Trustee
Atrusteeis a third party to a bond indenture. The trustee can be an individual,
a corporation, or (most often) a commercial bank trust department. The trustee
is paid to act as a “watchdog” on behalf of the bondholders and can take spec-
ified actions on behalf of the bondholders if the terms of the indenture are
violated.Cost of Bonds to the Issuer
The cost of bond financing is generally greater than the issuer would have to pay
for short-term borrowing. The major factors that affect the cost, which is the rate
of interest paid by the bond issuer, are the bond’s maturity, the size of the offer-
ing, the issuer’s risk, and the basic cost of money.Impact of Bond Maturity on Bond Cost
Generally, as we noted earlier, long-term debt pays higher interest rates than
short-term debt. In a practical sense, the longer the maturity of a bond, the less
accuracy there is in predicting future interest rates, and therefore the greater the
bondholders’ risk of giving up an opportunity to lend money at a higher rate.
In addition, the longer the term, the greater the chance that the issuer might
default.Impact of Offering Size on Bond Cost
The size of the bond offering also affects the interest cost of borrowing, but in an
inverse manner: Bond flotation and administration costs per dollar borrowed are
likely to decrease with increasing offering size. On the other hand, the risk to the
bondholders may increase, because larger offerings result in greater risk of default.Impact of Issuer’s Risk
The greater the issuer’s default risk,the higher the interest rate. Some of this risk
can be reduced through inclusion of appropriate restrictive provisions in the
bond indenture. Clearly, bondholders must be compensated with higher returns
for taking greater risk. Frequently, bond buyers rely on bond ratings (discussed
later) to determine the issuer’s overall risk.Impact of the Cost of Money
The cost of money in the capital market is the basis for determining a bond’s
coupon interest rate. Generally, the rate on U.S. Treasury securities of equal
maturity is used as the lowest-risk cost of money. To that basic rate is added a
risk premium(as described earlier in this chapter) that reflects the factors men-
tioned above (maturity, offering size, and issuer’s risk).CHAPTER 6 Interest Rates and Bond Valuation 275trustee
A paid individual, corporation, or
commercial bank trust depart-
ment that acts as the third party
to a bond indenture and can take
specified actions on behalf of the
bondholders if the terms of the
indenture are violated.