Understanding Long-Term Debt and Bond Indentures

Repayment:

Long-term debt is typically repaid in regular amounts over the life of the debt. The payment of long-term debt by installments is called amortization (usually arranged by a sinking fund. Each year the corporation places money into a sinking fund, and the money is used to buy back the bonds).

Seniority:

Indicates preference in position over other lenders. Some debt is subordinated. In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first.

Security:

It’s a form of attachment to property. It provides that the property can be sold in the event of default to satisfy the debt for which the security is given. A mortgage is used for security in tangible property. Debentures are not secured by a mortgage.

Bond Indenture:

Contract between the company and the bondholders that includes:

• The basic terms of the bonds
• The total amount of bonds issued
• A description of property used as security, if applicable
• Sinking fund provisions
• Call provisions
• Details of protective covenants

Bond Classifications:

• Registered vs. Bearer Forms
• Security
  • Collateral – secured by financial securities
  • Mortgage – secured by real property, normally land or buildings
  • Debentures – unsecured
  • Notes – unsecured debt with original maturity less than 10 years
• Seniority

Required Yields:

The coupon rate depends on the risk characteristics of the bond when issued.

Zero Coupon Bonds:

• Make no periodic interest payments (coupon rate = 0%)
• The entire yield to maturity comes from the difference between the purchase price and the par value
• Cannot sell for more than par value
• Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs)
• Treasury Bills and principal-only Treasury strips are good examples of zeroes

Floating Rate Bonds:

Coupon rate floats depending on some index value. Ex: adjustable rate mortgages and inflation-linked Treasuries. There is less price risk with floating rate bonds (The coupon floats, so it is less likely to differ substantially from the yield to maturity). Coupons may have a “collar” – the rate cannot go above a specified “ceiling” or below a specified “floor”.

1. Pure discount bonds
2. Floating rate bonds: Coupon rate floats depending on some index value. Ex: adjustable rate mortgages and inflation-linked Treasuries. There is less price risk with floating rate bonds (The coupon floats, so it is less likely to differ substantially from the yield to maturity). Coupons may have a “collar” – the rate cannot go above a specified “ceiling” or below a specified “floor”.

1. Other bond types:
   • Income bonds
   • Convertible bonds
   • Put bonds

There are many other types of provisions that can be added to a bond, and many bonds have several provisions – it is important to recognize how these provisions affect required returns.