Introduction to Corporate Finance

4: Valuing Bonds

bond rate, the prime rate charged by Australian banks for funds loaned overnight to each other (the

‘cash rate’ or the Bank Bill Swap Rate), and the London Interbank Offered Rate. The London Interbank

Offered Rate (LIBOR) is a rate at which large UK banks can borrow from one another, and it is perhaps

the most common benchmark interest rate for short-term debt on a global basis. This is an equivalent

of the cash rate in Australia.

The interest rate on floating-rate bonds is typically specified by starting with one of the benchmark

rates above and then adding a spread. The spread, also called the credit spread, is added to the benchmark

interest rate, according to the risk of the borrower. Lenders charge higher spreads for less creditworthy

borrowers.

example

In September 2013, BHP Billiton issued $5.0 billion of
bonds into global capital markets; its press release at
the time read, in part:

The Global Bond comprises US$500 million

Senior Floating Rate Notes due 2016 paying

interest at 3 month US Dollar LIBOR plus 25

basis points [the spread above the short-term

interbank offer rate], US$500 million 2.050%

Senior Notes due 2018, US$1,500 million

3.850% Senior Notes due 2023, and US$2,500

million 5.000% Senior Notes due 2043.

Once you have finished this chapter, you should

be able to decipher the challenging jargon of the

press release.

Source: http://www.bhpbilliton.com/~/media/bhp/documents/

investors/news/2013/130926_bhpbillitonpricesus$5.pdf?la=en. Accessed

18 October 2015. Used with permission.

The Australian Government also issues capital indexed bonds. Capital indexed bonds generally pay

interest on a quarterly basis at a fixed coupon rate, applied to the face value of the bond.

Unlike fixed coupon bonds, the face value of a capital indexed bond is adjusted each year by indexing

the principal amount of the bond to match changes in inflation. It is expected that inflation is positive, so

that the principal amount of the bond will increase at each adjustment date. At maturity, bondholders are

repaid the adjusted principal value of the security. This is the face value increased by inflation over the

life of the bond. Under this scheme, the coupon payment increases year to year, because it is calculated

as a percentage of the increased face value of the bond. For these reasons, capital indexed bonds are

often called inflation linked bonds.^10

Secured Versus Unsecured

What assurances do lenders have that borrowers will fulfil their obligations to make interest and principal

payments on time? In the case of unsecured debt, the only assurance is the borrower’s promise to repay,

combined with the recourse offered by the legal system if the borrower does not make all promised

payments.

If a corporation has conducted more than one offering of unsecured debt, some issues may have a

lower priority claim than others. The term subordinated unsecured debt refers to bonds that have legal claims

inferior to, or subordinate to, other outstanding unsecured bonds. The terms senior and junior describe

the relative standing of different bond issues, with senior bonds having a higher-priority claim than junior

bonds.

10 These bonds are described at http://www.australiangovernmentbonds.com/types-of-bonds.

London Interbank Offered

Rate (LIBOR)

The interest rate that large

UK banks charge each other

for overnight loans. Widely

used as a benchmark interest

rate for short-term floating-

rate debt

cash rate

The interest rate that

Australian banks charge each

other for overnight loans

spread

The difference between the

rate that a lender charges

for a loan and the underlying

benchmark interest rate. Also

called the credit spread

capital indexed bonds or

inflation linked bonds

Bonds issued by the

Australian government in

which the face value is

changed each year in line with

inflation

unsecured debt

Debt instruments issued by an

entity which is backed only by

the general faith and credit of

the borrowing company

subordinated unsecured

debt

Debt instruments issued by

an entity which is backed only

by the credit of the borrowing

entity and which is paid only

after senior debt is paid