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Published by Ahmad_Koujan_4509

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Published by: Ahmad_Koujan_4509 on Jan 16, 2010
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Chapter 16
Bonds are long term debt instruments. Generally, thecreditworthiness of the company issuing a bond is all that stands between theinvestor and the loss of their investment. Bond rating agencies provideinformation on issuer creditworthiness and this information bears on howmuch interest an issuer will have to pay to attract investors. Unlike venturecapitalists or equity investors who may have one or more seats on acompany's board of directors or a bank which has extensive covenants andon-going reporting requirements that they use to manage risk, bondholdershave very limited control once they make an investment. In addition, bondsgenerally have limited upside potential if a company prospers, butbondholders can lose everything if a company collapses and since bonds tieup invested capital for years or even decades it is easy to see why bonds havea unique risk
reward profile.This chapter discusses the general features of bonds and themotivation that a company has to sell bonds or an investor to buy them. Thiswill include a discussion of bond ratings and other ways that buyers evaluaterisk as well as how bonds can be made more attractive by adding features thatreduce risk or increase the potential reward for investors. Junk bonds andhow they differ from ordinary corporate bonds will be discussed as well asbond valuation, premiums and discounts, bond underwriting, the secondarymarket in bonds and legal considerations when using bonds.
Raising Capital
Bonds are means for a company to raise capital without giving upequity. This feature alone makes them a highly attractive source of capital.But there are other benefits as well. Interest on bonds is tax deductible, whichmeans that the tax code subsidizes the cost of interest.' Bonds are usually ameans of permanent, that is, long term financing. Ten, twenty or thirty yearbonds are not uncommon. Contrast this to banks which rarely extend termloans beyond five to seven years. Bonds are subject to less ongoingmonitoring than bank loans. Whereas bank covenants monitored monthly cantrigger acceleration of a loan, generally bond indenture agreements providelittle pre-maturity relief as long as the debt is being properly serviced. Properservice means that interest and sinking fund payments are being made timely.
sinking fund is a fund into which a company makes regular payments sothat when the bond matures there will be enough money set aside to repaybondholders. Not all bond indenture agreements require sinking funds.Bonds pay interest twice a year. The amount of the interest paymentis equal half the coupon rate times the face value of the bond to reflect thefact that half the interest is paid every six months. Unlike bank interest rateswhich generally float up and down as the prime rate or LIBOR (LondonInterbank Offer Rate) change, bond interest rates remain fixed over the life ofthe bond. For companies with good credit, bonds generally have lowerinterest rates than bank loans. For companies with marginal credit, high yieldbonds, also as junk bonds, may provide an alternative to banks afraid to lendbut interest is likely to be higher than bank rates.
When a person buys a corporate bond, he or she can only look to thecorporation for payment. The higher the risk that investors perceive in anyparticular investment, the greater the reward he or she will demand tocompensate for that risk. Here we run into the problem of asymmetricinformation. Bond issuers know more about their company and itscreditworthiness than bond buyers. To be "safe" bond buyers assume a worstcase risk scenario and set the required reward to match that estimated level ofrisk. The strategy from the issuers' perspective is to provide purchasers witha realistic assessment of the risk so that buyers do not indulge their naturaltendency to overstate it. One way to provide accurate risk information is tohave bonds rated by independent agencies.
Bond rating agencies include Moody's Investor Service, Standard andPoors, Fitch Investors Service and others, all of which evaluate the creditworthiness of companies throughout a bond's life. Each agency has slightlydifferent rating criteria. Figure 16.1 provides Bond Rating Definitions forMoody's Investor Service. The rating of individual company bonds can befound for Moody's and Fitch's at their respective websites:www.moodys.com and www.fitchratings.com.Figure 16-1 Bond Rating Definitions for Moody's Investor service2
Bonds and preferred stock which are rated Aaa are judged tobe of the best quality. They carry the smallest degree of investment risk andare generally referred to as "gilt edged." Interest payments are protected by alarge or by an exceptionally stable margin and principal is secure. While thevarious protective elements are likely to change, such changes as can bevisualized are most unlikely to impair the fundamentally strong position ofsuch issues.
Bonds and preferred stock which are rated Aa are judged tobe of high quality by all standards. Together with the Aaa group theycomprise what are generally known as high-grade bonds. They are ratedlower than the best bonds because margins of protection may not be as largeas in Aaa securities or fluctuation of protective elements may be of greateramplitude or there may be other elements present which make the long-termrisk appear somewhat larger than the Aaa securities.
Bonds and preferred stock which are rated A possess manyfavorable investment attributes and are to be considered as upper-medium-grade obligations. Factors giving security to principal and interest areconsidered adequate, but elements may be present which suggest asusceptibility to impairment some time in the future.
Bonds and preferred stock which are rated Baa areconsidered as medium-grade obligations (i.e., they are neither highlyprotected nor poorly secured). Interest payments and principal security appearadequate for the present but certain protective elements may be lacking ormay be characteristically unreliable over any great length of time. Suchbonds lack outstanding investment characteristics and in fact have speculativecharacteristics as well.

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