million to build a major regional distribution center. Bonds in the amount of $4
million, secured by a first mortgageon the property, were issued. (The remaining $6
million was financed with equity capital.) If Billingham defaults on the bonds, the
bondholders can foreclose on the property and sell it to satisfy their claims.
If Billingham chose to, it could issue second mortgage bondssecured by the same $10
million of assets. In the event of liquidation, the holders of these second mortgage
bonds would have a claim against the property, but only after the first mortgage bond-
holders had been paid off in full. Thus, second mortgages are sometimes called junior
mortgages,because they are junior in priority to the claims of senior mortgages,or first
mortgage bonds.
All mortgage bonds are subject to an indenture. The indentures of many major
corporations were written 20, 30, 40, or more years ago. These indentures are gener-
ally “open ended,” meaning that new bonds can be issued from time to time under the
same indenture. However, the amount of new bonds that can be issued is virtually al-
ways limited to a specified percentage of the firm’s total “bondable property,” which
generally includes all land, plant, and equipment.
For example, in the past Savannah Electric Company had provisions in its bond in-
denture that allowed it to issue first mortgage bonds totaling up to 60 percent of its
fixed assets. If its fixed assets totaled $1 billion, and if it had $500 million of first mort-
gage bonds outstanding, it could, by the property test, issue another $100 million of
bonds (60% of $1 billion $600 million).
At times, Savannah Electric was unable to issue any new first mortgage bonds be-
cause of another indenture provision: its interest coverage ratio (pre-interest income
divided by interest expense) was below 2.5, the minimum coverage that it must have in
order to sell new bonds. Thus, although Savannah Electric passed the property test, it
failed the coverage test, so it could not issue any more first mortgage bonds. Savannah
Electric then had to finance with junior bonds. Because first mortgage bonds carried
lower interest rates, this restriction was costly.
Savannah Electric’s neighbor, Georgia Power Company, had more flexibility un-
der its indenture—its interest coverage requirement was only 2.0. In hearings before
the Georgia Public Service Commission, it was suggested that Savannah Electric
should change its indenture coverage to 2.0 so that it could issue more first mortgage
bonds. However, this was simply not possible—the holders of the outstanding bonds
would have to approve the change, and they would not vote for a change that would
seriously weaken their position.
Debentures A debentureis an unsecured bond, and as such it provides no lien
against specific property as security for the obligation. Debenture holders are, there-
fore, general creditors whose claims are protected by property not otherwise pledged.
In practice, the use of debentures depends both on the nature of the firm’s assets and
on its general credit strength. Extremely strong companies often use debentures; they
simply do not need to put up property as security for their debt. Debentures are also
issued by weak companies that have already pledged most of their assets as collateral
for mortgage loans. In this latter case, the debentures are quite risky, and they will
bear a high interest rate.
Subordinated Debentures The term subordinatemeans “below,” or “inferior to,”
and, in the event of bankruptcy, subordinated debt has claims on assets only after se-
nior debt has been paid off. Subordinated debenturesmay be subordinated either to
designated notes payable (usually bank loans) or to all other debt. In the event of li-
quidation or reorganization, holders of subordinated debentures cannot be paid until
all senior debt, as named in the debentures’ indenture, has been paid.
Default Risk 171
Bonds and Their Valuation 167
