Bond Features and East Coast Yacht's Expansion Financing

Introduction to Bond Features and Coupon Rate Effects

A collateralized bond carries a lower coupon rate because the risk of loss to the bondholder is also lower. In the event of bankruptcy on the part of East Coast Yacht, bondholders still retain a claim on the collateral. Collateral therefore reduces the risk of loss for bondholders. The primary disadvantage of a collateralized bond, however, is that the company cannot sell the asset or assets it has pledged as collateral and must keep them in good condition at all times.

Bond seniority refers to the order of repayment in the event of bankruptcy or a sale. Senior bonds are paid before junior bonds in the event of liquidation (Jordan, Westerfield & Ross, 2010). The higher a bond's seniority, the lower its coupon rate, since senior bondholders are given preference over junior bondholders in a liquidation scenario, implying a lower risk of loss. Seniority thus helps mitigate risk for bondholders. However, holders of senior bonds may at times be restricted from taking on additional senior bonds (Jordan et al., 2010).

A sinking fund is a restricted account containing money that a corporation sets aside to pay off a bond or debt (Jordan et al., 2010). It reduces the coupon rate by serving as a guarantee for bondholders, thereby lowering their risk of loss. The primary disadvantage of a sinking fund is that it requires the company to generate extra cash flows to make regular payments into the fund; failure to do so results in default (Jordan et al., 2010).

A call provision is a clause in a bond that allows the issuer to repurchase and retire the bond before maturity — in this case, before the 30-year term expires. Call provisions with specific call dates and prices increase the coupon rate because they are generally advantageous to the company and disadvantageous to the bondholder. The higher interest rate represents the main cost to the company, as it must pay more to bondholders than it would under normal circumstances (Jordan et al., 2010). The primary benefit, however, is that the company can refinance at a reduced rate when conditions are favorable, such as when interest rates fall sharply (Jordan et al., 2010).

Call Provisions, Covenants, and Special Features

A deferred call is a provision that prohibits a company from calling a bond before a specified date (Jordan et al., 2010). The bond is considered call-protected during this period. Because the deferred call offers bondholders a degree of protection and thus reduces their risk, it results in a lower coupon rate (Jordan et al., 2010). Accordingly, a bond with a deferred call provision accompanying a call provision with specified dates will carry a lower coupon rate than one without such a provision (Jordan et al., 2010). The main advantage is the protection it provides to bondholders; the main disadvantage is that it prevents the company from calling the bond during the protection period, even when interest rates are extremely favorable.

A make-whole call provision is a clause allowing the issuing company to retire the bond early and pay the bondholder the outstanding amount owed (Jordan et al., 2010). The company calculates the present value of the expected cash flows from the bond to maturity and pays that amount to the bondholder. The main advantage is that it allows the bondholder to reinvest in comparable securities. On the downside, the cost to the company can be significantly high, and as a result, make-whole provisions are rarely invoked (Jordan et al., 2010).

A positive covenant is any clause that requires the issuer to meet specific obligations. Positive covenants reduce the coupon rate by offering bondholders a degree of protection (Jordan et al., 2010). Possible positive covenants that East Coast Yacht could adopt include: maintaining a minimum current ratio, committing to keep collateral in good working condition, and agreeing to notify bondholders in advance of any significant financial difficulty that threatens the company's sustainability. The disadvantage of positive covenants is that they bind the company to its commitments even when facing financial difficulty (Megginson, Lucey & Smart, 2008). On the positive side, they reduce the interest payable on bonds, which benefits the company.

A negative covenant prevents the issuer from engaging in certain activities without the bondholders' consent (Megginson et al., 2008). Such covenants protect bondholders' interests and are legally binding, thereby reducing the coupon rate. Examples of negative covenants for East Coast Yacht could include prohibitions on selling assets pledged as bond collateral or issuing bonds senior to the current bonds (Megginson et al., 2008). While negative covenants protect bondholders and help reduce interest payable on bonds, they restrict the company's freedom of action during periods of financial challenge.

A conversion feature allows the holder of a security to transform their investment into another form (Megginson et al., 2008). For instance, East Coast Yacht is not currently a public company but has an opportunity to become one given its recent growth. A conversion feature on the issued bonds would permit bondholders to convert their bonds into common stock or another security (Megginson et al., 2008). Conversion features lower the risk of loss and consequently reduce the coupon rate. The downside, however, is that the feature can be costly — particularly if the company is issuing equity at a low price (Megginson et al., 2008).

A floating rate coupon is a coupon rate that fluctuates with the prevailing interest rate over the life of the bond. If interest rates rise, the company must pay higher interest on its bonds; if rates fall, it pays less (Megginson et al., 2008). Consequently, the interest payable on bonds issued with a floating rate coupon is inherently unpredictable. For more background on how floating rate instruments work, see the Wikipedia article on floating rate notes.

Number of Bonds Required to Raise $45 Million

To determine how many coupon bonds must be issued, we first calculate the price of the bonds. For coupon bonds, the yield to maturity (YTM) depends on years to maturity (t), the coupon payment (c), the price of the bond (p), and the face value (FV). The rule of thumb is that when YTM equals the bond's coupon rate, the bond sells at par, meaning FV equals p (Gallagher & Andrew, 2007). In this case, both the coupon rate and YTM equal 5.5%, so the bond sells at par.

Assuming a face value of $1,000 (a standard face value for bonds), the market price of the bond is also $1,000. The number of coupon bonds to be issued is therefore:

$45,000,000 ÷ $1,000 = 45,000 coupon bonds

The YTM for a zero-coupon bond is given by: YTM = [(FV / P)^1/t] − 1. With FV = $1,000, t = 30, and YTM = 0.055, solving for price gives P = $200.64. The number of zero-coupon bonds to be issued is therefore:

$45,000,000 ÷ $200.64 ≈ 224,283 zero-coupon bonds