PART 4: CAPITAL STRUCTURE AND PAYOUT POLICYmarkets to offer conditions that encourage bond issuance. For example, in the US, two financial and
regulatory innovations transformed bond-issuance patterns and took business away from other national
bond markets. First, the introduction of shelf registration in the early 1980s allowed corporations issuing
debt in the US to register large blocks of debt securities, and then sell these in discrete pieces over the
subsequent two years as market conditions warranted. Shelf registration can be used for both debt and
equity offerings, but not all companies use this technique for selling shares. In contrast, most companies
that can use shelf registration for debt offerings do so.
The second major innovation occurred in 1990, when the US Securities and Exchange Commission
(SEC) created a new private-placement market by implementing Rule 144A. This allowed qualified
institutional investors (those with assets exceeding $100 million) to trade non-registered securities
among themselves, and corporate issuers soon found this was an attractive market for new equity and,
especially, new debt issues. International investors can participate in this market. Because Rule 144A
issues offer investors much greater liquidity than do traditional private placements and are less costly
than traditional public offerings, US and international corporations sell a total of between $400 billion
and $500 billion in securities most years under this rule.14 -3d GENERAL CHARACTERISTICS OF A BOND ISSUE
Three characteristics that may be observed in a bond issue are: (1) a call feature; (2) a conversion feature;
and (3) share purchase warrants. Each of these features grants an option, either to the issuer or the
investor, that can have a significant impact on a bond’s value.Call Feature
The call feature is included in many corporate bond issues, especially in the US, and gives the issuer
the opportunity to repurchase bonds prior to maturity. The call price is the stated price at which bonds
may be repurchased. Sometimes the call privilege is exercisable only during a certain period, and usually
bonds are not callable in the first few years. Typically, the initial call price exceeds the face value of a
bond by an amount equal to one year’s interest. For example, a $100 bond with a 10% coupon interest
rate would be callable for around $110 [$100 + (0.10 × $100)]. The amount by which the call price
exceeds the bond’s face value is commonly referred to as the call premium. This premium compensates
bondholders for having the bond called away from them and is the cost to the issuer of calling the bonds.
The call feature is generally advantageous to the issuer because it enables the issuer to retire
outstanding debt prior to maturity. Thus, when interest rates fall, an issuer can call an outstanding bond
and reissue a new bond at a lower interest rate. When interest rates rise, the call privilege will not be
exercised, except possibly to meet sinking fund requirements. Of course, to issue a callable bond, the
company must pay a higher coupon interest rate than that on noncallable bonds of equal risk in order to
compensate bondholders for the risk of having the bonds called away.Conversion Feature
The conversion feature of convertible bonds allows bondholders to exchange each bond for a stated number
of shares of ordinary shares. Bondholders will convert their bonds only when the market price of the
shares is greater than the conversion price, hence providing a profit to the bondholder. Because the option
to convert into shares is valuable, the interest rate paid on convertible bonds is usually lower than the
rate on traditional bonds, all else being equal. (The valuation of convertible bonds is discussed in detail
in Chapter 21.)LO 14.4Should a callable bond have
a lower or higher yield than a
similar noncallable bond? Why
would a company want to issue
callable bonds?
thinking cap
question
convertible bonds
Bonds that allow bondholder
to exchange each bond for
a stated number of ordinary
shares