Why is a call provision advantageous for a bond issuer?

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Class & Professor,

7-8 Indicate whether each of the following actions will increase or decrease a bonds yield to maturity:

Yield to Maturity (YTM) – The rate of return earned on a bond if it is held to maturity.

The calculation of bonds YTM takes into account the current market price, the par value, coupon rate and time to maturity and it is also assumed that all coupons are reinvested at the same rate. In a simple way YTM is the rate of return measuring the total performance of the bond (Coupon payments as well as capital gain or loss) from the time of purchase until maturity. There is an inverse relationship between the bonds price and the yield to maturity. As the bond price increases, the YTM decreases and as the bond price decreases, the bonds YTM increases.
a. The bonds price increases. Decreases.

b. The bond is downgraded by the rating agencies. Increase.

c. A change in the bankruptcy code makes it more difficult for bondholders to receive
payments in the event the firm declares bankruptcy. Increase.

d. The economy seems to be shifting from a boom to a recession. Discuss the effects of the
firms credit strength in your answer. Increase.

e. Investors learn that the bonds are subordinated to another debt issue. Increase.

(pg. 227 Brigham E. F., & Houston J. F. (2015))

Reference: Brigham E. F., & Houston J. F. (2015). Fundamentals of Financial Management. [MBS Direct]. Retrieved from https://mbsdirect.vitalsource.com/#/books/9781305480742/

Edited by Rodney Brown Jr on Jul 5 at 4:13pm
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Collapse SubdiscussionJoshua Long

YesterdayJul 5 at 5:48pm
7-9: Why is a call provision advantageous for a bond issuer? When would the issuer be likely to initiate a refunding call?

A call provision is a provision set in a bond contract which gives the issuer the right to redeem the bonders under specified terms prior to the normal maturity date (Brigham & Houston, 2014, p. 221). The call provision is advantageous for a bond issuer because this gives the issuer the ability to issue new bonds at a lower interest rate if the market rate were to drop. For example, if a company issued a 20-year bond with 10% interest, the company would pay a $100 coupon payment each year for 20 years. If the market rate were to drop to 5%, then the company would want to initiate a refunding call in order to issue a new set of bonds at the %5 market rate, which results in a $50 annual coupon payment. The initiation of a refunding call is similar to that of a homeowner refinancing their home. While there may be fees associated with the action, it is usually beneficial in the amount saved with a lower interest rate (Brigham & Houston, 2014, p. 222).

References:
Brigham, E. F., & Houston, J. F. (2014). Fundamentals of Financial Management (14th ed.). Boston, Massachusetts, United States of America: Cengage Learning.

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