issue: A sinking fund reduces coupon rate because it provides a kind of future guarantee to bondholders. The company must make payments into the sinking fund or default so it must have positive cash flow.
Advantages: For the organization retiring debt, it has the benefit that the principal of the debt or at least part of it, will be available when due. For creditors, sinking fund reduces the risk the organization will default when the principal is due: it reduces the credit risk.
Disadvantages: If the bonds are callable, this comes at a cost to creditors, because the organization has an option to buy back discount bonds at their market price or buy back premium bonds at par. Therefore, if interest rates fall and bond prices rise, a firm will benefit from the sinking fund provision that enables it to repurchase its bonds at below-market prices. In this case, the firm's gain is the bondholder's loss – thus callable bonds will typically be issued at a higher coupon rate, reflecting the value of the option.
4. A call provision with specified call dates and call prices. Effect on the coupon rate of the bond issue: A call provision would cause an increase in coupon rate. It must be used in the company’s advantage and bondholder’s disadvantage. The company can refinance the bond if interest rates drop and thus gain an advantage.
Advantages: A bond call will favor the issuer. Call options on bonds will be exercised by the issuer when interest rates have fallen, hence the issuer can simply issue new debt at a lower rate of interest, effectively reducing the overall cost of their borrowing, instead of continuing to pay the high effective rate on the borrowings.
Disadvantages: Purchasing a bond with a call provision will pose a negative impact on the investors. First, call provisions present reinvestment risk. When interest rates fall, the bond issuer is more likely to exercise the call provision in order to retire what has become high-interest debt and reissue the debt at the prevailing lower rate. This leaves the investor with cash that must be reinvested in a lower interest rate environment. The investors will miss out on all of the interest payments that they would have been eligible to receive. Second, call provisions limit a bond's potential price appreciation because when interest rates fall, the price of a callable bond will not go any...
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