Financial Markets and Institutions (2-downloads)

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F I G U R E   1 2 . 5

Corporate Bond Interest Rates, 1973–2009 (End of year)

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Chapter 12 The Bond Market

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A bond’s interest rate will also depend on its features and characteristics, which are

described in the following sections.

Characteristics of Corporate Bonds

At one time bonds were sold with attached coupons that the owner of the bond

clipped and mailed to the firm to receive interest payments. These were called bearer

bonds because payments were made to whoever had physical possession of the

bonds. The Internal Revenue Service did not care for this method of payment, how-

ever, because it made tracking interest income difficult. Bearer bonds have now been

largely replaced by registered bonds, which do not have coupons. Instead, the

owner must register with the firm to receive interest payments. The firms are

required to report to the IRS the name of the person who receives interest income.

Despite the fact that bearer bonds with attached coupons have been phased out,

the interest paid on bonds is still called the “coupon interest payment,” and the inter-

est rate on bonds is the coupon interest rate.

Restrictive Covenants

A corporation’s financial managers are hired, fired, and com-

pensated at the direction of the board of directors, which represents the corpora-

tion’s  stockholders. This arrangement implies that the managers will be more

interested in protecting stockholders than they are in protecting bondholders. You

should recognize this as an example of the moral hazard problem introduced in

Chapter 2 and discussed further in Chapter 7. Managers may not use the funds pro-

vided by the bonds as the bondholders might prefer. Since bondholders cannot look

to managers for protection when the firm gets into trouble, they must include rules

and restrictions on managers designed to protect the bondholders’ interests. These

are known as restrictive covenants. They usually limit the amount of dividends the

firm can pay (so to conserve cash for interest payments to bondholders) and the abil-

ity of the firm to issue additional debt. Other financial policies, such as the firm’s

involvement in mergers, may also be restricted. Restrictive covenants are included

in the bond indenture. Typically, the interest rate will be lower the more restric-

tions are placed on management through restrictive covenants because the bonds

will be considered safer by investors.

Call Provisions

Most corporate indentures include a call provision, which states

that the issuer has the right to force the holder to sell the bond back. The call pro-

vision usually requires a waiting period between the time the bond is initially issued

and the time when it can be called. The price bondholders are paid for the bond is

usually set at the bond’s par price or slightly higher (usually by one year’s interest

cost). For example, a 10% coupon rate $1,000 bond may have a call price of $1,100.

If interest rates fall, the price of the bond will rise. If rates fall enough, the price

will rise above the call price, and the firm will call the bond. Because call provisions

put a limit on the amount that bondholders can earn from the appreciation of a bond’s

price, investors do not like call provisions.

A second reason that issuers of bonds include call provisions is to make it possi-

ble for them to buy back their bonds according to the terms of the sinking fund. A

sinking fund is a requirement in the bond indenture that the firm pay off a portion

of the bond issue each year. This provision is attractive to bondholders because it

reduces the probability of default when the issue matures. Because a sinking fund pro-

vision makes the issue more attractive, the firm can reduce the bond’s interest rate.

A third reason firms usually issue only callable bonds is that firms may have to

retire a bond issue if the covenants of the issue restrict the firm from some activity

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Part 5 Financial Markets

that it feels is in the best interest of stockholders. Suppose that a firm needed to bor-

row additional funds to expand its storage facilities. If the firm’s bonds carried a

restriction against adding debt, the firm would have to retire its existing bonds before

issuing new bonds or taking out a loan to build the new warehouse.

Finally, a firm may choose to call bonds if it wishes to alter its capital structure.

A maturing firm with excess cash flow may wish to reduce its debt load if few attrac-

tive investment opportunities are available.

Because bondholders do not generally like call provisions, callable bonds must

have a higher yield than comparable noncallable bonds. Despite the higher cost,

firms still typically issue callable bonds because of the flexibility this feature pro-

vides the firm.

Conversion

Some bonds can be converted into shares of common stock. This fea-

ture permits bondholders to share in the firm’s good fortunes if the stock price rises.

Most convertible bonds will state that the bond can be converted into a certain num-

ber of common shares at the discretion of the bondholder. The conversion ratio will

be such that the price of the stock must rise substantially before conversion is likely

to occur.

Issuing convertible bonds is one way firms avoid sending a negative signal to

the market. In the presence of asymmetric information between corporate insiders

and investors, when a firm chooses to issue stock, the market usually interprets this

action as indicating that the stock price is relatively high or that it is going to fall in

the future. The market makes this interpretation because it believes that managers

are most concerned with looking out for the interests of existing stockholders and

will not issue stock when it is undervalued. If managers believe that the firm will

perform well in the future, they can, instead, issue convertible bonds. If the managers

are correct and the stock price rises, the bondholders will convert to stock at a rel-

atively high price that managers believe is fair. Alternatively, bondholders have the

option not to convert if managers turn out to be wrong about the company’s future.

Bondholders like a conversion feature. It is very similar to buying just a bond

but receiving both a bond and a stock option (stock options are discussed fully in

Chapter 24). The price of the bond will reflect the value of this option and so will

be higher than the price of comparable nonconvertible bonds. The higher price

received for the bond by the firm implies a lower interest rate.

Types of Corporate Bonds

A variety of corporate bonds are available. They are usually distinguished by the type

of collateral that secures the bond and by the order in which the bond is paid off if

the firm defaults.

Secured Bonds

Secured bonds are ones with collateral attached. Mortgage bonds

are used to finance a specific project. For example, a building may be the collateral

for bonds issued for its construction. In the event that the firm fails to make payments

as promised, mortgage bondholders have the right to liquidate the property in order

to be paid. Because these bonds have specific property pledged as collateral, they

are less risky than comparable unsecured bonds. As a result, they will have a lower

interest rate.