Question #9

Nancy arrives at the meeting, the Finance Executive from Moneymatters Inc. is engaged in a discussion with a fellow meeting participant, Chin Lee, about why his company should issue a callable bond to raise new debt capital. Chin Lee does not like the idea of a callable bond. He says that it can prove to be costly for Moneymatters Inc. Both gentlemen hold their ground citing their reasons. Seeing Nancy walk in, they deflect the question to her and before she can catch her breath, she finds herself speaking on the pros and cons of callable bonds. After her input on the matter and a subsequent decision, there is a brief discussion on which of the following two bonds should be included in a portfolio of securities: Bond A Bond B Coupon Rate 4% p.a. semi-annually 5% p.a. semi-annually Yield to maturity 5% p.a. 4% p.a. Maturity 2 years 2 years As the meeting discusses Bonds A and B, there is a sharp division in opinion. Given that bonds with higher interest rate risk carry a greater potential for return at the cost of higher risk, there is no conclusive agreement on which of the two bonds should be allowed into the portfolio, with votes equally divided between selecting Bond A and Bond B. Finally, the meeting chair, Samantha Hill, uses her veto power to arrive at a decision and there is no other business, the meeting ends and the delegates pack up and leave for home.

Question 9 (5 marks) In light of the argument between the Financial Executive of Moneymatters Inc. and Chin Lee and the subsequent speech by Nancy on the pros and cons of a callable bond, discuss why investors dislike a call provision in the bond indenture? How does this affect the yield on a callable bond? (5 marks)