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Corporate bonds |
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| When interest rates decline, a firm may wish to issue new bonds at the lower rate and using the funds obtained to retire its outstanding higher-rate bonds.
Corporate Bonds
A Corporate Bonds is a certificate issued by a corporation. It indicates that a corporation has borrowed some money from an institution or an individual and promises to repay it in the future under clearly defined terms. Many corporate bonds bear a maturity period of 10 years to 30 years and a face value of $1,000. The 'coupon interest rate' on a bond depicts the percentage of the face value of the bond to be paid annually, typically in two equal semiannual payments. The bondholders are guaranteed semiannual interest payments, and repayment of the principal amount at maturity. Legal Aspects of Corporate Bonds
Since a Corporate Bonds issue may be for hundreds of millions of dollars obtained by selling portions of the debt to numerous unrelated people, certain legal arrangements are required to protect purchasers. Bondholders are protected legally through the indenture and the trustee.
Bond Indenture:
It is a complex and extensive legal document that states the conditions under which a bond is issued. It describes the rights of the bondholders and specifies the dates of the issuing corporation. In addition to specifying the interest, principal payments, and dates, and containing various standard & restrictive provisions, it frequently contains sinking-fund requirements and provisions with respect to a security interest (if the bond is secured).
Sinking Fund Requirements:
Besides the standard and restrictive provisions, another restrictive provision included in a bond indenture is a sinking-fund requirement. Their primary objective is to offer the systematic retirement of funds before their maturity. To carry out this requirement, the corporation makes semiannual or annual payments to a trustee, who uses these funds to retire bonds by purchasing them in the marketplace. The process becomes simpler when a call feature is introduced into it. It allows the issuer to purchase bonds again at a price stated before maturity. When adequate bonds cannot be purchased in the marketplace, and when the market price of the bond is more than the call price, the trustee will "call" bonds.
Security Interest:
The CorporateBonds indenture is quite similar to a loan agreement. Any collateral that is guaranteed against the bond is explicitly identified in the document. Generally, the title to the security is attached to the indenture, and the outlook of the security in various circumstances is explicitly described. The security of a bond is crucial to the safety. It enhances the marketability of a bond issue.
Trustee:
A trustee is looked upon as a third party to a bond indenture. A trustee may include an individual, a corporation, or a commercial bank trust department. The trustee, whose services are paid for, acts as a "watchdog" on behalf of the bondholders, making sure that the issuer does not default on its contractual responsibilities. The trustee is empowered to take specified actions on behalf of the bondholders if the terms of the indenture are violated.
General features of a bond issue
Following are the salient features of a bond issue: (a) A Conversion Feature
(b) A Call Feature
(c) Sock-Purchase Warrants
These features provide both the issuer and the purchaser with certain opportunities for replacing, retiring, and / or supplementing the bond with some type of equity issue.
Conversion Feature:
This attribute allows bondholders to convert each bond into a specific number of shares of common stock. Bondholders will convert their bonds when the market price of the stock is greater than the conversion rate. Hence, it provides a profit for the bondholder.
Call Feature:
The call feature is included in almost all corporate bond issues. It allows the issuer to repurchase bonds before maturity. The call price is called the stated price. Bonds can be repurchased at the price stated before maturity. Most of the time, the call price beats the face value of a bond with an amount equal to the interest of one year. For e.g. a bond worth $1,000 with a 10 percent rate will have a 'coupon interest rate' callable for around $1,100. The difference between the call price and the bond's par value is known as the 'call premium'. When the interest rates are high, investors look for a higher call premium because they know that the rates will decline, the issuer will exercise the call, and the bondholders will experience large opportunity losses.
The 'call feature' is quite advantageous to the issuer, since it enables the issuer to withdraw outstanding debt before maturity. When interest rates descend, an issuer can call an outstanding bond and reissue a new bond at a lower interest rate. When interest rates rise, the call privilege will not be exercised, except possibly to meet sinking funds requirements. The issuer has to bear a higher interest rate on callable bonds to sell them to compensate bondholders for the risk of having the bonds called away from them. In case of non-callable bonds of equal risk, the interest rates are much lower.
Stock-Purchase Warrants:
Warrants are occasionally attached to bonds as "sweeteners" to make them more attractive to prospective buyers. A stock-purchase warrant allows its holder to purchase a certain number of shares of common stock at a specified price over a certain period.
Bond ratings
The risk level of publicly traded bond issues is assessed by independent agencies such as Moody's and Standard & Poor's. Moody's has nine major ratings; Standard & Poor's is an agency that has ten major ratings. These agencies derive the ratings by using financial ratio and cash flow analyses. The quality of a bond and the rate of return that it must provide bondholders share an inverse relationship. High-quality bonds provide lower returns than lower-quality bonds. This reflects the lender's risk-return tradeoff. When considering bond financing, the financial manager must therefore be concerned with the expected ratings of the firm's bond issue, since these ratings can significantly affect salability and cost.
Popular types of bonds
Bonds can be classified in a variety of ways. Bonds can be classified into traditional bonds and contemporary bonds. The traditional types of bonds include debentures; subordinated debentures; income bonds; mortgage bonds; collateral trust bonds; and equipment trust bonds. Debentures; subordinated debentures, and income bonds are unsecured bonds. Mortgage bonds; collateral trust bonds, and equipment trust bonds are secured bonds.
The contemporary types of bonds are zero coupon bonds, junk bonds, floating rate bonds, extendable bonds, and potable bonds. These bonds can be either unsecured or secured. The contemporary bonds are issued to cope up with the changing capital market conditions and investor preferences. Zero coupon bonds are designed to provide tax benefits to the issuer and the purchaser. Junk bonds were recently widely used to finance mergers and takeovers. The floating rate bonds and extendable notes provide protection from inflation to the purchasers. Putable bonds provide an option to the bondholder to sell the bond at par. These contemporary bonds allow the firms to more easily raise funds at a reasonable cost by better meeting the needs of investors. Any change in the needs in capital market conditions, investor preferences, and corporate financing will result in development of further innovations in bond financing.
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