COMM 101 Lecture Unit 3 Debt Markets (1) PDF

Debt Markets in Canada In the previous unit we saw how investments could broadly be classified as debt, equity or derivatives. In this unit we delve into the first of the three investment types, debt. **The primary debt markets in Canada for investors are the money market and the bond market.** The...

Debt Markets in Canada In the previous unit we saw how investments could broadly be classified as debt, equity or derivatives. In this unit we delve into the first of the three investment types, debt. **The primary debt markets in Canada for investors are the money market and the bond market.** The difference between them is the length of time that money is invested. The money market is for funds being invested for less than a year, whereas the bond market is for investments greater than a year. In terms of size, the bond market passed the \$2 trillion mark in 2014, whereas the money market was about one-sixth of that. The Money Market The money market is comprised of **very short term debt securities**. The objective of money market investors is to generate **safe**, short term returns. Investors are investing their surplus cash on a short term basis in order to maintain liquidity for their operations. Every type of business from manufacturers to financial institutions to high tech companies, as well as governments participate in this market. Investments can be overnight or for up to a year. The risk levels vary by instrument but are generally fairly small, given the debt must be repaid within the year. The 5 main investment alternatives in the Canadian money market are treasury bills, certificates of deposit, bankers acceptances, commercial paper, and repurchase agreements. *Treasury Bills* Treasury bills (t-bills) are short term debt securities **issued by the government.** In Canada they are usually issued at a bi-weekly auction for maturities of 1 month, 2 months, 3 months, 6 months and 1 year. They can subsequently trade in a secondary market though most investors hold them to maturity. As they are backed by the government, the credit risk is considered to be as close to nil as possible. T-bills are quoted based on a **face value** of \$1,000, meaning they are worth \$1,000 at maturity. T-bills do not pay interest on the face value but rather, they are sold at a discount. This means the investor buys them for a price **less** than \$1,000 and receives \$1,000 at maturity. The price of a t-bill at any time is therefore the **present value of \$1,000**, given the maturity date. This is a direct example of the present value of a single payment we studied in Unit 1. Example Box a. What is the price of a 6 month \$1,000 treasury bill that was issued at a 2% semi-annual yield? b\) How much would the investor receive at maturity? Solution a. The treasury bill would be sold to the investor at a price of: PV = 1000\*(1 +.02/2)**^-1^** = \$990.10 b. At the end of 6 months, the investor would receive \$1,000, thus earning 2% semi-annual on their investment. *Certificates of Deposit* Certificates of deposit are **deposits with a bank** for a specific term. They are similar to a retail GIC (Guaranteed Investment Certificate). The term can be virtually any length of time the investor chooses from overnight to a year, and can include a non-standard number of days (i.e. does not have to be a set number of weeks or months). The risk is that of the bank holding the deposit. In Canada, all of the largest banks have their short-term deposits rated in the safest category. Unlike the t-bill, the interest on a certificate of deposit is paid at the end of the term on the face value. Example: a. What is the price of a 6 month certificate of deposit for \$1,000 at a 2% semi-annual yield? b. How much would the investor receive at maturity? Solution a. The investor would pay \$1,000 for the deposit. b. At the end of the 6 months the investor would receive: FV = 1000\*(1+.02/2) = \$1,010.00. *Bankers' Acceptances* Bankers' Acceptances (BAs) are post-dated cheques **issued by a corporation** and then **physically stamped** by a bank. The stamp guarantees the cheque will be honoured by the bank. Historically BAs were used for international trade to guarantee foreign suppliers that they would be paid. Today, they are also used as pure financial transactions to raise money - the corporation can choose any term up to a year. Normally the term is less than 90 days. The credit risk is the same as the bank's which as mentioned above, means that in the case of the big Canadian banks, the risk is quite small. BAs can be traded between investors - when they are sold, they sell at a discount to the face value on the draft, based on the credit rating of the bank and the time to maturity (similar to a t-bill). The bank charges the issuing corporation a **stamping fee -** the size of the fee depends on the corporation's credit rating. The holder of the BA can present it to the stamping bank for payment on the maturity date. *Commercial Paper* Commercial paper (CP) is short term unsecured debt **issued by a corporation**; the term is less than one year and they are normally issued in multiples of \$50,000. The CP is rated by a rating agency (Standard & Poor's, Moody's, Fitch, Dominion Bond Rating Service) which lets investors know the agency's opinion on the safety of the CP. Many investors set their investment policies based on these ratings (e.g. will only invest in paper rated in the safest or second safest rating). Similar to t-bills, CP is sold at a discount, paying the face amount on the maturity date. They can trade between investors but typically investors hold them to maturity. *Repurchase Agreements* Repurchase Agreements (repos) are standardized agreements whereby an investor (or lender) buys a security from an investee (or borrower). The investee **agrees to buy it back** at a higher price on a specified future date (normally within 2 weeks). The most common term is overnight. This gives the investor a debt-like return. The rationale for this type of arrangement was to get the security off the investee's balance sheet. Repos are almost always done using government securities. For example, an investee sells \$100,000 of 3 month Canadian t-bills to an investor, agreeing to buy them back in 1 week for say, \$100,019.23 (the rate in this case is 1% compounded weekly). Repos are considered to be very secure since if the investee defaults, the investor can sell the underlying government security (in this case, the 3 month t-bills). The investees (or borrowers) are typically the banks and broker/dealers; the investors (or lenders) are money market funds and large financial institutions Risk and Return of Money Market Alternatives In terms of ranking the risk and hence the size of the returns offered by each alternative, t-bills are the least risky and offer the lowest return, followed by repos (since the underlying security is a government security), followed by certificates of deposit and BAs (both represent bank credit risk) and lastly, CP (corporate risk which in Canada is almost always inferior to the big banks). Hence 1-month CP will typically carry higher returns than 1-month returns in any of the other alternatives. The Bank of Canada publishes an updated list of current rates at the following website: [ ] Other rates that are utilized as benchmarks in the money market are: - Canadian Overnight Rate: the rate at which Canadian banks borrow from each other on an overnight, unsecured basis; the target is set and published by the Bank of Canada - U.S. fed funds rate: the rate at which U.S. banks borrow from each other on an overnight, unsecured basis - U.S. fed discount rate: the rate charged by the U.S. federal reserve bank when it lends to banks, again, on an overnight, unsecured basis - LIBOR -- the London InterBank Offering Rate: the rate banks in London (U.K.) charge each other for unsecured borrowings. It is currently quoted for 5 currencies (US, EURO, GBP, JPY and Swiss Franc) and 7 borrowing periods (overnight to a year). It is an important rate since it is used on a huge number of debt and derivative agreements around the world as the base rate for their interest calculation (e.g. interest to be calculated as LIBOR + 1%). Presently, the total dollar value of contracts using LIBOR is estimated at US\$260 trillion. The Bond Market A bond is a form of debt in which the borrower (or issuer) issues a debt **security** to an investor. Unlike other forms of borrowing, bonds can trade publicly and are regulated by securities commissions. The most common structure is a security that pays a fixed amount of interest every six months, i.e. a semi-annual interest rate, with the full amount of principal being repaid at maturity. The debt can be either secured or unsecured and can have many other features as well. Every bond issue has a **bond indenture** that states in legal terms what the features of that particular issue are. The objectives of bond investors range from the desire for a long term predictable cash flow (e.g. retirees, people living off their investment income) to the desire on the part of a corporation to match a long term obligation with a similar or identical cash inflow. For example, life insurance companies use the bond market to match their obligations to pay policyholders (20 year obligation matched with 20 year bond). The basic features of every bond are the face or par value, the coupon rate, the maturity, and the price. *Definitions* The **face or par value** of a bond is the amount that will be paid at maturity. The par value of most bonds is \$1,000 and we will assume for this course that all individual bonds repay \$1,000 at maturity. The **coupon rate** of a bond is the rate that determines the interest payments that will be paid at the end of every period. The interest payments are referred to as **coupon payments.** The coupon payments are usually made semi-annually (every 6 months) and the coupon rate is normally a compounded semi-annual rate. *Unless stated otherwise, assume all bond rates are nominal semi-annual rates (i.e. \$1,000 3% coupon bond means coupons will be \$15 every 6 months).* The **maturity is** the **date** the bond will be repaid on. The **yield rate** is the rate a bond investor will earn if they hold the bond to maturity; it is usually not the same as the coupon rate, even at the time the bonds are issued. Yield rates reflect the market interest rate at the time the bond is purchased. Hence yield rates can change literally from one minute to the next. The coupon rate is set before the bonds are issued and never changes. The **price** of a bond is the present value of the cash flows (i.e. the coupon payments and the par value), discounted using the **yield rate**. Bond Pricing Note that the pricing convention is to **quote** all bond prices using 100 as a par value, rather than \$1,000. Hence a quote of 99.583 means the \$1,000 bond is trading at \$995.83; a quote of 125 means it is trading at \$1,250. The \$ sign is omitted from the quote and it will normally have 3 decimal places. Consider a \$1,000 five year bond, with a 4% semi-annual coupon rate, priced to yield 3% semi-annual. The par value is \$1,000, the coupon rate is 4% semi-annual, the maturity is 5 years and the yield rate is 3% semi-annual. The investor will receive cash flows as follows: Every 6 months for 5 years: \$1,000 \* 0.04/2 = \$20. At maturity: \$1,000 (plus the final coupon) Hence the cash flows are really an annuity of \$20 every 6 months -- 10 in total -- and a single payment of \$1,000. The price is the present value of the cash flows, discounted at the yield rate, in this case 3% semi-annual. Hence the price is the present value of an annuity plus the present value of a single payment and we can use the formulas presented in Unit 1. In this case the price will be: PV = \$20 \* ((1 -- (1 +.03/2)^-10^ )/(.03/2)) + \$1,000 \* (1 +.03/2)^-10^ = \$1,046.11 Using the pricing convention mentioned above, the bond will be **quoted** at 104.611. *Concept Check:* What is the price of a \$1,000 fifteen year bond, priced to yield 7% semi-annual if its coupon rate is 6% semi-annual? What will the bond quote be? **The par value is \$1,000, the maturity is in 15 years, the yield rate is 7% semi-annual and the coupon payments every 6 months are \$1,000\*.06/2 = \$30** **The price of the bond is the present value of the cash flows or** **PV = \$30 \* ((1 -- (1 +.07/2)^-30^)/(.07/2)) = \$1,000 \* (1 +.07/2)^-30^ = \$908.04** **Hence the bond quote will be 90.804.** Zero Coupon Bonds It is possible for a bond not to pay any coupons, referred to as a zero coupon bond. The price of the bond is still the present value of the cash flows, which in this case is simply the present value of the par value - \$1,000. Just as with coupon bonds, there will be a yield rate and a maturity. *Example:* What is the price of a thirty year zero coupon bond, priced to yield 5% semi-annual? What will the bond quote be? **The price is the present value of \$1,000 to be received in 30 years at 5% semi-annual.** **PV = \$1,000\*(1 +.05/2)^-60^ = \$227.28** **Hence the bond will be quoted at 22.728.** *Concept Check* What is the price of a ten year zero coupon bond, priced to yield 10% semi-annual? What will it be quoted at? **The price is the present value of \$1,000 in 10 years, discounted at 10% semi-annual.** **PV = \$1,000\*(1 +.10/2)^-20^ = \$376.89** **The bond will be quoted at 37.689.** Issuing Bonds When a corporation decides to issue bonds, it approaches an investment bank to assist in finding investors for the bonds. The biggest bond investors in Canada are pension funds, banks, insurance companies, mutual funds and exchange traded funds. Individual investors can purchase bonds directly but instead, they typically buy bonds through a mutual fund or exchange traded fund (we will be exploring mutual funds and exchange traded funds in Unit 7). The investment bank approaches these investors to see if they have an interest in buying the issuer's bonds and if so, what sort of yield they will demand. The corporation needs to get the bonds rated (explained below) and needs to prepare a bond indenture. The indenture is a legal document that will describe the bond issue in detail, including the coupon rate. The coupon rate is set based on the investment bank's feedback. However, there is a time lag between the setting of the coupon rate and the bonds being issued to investors. During this time lag, interest rates can change. The interest rate in effect at the exact time the bonds are issued will be the initial yield rate for the bonds. An example will illustrate. *Example:* ABC Corporation wants to issue \$100 million in 10-year bonds to fund a new factory they are building. ABC has issued bonds before and those bonds were rated A. The rating agency confirms the new bonds will also be rated A. ABC approaches an investment bank who confirms that the investment environment is such that investors will be receptive to \$100 million in bonds rated A and that the current interest rate for 10-year bonds rated A is 2.40%. ABC prepares a bond indenture for \$100 million in 10-year bonds using a coupon rate of 2.4% semi-annual. On June 1, 2018, when ABC is ready to issue the bonds, the rate for A bonds is 2.35% semi-annual. The bonds are issued to a group of 12 investors. A. What will be the par value of the entire issue? **The par value of the bond issue is \$100 million.** B. What will be the coupon rate? **The coupon rate is stated in the indenture and is 2.4% semi-annual.** C. What will be the maturity date? **The maturity date will be ten years from June 1, 2018, or May 31, 2028.** D. What will be the yield rate? **The yield rate is 2.35% semi-annual.** E. What will be the price of the bonds? **The price is the present value (PV) of the cash flows, discounted at the yield rate. So for a \$1,000 bond, the coupon payments will be \$1,000\*0.024/2 = \$12** **The price will be:** **PV = 12\*((1 -- (1 +.0235/2)^-20^)/(.0235/2)) + \$1,000\*(1 +.0235/2)^-20^ = \$1,004.43** **Hence the quote will be 100.443.** F. How much money will ABC receive prior to paying legal and other fees? **The proceeds that ABC will receive is the present value of all the cash flows associated with the entire issue, discounted using the yield rate. The PV of the entire issue will be:** **PV = \$1,200,000 \* (1 -- (1 +.0235/2)^-20^)/(.0235/2) + \$100,000,000 \* (1 +.0235/2)^-20^ = \$100,443,288.09** **The amount of money ABC will receive is the PV of the cash flows, discounted at the yield rate or \$100,443,288.09.** **Note that ABC will still repay \$100,000,000.00 at maturity (and will be paying coupons of \$1,200,000). Since investors were willing to accept a lower yield rate than the expected 2.4% semi-annual, ABC received higher proceeds at issue. If investors demanded a higher yield rate than 2.4% semi-annual, then ABC would have received less than \$100,000,000 at issue.** *Concept Check* Beta Inc. plans to issue \$250 million in 5-year bonds. Since the bonds will be rated BBB, Beta's investment bank informs them that the issue ought to be successful at a rate of 2.8% semi-annual. Beta prepares its bond indenture using that rate. On May 1, 2019 Beta issues the bonds. Investors demand a 2.9% semi-annual rate. A. How much money did Beta receive? **The amount of money Beta received is the PV of the cash flows, discounted at the yield rate:** **The coupon payments are \$250 million \*.028/2 = \$3,500,000** **The par value is \$250 million** **PV = \$3,500,000 \* (1 -- (1 +.029/2)^-10^)/(.029/2) + \$250,000,000 \* (1 +.029/2)^-10^ = \$248,844,167.42** **Beta received \$248,844,167.42** B. What was the quote of the bonds at issue? Express your answer rounded to 3 decimal places. **The quote is the % of par value to 5 decimal places or** **\$248,844,167.42/\$250,000,000 \* 100 = 99.53767** **The quote of the bonds at issue was 99.538.** Bonds that are issued (or trading) at less than face value are said to be issued (trading) at a **discount**. Bonds that are issued (trading) at more than face value are said to be issued (trading) at a **premium**. So ABC's bonds were issued at a premium and Beta's bonds were issued at a discount. Note that regardless of the amount of money received at issue, the cash flows paid by the issuer over the life of the bond remain the same. In other words, even though Beta received less than \$250 million at issue, they will still repay \$250 million at the end of the 5 year term. Since the price of the bond is the present value of the cash flows, discounted at the yield rate, the price of the bonds has an **inverse relationship with the yield rate**. As the yield rate goes **up**, the price of the bond goes **down**. As the yield rate goes **down**, the price of the bonds goes **up**. Additional Bond Features Thus far we have been describing a **straight** bond which is the most common bond. However, bonds can also have additional features, depending on the issuer and the investing environment at the time of issue. Some features are desirable for the issuer, and they may be willing to pay a higher interest rate to get the feature. Similarly, some features are desirable for investors and they may be willing to accept a lower interest rate in exchange for that feature. Examples that have been appealing in the past include: - **Secured or unsecured**: a secured bond means the investor has access to other assets if the borrower fails to pay interest or principal and therefore this reduces the risk of the investment. - **Registered or bearer**: A registered bond means the owner's name is registered with the trustee of the bond indenture; a bearer bond means whoever is holding the bond is considered to be the owner. - **Callable**: A callable bond means the issuer can repay the bond at a specified date *before maturity* at a specified price. This feature could be appealing to the issuer if they expect interest rates to go down in the short or medium term. In that case, they would call the bonds and replace them with bonds carrying a lower interest rate. The **issuer** must pay for this feature by offering a higher coupon rate. - **Retractable**: A retractable bond means the investor can sell the bond back to the issuer at a specified date *before maturity* at a specified price. The investor might like this feature if they expect interest rates to rise in the short to medium term; they could then sell the bonds back to the issuer and re-invest the proceeds at a higher interest rate. The **investor** must pay for this feature by accepting a lower coupon rate. - **Extendible**: An extendible bond means the investor can extend the maturity date to a specified date *beyond the original maturity date*. The investor might desire this feature if they are expecting interest rates to drop over the term of the bond; if interest rates are lower at maturity, they can extend the life of the bond and thus continue to receive the higher rate. The **investor** must pay for this feature by accepting a lower coupon rate. - **Convertible:** A convertible bond means the investor can convert the bond into the common shares of the issuer at or beyond a specified date, at a specified conversion ratio. For example, each \$1,000 bond is convertible into 100 common shares. This is the investor's option -- if they don't convert, they will receive the coupons on time and par value at maturity. Note that the conversion ratio translates into a higher price than the stock is trading at when the bonds are issued. In this example, the stock might be trading at \$6 when the bonds are issued. Since each \$1,000 bond converts into 100 common shares, it would not make sense for any bondholder to convert the bond into shares unless the price rose above \$10 (\$1,000/100). If the stock rose to \$15 say, the investor could convert each \$1,000 bond into 100 common shares and immediately sell them for \$1,500. The investor might desire this feature if they view the shares as somewhat attractive; they receive interest payments on their investment but if the stock appreciates, they can increase their return. The **investor** must pay for this feature in the form of a lower coupon rate. - **Floating rate**: A floating rate bond means the issuer pays a floating interest rate rather than a fixed rate of interest over the life of the bond. Floating just means the rate will change periodically when a benchmark rate changes. The most common benchmark is the LIBOR rate mentioned above. So a floating rate bond that paid LIBOR + 1.2%, means the rate will change whenever LIBOR changes, and the full rate paid will be 1.2% over the LIBOR rate. - **Real return bonds**: A real return is the return **after** taking into account the effect of **inflation**. For example, if you invest \$1,000 for a year and earn 7%, your return before inflation is \$70. If inflation is running at 3%, goods that cost \$1,000 a year ago now cost \$1,030 (\$1,000\*(1+.03)). So your **real return** is only 3.88% (i.e. \$1,070/\$1,030). A real return bond means the investor will earn a fixed real return, accomplished by adjusting the par value of the bond for inflation. For example, if the real rate is 4% annual and inflation is at 1.2% annual, the \$1,000 par value of each bond would be increased to \$1,012 (\$1,000 \* (1+.012)) and the interest payment for that year would be \$1,012 \* 4% = \$40.48. *Concept Check* 1\. A callable bond and a straight bond issued by the same company have the same maturity dates and pay the same coupons. Which will be trading at a higher price? a. Callable bond b. Straight bond **The callable bond benefits the issuer so the investor must be compensated in the form of a higher yield. If the yield rate is higher the price will be lower. Hence the straight bond will be trading at the higher price.** 2\. A convertible bond with 3% semi-annual coupon rate and 2 years until maturity is convertible into 20 common shares of the issuer. The shares are trading at \$65. Should a rational investor convert the bonds into common shares? a. Yes b. No **Yes -- the bond converts into 20 common shares which can be sold for \$1,300 -- quite a bit more than the maturity value of the bond and the remaining 4 coupons (total \$1,060). As an aside, note that the convertible bond would be trading very close to this value.** 3\. A one-year zero coupon bond is priced to yield 5% semi-annual. An investor holds the bond to maturity. Inflation over the year was 2.3% annual. What was the investor's real return? **The price of the zero coupon bond was \$1,000\*(1+.05/2)^-2^ = \$951.81** **Goods that cost \$951.81 a year ago now cost \$951.81\*(1+.023) = \$973.70** **Hence the investor's real return was \$1,000/\$973.70 -- 1 = 2.70%** Assessing Default Risk Investors in bonds expect the bond's cash flows (coupon payments and principal repayment) to be paid on time. The risk that the payments will not be made is referred to as **default risk**. Bond investors typically rely on bond rating agencies and their own credit analysts to assess default risk. They will then demand certain protections in the bond indenture, to reduce the default risk to a level they are comfortable with. Bond Ratings The price that bonds trade at in the market depends to a large part on the bond's rating. A **bond rating** is the opinion of a bond rating agency on how creditworthy the issuer is. The agency is hired by bond issuers prior to issue so that the investors can assess the default risk for any particular bond. The three main rating agencies are: Standard & Poor's (S&P), Moody's, and the Dominion Bond Rating Service (DBRS). They award ratings as follows: +-----------------+-----------------+-----------------+-----------------+ | ***DBRS*** | ***S&P*** | ***Moody's*** | ***Comments*** | +=================+=================+=================+=================+ | AAA | AAA | Aaa | Extremely | | | | | strong capacity | | | | | to pay | | | | | principal and | | | | | interest | +-----------------+-----------------+-----------------+-----------------+ | AA | AA | Aa | Very strong | | | | | capacity to pay | | | | | principal and | | | | | interest | +-----------------+-----------------+-----------------+-----------------+ | A | A | A | Strong capacity | | | | | to pay | | | | | principal and | | | | | interest | +-----------------+-----------------+-----------------+-----------------+ | BBB | BBB | Baa | Adequate | | | | | capacity to pay | | | | | principal and | | | | | interest | +-----------------+-----------------+-----------------+-----------------+ | BB | BB | Ba | *Debt from CC | | | | | to BB is | | | | | regarded as | | | | | somewhat | | | | | speculative.* | | | | | | | | | | *BB is least | | | | | speculative; CC | | | | | is most | | | | | speculative* | | | | | | | | | | *Large | | | | | uncertainties | | | | | or major risk | | | | | exposures | | | | | exist* | +-----------------+-----------------+-----------------+-----------------+ | B | B | B | | +-----------------+-----------------+-----------------+-----------------+ | CCC | CCC | Caa | | +-----------------+-----------------+-----------------+-----------------+ | CC | CC | Ca | | +-----------------+-----------------+-----------------+-----------------+ | C | C | C | Income bonds -- | | | | | no interest | | | | | being paid | +-----------------+-----------------+-----------------+-----------------+ | D | D | D | Debt is in | | | | | default | +-----------------+-----------------+-----------------+-----------------+ The ratings BBB and above are referred to as **investment grade**. Ratings below BBB are referred to as high yield or junk bonds. The rating determines the interest rate that the company must pay in order to attract investors. Obviously the highest rated issuers pay the lowest rates. When trading in the market, bonds with the same rating should trade at the same yield rate. For an easy to read description of how Standard & Poor's rates companies see: [[http://regulationbodyofknowledge.org/wp-content/uploads/2013/03/StandardAndPoors\_Corporate\_Ratings\_Criteria.pdf]](http://regulationbodyofknowledge.org/wp-content/uploads/2013/03/StandardAndPoors_Corporate_Ratings_Criteria.pdf) Credit Analysis In addition to looking at a bond's rating, bond investors will also assess the default risk by performing their own **credit analysis.** In evaluating a company, many analysts refer to the four C's of Credit: capacity, collateral, covenants and character. - Capacity refers to the borrowers' ability to meet current obligations and to take on additional debt. - Collateral refers to any assets that provide security for the debt. - Covenants are additional features of the debt that protect lenders and allow the lender to take action before all is lost. - Character refers to the character of the senior management and the culture of the company -- almost always a matter of judgment. In Unit 5 -- Financial Statement Analysis -- we detail the use of financial statements to analyse a company. Protecting Against Default Risk Once the investor has come to a conclusion on the level of default risk, they may decide they need **additional protection** in the bond indenture. Bond indenture provisions that protect bondholders from default risk include the following: - **Sinking funds:** This is a fund that an issuer must contribute to every year (usually on the coupon dates) in an amount sufficient to repay the debt at maturity. The fund invests in fixed income securities. The issuer does not have access to the fund for any other purpose. A similar alternative is to require the issuer to repurchase a certain amount of bonds every year in the open market, thus reducing the risk of default on the final payment. - **Serial bonds:** Instead of the entire bond issue maturing on a single date, the issuer staggers maturity dates (e.g. 10% is due after one year, 10% after two years, etc.), thus reducing the repayment burden and associated risk of default at the end. - **Subordination of future debt:** This refers to a restriction on the issuer's ability to issue more debt, since additional debt increases risk. It can either call for any future debt to rank behind the existing bond issue in a liquidation, or it can be an outright prohibition on issuing any more debt. - **Dividend restriction:** This refers to the ability of the issuer to pay dividends, either restricting them to a certain amount, a certain class (e.g. preferred shares) or prohibiting them entirely. - **Collateral/Security:** As mentioned previously, these are assets of the firm that the bondholders can sell in the event of default. - **Financial covenants:** These are financial ratios that the issuer must meet on an ongoing basis. Typically they are indicators of failing financial health -- declining profits, cash flows, etc. If the issuer is unable to meet a covenant, the bond issue is in default and investors can demand immediate repayment. They protect investors since there is a far greater likelihood of recovering the full amount of the issue when the company is still operating than there is if the company has declared bankruptcy.