Question

1. How does collateral affect the interest rate on a bond? How does subordination affect the interest rate on a bond too? What else might affect the interest rate on a bond?

Answer 1

1. Collateral acts as a source of re-payment in case a debtor defaults on its obligations to pay back bond principle or pay interest payments to bondholders. Hence since availablity of good quality collateral means there is less risk as compared to low quality collateral or no collateral. Therefore, as the quality of collateral increases, risk decreases and hence interest paid should also go down - assuming everything else same. If there is no collateral posted, interest rate can be considerably higher than if there is collateral posted - specially in case of counterparties with lower credit ratings.

2. Sub-ordiation essentially creates a waterfall structure for priority of claims on debtor's assets. As low one is on the priority list, there is more risk and hence it should be compensated with higher interest rates - assuming everything else same.

3. Other factors which might affect interest rate on a bond are:

a. Maturity: Under normal yield curve scenario, higher maturity bonds are likely to have higher interest rate as compared to lower maturity bonds. Reverse cases occur when yield curve inverts during recession.

b. Credit Rating: Higher the credit rating of the issue, lower the risk and hence lower the interest rate.

c. Option features such as callable bonds, putable bonds: Depending upon whether option value is for investor/lendor, interest rates will vary