PART 4: CAPITAL STRUCTURE AND PAYOUT POLICYTABLE 14.2 CHARACTERISTICS OF SOME NEWER TYPES OF DEBT INSTRUMENTSBond type Characteristicsa
Zero (or low) coupon bonds Issued with no (zero) or very low coupon (stated interest) rate and sold at a large discount from par. A significant
portion (or all) of the investor’s return therefore comes from gain in value – face value minus purchase price –
and is paid at maturity. Generally callable at face value. Because the issuer can deduct the current year’s
interest accrual without having to actually pay the interest until the bond matures (or is called), its cash flow
each year is increased by the amount of the tax shield provided by the interest deduction. Although interest is
not actually paid, the investor must pay taxes on the implicit interest payments.
Junk (or high-yield) bonds Debt rated Ba or lower by Moody’s or below BBB– by Standard & Poor’s. Beginning in the mid-1980s; commonly
used by rapidly growing companies to obtain growth capital, most often as a way to finance mergers and
takeovers of other companies. High-risk bonds with high yields – typically yielding at least 3 percentage points
more than high-quality corporate debt.
Floating-rate bonds Stated interest rate is adjusted periodically within stated limits in response to change in specified money or
capital market rates. Popular when future inflation and interest rates are uncertain. Tend to sell at close to
par as a result of the automatic adjustment to changing market conditions. Some issues provide for annual
redemption at par at the option of the bondholder.
Extendible notes Debt instruments with short maturities, typically one to five years, which can be redeemed or renewed for a
similar period at the option of the holders. Similar to a floating-rate bond. An issue might be a series of three-
year renewable notes over a period of 15 years; every three years, the notes could be extended for another
three years at a new rate that is competitive with market interest rates prevailing at the time of renewal.
Putable bonds Bonds that can be redeemed at par (typically, $100 in Australia, but may more commonly be $1,000 in the US)
at the option of their holder either at specified dates, such as three to five years after the date of issue and
every one to five years thereafter, or when and if the company takes specified actions such as being acquired,
acquiring another company or issuing a large amount of additional debt. In return for the right to put the bond at
specified times or actions by the company, the bond’s yield is lower than that of a nonputable bond.
a The claims of lenders – bondholders – against issuers of each of these types of bonds vary, depending on their other features. Each of these bonds can
be unsecured or secured.14 -3b LEGAL ASPECTS OF CORPORATE BONDS
When they issue bonds, corporations typically raise hundreds of millions of dollars from many unrelated
investors. The dispersion in the investor base creates a need for special legal arrangements to protect
lenders.Bond Indenture
A bond indenture is a complex and lengthy legal document stating the conditions under which a bond has
been issued. It specifies both the rights of the bondholders and the duties of the issuing corporation.
In addition to specifying the interest and principal payment dates and containing various positive and
negative covenants, the indenture frequently contains sinking fund requirements and, if the bond is
secured, provisions with respect to a security interest.Sinking Fund Requirements
A positive covenant often included in a bond indenture is a sinking fund requirement. Its objective is to
provide for the systematic retirement of bonds before their maturity. To carry out this requirement, the
corporation makes semiannual or annual payments to a trustee, who uses the payments to retire bonds by
purchasing them in the marketplace. This process is simplified by the inclusion of a limited call feature,
which permits the issuer to repurchase a fraction of outstanding bonds each year at a call price. The
trustee will exercise this option only when sufficient bonds cannot be purchased in the marketplace or
when the bond’s market price exceeds its call price.
The typical life of a corporate bond may be shorter than its stated maturity implies. The reasons for this
are the ability of companies to call (and then refinance) bonds and the pervasiveness of mandated sinkingindenture
A legal document stating the
conditions under which a bond
has been issued
sinking fund
A positive covenant included
in a bond indenture, the
objective of which is to
provide for the systematic
retirement of bonds prior to
their maturity