Question

You are an investor considering purchasing five-year corporate bonds as an investment. You have a choice of terms available. Which of the following terms would you find desirable, ceteris paribus? How does each feature affect the bond's required rate of return? Explain.

a. Call feature

b. Convertible feature

c. Warrants

Answer 1

a]

A call feature is not desirable. This is because with a call feature, the issuer can "call", or redeem the bonds after the call date, and before their maturity. This increases risk for the investor, as the bonds would be called if the interest rates fall, and the investor would have to reinvest the bond proceeds at the lower interest rates.

Risk and required return are directly related. A call feature increases the risk, and hence increases the bond's required rate of return.

b]

A convertible feature is desirable. This is because with a convertible feature, the bonds can be converted into equity shares at maturity, which give ownership rights, and rights to dividends. This decreases the risk of the bonds.

Risk and required return are directly related. A call feature decreases the risk, and hence decreases the bond's required rate of return.

c]

Warrants are desirable. This is because with warrants, a fixed number of equity shares can be bought at maturity, which give ownership rights, and rights to dividends. This decreases the risk of the bonds.

Risk and required return are directly related. A call feature decreases the risk, and hence decreases the bond's required rate of return.