Corporate Bonds PDF - Business Finance Chapter 5

MODULE BUSINESS FINANCE CHAPTER 5 CORPORATE BONDS Learning Objectives: 1. Define corporate bond 2. Enumerate the types of bonds...

MODULE BUSINESS FINANCE CHAPTER 5 CORPORATE BONDS Learning Objectives: 1. Define corporate bond 2. Enumerate the types of bonds 3. Distinguish the difference between bonds and stocks 4. Explain the features of long-term bonds What Is a Corporate Bond? A corporate bond is a type of debt security that is issued by a firm and sold to investors. The company gets the capital it needs and in return the investor is paid a pre-established number of interest payments at either a fixed or variable interest rate. When the bond expires, or "reaches maturity," the payments cease and the original investment is returned. Bonds are a form of long-term debt, a liability of a company that has a specified principal value and maturity date. Its principal is called the face value, where the amount of the bond is printed on the face, or its par value. The company, as the debtor, is the bond issuer; and the investor, as creditor, is the bond holder. Bond holders receive interest that is stated on the face of the bond. Interest is also called the yield expressed as current yield or yield to maturity. Understanding Corporate Bonds Each debt instrument has terms that the debtor must meet. The terms, also called covenants, are stated in a legal document known as indenture and may vary on the financial condition of the borrower. It is important to monitor the performance of the issuing company and be Page 1  MODULE BUSINESS FINANCE aware of the terms of the bond issue. If the issuer does not make the required interest or principal payment, the bond is said to be in default. If the issuer defaults, the indenture states what actions the investors can take. A trustee is appointed for each publicly held bond, whose main task is to monitor that the terms in the indenture are met and to work with the firm in cases where intervention is needed. Commercial banks commonly act as trustees for major corporate bond issues. When a company decides to issue bonds, it usually gets the services of an investment banker to facilitate the process. Investment bankers charge fees for their services which will depend on the complexity of the bond offering and the number of services the issuer requires. In the investment hierarchy, high-quality corporate bonds are considered a relatively safe and conservative investment. Investors building balanced portfolios often add bonds in order to offset riskier investments such as growth stocks. Over a lifetime, these investors tend to add more bonds and fewer risky investments in order to safeguard their accumulated capital. Retirees often invest a larger portion of their assets in bonds in order to establish a reliable income supplement. Corporate bonds are considered to have a higher risk. TYPES OF BONDS 1. According to Type of Security Secured bonds or mortgage bond are backed by the firm-owned property. Mortgages are the most common type of secured bonds and are backed by real estate assets. Mortgage bonds are secured by a lien on specifically named property such as land, buildings, equipment, and other fixed assets specifically pledged as security. Specific types are:  Real estate which include land and property attached to the land;  Chattel which consist of personal and movable property Other sub-classes of real estate mortgages may include:  Senior liens which have prior claim to fixed assets pledged as security, or sometimes called first mortgage bonds;  Junior liens have subsequent claims to fixed assets pledged as security, or subordinate claim to the senior liens. Also called second-mortgage or third- mortgage bonds. Real estate mortgages can also be classified according to type of issue:  Closed-end issue where subsequent issues on the specific property pledged as collateral are not allowed;  Open-end issue permits issuance of additional bonds or a series of issues to be made under the original mortgage secured by a single lien;  Limited open-end issue allows additional bonds to be sold after the original issue, but stipulates a maximum amount. An issue becomes closed when the specified amount of bonds have been issued. Page 2  MODULE BUSINESS FINANCE Debentures are unsecured long-term bonds of a corporation. These debentures are paid after the secured bond holders have been satisfied, making these bonds more risky than secured bonds. Subordinate debentures are those with lower payment in the hierarchy. Because of the high risk, subordinate debentures require that the firm pay a higher rate of interest. The issuing company can lower the interest on its subordinated debentures by adding a convertibility feature. Convertible bonds have a stated maturity value and coupon rate, but it offers the investor the opportunity to convert the debt to equity at stated periods of time. For example, ABC Manufacturing could offer a 1M – 10-year bond, convertible into 20 shares of common stock on its fifth year. The firm may benefit from the conversion feature because convertible bonds carry a lower rate of interest than subordinated bonds without conversion feature. Assumed bonds are those absorbed by the surviving corporation. They remained unchanged with the same protection on mortgage lien given to the bond. Guaranteed bond is a type of bond where the payment of interest, or principal, or both, is guaranteed by one or more individuals or corporations. This assures additional protection for the bondholder. Joint bonds are owned by several companies. The same property may be used as security for a bond issue. The companies bind themselves jointly as debtors. 2. According to Participation in Earnings a. Municipal bonds or government bonds are issued by a country, cities, municipalities or any authorized public authority such as school boards, highway commissions, port districts. The funds appropriated by the citizens will be paid over a period of time as stated in the levy proposal, but it allows the agency to sell bonds immediately to fund the projects. Municipal bonds are able to offer a lower rate of interest than corporate bonds, because the interest income is exempt from income taxes. The types of municipal bonds are: 1. General obligation bonds – backed by the full faith and credit of the issuer. 2. Revenue bonds – derive funds from the income produced by the funded asset. b. Pure Discount bond promises to pay a certain amount at a specified time in the future. c. Registered bonds identify the names of the owners in the transfer books of the company. d. Income bonds have a fixed rate of interest payable only if earned and declared by the board of directors. e. Participating bonds stipulate a fixed coupon rate but also provide a method of receiving additional income over the and above the minimum sun. f. Convertible bonds are generally debenture bonds or junior-lien mortgage bonds Page 3  MODULE BUSINESS FINANCE where the owner has the option to exchange his bond for a specified number of shares of common stock, preferred stock or other types of bonds. g. Bonds with warrants have the option or right to purchase stock at a stated price during a stipulated period of time. Detachable warrants are sold or exercises apart from the bond, while non-detachable warrants cannot be sold or exercises separately from the bond. 3. According to Method of Retirement When bonds mature, the principal and interest shall be paid whole at a definite time and place. Sometimes, deviations from the agreement may happen, thus classifying bonds according to its period of retirement. a. Serial bonds mature semi-annually or annually, and are paid on staggered bases. b. Sinking fund bonds require the issuer to deposit annually a specific sum of money with the trustee of the issue for the retirement of the part of the issue. This occurs before maturity of the bond and has periodic repayment of the obligation. c. Callable bonds provide that the issue be cancelled or called. The call privilege enables the issuing company to pay off a bond issue pprior to maturity. d. Perpetual bonds are those where the holder cannot redeem payment. This is commonly used in public finance, where the government as the debtor, has permanent existence. All bonds can be classified as premium, par or discount bonds. These classifications depend o whether their current price exceeds, is equal to, or is less than the face value. If a bond is selling at a premium, the price must fall toward face value as maturity approaches, even if interest rates do not change. If a bond is selling at a discount, the price must rise toward the face value as maturity approaches, even if interest rates do not change. The effect of a given change in interest rates on the price of the bond depends upon these variables: (Mayo)  The maturity of the bond  The coupon rate  The level of interest rates at the time of the change in interest rates Why Corporations Sell Bonds Corporate bonds are a form of debt financing. They are a major source of capital for many businesses, along with equity, bank loans, and lines of credit. They often are issued to provide the ready cash for a particular project the company wants to undertake. Debt financing is sometimes preferable to issuing stock (equity financing) because it is typically cheaper for the borrowing firm and does not entail giving up any ownership stake or control in the company. Page 4  MODULE BUSINESS FINANCE Generally speaking, a company needs to have consistent earnings potential to be able to offer debt securities to the public at a favorable coupon rate. If a company's perceived credit quality is higher, it can issue more debt at lower rates. When a corporation needs a very short-term capital boost, it may sell commercial paper, which is similar to a bond but typically matures in 270 days or less. The Difference Between Corporate Bonds and Stocks  An investor who buys a corporate bond is lending money to the company. An investor who buys stock is buying an ownership share of the company.  The value of a stock rises and falls, and the investor's stake rises or falls with it. The investor may make money by selling the stock when it reaches a higher price, or by collecting dividends paid by the company, or both.  By investing in bonds, an investor is paid in interest rather than profits. The original investment can only be at risk if the company collapses. One important difference is that even a bankrupt company must pay its bondholders and other creditors first. Stock owners may be reimbursed for their losses only after all of those debts are paid in full. Bonds: As Differentiated from Stocks  Bond is an instrument of debt, while stock is an instrument of ownership in the business;  Bondholders are given priority in payment of obligations, over the stockholders;  Bonds have a maturity date to pay principal and interest, while stocks as capital financing do not have maturity dates; and  Bondholders have no voting right nor influence in management of the company, except if there are provisions in the indenture agreement, while common stock have voting rights. Features of Long-term Bonds  Coupon Rate. New bond rates are normally fixed and set according to market rates on bonds of comparable quality and maturity so that the bonds sell at near par value. However, some bonds have floating coupon rates, which are reset periodically, usually twice a year, depending on prevailing interest rates.  Maturity. The typical maturity on long term debt is about 20-30 years.  Call feature and bond refunding. An optional retirement provision that permits the issuing company to redeem, or call, a debt issue prior to its maturity date at a specified price.  Put feature. An option that entitles the bondholder to sell the bond back (put back) to the issuer before maturity at a predetermined price; and reinvest the proceeds in new bonds with higher coupon rates.  Sinking fund. The method of providing for a gradual retirement of bond issues, in which a certain amount is put aside annually, or ‘sunk’ into a fund account.  Equity-linked debt. A conversion ratio is determined, which refers to the number of shares a convertible bond can be converted. Page 5  MODULE BUSINESS FINANCE INDENTURE This is a contract between the corporation and the trustee on behalf of the bondholders The indenture contains the terms of the bond issue covering the obligations of the corporation, the manner of its fulfillment, the rights and responsibilities of the bondholders, and the duties of the trustee. Its contents are: (Mayo)  The amount, length of time, and denomination of the bond issue;  Serial issues and the size of each issue;  The rate of interest, terms of payment, and the designated place of collection;  Rights, privileges, or limitations attached to the issue;  Security type and its terms;  Mortgage or pledge of securities, if any;  Manner of redemption;  Remedies available to bondholders, in case of bond issuer’s default;  Replacement procedure of mutilated or lost bond certificate;  Duties and remunerations of the trustees TRUSTEE This is the person or entity who handles monies or property on behalf of another in a trust. Trustees see to it that issuing corporations comply with the provisions in the indenture. Its duties include:  Representing the bondholder in case of default;  Making payment of principal and interest;  Managing sinking fund;  Reporting annually to bondholders results of operations, condition of the bond issue and pledged security;  Providing bondholder lists of other bondholders, when needed, to form special committees to protect their interests;  Notifying the bondholders of any default;  Informing bondholders of any loans by the trustee to the corporation For further discussion, please refer to the link provided: How Bond Investing Works https://www.youtube.com/watch?v=C1FPhvk17B8 For further discussion, please refer to the link provided: Investing bonds https://www.youtube.com/watch?v=IuyejHOGCro REFERENCES: Basic Business Finance: Management Approach, 2nd Ed., BY: Ruby F. Alminar-Mutya Page 6  MODULE BUSINESS FINANCE ICCT Colleges Foundation Inc. V.V. Soliven Avenue II, Cainta Rizal Page 7