Question

1. If a corporation’s bonds are unexpectedly given a downgrade (e.g., Moody’s lowers the rating on Brady Corp. Bonds to Baa from Aa), what do you expect will happen to the yield to maturity on Brady’s bonds?
2. What is a call feature in a debt issuance? Is this beneficial to the corporation issuing the bond, the bond investor, or both? Explain.
3. Assuming everything else is the same, which bond would have a lower coupon rate at issuance: one with a sinking fund provision or one without a sinking fund provision? Why?
4. What is the difference between the coupon rate of a bond and the yield to maturity of a bond? Which rate is more important and why?
5. What is a preemptive right as it relates to common stock? Which investor would value preemptive rights more, Benjamin Solowitz who owns .0001% of the shares of XYZ Inc., or Carl Icahn who owns 50.1% of the shares of XYZ Inc.? Why?
6. Why do firms accept underpricing of their initial public offerings (IPOs)?

Answer 1

Solution for question 1

Since Moody's has downgraded the company's bond, it means that the credit risk of the bond has increased. As a result, the bond price will fall, and, yield-to-maturity will increase, as investors now want a higher return from the bond to compensate for the risk.

Solution for question 2

A call feature allows the issuer of the bond to redeem the bond even before the maturity of the bond. This is an advantage for the company issuing callable bonds. However, the company has to pay a higher coupon rate to an otherwise comparable bond, in order to lure investors. A higher coupon rate is an advantage of investing in callable bonds from an investor's perspective.

Hence, the call feature is beneficial to both the company and the bond investor.

Solution to question 3

A bond with a sinking fund provision sets aside some money just as a provision to pay off debt. Hence a bond with a sinking fund is safer, which means that the company issuing it can offer a lower coupon rate, compared to another bond with no sinking fund, all else equal.

Solution to question 4

A coupon rate is the payment the bond issuer makes semiannually or annually to the bond holder, until its maturity. yield-to-maturity can be considered as the required rate of return for investors, given the risks involved in the bond. If the bond's credit risk or interest risk increases, so will its yield-to-maturity, which will cause the bond price to fall, and the other way around.

Yield-to-maturity is more important because it indicates the required rate of return on the bond, given the circumstances.

Solution to question 5

Pre-emptive rights give early shareholders the right to buy more shares of the company, before shares are offered to the public. This prevents an early investor's stake from being diluted.

Carl Icahn would value pre-emptive rights more because he owns majority of the company. If stocks were to be offered to public without pre-emptive rights, Icahn's stake will be diluted and he may not be majority stake holder anymore, which would dilute his control over the company.

Solution to question 6

Underpricing the IPO is done so that the company may sell more shares and raise more money. This is particularly true if there isn't much demand for the stock. The company would hope, in such a case that, underpricing the IPO would lure more investors.