© 2000 John Petroff
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© 2000 John Petroff |
A bond issue can be retired without any restriction by buying the bonds in the market. It is cheaper to force redemption of the bonds (than buying in the market) whenever the coupon rate is higher than the yield to maturity, but in that case a call premium is often added to the par value. Retirement of bonds is normally part of the stipulated sinking fund provision. But it can also take place strictly for financial reasons: by replacing one bond by another; this is called refunding. Refunding can take place in both case: whether prevailing yields have gone up or down.
If rates went up, bonds will sell at a discount. A firm can issue a new bond at the prevailing yield and buy with the proceeds the old bond at a low price. This is rather rarely done because the firm will be subject to corporate income tax on its gain calculated as the difference between par value and purchase price. The price of the bond would have to fall by over 30% to make this strategy worth considering. However, if the corporation is experiencing losses and can avoid the tax, it would make much more sense.
If rates went down, the yield on new bonds is much lower than the coupon rate of old bonds. To avoid having to pay the large coupon for years, the corporation can issue a new bond with a prevailing coupon rate and call the old bond. (Note that buying the old bond in the market is not beneficial because if rates went down that implies that the price went up).
See review questions Q-12G2.1 through Q-12G2.10.
See research assignment R-12G2.1.
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