corporate bonds - When interest rates decline, a firm may wish to issue new bonds at the lowe
Corporate bonds are debt securities issued by companies to raise capital. When you purchase a corporate bond, you are essentially lending money to the corporation, which promises to repay the principal amount at a future date (maturity) and make regular interest payments along the way. Companies may issue new bonds, often at lower interest rates, to retire existing higher-rate debt, especially when market interest rates decline.
What Are Corporate Bonds?
A corporate bond is a certificate issued by a corporation, signifying that the company has borrowed money from an investor (an institution or individual) and promises to repay it under clearly defined terms. Many corporate bonds typically have a maturity period ranging from 10 to 30 years and a face value of $1,000. The "coupon interest rate" on a bond indicates the percentage of the bond's face value that will be paid annually, usually in two equal semiannual installments. Bondholders are guaranteed these semiannual interest payments and the repayment of the principal amount at maturity.
What Legal Protections Do Corporate Bonds Offer?
Since a corporate bond issue can involve hundreds of millions of dollars obtained from numerous unrelated investors, specific legal arrangements are necessary to protect purchasers. Bondholders are legally protected primarily through two mechanisms: the bond indenture and the trustee.
Bond Indenture
The bond indenture is a complex and extensive legal document that outlines the conditions under which a bond is issued. It details the rights of the bondholders and specifies the obligations of the issuing corporation. Beyond specifying interest and principal payments and their dates, it includes various standard and restrictive provisions. It frequently contains sinking-fund requirements and provisions regarding any security interest if the bond is secured by collateral.
Sinking Fund Requirements
A common restrictive provision included in a bond indenture is a sinking-fund requirement. The main purpose of a sinking fund is to ensure the systematic retirement of bonds before their stated maturity date. To fulfill this requirement, the corporation makes regular payments (semiannual or annual) to a trustee. The trustee then uses these funds to retire bonds by purchasing them in the open market. This process is often made simpler by a call feature, which allows the issuer to repurchase bonds at a predetermined price before maturity. If sufficient bonds cannot be purchased in the market, or if the market price of the bond exceeds the call price, the trustee will "call" bonds from bondholders.
Security Interest
A corporate bond indenture is similar to a loan agreement. Any collateral pledged against the bond is explicitly identified in this document. Generally, the title to the security is attached to the indenture, and the handling of the security under various circumstances is clearly described. The security of a bond is crucial for its safety and significantly enhances the marketability of a bond issue.
Trustee
A trustee acts as a third party to a bond indenture. A trustee can be an individual, a corporation, or a commercial bank trust department. The trustee, whose services are paid for by the issuer, serves as a "watchdog" on behalf of the bondholders. Their role is to ensure that the issuer does not default on its contractual responsibilities. The trustee is empowered to take specific actions on behalf of the bondholders if the terms of the indenture are violated.
What Are the Key Features of Corporate Bonds?
Beyond the basic structure, corporate bond issues often include special features that provide both the issuer and the purchaser with certain opportunities for replacing, retiring, or supplementing the bond with some type of equity issue. These salient features include:
- A Conversion Feature
- A Call Feature
- Stock-Purchase Warrants
Conversion Feature
This attribute allows bondholders to convert each bond into a specific number of shares of common stock. Bondholders typically exercise this option when the market price of the stock is greater than the conversion value, thereby providing a potential profit for the bondholder.
Call Feature
The call feature is included in almost all corporate bond issues. It grants the issuer the right to repurchase bonds before their maturity date at a predetermined "call price." This call price often exceeds the bond's face value by an amount equal to one year's interest. For example, a $1,000 bond with a 10% coupon rate might be callable for around $1,100. The difference between the call price and the bond's par value is known as the "call premium." When interest rates are high, investors may seek a higher call premium because they anticipate that if rates decline, the issuer will likely exercise the call, leading to opportunity losses for bondholders.
The call feature is quite advantageous for the issuer, as it allows them to withdraw outstanding debt before maturity. If interest rates fall, an issuer can call an existing bond and reissue new bonds at a lower interest rate, reducing their borrowing costs. Conversely, if interest rates rise, the call privilege will generally not be exercised, except possibly to meet sinking fund requirements. Issuers typically have to offer a higher interest rate on callable bonds to compensate bondholders for the risk of having their bonds called away. Non-callable bonds of equal risk usually carry lower interest rates.
Stock-Purchase Warrants
Warrants are sometimes attached to bonds as "sweeteners" to make them more attractive to potential buyers. A stock-purchase warrant grants its holder the right to purchase a certain number of shares of common stock at a specified price over a defined period.
How Are Corporate Bonds Rated?
The risk level of publicly traded bond issues is assessed by independent agencies like Moody's and Standard & Poor's. These agencies use financial ratio and cash flow analyses to derive their ratings. Moody's typically uses nine major ratings, while Standard & Poor's uses ten. There is an inverse relationship between the quality of a bond and the rate of return it must provide to bondholders: high-quality bonds offer lower returns than lower-quality bonds, reflecting the lender's risk-return tradeoff. When considering bond financing, a financial manager must therefore be concerned with the expected ratings of the firm's bond issue, as these ratings can significantly affect the bond's salability and the cost of borrowing.
What Are the Different Types of Corporate Bonds?
Bonds can be classified in various ways, often categorized into traditional and contemporary types. The specific structure and features of a bond are designed to meet diverse capital market conditions and investor preferences.
Traditional Bonds
Traditional types of bonds are often categorized by whether they are secured by collateral or unsecured:
- Unsecured Bonds:
- Debentures: Unsecured bonds backed only by the issuer's creditworthiness and general earning power.
- Subordinated Debentures: Similar to debentures but have a lower claim on assets than other unsecured debt in case of liquidation.
- Income Bonds: Pay interest only if the issuer earns a specified amount of income.
- Secured Bonds:
- Mortgage Bonds: Secured by real estate or other specific physical assets of the corporation.
- Collateral Trust Bonds: Secured by financial assets, such as stocks or bonds of other companies, held by a trustee.
- Equipment Trust Bonds: Secured by specific equipment, such as rolling stock for railroads or aircraft for airlines.
Contemporary Bonds
Contemporary bond types are innovative debt instruments developed to adapt to changing capital market conditions and investor preferences. These can be either secured or unsecured:
- Zero Coupon Bonds: Do not pay periodic interest; instead, they are sold at a deep discount to their face value and mature at par, providing tax benefits to both the issuer and the purchaser in certain scenarios.
- Junk Bonds: High-yield, high-risk bonds, historically used to finance mergers and takeovers.
- Floating Rate Bonds: Have interest rates that adjust periodically based on a benchmark rate, offering purchasers protection from inflation.
- Extendable Bonds: Allow the bondholder to extend the bond's maturity date.
- Putable Bonds: Provide an option to the bondholder to sell the bond back to the issuer at par before maturity, offering additional flexibility.
These contemporary bonds enable firms to raise funds more easily and at a reasonable cost by better meeting the specific needs of investors. Ongoing changes in capital market conditions, investor preferences, and corporate financing strategies will continue to drive further innovations in bond financing.
Frequently Asked Questions
What is a corporate bond?
A corporate bond is a debt security issued by a company to borrow money from investors. In exchange for the loan, the company promises to pay regular interest payments and return the principal amount at a specified maturity date.
What is a bond indenture?
A bond indenture is a comprehensive legal document that outlines the terms and conditions of a bond issue, including the rights of bondholders, the obligations of the issuer, and any special provisions like sinking fund requirements or collateral details.
What is a call feature on a bond?
A call feature allows the bond issuer to repurchase the bonds before their scheduled maturity date at a predetermined call price. This is advantageous for the issuer if interest rates decline, as they can refinance the debt at a lower cost.
How are corporate bonds rated?
Corporate bonds are rated by independent agencies like Moody's and Standard & Poor's, which assess the issuer's creditworthiness and the bond's risk level. These ratings influence the bond's marketability and the interest rate the issuer must offer.