Question

Mike Jackson and Terrence Jensen are the owners of J&J Air, and they recently decided to expand the company. Recently hired financial analyst, Gus Christie, has been instructed to locate an underwriter who can help the firm sell $35 million in new 10-year bonds. The bonds will be used to finance construction as part of the firm's expansion. Valerie Harper is an underwriter with the investment banking firm of Warren & Zevon. After Gus contacted her, Valerie briefed him regarding various bond features J&J should consider, along with an appropriate coupon rate for the anticipated bond issue.

Gus is aware of the bond features, although he is uncertain regarding the costs and benefits of some features. Accordingly, he remains unsure about how each of these features might influence the bond issue's coupon rate. Assume you are Valerie's assistant, and she has asked you to draft a memo to Gus that clearly describes the effect of each of the following bond features on the coupon rate of the new bond issue. She also instructed you to describe the advantages and disadvantages of each feature.

1. The security of the bond; i.e., whether the bond has collateral.
2. The seniority of the bond.
3. The presence of a sinking fund.
4. A call provision with specified call dates and call prices.
5. A deferred call accompanying the call provision.
6. A make-whole call provision.
7. Any positive covenants. Also, discuss several possible positive covenants J&J Air might consider.
8. Any negative covenants. Also, discuss several possible negative covenants J&J Air might consider.
9. A conversion feature (note that S&S Air is not a publicly traded company).
10. A floating rate coupon.

Answer 1

1) The security of the bond i.e., whether the bond has collateral

if bond is backed by the collateral, when the bond issuer is defaulted the assets pledged under collateral will be liquidated and payouts to the bondholders. if the bond is issued under municipalities, the backing of the bond is the government's credit profile default rate is almost 0 and the yield is also comparably low.

2)The seniority of the bond

if the seniority of the bond is less the return would be higher since the risk is more, bonds with lower seniority are paid after the higher seniority but the yield is less and payouts are inevitable

3)The presence of a sinking fund

the cash outflows from a sinking fund pay out the bond over time rather than requiring a steep cash outflow when the bond matures. From a single bondholder's perspective, they will receive cash inflows on a regular basis between the start of the sinking fund and the maturity of the bon

4)A call provision with specified call dates and call prices

A call provision makes to the company to buy back the issued whenever it feels the cost of debt is reduced and can re-issue the new bonds with lesser interest rates, call dates and call prices drive advantage when you need a huge flow at a particular time and till then repayments would be enough.

5)A deferred call accompanying the call provision

deferred call protects the bondholder since the company is not allowed to call back the bond for a certain period during this period the bond is said to be call protected and the bondholder enjoys the repayments with fear of bond being call backed by the bond issuer

6)A make-whole call provision

A make-whole call provision is a call provision attached to a bond, whereby the borrower must make a payment to the lender in an amount equal to the net present value of the coupon payments that the lender will forgo if the borrower pays the bonds off early. the advantage is in the future the interest rate in the market may reduce and the prices of the bond might increase, the disadvantage is the other way around. future default risk is mitigated since lump-sum payments are making by the bond issuer

7)Any positive covenants.

a covenant is the condition in the agreement between the bondholder and the bond issuer, any positive covenant company could consider is the bond issuer can go public only if the bond is fully insured by the external insurance agency, get timely audited, timely credit rating report for example in this case if the bond issuer meets the conditions can go public and liquidity is higher if bond issuer goes public

8)Any negative covenants

Negative covenants are also referred to as restrictive covenants

negative covenants include preventing a bond issuer from issuing more debt until one or more series of bonds have matured. Also, borrowing firms may be restricted from paying dividends over a certain amount to shareholders so as not to increase the default risk to bondholders, etc..

Generally, the more negative covenants exist in a bond issue, the lower the interest rate on the debt will be since the restrictive covenants make the bonds safer in the eyes of investors and the price of the bond would be more yields would be less but payouts are less lenient towards default

9)A conversion feature

even if the bond issuer is not public listed company, if the company is getting profits and expected to expand exponentially in the near future convertibles provide option to convert bond with high share price which increases the value of the invested money but coupons would be lesser compared to the market rates but owner would be taken after converting into equity.

10)A floating-rate coupon

float rate coupon is the payouts changes based on the market rates changes, by this, the holder of the bond can mitigate the main risk associated with bond, interest rate risk. if prevailing rates go up then floating bonds pay better payouts than fixed coupon bonds