The Foundation
5.2 Bond Characteristics and Features
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6 What is the basic DCF valuation model and its three key inputs?
7 What are the three steps in the DCF valuation process?
8 How do the cash flows differ between bonds and common stock?
9 What are the three major components of the required rate of return?
I = c(M) (5.3) where I is the coupon (annual cash interest payment); c is the coupon interest rate per year as a percentage; and M is the maturity or par value of the bond.
The coupon interest rate, also called the nominal yield, is the contractual rate of interest based on a bond’s par value. Calculating the coupon interest rate involves dividing the annual coupon (I) by the maturity or par value of the bond (M).
Example 5.2 Annual Interest Rate on a Bond
Assume that a bond has an 8 percent coupon rate and a par value of $1,000. What is the annual interest payment?
Solution: Substituting c = 0.08 and M = $1,000 into Equation 5.3, the annual cash interest payment is:
I = 0.08($1,000) = $80
Many bonds issued outside of the US pay interest payments on an annual basis. These bonds are annual-pay bonds. In contrast, most corporate bonds in the US pay interest semi- annually and are semiannual-pay bonds. If the bond in Example 5.2 were a semiannual-pay bond, the interest payments would be $40 every 6 months.
Bonds often differ based on the kinds of coupons they carry. Two common bonds with different coupon rate structures are zero-coupon bonds and floating-rate bonds.
Zero coupon bonds
A zero coupon bond or zero is a bond that pays all of the cash payments, both interest and principal, at maturity. Because these bonds do not carry coupons, they sell at a substantial discount from their par values and provide capital appreciation rather than interest income.
Zeros typically appreciate to their par values at maturity. Thus, the difference between the discounted initial price and the bond’s par value represents the implied interest earned by the bondholder.
Floating rate bonds
A floating rate bond is a bond that pays a variable rate of interest. Several factors influence the coupon rate including the type, maturity, and quality of the bond. The coupon rates on floating-rate securities are reset periodically, typically every 6 or 12 months, depending on interest rate conditions in the market. The coupon setting process typically starts with a reference rate, such as the rate on specific US Treasury securities or the London interbank offered rate (LIBOR). An additional amount, called quoted margin, is then added to or subtracted from the reference rate, as shown in Equation 5.4:
New coupon rate = Reference rate ± quoted margin (5.4)
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Example 5.3 New Coupon Rate
Suppose a corporation issues a floating rate bond that requires resetting the interest rate every 6 months. The reference rate is the 3-month LIBOR and the quoted margin is 125 basis points. If the current 3-month LIBOR is 5 percent, what is the relevant coupon rate for the next interest payment period?
Solution: Inserting the LIBOR = 5 percent and the quoted margin of 1.25 percent into Equation 5.4 gives a new coupon rate of 6.25 percent.
New coupon rate = 5.00% + 1.25% = 6.25%
Because the coupon rate for floating rate bonds may result in extreme fluctuations, issuers often place an upper and lower limit to reduce their potential exposure. The upper limit or cap is the maximum interest that the borrower pays, while the lower limit or floor is the minimum interest that the lender receives. When a floating rate bond has both limits simul- taneously, this feature is called a collar.
Maturity
Term to maturity or simply maturity of a bond is the length of time until the agreement expires. At maturity, the bondholder receives the last coupon interest payment and the bond’s par value payment from the issuer. On most bond issues, the maturity of all bonds occurs on the same date. With serial bonds, the maturity dates are staggered over time to avoid one very large repayment on a single date from the issuer.
Various provisions in the bond contract, called embedded options, may affect paying all or part of the principal before maturity. Common embedded options include call provisions, sinking fund provisions, conversion rights, and put provisions. The first two embedded options favor the issuer, while the latter two favor the bondholders.
Call provisions
A call provision gives the issuer the right to buy back or “call” all or a part of a bond issue before maturity (under specified terms). Most corporate bonds are callable. With a call feature, the issuer may decide to retire bonds to take advantage of lower interest rates, to get rid of restrictive indenture provisions, or to reduce indebtedness. Because a call pro- vision is beneficial to the issuer, the issuer usually has to offer investors some enticements to sell such a bond. These enticements include a higher-than-normal coupon rate, a provision not to call the bond until after a specified period (called a deferred call provision), and a call premium. A call premium is an additional amount that the issuer agrees to pay above the bond’s par value to repurchase the bond. The price at which the issuer may call a bond (par plus any call premium) is termed the call price.
Sinking fund provisions
A sinking fund provision permits the issuer to retire a bond through a series of predefined principal payments over the life of the issue. Sinking fund requirements often do not apply
during the early years of a bond issue. Some bonds carry an accelerated sinking fund provision, which allows the issuer to retire a larger proportion of the issue at par, at its discretion. The issuer can satisfy the sinking fund requirement in one of two ways – cash or delivery. The company can either deposit sufficient cash with the trustee, who redeems the bonds generally by a lottery, or buy the required number of bonds in the open market and deliver them to the trustee. In some instances, the trustee buys the bonds in the market.
The company uses the least expensive method. For example, if current interest rates are above the bond’s coupon rate, the current market price of the bond will be less than its par value. That is, the bond will sell at a discount. Thus, the firm should buy the bonds on the open market to meet its sinking fund requirement.
Conversion rights
Conversion rights give the bondholder the right to convert the bond into a specified number of shares of common stock at a predetermined fixed price. Such bonds, called convertible bonds, typically have a lower coupon rate than non-convertible debt because they offer the bondholder a chance for capital gains in exchange for lower coupon payments. This option benefits the bondholder if the equivalent value of the common shares from conversion is greater than the value of the bond. Almost all convertible bonds are callable.
Put provisions
Some bonds have a put provision, which gives the bondholder the right to sell the bond back to the issuer at the put price on certain dates before maturity. The put price is a price at or near par. If interest rates increase, causing the bond price to fall below par, the bond- holder may sell the bond back to the issuer at a higher price.
Other Features of Bonds
Other important features of bonds include the indenture, trustee, collateral, and bond rating.
Indenture
An indenture is a legal document between the issuer and the bondholders detailing the terms and conditions of the debt issue. The purpose of this agreement is to address all matters pertaining to the bond. In the United States, the company must register the inden- ture of publicly issued bonds with the Securities and Exchange Commission (SEC) under the provisions of the Trust Indenture Act of 1939.
An indenture generally contains protective covenants, which limit certain actions that the company might be taking during the term of the agreement. Two types of protective covenants are negative covenants and positive covenants. Negative covenants limit or pro- hibit the borrower from taking certain actions such as paying too much dividends, pledging assets to other lenders, selling major assets, merging with another firm, and adding more long-term debt. Positive or affirmative covenants are actions that the borrower promises to perform such as maintaining certain ratios, keeping collateral in good condition, and making timely payments of interest and principal. Failing to adhere to these covenants could place the bond issuer in default.
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Trustee
The issuer must appoint a trustee for each bond issue of substantial size. A trustee is the bondholders’ agent, typically a bank, in a public debt offering. The issuer appoints the trustee before selling the bonds to represent the bondholders in all matters concerning the bond issue. This is necessary because some bond issues have many bondholders. The trustee monitors the issuer to ensure that it complies with all terms of the indenture. If the borrower violates the terms, the trustee initiates action against the issuer and represents the bondholders in this action.
Collateral
Corporations can issue bonds as secured or unsecured debt. Secured debt is a debt backed by the pledge of assets as collateral. These assets are typically in the form of real property such as land and buildings (mortgage bonds) or financial assets such as stocks and bonds (collateral trust bonds). Unsecured debt, also called a debenture, represents bonds raised without any collateral. In the case of unsecured debt, the bondholders have a claim on the assets that the issuer has not pledged to other securities. With a subordinated debenture, the claims against a firm’s assets are junior to those of secured debt and regular debentures.
Bond rating
A bond rating is an assessment of the creditworthiness of the issuer. Major rating services include Standard & Poor’s Corporation (S&P), Moody’s Investors Service, Inc. (Moody’s), and Fitch. The purpose of bond ratings is to help investors assess default risk, which is the possibility that the issuer will fail to meet its obligations as specified in the indenture. Bond ratings range from AAA (S&P) or Aaa (Moody’s), the highest or prime grade, to D, debt in default. Investment-grade securities have a rating of at least BBB by S&P or Baa by Moody’s, while the remaining represent noninvestment grade securities, commonly referred to as junk bonds. An inverse relationship generally exists between the rating and quality of a bond and its interest rate or yield to maturity. That is, high-quality (high-rated) bonds have lower yields than low-quality (low-rated) bonds.
Concept Check 5.2
1 Why may the market price of a bond not equal its par value?
2 How do zero coupon bonds differ from floating rate bonds?
3 What types of embedded options favor the issuer and which ones favor bond- holders? Why?
4 What is the purpose of an indenture?
5 What are protective covenants? What are examples of negative covenants and positive covenants?
6 What is the priority of claims on the assets of the issuer for secured debt, deben- tures, and subordinated debentures?
7 What does a bond rating say about the potential default risk of a bond?
6 For a discussion of bond valuation using Treasury spot rates, see Frank J. Fabozzi, Fixed Income Analysis for the Chartered Financial Analyst® Program, Frank J. Fabozzi Associates, 2000.