Bond Financing

Bonds are actually loans that people, like you and me, make to companies. In exchange for the loan money, companies issue bonds. The terms of the loan are set out in a written agreement called the bond indenture. This stipulates the interest rate that will be paid to bondholders and when the principal will be repaid. It also designates a trustee, who is responsible for seeing that the terms of the agreement are met.

Illustration: A $1,000 bond may guarantee to pay 10 percent interest (often referred to as a 10 percent coupon rate) annually over 10 years. The interest is paid at specific times, usually every six months. At the end of the 10-year period (the maturity date) the company repays the investor the original $1,000 (the principal).

Although your firm may decide to issue bonds on its own, it’s more likely that management will use an outside investment banker to underwrite the bond offering. Like stock offerings, the selling or issuing of bonds is heavily regulated by the Securities and Exchange Commission, which requires a company to meet a number of legal requirements. Thus, it’s often much easier for a company to turn the “floating” of bonds over to a professional investment banker, especially if it’s the first time your firm is going into the bond market.

An investment banker buys the company’s bond issue and then resells it to the public; it absorbs the loss if there are any bonds that it cannot resell. For its services, the investment banker receives a fee. Keep in mind that bond interest is paid from pretax dollars, and that bondholders are creditors of your firm.

There are all sorts of bonds, but here are a few of the more common types:
● Mortgage bonds. As the name indicates, the company pledges as collateral specific fixed assets, such as a building. Generally, the asset is of greater value than the value of the bonds issued. This ensures that, in case of a bond default, the investors have sufficient financial protection through resale of the asset.
● Collateral trust bonds. In this variation of mortgage bonds, the assets used as collateral are stocks and bonds of other companies in which your firm holds an interest.
● Equipment trust certificates. This type of financing is favored by railroads and airlines to make major equipment purchases. The company sells the certificates to investors, and the proceeds are used to pay for the equipment, such as railroad cars or airplanes. The trustee takes title to the equipment. The railroad or airline then pays the periodic interest and the principal to the investors over a period of time, say 15 years. When all the certificates are finally paid off, title passes from the trustee to the airline or railroad.
● Debentures. These are, in effect, unsecured bonds. As an issuing company, you simply promise to pay interest on the debenture and repay it in the same way you would a bond, except that you don’t pledge any assets. Because there isn’t any collateral, investors assume a greater risk and require a higher interest rate than they would on a secured bond.

In another variation, your company may want to add a bit of incentive to investors by making your bonds and debentures convertible. This means the purchaser of your convertible bonds or debentures has the option of exchanging them for a specified number of shares of your common stock. The attraction here is that the price of your stock may increase, so it pays the investor to convert to stock. If this occurs, your company no longer has to pay interest or the principal.

Your company may employ other factors that are attractive to the prospective bondholder, as well as your company. For example, the company may develop a sinking fund, which means the firm sets aside specified amounts to provide for the gradual retirement (repurchase) of part of the bond issue. This provides added protection for bondholders because reducing the amount of outstanding bonds lessens the risk of a default.

A company can also include a call feature for greater financing flexibility. This simply means that the company reserves the right to buy back the bond at a specified date before the bond falls due. The call price is greater than the principal amount and generally decreases as the bond approaches its maturity date. Companies can exercise the call feature, for example, when market interest rates drop, allowing the firm to repay the bondholder and then refinance at a lower interest rate. Although the call feature is attractive for the company, it’s not an advantage for the bondholder because he or she is giving up the higher interest payments of the bond. As a partial remedy, bonds with call features typically carry a higher interest rate.