Systems Engineering Laboratories (SEL) sells an issue of $300 million face value of subordinated debentures with a coupon rate of 9.375% (assume coupons are paid annually). Each bond in the issue has a face value of $1,000 and matures in 15 years. The bonds were originally sold at par. The 15-year risk free interest rate is 4.5%. The expected market risk premium (remember, this is rm-rf), is 7%.
Suppose the market believes that, if SEL were to default, the subordinated debenture holders would receive a recovery rate of 40%. Suppose also, in each year of the bond’s life, if the bond is still alive, that there is a 5% probability of default. Calculate the expected rate of return on SEL subordinated debenture bond.