1. Question 1 (corporate bond seniority). Please note that the stated interest rate does not necessarily
equal expected returns for bonds that may default.
Consider one-year bonds issued by Pineapple Inc. If the company does not default, the bond will pay the stated interest plus principal back in one year. If the company does default — which happens with a 10% probability — then the company defaults on all bonds, and bond investors only get R fraction of the principal back (and none of the coupon). R is known as the “recovery rate”. Suppose the company issues two types of bonds: senior and junior bonds. If bankruptcy happens, senior bondholders have higher recovery rates
(a) Suppose investors require an expected (average) rate of return of 5%.3 Suppose the recovery rates for senior and junior bonds are R= 70% and R= 30%, respectively. Assume bond interest rates are determined such that all bonds’ expected returns exactly equal 5%.4 What will be the stated interest rates of the senior and junior bonds, respectively?
(b) In general, do you expect the stated interest rate on senior bonds to be higher than, equal to, or lower than that of junior bonds? Why? Please justify your answer using explicit arguments.
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