Question

Quick Air S.L. was founded 10 years ago by friends Peter Smith and Javier Benet. 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. Peter and Javier have decided to expand their operations. They instructed their newly hired financial analyst, Laura Sanchez, to enlist an underwriter to help sell $35 million in new 10-year bonds to finance construction. Laura has entered into discussions with Sandra Harper, an underwriter from the firm of Castle & Partners, about which bond features Quick Air should consider and what coupon rate the issue will likely have.

Although Laura is aware of the bond features, she is uncertain about the costs and benefits of some features, so she isn’t sure how each feature would affect the coupon rate of the bond issue. You are Sandra’s assistant, and she has asked you to prepare a memo to Laura 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.

QUESTIONS:

1. The security of the bond (that is, whether the bond has collateral). (5 points)

2. The seniority of the bond. (5 points)

3. The presence of a sinking fund. (5 points)

4. A call provision with specified call dates and call prices. (5 points)

5. Any positive covenants. Also, discuss several possible positive covenants Quick Air might consider. (5 points)

6. Any negative covenants. Also, discuss several possible negative covenants Quick Air might consider. (5 points)

7. A conversion feature (note that Quick Air is not a publicly traded company). (5 points)

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 or coupon 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.

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 call provision with specified call dates and call prices: A call provision in the bond's indenture gives the issuer the right to call back a part of the issue before the maturity date. A provision with specified calls and date will increase the coupon rate because the bond holders cannot take initiatives. This kind of a provision is more advantegous to the issuer as an issuer will highly likely call a bond when interest rates have fallen as the issuer can issue debt again at lower levels of coupon and reduce the cost of borrowing.

5. Positive and Negative bond covenants: A bond covenant is a legally binding term of agreement between bond issuer and a bondholder. Positive or affirmative covenants require the issuer to meet certain requirements while negative covennats are restrictive and restrict the issuer from taking up certain activities. Positive covenants may include maintaining certain standards of financial performance, ensure compliance with certain standard practices etc. Negative covenants may include retrictions on the firm issuing additional debt, participation in mergers, selling certain assets etc. Generally negative covenants are considered safe and reduce the default risk. Hence the issuer needs to pay less coupon to compensate for the minimal risk taken by investor. Bonds with postive covenants pay higher coupons.

6. A conversion feature when the firm is not publicly traded. A conversion firm allows the asset holder to change from once investment vehicle to another. Example: Bonds converted to equity shares at a certain point in time. Since this firm is not publicly traded, a conversion would likely lower the coupon rate. The holder of the security with a conversion feature determines whether and when to convert the asset.