Question

Question: Assume that two firms issue bonds with the following characteristics. Both bonds are issued at par.

	ABC Bond	XYZ Bond
Issue size	1.2 Billion	150 Million
Maturity	10 Years*	20 Years
Coupon	9%	10%
Collateral	First Mortgage	General Debenture
Callable	Not callable	In 10 Years
Call Price	None	110
Sinking fund	None	Starting in 5 Years
Bond is extendable at the discretion of the bondholder for an additional 10 years.

Ignoring credit quality, identify four features of these issues that might account for the lower coupon on the ABC debt. Explain.

Short answer

Answer

ABC - large debt, more senior claim, call feature very attractive, no sinking fund hence no likelihood for it to sell to the detriment of the bondholders.

Step-by-step solution

Given information

Issuing the bonds ‘at par’ refers to the issue of bonds at face value. When the same is issued for less or more than the face value, it is said to be issued at a discount or premium respectively.

Identification of four features of these issues that might account for the lower coupon on the ABC debt 

1. The ABC debt is a larger issue and therefore may sell with greater liquidity.
2. In the event of trouble, the ABC debt is a more senior claim. It has more underlying security in the form of a first claim against real property.
3. The call feature on the XYZ bonds makes the ABC bonds relatively more attractive since ABC bonds cannot be called from the investor.
4. The XYZ bond has a sinking fund requiring XYZ to retire part of the issue each year. Since most sinking funds give the firm the option to retire this amount at the lower of par or market value, the sinking fund can work to the detriment of bondholders.