642 Part Seven Debt Financing
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You should now have a fair idea of what you are letting yourself in for when you make an issue
of bonds. The detailed bond agreement is set out in the indenture between your company and a
trustee, but the main provisions are summarized in the prospectus to the issue. The indenture states
whether the bonds are senior or subordinated, and whether they are secured or unsecured. Most
bonds are unsecured debentures or notes. This means that they are general claims on the corpora-
tion. The principal exceptions are utility mortgage bonds, collateral trust bonds, and equipment
trust certificates. In the event of default, the trustee to these issues can repossess the company’s
assets to pay off the debt. Sometimes firms raise money using asset-backed securities, which
involve bundling assets together and selling the cash flows from them.
Some long-term bond issues have a sinking fund. This means that the company must set aside
enough money each year to retire a specified number of bonds. A sinking fund reduces the average
life of the bond, and it provides a yearly test of the company’s ability to service its debt. It therefore
helps to protect the bondholders against the risk of default.
Long-dated bonds may be callable before maturity. The option to call the bond may be very
valuable. If interest rates decline and bond value rises, you may be able to call a bond that would
be worth substantially more than the call price. Of course, if investors know that you may call the
bond, the call price will act as a ceiling on the market price. Your best strategy, therefore, is to call
the bond as soon as the market price hits the call price. You are unlikely to do better than that.
Lenders usually seek to prevent the borrower from taking actions that would damage the value
of their loans. Here are some examples of debt covenants:- The loan agreement may limit the amount of additional borrowing by the company.
- Unsecured loans may incorporate a negative pledge clause, which prohibits the company from
securing additional debt without giving equal treatment to the existing unsecured bonds. - Lenders may place a limit on the company’s dividend payments or repurchases of stock.
Bonds can be issued in the public markets in the U.S., in which case they must be registered
with the SEC. Alternatively if they are issued to a limited number of buyers, they can be privately
placed. They can also be issued in a foreign bond market or in the Eurobond market. Eurobonds are
marketed simultaneously in a number of foreign countries by the London branches of international
banks and security dealers.
Most bonds start and finish their lives as bonds, but convertible bonds give their owner the option
to exchange the bond for common stock. The conversion ratio measures the number of shares into
which each bond can be exchanged. You can think of a convertible bond as equivalent to a straight
bond plus a call option on the stock. Sometimes, instead of issuing a convertible, companies may
decide to issue a package of bonds and options (or warrants) to buy the stock. If the stock price rises
above the exercise price, the investor may then keep the bond and exercise the warrants for cash.
There is an enormous variety of bond issues and new forms of bonds are spawned almost daily. By
a process of natural selection, some of these new instruments become popular and may even replace
existing species. Others are ephemeral curiosities. Some innovations succeed because they widen
investor choice or reduce agency costs. Others owe their origin to tax rules and government regulation.
Many corporations, particularly smaller ones, obtain finance from banks. Bank loans usually
have shorter maturities than bonds. Most bank loans come in the form of commitments. Firms pay
a commitment fee to keep a credit line open that they can draw upon when they need the cash.
Many bank loans are short term at a fixed rate of interest. The interest rate on longer-term bank
loans is usually linked to LIBOR or some other index of interest rates. Often bank loans are pro-
vided by a syndicate of banks if the amount needed is too large to be provided by a single bank.
Loans are frequently secured by collateral such as receivables, inventories, or securities. Covenants
are usually more restrictive than with bonds.
Commercial paper and medium-term notes are a cheaper alternative to bank loans for many
large firms. They can be sold directly to lenders or through dealers. Commercial paper can be
unsecured or asset-backed. Medium-term notes are a hybrid between bonds and commercial paper.
They are longer term than commercial paper but are sold in a similar way.
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