Question

Suppose a firm issues 2 identical bonds, C and D, except that bond C is callable and is junior debt, whereas bond D is not callable and is senior debt. Which bond should have a higher coupon?

Answer 1

Bond C is callable and is designated as junior debt whereas Bond D is not callable and is designated as senior debt. Any callable bond is an advantage to the issuer as it can call the bonds when interest rates are low at a significant loss to the bond investors and then reissue them at the lower prevalent rate of interes. Further, a bond designated as junior debt will have a lower priority of repayment in case the bond issuing entity defualts on repayment. Consequently, Bond C has a lower repayment priority in case of default and higher probability of being called, thereby putting holders of this bond at a significant disadvantage to that of Bond D holder. Therefore, Bond C holders (investors) would need greater coupon payments (as compared to Bond D holders) to compensate them for the aforementioned disadvantages. Hence, Bond C will have a higher coupon as compared to Bond D.