Question

Sam Strother and Shawna Tibbs are vice presidents of Mutual of Seattle Insurance Company and co-directors of the company’s pension fund management division. An important new client, the North-Western Municipal Alliance, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them by answering the following questions.

1. What are the key features of a bond?

2. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?

Please give me at least one reference. Using complete sentences and academic vocabulary, please answer questions. Please don't copy from other sources. Thank you

Answer 1

1.

Bond is a fixed income instrument which is issued by government, corporate bodies and bank etc. to pool the money as loan from its buyer, the investor. Bonds generally pays its buyer specified periodic coupons amount till its maturity except in case of zero coupon bond or deep discount bond.

Key features of a Bond

1. Face value

A bond has a Face value which is its basic value and normally its payable to bond holder at maturity of bond.

2. Coupon rate

A bond has coupon rate at which bond holder gets periodic coupon payment from its issuer.

3. Maturity.

Every bond has a maturity, on maturity date bond holder gets bond face value from issuer as a final payment of principal.

4. Yield to Maturity(YTM)

YTM is the rate at which present value of all cash flows becomes equals to Bond value or bond issue price.

5. Issuer

Bonds generally issued by Government , Corporate bodies and Bank etc. to pool the money from market.

2.

Call provision of a Bond

A call provision of bond is a provision which allows issuer of bond to repurchase or retire the bond. This provision gives issuer of bond a right to call bond within specified time horizon by paying specified amount to bondholders.

As call provision gives right to company to call the bond at any time within specified time horizon, now if interest rate falls then company call the bond and reissue the bond at lower interest rate, exercising this option issuer would have following benefit in terms of annual interest payment to bond holder.

Annual Benefit to company = fall in Interest rate * Bond value

Normally callable Bond has high interest rate as compare to non-callable bonds which if company issue a bond with call provisions then it must pay high interest rate on it.

As we discussed above, a callable bond has high interest rate to compensate the exist risk to investor which means if investor hold a callable bond then he will get high interest income as compare to non-callable Bond.

Now if interest rate falls and bond called then investor may have to reinvest in bond with lower interest rate as compare to previous bond.

Sinking fund provisions

Bond with sinking fund provisions requires its issuer to set aside money in a specific bank account on regular basis to repay bondholder on maturity date.

Account in which issuer deposit money to repay bondholder is called custodial account.

Sinking fund provisions minimize the risk of investors and on the other hand, Bond with sinking fund provision is less costly to the issuer.

Call provisions makes Bond more risky

A call provision of Bond makes Bond riskier because call provision gives its issuer a right to call the bond within a time horizon. If interest rate fall then issuer could call the bond and Investor must reinvest the money at lower interest rate. Thus, call provision increases the reinvestment risk of bondholder.

Sinking fund provisions makes Bond less risky

Sinking fund provisions requires issuer to set aside money to repay the bondholder on maturity date and thus, it reduces the default risk of Bond. It also protects investor from downside of bond price due to increase in interest rate.