Question

M&T Air was founded 10 years ago. The company has manufactured and sold light airplanes over this period, and the company’s products have received high reviews for safety and reliability. The company has a niche market in that it sells primarily to individuals who own and fly their own airplanes. The company has two models: The Birdie, which sells for $53,000, and the Eagle, which sells for $78,000. S&S Air is not publicly traded, but the company needs new funds for investment opportunities. Mark Sexton and Todd Story, the owners of S&S Air, have decided to expand their operations. They instructed their newly hired financial analyst, Chris Guthrie, to enlist an underwriter to help sell $20 million in new 10-year bonds to finance construction. Chris has entered into discussions with Renata Harper, an underwriter from the firm of Crowe & Mallard, about which bond features S&S Air should consider and what coupon rate the issue will likely have.

Although Chris is aware of the bond features, he is uncertain as to the costs and benefits of some features, so he isn't clear on how each feature would affect the coupon rate of the bond issue. You are Renata's assistant, and she has asked you to prepare a memo to Chris describing the effect of each of the following bond features on the coupon rate of the bond. She would also like you to list any advantages or disadvantages of each feature.

a. The security of the bond—that is, whether the bond has collateral.

b. The seniority of the bond.

c. The presence of a sinking fund.

d. A call provision with specified call dates and call prices.

e. A deferred call accompanying the preceding call provision.

f. A floating rate coupon.

Answer 1

Solution

Memo:

To: Chris Guthrie

With reference to the requirement of S&S Air for deciding the coupon rate for the planned $20 million bond issue, here is a brief description of how some of the features would affect the coupon rate along with the associated merits & demerits:

a. Security (collateral) of the bond: If the bonds have collateral i.e. they are backed by assets which would be used to compensate bondholders in case of a default, the bond would be considered safer by investors. This would make the bond attractive to investors even if it has a lower coupon rate. Thus the effect of using collateral would be to lower the coupon rate that need to be offered.

b. The seniority of the bond: Among all the debt capital raised by the company though various sources, there may be different precedence orders that will be followed to repay the lenders in case of bankruptcy. The confidence of investors of this round of bond issue will be directly related to the seniority order assigned to these bonds i.e. it will be highest if the bonds are assigned top seniority precedence & lowest in case of subordinate seniority. If the seniority is low, comparatively higher coupon rate will need to be offered to make up for the lower investor confidence to make them invest in the bonds & vice versa.

c. The presence of a sinking fund: sinking fund provisions require the issuer to buy back a specified percentage of the issue each year. There are some advantages & disadvantages of using sinking fund provision as listed below:

Advantages of using sinking funds

1. Sinking funds are designed to protect investors by ensuring that the bonds are retired in an orderly manner in regular intervals.

2. Bonds that have a sinking fund are regarded as being safer than those without such a provision.

3. As they are considered safer, sinking fund bonds have lower coupon rates than otherwise similar bonds without sinking funds.

Disadvantages:

1. These funds work to the detriment of bondholders if the bond’s coupon rate is higher than the current market rate as the investor may get asked to redeem his higher interest paying bond whereas he would not want to do that.

d. A call provision with specified call dates and call prices: The coupon rate on a new issue of callable bonds will exceed that on the bonds if the are non-callable. This is because the most likelihood of the call provision being used & bond called will be when interest rates in the market fall as the company would like to resell the bonds at the then prevailing lower coupon rates. The long term investor, though,  will need to reinvest the funds they receive at the new and lower rates which will be detrimental to him. Also the call price will have to be higher than the par (face) value of the bond which will be a disadvantage.

e. A deferred call accompanying the preceding call provision: These bonds are often not callable until several years after the issue. This would help lower the coupon rate as the long term investor would be more willing to invest in the bond due to protection from being called for the specified period (usually 5 or more years). The disadvantage will occur if the interest rates fall significantly within this period as the company will find itself locked in the higher interest paying bonds even though cheaper credit would be available in the market.

f. A floating rate coupon: A floating rate coupon, with coupon rate tied to a benchmark (such as US T-Notes etc.) would raise or decrease the coupon rate depending on the prevailing market conditions through its benchmark. It can be both advantageous or disadvantageous depending on the direction of future interest rates. If the prevailing interest rates in coming years decline, it would help S&S Air automatically reduce its interest expenses without calling back the bonds. On the other hand if interest rates actually rise, the company will be forced to pay higher interest to bondholders whereas it could have kept paying the fixed interest amount had floating rate coupon not been used. So this requires careful deliberation before deciding to go with a floating rate coupon.