of issue. If interest rates have risen, holders will turn in the bonds and reinvest the pro-
ceeds at a higher rate. This feature enabled Transamerica to sell the bonds with an 8^1 ⁄ 2
percent coupon at a time when other similarly rated bonds had yields of 9 percent.
In late 1988, the corporate bond markets were sent into turmoil by the leveraged
buyout of RJR Nabisco. RJR’s bonds dropped in value by 20 percent within days of the
LBO announcement, and the prices of many other corporate bonds also plunged, be-
cause investors feared that a boom in LBOs would load up many companies with ex-
cessive debt, leading to lower bond ratings and declining bond prices. All this led to a
resurgence of concern about event risk, which is the risk that some sudden event, such
as an LBO, will occur and increase the credit risk of the company, hence lowering the
firm’s bond rating and the value of its outstanding bonds. Investors’ concern over
event risk meant that those firms deemed most likely to face events that could harm
bondholders had to pay dearly to raise new debt capital, if they could raise it at all. In
an attempt to control debt costs, a new type of protective covenant was devised to
minimize event risk. This covenant, called a super poison put, enables a bondholder to
turn in, or “put” a bond back to the issuer at par in the event of a takeover, merger, or
major recapitalization.
Poison puts had actually been around since 1986, when the leveraged buyout trend
took off. However, the earlier puts proved to be almost worthless because they allowed
investors to “put” their bonds back to the issuer at par value only in the event of an un-
friendly takeover. But because almost all takeovers are eventually approved by the target
firm’s board, mergers that started as hostile generally ended as friendly. Also, the earlier
poison puts failed to protect investors from voluntary recapitalizations, in which a com-
pany sells a big issue of bonds to pay a big, one-time dividend to stockholders or to buy
back its own stock. The “super” poison puts that were used following the RJR buyout
announcement protected against both of these actions. This is a good illustration of
how quickly the financial community reacts to changes in the marketplace.Sinking Funds
Some bonds also include a sinking fund provisionthat facilitates the orderly retire-
ment of the bond issue. On rare occasions the firm may be required to deposit money
with a trustee, which invests the funds and then uses the accumulated sum to retire the
bonds when they mature. Usually, though, the sinking fund is used to buy back a cer-
tain percentage of the issue each year. A failure to meet the sinking fund requirement
causes the bond to be thrown into default, which may force the company into bank-
ruptcy. Obviously, a sinking fund can constitute a significant cash drain on the firm.
In most cases, the firm is given the right to handle the sinking fund in either of
two ways:- The company can call in for redemption (at par value) a certain percentage of the
bonds each year; for example, it might be able to call 5 percent of the total original
amount of the issue at a price of $1,000 per bond. The bonds are numbered serially,
and those called for redemption are determined by a lottery administered by the
trustee. - The company may buy the required number of bonds on the open market.
The firm will choose the least-cost method. If interest rates have risen, causing bond
prices to fall, it will buy bonds in the open market at a discount; if interest rates have
fallen, it will call the bonds. Note that a call for sinking fund purposes is quite different
from a refunding call as discussed above. A sinking fund call typically requires no call
premium, but only a small percentage of the issue is normally callable in any one year.^5
154 CHAPTER 4 Bonds and Their Valuation(^5) Some sinking funds require the issuer to pay a call premium.