3. Question 3 (corporate bond seniority). This question guides you through thinking about the role of bond seniority in determining bond yields (stated interest rate at purchase).

Consider one-year bonds issued by Pineapple Inc. If the company does not default, the bond will pay the interest plus principal back in one year. If the company goes bankrupt (which happens with 10% probability), then the company defaults on all bonds, and bond investors only get R% of the principal back (and none of the coupon). R% is known as recovery rate.

Suppose the company issues two types of bonds: senior bonds and junior bonds. In the case of bankruptcy, senior bondholders have a higher recovery rate than junior bondholders.

(a) Do you expect the interest rate on senior bonds to be higher than, equal to, or lower than that of junior bonds? Why? Please justify your answer as explicitly as possible.

(b) Suppose investors require an expected (average) rate of return of 5%. Suppose the recovery rates for senior and junior bonds are 70% and 30%, respectively. Assume bond prices are determined such that all bonds expected returns exactly equal 5%. What will be the interest rates of the senior and junior bonds, respectively?