Q1.

You are Renatas assistant, and she has asked you to prepare a memo to Dan describing the effect of each of the following bond features on the coupon rate of the bond. List any ad antages and disad antages of each feature.

!." #ffect of collateral on coupon rate $ %f #&Y pledges assets against bonds as collateral, issued bonds will ha e less risk, and will ha e the effect of a lower coupon rate. $ $ !d antage' lower coupon rate Disad antage' %nfle(ibility with assets

)." )ond *eniority $ +he more senior the bonds are relati e to other debt obligations, the lower the risk, and lower the coupon rate. $ !d antages' ,igher seniority will re-uire lower coupon rate due to higher payment priority. $ Disad antages' .ay constrain ability to issue more/senior bonds in the future.

&." 0resence of a sinking fund $ Reduces coupon rate due to trustee management of bond interest payments. Lowers risk by partially guaranteeing repayment of bond obligations. $ !d antages' !llows #&Y more control of bond obligations through the ability to buy back bonds. Reduces coupon rate. $ Disad antages' 1eed for annual cash flow or risk default.

D." &all 0ro ision 2specific dates3prices" $ ,a ing a call pro ision will increase the coupon rate due to reduced profit potential for buyer. $ !d antages' 0ossibility of purchasing bonds at a more attracti e price and issuing new bonds at lower rate. $ Disad antages' ,igher coupon rate. .ay pay unnecessary premium in rates if interest rates increase.

#." Deferred &all 0ro ision

$ Lower coupon rate relati e to standard call pro ision due to longer period of call prohibition. $ $ !d antages' 0ossibility of buying back bonds at a fa orable price 2after deferred period" Disad antages' 0ossibility of paying coupon premium unnecessarily.

4." .ake/whole call pro ision $ $ $ Lower coupon rate relati e to specified call date3price bonds. !d antages' 4le(ibility in buying back bonds at 1053market alue. Disad antages' 13!

6." 0ositi e &o enants $ $ $ $ Reduce coupon rates due to guarantees offered in the co enant. !d antages' Reduce coupon rate. Disad antages' Restricts certain actions. #(amples' / .ust maintain collateral in good condition / .ust periodically pro ide audited financials / .ust maintain working capital at or abo e specified le el

,." 1egati e &o enants $ $ $ $ Reduce coupon rates due to restricti e guarantees offered in the co enant. !d antages' Lowers coupon rate, reassures bond holders due to guarantees. Disad antages' Restricts certain actions. #(amples'

/ .ust limit amount of di idends it pays / &annot pledge assets to lenders / &annon merge with another firm / &annont issue additional long/term debt or until certain D3# / &annont sell or lease ma7or assets without appro al by bondholders

%." &on ersion 4eature $ Lowers the coupon rate due to the potential upside of bondholders 2if the company goes to %08" $ $ !d antages' )ond is more attracti e for e-uity seekers, and likely reduce coupon rate. Disad antages' &ompany may be selling e-uity at a discounted price.

9." 4loating Rate &oupon $ $ $ &oupon rate will be dependent on interest rate inde(. !d antages' %f interest rates fall, #&Y will pay lower coupon rate. Disad antages' %f interest rates rise, #&Y will pay higher coupon rate.

!1*:#R* 1. &ollateral ! kind of security pro ided in lieu of loan. %f the borrower defaults, )ank confiscates the collateral. %t could be Li-uid' eg houses. Li-uid eg treasury bills3 other instruments. +heory of &ollateral' !fter been gi en a loan % ha e ; options to pay3 not repay. .y effort is unobser able. 1ow there is a continuum of types of debtors, with a certain distribution. Result' 8nly the good type will produce. !nother theory is there is a lifetime blacklisting, so we do a net discounting. Result' 8nly people with a large <delta< who discount future little, will actually repay. +ake away' 0rincipal agent problem 2incenti es" and hidden action problem, respecti ely seems to raise the rate of interest 2break/e en cost of lender" )ut since rate of interest is so high, we ha e left a worse set of borrowers who would default. &8/lateral is one way of mitigating the problem. !gent2borrower" defaults, principal2lender" confiscates the collateral. Reduces the incenti es to lea e the co/lateral and interests .ore borrowers will repay 20robability of repayment is higher" Lower )reak/e en point and &oupon rate. 0roblems' %lli-uidity of assets. %t may not be wise to li-uidate a pro7ect prior to completion, that would fetch a cost low, perhaps lower than amount

originally lent out. 0otential loss of good business. Lending on basis of physical capital, certainly doesn<t let )anks e(ploit their knowledge of customers. %t<s lending business 2total amount of credit generated" is on the lower side, so the nation<s 6D0. +here is no meaning in preferring production loans to business loans or some other loans. ,ence there is a practice of accepting more li-uid assets like stock, *ecurities etc... 1ow depending on pro7ect risk, and state of economy 2banks also like to trade in securities" +he class of stock and securities get loose, which are a prescription of 6rowth. &on' 0oor financial Discipline can lead to banks getting into a run if the )oom bursts out. ;. )81D *#1%8R8+Y' !mong a class of issued financial assets 2)onds" some are more secured than others. +hey can be by' a.)acked by assets 2+hese are usually bonds with a threshold alue if the business fails" +he &8mapny cannot buy or sell out such assets %f these are cacked by stock, company cannot keep lower stock than the threshold mentioned. Risk' .arket 5olatility in the underlying asset price, depriciation b. *eniority by issue' +he other bonds can ha e classes which would imply, one kind of bond first repayed completely before going down to another class of )onds. c. 0referred stock =sually on Dissolution the following charges are placed on order, wherein there might be multiple classes, but the table tells us fairly of ad antages of seniority' 1. Li-uidators costs ;. &reditors with fi(ed charge o er assets >. &osts incurred by an administrator ?. !mounts owing to employees for wages3superannuation @. 0ayments owing in respect of workers in7uries A. !mounts owing to employees for lea e B. Retrenchment payments owing to employees C. &reditors with floating charge o er assets D. &reditors without security o er assets 1E. *hareholders 2Li-uidating distribution"

>. ! sinking fund is a fund established by an economic entity by setting aside re enue o er a period of time to fund a future capital e(pense, or repayment of a long/term debt. +he sinking 4und is a near li-uid capital. %t also shows the management<s commitment to build business and repay capital. 8ther name for *inking funds is Reser e. Reser e for ac-uiring .achinery or Reser e for F purpose. ?. &all 0ro ision +he issuing entity or corporate can buy back the bonds at a said date or whene er the price of such bonds are abo e a said price. +he *tock market is an arena for speculators. :e often buy )onds to sell them at a higher price. %f the call procision is there, one of the two happens' a. +he buyer sees a lower horiGon for interest recie ed b. +he speculator knows he can ne er achie e beyond a certain returns, so the longer he e(pects to wait for it the worse. )onds get illi-uid in the secondary markets as a result of such restrictions. @. Deffered call 0ro ision. &all shall not be made until a said date. .ore li-uidity of bonds and more interest of secondary in estors. A. make whole &all' %n case a company wants for some reason to buy back bonds, the lenders shall be paid 105 of remaining lifetime payments from the company. +his is as good as deferring the call altogether. B H C' 0ro ided in e(ample' &o enant means <0romise<. %ts a legal agrreement with the borrower to carry out certain fa orable acti ities o er the underlying assets3 maintin certasin proportion of in estment in certain agreed fields. 1egati e, puts restrictions o er the )orrower o er certain acti ities. )oth of these increase financial stability of the bond, and hence the lender would accept a lower rate. D. +he ability to change from one in estment ehicle to another. 4or e(ample, one may be able to switch between mutual funds in a fund family without incurring a penalty. Likewise, one may e(change a con ertible bond to common stock in the issuing company. *ometimes, one e en may be able to change an ad7ustable/rate mortgage into a fi(ed/rate mortgage. !ll of these e(amples describe a con ersion feature on the in estment ehicles. !lso known as a 0ut option +he buyer may put the bonds and legally claim e-uity in e(change as per the terms in agreement.

1E. !lready Defined. %t sometimes seems sensible to pay interest depending on the risk free rate. %f somehow the risk free rate increases due to a tightening policy, the issuer ends up paying a higher rate. Rates might be pegged to any inde(, or security.