BUSI 321 T2 CH.7

Explain the use of call provisions on bonds. How can a call provision affect the price of a bond?

A call provision allows the issuing firm to purchase its bonds back prior to maturity at a specific price (the call price). Investors require a higher yield to compensate for this provision, other things being equal.

Explain the use of a sinking-fund provision. How can it reduce the investor's risk?

A sinking-fund provision is a requirement that the firm retire a certain amount of the bond issue each year. This reduces the payments necessary at maturity and therefore can reduce the risk of investors.

Explain the use of bond collateral, and identify the common types of collateral for bonds.

Bond collateral may be established by the bond issuer as a means of backing the bond. If the issuer defaults on the bonds, the investors would have a claim on the collateral. Some of the more common types of collateral for bonds are mortgages or real property (land and buildings)

Why can convertible bonds be issued by firms at a higher price than other bonds?

Convertible bonds allow investors to exchange the bonds for a stated number of shares of the firm's common stock. This conversion feature offers investors the potential for high returns if the price of the firm's common stock rises. Because of this feature, the bonds can be issued at a higher price.

Explain the new guidelines for credit rating agencies resulting from the Financial Reform Act of 2010.

Credit rating agencies are subject to new reporting requirements in which they must disclose their methodology for determining ratings. They must consider credible information from sources other than the issuer when determining the rating of the issuer's debt. They must establish new internal controls over their operations. They must disclose the performance of their ratings over time, and are to be held accountable if they experienced poor performance. Their ratings analysts are required to take qualifying exams.

What are debentures? How do they differ from subordinated debentures?

Debentures are backed only by the general credit of the issuing firm. Subordinated debentures are junior to the claims of regular debentures, and therefore may have a higher probability of default than regular debentures

What are the advantages and disadvantages to a firm that issues low- or zero-coupon bonds?

From the perspective of the issuing firm, low or zero coupon bonds have the advantage of requiring low or no cash outflow during the life of the bond. The issuing firm is allowed to deduct the amortized discount as interest expense for federal income tax purposes, which adds to the firm's cash flow. However, the lump-sum payment made to bondholders at maturity can be very large, and could cause repayment problems for the firm

If bond yields in Japan rise, how might U.S. bond yields be affected? Why?

If bond yields rise in Japan, there may be an increased flow of funds to purchase these bonds. This reduces the amount of funds available to purchase U.S. bonds. Consequently, U.S. bonds will sell at lower prices than before, implying higher yields than before.

Explain how the downgrading of bonds for a particular corporation affects the prices of those bonds, the return to investors that currently hold these bonds, and the potential return to other investors who may invest in the bonds in the near future

If corporate debt is downgraded, the required rate of return by investors would increase, as the bonds are now perceived to have a higher degree of default risk. Consequently, the price of those bonds would drop, resulting in a capital loss for current investors in those bonds. New investors in these bonds can purchase the bonds at a relatively low price, as this low price compensates for their recognition that the default risk of the bonds has increased.

Are variable-rate bonds attractive to investors who expect interest rates to decrease? Explain. Would a firm that needs to borrow funds consider issuing variable-rate bonds if it expects that interest rates will decrease? Explain

If investors expect interest rates to decrease, they would avoid variable-rate bonds because the return to the investors would be tied to market interest rates. The investors would prefer fixed-rate bonds if interest rates are expected to decrease. If a firm expects that interest rates will decrease, it may consider issuing variable-rate bonds, because the interest paid on the bonds would decline over time with the decline in market interest rates.

Explain the conditions that led to the debt crisis in Greece.

In spring of 2010, Greece experienced a credit crisis, because of its weak economic conditions, and large government budget deficit. As its deficit grew and its economy weakened, investors were concerned that the government of Greece would not be able to repay its debt. In addition, credit rating agencies reduced the ratings on the Greek debt several times

Explain how the credit crisis affected the default rates of junk bonds and the risk premiums offered on newly issued junk bonds

Many junk bonds defaulted during the credit crisis, as economic conditions weakened and some issuers of junk bonds failed. The risk premium offered on newly issued junk bonds increased during the credit crisis as investors would only consider purchasing junk bonds if the premium was high enough to compensate for the high degree of risk at that time.

What are protective covenants? Why are they needed?

Protective covenants are restrictions placed on the firm issuing bonds, in order to protect the bondholders. For example, they may limit the dividends or corporate officer salaries, or limit the amount of debt the firm can issue.

What is a bond indenture? What is the function of a trustee, with respect to the bond indenture?

The bond indenture is a legal document specifying the rights and obligations of both the issuing firm and the bondholders. It is designed to address all matters related to the bond issue, such as collateral, and call provisions.