Question

Mark Hughes and Todd Hesse, the owners of H&H Associates, have decided to expand their operations. They instructed their newly hired financial analyst, Christine Toth, to enlist an underwriter to help sell $20 million in new 10 year bonds to finance construction. Christine has entered into discussions with Phil Granite, an underwriter from the firm Lewis, Brisbee and Granite, about which bond features H&H Associates should consider and what coupon rate the issue will likely have.

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

Questions

1. The security of the bond – that is, whether the bond has collateral.

2. The seniority of the bond.

3. The presence of a sinking fund.

4. A floating rate coupon.

Answer 1

1. The security of the bond: This feature is a significant feature as this classification decides the order in which payout would occur if there is a default by the issuer. If we compare secured and unsecured debt, secured debt assumes seniority. Secured debt is the one which is highest in the tranche of bonds in terms of seniority and is backed by a collateral in the event of a default. The collateral might be an industrial equipment, warehouse etc. The recovery rate is high in this type of bond. Adding a collateral back up lowers the risk of the bond and also effects the return. The higher the risk of default higher is the investor's expectation of compensation for risk. So if the quality of collateral is high and bond credit rating is good, the return will be low. The riskiness effects the coupon rates. A collateralised bond will pay less coupon as compared to a bond without collateral.

2. As explained above, corporate bonds are issued in tranches. The bond at the highest tranche i.e. the most senior bond has the highest credit quality, lowest default risk and is backed by a collateral. This offers the lowest return due to the low inherent risk. As we go down the tranche, the bonds become more risky, have higher default rates, lower recovery rates, with little or no collateral, lower credit rating and higher return.

This is in sync with the concept that a riskier bond will pay more return to investors to compensate for the risk they are taking by investing in the particular tranche.

The bonds are divided in the following manner:

1. Secured corporate bonds

2. Senior secured bonds

3. Senior unsecured bonds

4. Junior subordinated bonds

5 .Convertible bonds

3. The presence of a sinking fund: Bonds issued with a sinking bond feature set aside some funds periodically with a trustee to help repay the bonds and reduce the risk of the bonds. The trustee retires part of the bonds by repurchasing them in the market when interest rates fall. This helps the issuer to reduce the risk of default by receiving a huge bill at maturity. A sinking fund provision makes the bond more attractive to investors through reduced risk of default and at the same time it becomes less attractive due to the repurchase risk associated with it i.e the issuer may repurchase the bond from the investor. A sinking fund will reduce the coupon rate as it's a partial guarantee.

4. A floating rate coupon: Floating rate bonds are those which have a variable coupon rate linked to a money market reference rate such as LIBOR plus a quoted spread. Floating rate notes attract investors due to the variable coupon which is favourable when interest rates rise. But they become less attractive when interest rates fall.