Which of the following would be most likely to increase the coupon rate that is required to enable a bond to be issued at par? (Points: 4)
Adding a call provision.
Adding additional restrictive covenants that limit management's actions.
Adding a sinking fund.
The rating agencies change the bond's rating from Baa to Aaa.
Making the bond a first mortgage bond rather than a debenture.
To determine which option would be most likely to increase the coupon rate required for a bond to be issued at par, we need to understand the impact of each option on the risk associated with the bond. The coupon rate represents the interest paid on the bond, and is influenced by various factors including the creditworthiness and risk of the issuer.
1. Adding a call provision: A call provision gives the issuer the right to redeem the bond before its maturity date. This option can increase the coupon rate because it introduces the risk that the bond might be called before all the scheduled interest payments are made, which adds uncertainty for the bondholder.
2. Adding additional restrictive covenants: Restrictive covenants are provisions that limit the actions of the issuer, typically designed to protect bondholders. By adding more restrictive covenants, management's freedom to act is restricted, which reduces their flexibility to manage the company. This additional limitation on management can increase the coupon rate to compensate for the increased risk associated with the restricted actions.
3. Adding a sinking fund: A sinking fund is a provision that requires the issuer to set aside funds periodically to repay the bond at maturity. This provision enhances the bondholder's protection by ensuring a portion of the principal is repaid regularly, reducing the risk of default. However, because the sinking fund reduces the risk for bondholders, it could potentially decrease the coupon rate.
4. Rating agencies change the bond's rating: Bond ratings represent the creditworthiness of the issuer. A higher rating indicates lower credit risk, which generally lowers the coupon rate. In this case, if the bond's rating is upgraded from Baa to Aaa, it suggests a lower risk, and therefore the coupon rate is likely to decrease, not increase.
5. Making the bond a first mortgage bond: A first mortgage bond is secured by specific assets of the issuer, providing additional security to bondholders. This security reduces the risk associated with the bond, which could possibly result in a lower coupon rate. Therefore, making the bond a first mortgage bond is unlikely to increase the coupon rate.
Based on these explanations, adding a call provision or adding additional restrictive covenants that limit management's actions are the most likely options to increase the coupon rate required for the bond to be issued at par.