Question

ABC Aviation Corporation, a subsidiary of XYZ Aviation Corporation, sold some securities to the public on June 15, 2017. The securities were bought and sold on the New York Stock Exchange. The terms of the deal are as follows: Promise to repay the owner of one of these securities $100,000 on June 15, 2047 The securities DO NOT pay interest ABC has the right to buy back the securities on the anniversary date at a price established at the time of sale Investors paid ABC $24,500 for each of these securities Discuss Why would ABC be willing to accept such a small amount today ($24,500) in exchange for a promise to repay approximately 4 times that amount in the future? What impact does the buyback feature have on the desirability of the investment? Would you be willing to pay $24,500 in exchange for $100,000 in 30 years? What would be your key consideration in answering yes or no? If the U.S. Treasury had offered basically an identical security, do you think it would have a higher or lower price? Why? If you looked at the New York Stock Exchange price of the stock TODAY, do you think the price would exceed the $24,500 original price? Why? If you looked in the year 2025, do you think the price would be higher or lower than today's price? Why?

Answer 1

The securities issued by ABC are basically callable zero coupon bonds. A zero coupon bond does not pay any coupon payments. A callable bond can be bought back by the issuer (ABC) at a specified price at specified dates.

Though, the amount is becoming four times, it is doing so in a long period of 30 years with no interest payment. You can calculate the rate of interest inbuilt in this by using the equation for compound interest,

, where A is amount (100000), P is principal (24500), r is rate (to be calculated and n is time in years (30).

Solving this will give r approximately equal to 4.8% per annum. Now 4.8% may be a low or high rate depending on the credit rating of ABC. Given that US 30 year G-Secs are around 2.5-3%, it is a reasonable rate for a long term callable corporate loan.

The buy-back is on the discretion of ABC. It reduces the attractiveness of the bond. Imagine the scenario, the interest falls drastically in a future year. ABC buys back its bonds and re-issues them at much lower interest. So, the investor has limited upside incase of fall in interest rate. But, in case interest rates rise, ABC will not buy back (call) its bonds, so investors will not be able to buy new bonds at higher rates. Typically, callable bonds have higher interest rate (hence issued at lower prices) than non-callable bonds. The higher rate (lower price) compensates investors for the extra risk taken.

The key consideration to take the decision would be the iyield on similar term callable bonds of same credit rating. If the yield is same or greater, it is acceptable.

If US Treasury had offered a similar security, you would have to pay a higher price (lower interest rate). The reason is US Treasury securities are considered risk-free. Incase of difficulties, US government can repay by printing extra dollars or raising taxes. ABC is a corporate, and cannot do either. So, even if ABC is a top rated corporate, it will still command a lower price (higher interest rate) than US G-Secs/ T Bills.