Introduction to Corporate Finance

PArT 2: VALUATION, rISk AND reTUrN

issue highly rated (very low-risk) bonds, although not all states are rated at the lowest risk rating of AAA

(using Standard & Poor’s rating system).

For all these bonds, the prices can fluctuate as market interest rates change. Australian resident

holders of the government bonds are generally subject to federal income tax on their earnings.

In this section, our focus has been on bond issues. Why do companies and government entities

sell bonds? The simple answer is that bond issuers need money – money to finance a deficit, to build

public infrastructure or to pay for expanded manufacturing facilities. An important characteristic that

distinguishes corporations from government entities is that when the latter group needs to issue a security

to raise funds, they are essentially limited to issuing a bond or other debt instrument. Corporations, on

the other hand, can issue either debt (bonds) or equity (shares).

Debt securities offer a series of cash payments that are, for the most part, contractually fixed.

The cash payout that bond investors expect from a company generally does not fluctuate each

quarter, as the company’s earnings do, and if a company fails to live up to its promise to make

interest and principal payments, bondholders can take legal action against the company and force

it into bankruptcy court.

In contrast, ordinary shares, which we cover in the next chapter, represent an ownership or equity

claim on the company’s cash flows. Unlike bondholders, shareholders generally have the right to vote

on corporate matters ranging from electing a board of directors to approving mergers and acquisitions.

However, ordinary shareholders have no specific legal entitlement to receive periodic cash payments.

Whether they receive any cash payments at all depends on the company’s profitability and on the board

of directors’ decision to distribute cash to investors.

As we will see, some bonds have features that put them into a grey area between pure debt and

equity. In the rest of this section, we discuss a wide range of bond features commonly observed in the

bond markets.

4-3b BY FeATUreS

To comprehend the range of bonds in the capital markets, it is easier to sort them by their characteristics –

fixed versus floating rates, secured versus unsecured, callable and putable, and so on. This section runs

you through a range of these pairings. A given bond may have one of each characteristic – for example, a

floating rate, unsecured, callable bond – in order to meet a specific market segment of lenders that the

company is hoping to attract.

Fixed Versus Floating rates

As we have already discussed, most bonds require the borrower to make periodic coupon payments

and to repay the bond’s face value at maturity. The coupon payments themselves may be fixed in dollar

terms over the bond’s life, or the coupons may adjust occasionally, if the benchmark market interest

rate changes while the bond is outstanding. Floating-rate bonds, also called variable-rate bonds, provide

some protection against interest-rate risk. If market interest rates increase, then eventually, so do

the bond’s coupon payments. Of course, this makes the borrowers’ future cash obligations somewhat

unpredictable, because the interest-rate risk of floating-rate bonds is effectively transferred from the

buyer to the issuer.

The interest rate on floating-rate bonds is typically tied to a widely quoted market interest rate.

Some of the benchmark interest rates that are often used to determine how a floating-rate bond’s

interest rate changes over time are the short-maturity (less than one-year) Australian government

floating-rate bonds
Bonds that make coupon
payments that vary through
time. The coupon payments
are usually tied to a
benchmark market interest
rate. Also called variable-rate
bonds