Question

All but which one of the following will tend to reduce the required yield on a corporate bond?

A.) A sinking fund where the issuer may repurchase a given fraction of the outstanding bonds each year.
B.) A call provision with a five year deferred call.
C.) A requirement that all future debt issues must be subordinated to the current debt.
D.) A sinking fund where the issuer sets aside money each year to ensure the bond principal can be repaid when due

Answer 1

B - A call provision will expose the investor to reinvestment risk, because if the bonds are called when the market interest rates fall, the investor has to reinvest the proceeds at the lower market interest rates. Hence, due to higher risk, the required yield will increase

A is incorrect - A sinking fund reduces default risk as the a portion of the bonds are repurchased ever year. Due to lower risk, the required yield will decrease

C is incorrect - subordination of future debt issues will decrease the credit risk, and hence the required yield will decrease

D is incorrect - A sinking fund reduces default risk as money is set aside each year towards bond repayment. Due to lower risk, the required yield will decrease