Listed below are some provisions that are often contained in bond indentures: Wh

Question

Listed below are some provisions that are often contained in bond indentures:

Which of the above provisions, each viewed alone, would tend to reduce the yield to maturity investors would otherwise require on a newly issued bond?

1. Fixed assets may be used as security. 2. The bond may be subordinated to other classes of debt. 3. The bond may be made convertible. 4. The bond may have a sinking fund. 5. The bond may have a call provision. 6. The bond may have restrictive covenants in its indenture.

Explanation / Answer

The following table indicates the provisions which will reduce the yield to maturity marked by "Yes".

Answer is 1,3,4,6

_________

Explanation:

Use of fixed assets as security will reduce the risk for the bondholders as in the event of default in the payment of interest or prinicipal amount by the company, the assets will be liquidated and amount so realized will be first used to dispose off the debts due to bondholders. Lower risk would mean lower yield to maturity. In other words, secured bonds (backed by any asset) would offer a lower return as compared to unsecured bonds.

Convertibility feature enables the bondholders to convert their holdings into shares, thereby, providing an opportunity to take advantage of upside movement in stock prices. This feature reduces the risk for bondholders as they continue to receive interest payments, even when there is a decline in stock prices. Any upward movement in the prices will only add value to the investments of bondholders. This would mean lower risk resulting in lesser return (YTM) offered on new bonds.

In case of sinking funds, company has the right to retire all or any part of the bonds (partial retirement) at a value which may be less than or equal to the par value of the bonds on a periodical basis. This provision acts as a safety measure for the investors as regular retirement reduces the amount payable by the company at the time of maturity. This safety results in lower risk and therefore, lower returns are offered on bonds with the sinking fund provision.

Restrictive covenants are included in the bond indenture to protect the interests of the bondholders and to restrict the company from taking certain actions which may be detrimental to the interest of bondholders. Again, such bonds would offer lower return (YTM) for lesser risk. Higher returns (YTM) are generally associated with higher risks.

Reduction of YTM 1 Fixed assets may be used as security. Yes 2 The bond may be subordinated to other classes of debt. No 3 The bond may be made convertible. Yes 4 The bond may have a sinking fund. Yes 5 The bond may have a call provision. No 6 The bond may have restrictive covenants in its indenture. Yes

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