Introduction to Corporate Finance

PArT 2: VALUATION, rISk AND reTUrN

bond indenture requires that, at maturity, bondholders accept ordinary shares in the underlying company.

In that case, the securities are called mandatory exchangeable bonds.

Callable and Putable Bonds

Bonds may be callable. This means that the bond issuer retains the right to repurchase the bonds in the

future at a predetermined price known as the call price. That right is valuable when market interest rates

fall. Recall that bond prices generally rise as market interest rates fall. A company that issued noncallable

bonds when rates were high may want to retire those bonds and reissue new ones after a decline in interest

rates. However, retiring the outstanding bonds requires paying a significant premium over face value. With

callable bonds, the call price establishes an upper limit on how much the company must pay to redeem

previously issued bonds. Investors recognise that the call feature works to the advantage of the bond issuer,

so callable bonds must generally offer higher coupon rates than otherwise similar noncallable bonds.

Putable bonds work in just the opposite way. Putable bonds allow investors to sell their bonds back

to the issuing company at a predetermined price under certain conditions. This option is valuable to

bondholders because it protects them against a decline in the value of their bonds. Therefore, putable

bonds typically have lower coupon rates than otherwise similar nonputable bonds.

The Australian corporate bond market currently has almost no putable bonds issued by local

companies, and a relatively small number of corporate bonds are callable. The same is true of New

Zealand’s corporate bond market. A key explanation for the lack of some variety is that both bond markets

are small, especially relative to the respective government and semi-government markets in Australia

and, in New Zealand, the markets for bonds issued by the banks and utilities (power, airport or NZ Post).

Protection From Default risk

Besides interest-rate risk, bond investors also have to worry about default risk – the possibility that

a bond issuer may not be able to make all scheduled interest and principal payments on time and

in full. The bond indenture, the contract between a bond issuer and its creditors, usually contains a

number of provisions designed to protect investors from default risk. We have already discussed some

of these features, including a bond issue’s seniority and whether it is secured or unsecured. Additional

examples of these provisions include sinking funds and protective covenants. A sinking fund provision

requires the borrower to make regular payments to a third-party trustee. The trustee then uses those

funds to repurchase outstanding bonds. Usually, sinking fund provisions require the trustee to retire

bonds gradually, so that by the time a bond issue’s maturity date arrives, only a fraction of the original

issue remains outstanding. The trustee may purchase previously issued bonds on the open market, or the

trustee may repurchase bonds by exercising a call provision, as described above.

Protective covenants, part of the bond indenture, specify requirements that the borrower must meet

as long as bonds remain outstanding. Positive covenants specify things that the borrower must do. For

example, positive covenants may require a borrower to file quarterly audited financial statements,

maintain a minimum amount of working capital or maintain a certain level of debt coverage ratios.

Negative covenants specify things that the borrower must not do, such as pay unusually high dividends,

sell off assets or issue additional senior debt.

Clearly, investors have a lot of choices when they consider buying bonds. The number and variety

of fixed-income investments available in the market is truly astounding, and far exceeds the number of

ordinary shares available for trading. Let us turn now to the bond markets to see how bonds are traded,

how bond prices are quoted and what external information is available to bond traders to help them make

investment decisions.

callable (bonds)

Bonds that the issuer can

repurchase from investors at a

predetermined price known as

the call price

call price

The price at which a bond

issuer may call or repurchase

an outstanding bond from

investors

putable bonds

Bonds that investors can

sell back to the issuer at a

predetermined price under

certain conditions

sinking fund

A provision in a bond

indenture that requires the

borrower to make regular

payments to a third-party

trustee for use in repurchasing

outstanding bonds, gradually

over time

protective covenants

Provisions in a bond indenture

that specify requirements

the borrower must meet

(positive covenants) or things

the borrower must not do

(negative covenants)

Annette Poulsen, University

of Georgia

‘There is a trade-off

between flexibility for

the corporation and

protection for the

bondholder.’

See the entire interview on

the CourseMate website.

COUrSeMATe
SMArT VIDeO