Chapter 21 Notes

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10 Oct 2011

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Chapter 21 Long-Term Debt Notes
21.2 The Public Issue of Bonds
public issue sale of securities to the public
indenture (deed of trust) written agreement between the corporate debt issuer (the borrower) and the lender (trust company),
setting forth maturity date, interest rate, and other terms
the trust company must (1) be sure the terms of the indenture are obeyed; (2) manage the sinking fund; and (3) represent the
bondholders if the company defaults on its payments
the indenture includes—(1) the basic terms of the bonds; (2) a description of property used as security; (3) the seniority of the
bonds; (4) details of the protective covenants; (5) the sinking fund arrangements; and (6) the call provision
Protective Covenants
protective covenant parts of the indenture or loan agreement that limits certain actions a company takes during the term of the
loan to protect the lender’s interest; there are two types: positive and negative covenants
negative covenant part of the indenture or loan agreement that limits or prohibits actions that the company may take
positive covenant part of the indenture or loan agreement that specifies an action that the company must abide by
The Sinking Fund
sinking fund an account managed by the bond trustee for the purpose of repaying the bonds
there are many different kinds of sinking fund arrangements:
omost sinking funds start between 5 and 10 years after the initial issuance
osome sinking funds establish equal payments over the life of the bond
omost high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue; as
a consequence, there is the possibility of a large balloon payment at maturity
sinking funds have two opposing effects on bondholders:
1) Sinking funds provide extra protection to bondholders. A firm experiencing financial difficulties would have trouble
making sinking fund payments. Thus, sinking fund payments provide an early warning system to bondholders.
2) Sinking funds give the firm an attractive option. If bond prices fall below the face value, the firm will satisfy the sinking
fund by buying bonds at the lower market prices. If bond prices rise above the face value, the firm will buy the bonds
back at the lower face value.
The Call Provision
a call provision lets the company repurchase or call the entire bond issue at a predetermined price over a specified period
call premium the price of a call option on common stock
deferred call a provision that prohibits the company from the calling the bond before a certain period; during this period the
bond is said to be call protected; call provisions are not operative during this time
call protected describes a bond that is not allowed to be called, usually for a certain early period in the life of the bond
21.3 Bond Refunding
4 reasons why a firm a company might use a call provision include—(1) superior interest rate predictions; (2) taxes; (3) financial
flexibility for future investment opportunities; and (4) less interest-rate risk
company insiders may know more about interest rate changes on its bonds than does the investing public
thus, a company may prefer the call provision at a particular time because it believes that the expected fall in interest rates (the
probability of a fall multiplied by the amount of the fall) is greater than the bondholders believe
call provisions may have tax advantages if the bondholder is taxed at a lower rate than the company
21.8 Summary and Conclusions
1. The written agreement describing the details of the long-term debt contract is called an indenture. Some of the main provisions
are security, repayment, protective covenants, and call provisions.
2. There are many ways in which shareholders can take advantage of bondholders. Protective covenants are designed to protect
bondholders from management decisions that favour shareholders at bondholders’ expense.
3. Unsecured bonds are called debentures or notes. They are general claims on the company’s value. Most public corporate bonds
are unsecured. In contrast, utility bonds are usually secured. Mortgage bonds are secured by tangible property, and collateral trust
bonds are secured by financial securities such as stocks and bonds. If the company defaults on security bonds, the trustee can
repossess the asset. This makes secured bonds more valuable.
4. Long-term bonds usually provide for repayment of principal before maturity. This is accomplished by a sinking fund. With a
sinking fund, the company retires a certain number of bonds each year. A sinking fund protects bondholders because it reduces
the average maturity of the bond, and its payment signals the financial condition of the company.
5. Most publicly issued bonds are callable. A callable bond is less attractive to bondholders than a non-callable bond. A callable
bond is bought back by the company at a call price that is less than the true value of the bond. As a consequence, callable bonds
are priced to obtain higher stated interest rates for bondholders than non-callable bonds.
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