Chapter 10

10

Bonds

C H A P T E R

Chapter Objectives

• Understand how issuing bonds creates a fixed-cost solution to raising funds.

• Describe what types of bonds are available and how they are secured.

• Understand how a company repays bondholders.

• Understand the dynamics of using government-issued bonds to finance sports facilities.

• Describe capital structuring through various examples.

Bonds

• A bond is an obligation that needs to be repaid with interest, similar to a loan from a bank.

• They are typically issued by larger corporations or government entities with a good repayment history and are sought after by investors because of either favorable interest rates or tax benefits.

• Bonds have the financing characteristics of loans as well as a market in which they can be bought and sold, like stocks.

Corporate Bonds

• A bond is similar to a long-term loan; it is a contract under which a borrower agrees to make specified interest and principal payments on specified dates for a specified time period.

• There are many types of bonds:– Convertible bonds, warrant bonds, income bonds,

indexed bonds, zero coupon bonds (or discount bonds), junk bonds

(continued)

Corporate Bonds (continued)

• Bond Financing– Advantages

• Interest on bonds is tax deductible (versus stock dividends, which are not deductible).

• Bond financing can be reasonably inexpensive for an established company with a good credit rating.

• There is a strong, established market for trading and issuing bonds.

(continued)

Corporate Bonds (continued)• Bond Financing

– Disadvantages• Interest is a fixed charge that needs to be paid regardless of

whether income was or was not earned.

• The principal loaned amount must be paid in full when the bond matures.

• Issuing bonds can harm a company’s credit rating and make it more difficult for the company to borrow money in the future.

• If the bond is secured by collateral, a corporation might not be able to sell or otherwise dispose of the asset without bondholder approval.

• Bondholders have the upper hand whenever a company declares bankruptcy.

(continued)

Corporate Bonds (continued)

• Secured Bonds– If an asset is secured, the corporation does not have

exclusive use of the asset and might need to obtain approval before using the asset for various activities.

– A secured bondholder receives preferential treatment.

• Unsecured Bonds

– These bonds provide the greatest flexibility for the issuing corporation but minimal protection for the bond purchaser.

(continued)

Corporate Bonds (continued)• Debentures

– These are unsecured bonds.– Only companies with the best credit rating can issue

debentures.– Subordinate debentures: Assets are pledged to back

them; claims on these assets are subordinate to senior claims against the assets.

• Bearer Bonds– Bondholder retains possession of the bond document.– Bonds typically have coupons attached to them that the

bondholder can redeem at the bank on a semiannual basis to receive the specified interest payment.

(continued)

Corporate Bonds (continued)• Issue Size and Maturity

– The primary concern associated with bonds is determining the appropriate interest rate to attach to the bonds and determining how many bonds should be issued.

– Moody’s Investors Service and Standard & Poor’s rate bonds.• Examine the bond issuer and determine the potential for default

based on various factors such as revenue stream to repay the bonds, current economic conditions, interest rates, and past repayment history

– Bonds with high ratings have the lowest risk for default and do not need to pay as high an interest rate.

– Bonds that have a low rating are sometimes classified as junk bonds and need to pay a much higher interest rate to attract investors.

(continued)

Corporate Bonds (continued)• Issue Size and Maturity

– Demand for long-term funds arises from four major sources: 1. Mortgage borrowing

2. Corporate bond financing

3. State and local government bond financing

4. Long-term U.S. Treasury borrowing

– Suppliers for long-term funds include the following:• Life insurance companies• Savings and loan associations• Mutual savings banks• Insurance companies (fire, property, and casualty)• Corporate pension funds• State and local government retirement funds• Mutual funds that purchase bonds

Costs of Issuing Bonds• Primary cost associated with issuing bonds is

the required interest payments.– Payments are due on a semiannual basis for as long as

the bond is outstanding. • For example, a 20-year $100 million bond issued with 10%

interest would require semiannual payments of $5 million for 20 years.

• There is a discount or risk premium at which bonds are sold.– For example, if a discount for a $100 million bond issue

is $5 million, the issuing or selling entity for the bonds would take $5 million (5%) as a fee to process and help sell the bonds.

Loan Repayment• Bond repayment occurs when the bond

matures and the issuer repays all remaining obligations.

• Repayment can occur via the following:

– Sinking funds

– Serial bonds

– Bond redemption before maturity

– Convertible bonds(continued)

Loan Repayment (continued)

• Sinking Funds– These are the most common technique for repaying a

note.– Money is set aside, either in preset amounts or on a

variable basis.

• Serial Bonds– The bonds are issued with maturity dates at

predetermined redemption dates.– They are often issued by states and municipalities that

have fairly reliable tax revenue.(continued)

Loan Repayment (continued)• Bond Redemption Before Maturity

– Corporations may issue newer bonds with more favorable interest rates and use the proceeds to buy older bonds on the open market.

• Bonds often have a call provision to allow the corporation to repurchase the bonds at a moderate premium if interest rates drastically change.

– If a bond is not callable, a company can purchase a bond on the open market or from a bondholder who is willing to exchange it voluntarily.

(continued)

Loan Repayment (continued)

• Convertible Bonds– These bonds can be converted to common stock.– They are designed to redeem themselves and retire the

debt through converting the debt to equity ownership.– Buyers often prefer convertible bonds because investors

can obtain interest payments on their investment but can also choose to switch to the equity ownership option if the corporation starts to experience significant growth.

– Buyers also prefer convertibles because they still retain the position of a secured creditor but also have an option to purchase stock.

(continued)

Loan Repayment (continued)

• Convertible Bonds– Companies can benefit in the following ways:

• Conversion usually occurs at a share price that is higher than it would have been if the shares had been purchased earlier.

• A corporation can lower its debt obligation by exchanging that obligation for shares that are valued significantly less on the corporate books.

Government-Issued Bonds

• Bonds represent the most likely funding source for publicly financed projects such as stadiums and arenas.

• The primary types of government bonds are:

– General obligation bonds

– Revenue bonds

(continued)

Government-Issued Bonds (continued)• General Obligation Bonds

– They are often called full faith and credit obligations.• The city, county, municipality, state, or other government unit

pledges to repay the obligation with existing tax revenues or by levying new taxes.

– Strength of the tax base is one of the most important criteria for GOBs.

• Small city vs. a large city

• Revenue Bonds– The tax revenue to support repayment may come from the

project itself.• For example, an entrance tax per ticket to a sporting event could

be charged, and all revenues from this tax would first be allocated to repaying the revenue bond.

(continued)

Government-Issued Bonds (continued)• Repayment Sources

– Utility taxes– Ticket surcharges– Real estate taxes– Specific sales taxes– Tourist development taxes– Restaurant sales taxes– Excise or sin taxes– Lottery and gaming revenue– Nontax fees such as permits– General sales and use taxes

(continued)

Government-Issued Bonds (continued)• Contractually Obligated Revenues

– This refers to any contract whereby a party agrees to pay a specific sum for a guaranteed number of years.

– This approach has two primary functions:1. Used as a source of revenue to guarantee repayment of

bonds or other loans2. Utilized as an independent funding source

(continued)

Government-Issued Bonds (continued)

• Contractually Obligated Revenues– Here are typical long-term contracts that form the basis of

COR:• Premium seat contracts• Luxury box contracts• Concession and novelty rights contracts• Naming rights contracts• Pouring rights (beer and soft drink) contracts• Personal seat licenses• Parking rights contracts

(continued)

Government-Issued Bonds (continued)

• Industrial Development Bonds– These are mainly used for small businesses.– Government units in each state have the authority,

through sport authorities, economic development commissions, and similar divisions, to offer small-issue IDBs.

– A business owner can raise up to $10 million using IDBs, carrying an interest rate ranging from one-half to three-quarters of the prime interest rate, with a 30-year maturity.

– They are tax free.

Potential Capitalization Problems

• Overcapitalization

– The company raises too much money and does not have the financial means to pay everything off.

• Issuing too much bond-backed capital most serious form.

• Undercapitalization

– The business issues too few shares or bonds in relation to the expected earnings.

– If most of the funds for growth come from internal sources such as retained earnings, the business may have a hard time raising funds externally.

Questions for Class Discussion1. Should the general population pay the debt service for bonds

issued to pay for a stadium or arena that is used primarily by a privately owned professional team? Debate the topic, citing all the pros and cons associated with the question. What innovative ideas could be used to help repay the bonds?

2. What is the value of bonds versus stocks?

3. What happens when a company defaults on paying a bond?

4. Is a bond a safer investment for an investor than other investing options such as stocks?

(continued)

Questions for Class Discussion (continued)

5. Should companies be allowed to sell junk bonds?

6. Besides the various backings for bonds highlighted in this chapter, what other resources can be tapped to help repay government-backed bonds to build stadiums and arenas?

7. What do you think the biggest problems are with under- and overcapitalization?