FINE2005 Financial Management

Lecture 2b
Bonds I

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 Reference

Essentials of Corporate Finance: Ross, Westerfield and Jordan.

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 Overview
• Bond Features
• Types of Bonds

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 Bond Features
• Bonds are debt securities. A debt represents something that must be
repaid: it is the result of borrowing money.
• Debtholder generally do not have voting power.
• Unpaid debt is a liability of the firm. If it is not paid, the creditors can
legally claim the assets of the firm.

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 Cash Flows Associated with a Bond

Maturity
0 1 2 3 t
Coupon Coupon Coupon Coupon
+
Face Value

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 Cash Flows Associated with a Bond
Coupon
- Stated interest payment made on a bond.
Face Value/Par Value
- The principal amount of a bond that is repaid at the end of the term.
Coupon rate
- The annual coupon divided by the face value of the bond.

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 Cash Flows Associated with a Bond
Maturity
- Date on which the principal amount of a bond is paid.

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 Bond Features
• A bond indenture is a contract between the corporation (borrower) and its
creditors (bondholders) that includes
- The basic terms of the bonds.
- The total amount of bonds issued.
- A description of asset used as security, if applicable.
- The repayment arrangements.
- Call provisions.
- Details of protective covenants.

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 Bond Features
• Bonds can be classified as registered or bearer form.

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 Bond Security
• Debt securities are classified according to the collateral and mortgages used
to protect the bondholders.
- Collateral is commonly used to refer to any asset pledged on a debt.
• Some bonds are secured by collateral (e.g. mortgage bonds)
• A debenture is an unsecured debt usually with a maturity of 10 years or
more.
• A note is an unsecured debt usually with a maturity of under 10 years.

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 Bond Security
• Debt securities can also be classified in terms of seniority (senior vs.
junior).

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 Repayment
• Bonds can be repaid
- At maturity.
- In part or in entirely before maturity.
• A sinking fund is an account managed by the bond trustee for early
bond redemption.

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 Repayment
• A call provision is an agreement giving the corporation the option to
repurchase a bond at a specified price (call price) prior to maturity.
• A call premium is the amount by which the call price exceeds the face/
par value of a bond.

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 Protective Covenants
• A protective covenant is that part of the indenture that limits certain
actions a company might otherwise wish to take during the term of the
loan.
• A negative covenant limits/prohibits actions the company might take.
Examples are
- the firms cannot sell any major assets without lenders’ approval.
- the firms cannot issue additional long-term debt.

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 Protective Covenants
• A positive covenant specifies an action the company agrees to take.
Example
- The firm must maintain any collateral in good condition.

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 Types of Bonds
• Government Bonds
- Debt securities issued by government.
- Treasury Bonds, Treasury Bills, Exchange Fund Notes
• Corporate Bonds
- Debt securities issued by corporation.

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 Types of Bonds
• Zero Coupon Bonds
- A bond that makes no coupon payments and is initially priced at a deep
discount
• Floating rate bonds
- Coupon rate floats depending on some index value.

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 Types of Bonds
• Convertible bonds
- A convertible bond can be swapped for a fixed number of shares of stock
anytime before maturity at the holder’s option.

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