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Q1. You are Renatas assistant, and she has asked you to prepare a memo to Dan

describing the effect of each of the following bond features on the coupon rate of the bond.

List any adantages and disadantages of each feature.

!." #ffect of collateral on coupon rate

$ %f #&Y pledges assets against bonds as collateral, issued bonds will hae less risk, and

will hae the effect of a lower coupon rate.

$ !dantage' lower coupon rate

$ Disadantage' %nfle(ibility with assets

)." )ond *eniority

$ +he more senior the bonds are relatie to other debt obligations, the lower the risk, and

lower the coupon rate.

$ !dantages' igher seniority will re-uire lower coupon rate due to higher payment

priority.

$ Disadantages' ay constrain ability to issue more/senior bonds in the future.

&." 0resence of a sinking fund

$ Reduces coupon rate due to trustee management of bond interest payments. Lowers

risk by partially guaranteeing repayment of bond obligations.

$ !dantages' !llows #&Y more control of bond obligations through the ability to buy

back bonds. Reduces coupon rate.

$ Disadantages' eed for annual cash flow or risk default.

D." &all 0roision 2specific dates3prices"

$ aing a call proision will increase the coupon rate due to reduced profit potential for

buyer.

$ !dantages' 0ossibility of purchasing bonds at a more attractie price and issuing new

bonds at lower rate.

$ Disadantages' igher coupon rate. ay pay unnecessary premium in rates if interest

rates increase.

#." Deferred &all 0roision

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$ Lower coupon rate relatie to standard call proision due to longer period of call

prohibition.

$ !dantages' 0ossibility of buying back bonds at a faorable price 2after deferred period"

$ Disadantages' 0ossibility of paying coupon premium unnecessarily.

4." ake/whole call proision

$ Lower coupon rate relatie to specified call date3price bonds.

$ !dantages' 4le(ibility in buying back bonds at 053market alue.

$ Disadantages' 3!

6." 0ositie &oenants

$ Reduce coupon rates due to guarantees offered in the coenant.

$ !dantages' Reduce coupon rate.

$ Disadantages' Restricts certain actions.

$ #(amples'

/ ust maintain collateral in good condition

/ ust periodically proide audited financials

/ ust maintain working capital at or aboe specified leel

." egatie &oenants

$ Reduce coupon rates due to restrictie guarantees offered in the coenant.

$ !dantages' Lowers coupon rate, reassures bond holders due to guarantees.

$ Disadantages' Restricts certain actions.

$ #(amples'

/ ust limit amount of diidends it pays

/ &annot pledge assets to lenders

/ &annon merge with another firm

/ &annont issue additional long/term debt or until certain D3#

/ &annont sell or lease ma7or assets without approal by bondholders

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%." &onersion 4eature

$ Lowers the coupon rate due to the potential upside of bondholders 2if the company

goes to %08"

$ !dantages' )ond is more attractie for e-uity seekers, and likely reduce coupon rate.

$ Disadantages' &ompany may be selling e-uity at a discounted price.

9." 4loating Rate &oupon

$ &oupon rate will be dependent on interest rate inde(.

$ !dantages' %f interest rates fall, #&Y will pay lower coupon rate.

$ Disadantages' %f interest rates rise, #&Y will pay higher coupon rate.

!*:#R*

1.

&ollateral

! kind of security proided in lieu of loan.

%f the borrower defaults, )ank confiscates the collateral.

%t could be Li-uid' eg houses.Li-uid eg treasury bills3 other instruments.

+heory of &ollateral'

!fter been gien a loan % hae ; options to pay3 not repay.

y effort is unobserable.

ow there is a continuum of types of debtors, with a certain distribution.

Result'

8nly the good type will produce.

!nother theory is there is a lifetime blacklisting, so we do a net discounting.

Result' 8nly people with a large

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originally lent out.

0otential loss of good business.

Lending on basis of physical capital, certainly doesn

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>.

! sinking fund is a fund established by an economic entity by setting aside reenue oer a

period of time to fund a future capital e(pense, or repayment of a long/term debt.

+he sinking 4und is a near li-uid capital. %t also shows the management

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1E.

!lready Defined. %t sometimes seems sensible to pay interest depending on the risk free

rate.

%f somehow the risk free rate increases due to a tightening policy, the issuer ends up paying

a higher rate. Rates might be pegged to any inde(, or security.