A bond is a fixed obligation to pay, usually at a stated rate of $1,000 per bond, that is issued by a corporation to investors. It may be a registered bond, under which a company maintains a list of owners of each bond. The company then periodically sends interest payments, as well as the final principal payment, to the investor of record. It may also be a coupon bond, for which the company does not maintain a standard list of bond holders. Instead, each bond contains interest coupons that the bond holders clip and send to the company on the dates when interest payments are due. The coupon bond is more easily transferable between investors, but the ease of transferability makes them more susceptible to loss.
Bonds come in many flavors. Here is a list and short description of the most common ones:
- Collateral trust bond. A bond that uses as collateral a company’s security investments.
- Convertible bond. A bond that can be converted to stock using a predetermined conversion ratio. The presence of conversion rights typically reduces the interest cost of these bonds, since investors assign some value to the conversion privilege. See the “zero coupon convertible bond” for a variation on this approach.
- Debenture. A bond issued with no collateral. A subordinated debenture is one that specifies debt that is senior to it.
- Deferred interest bond. A bond that provides for either reduced or no interest in the beginning years of the bend term, and compensates for it with increased interest later in the bond term. Since this type of bond is associated with firms having short-term cash flow problems, the full-term interest rate can be high.
- Floorless bond. A bond whose terms allow purchasers to convert them to common stock, as well as any accrued interest. The reason for its “death spiral” nickname is that bond holders can convert some shares and sell them on the open market, thereby supposedly driving down the price and allowing them to buy more shares, and so on. If a major bond holder were to convert all holdings to common stock, the result could be a major stock decline, possibly resulting in a change of control to the former bond holder. However, this conversion problem can be controlled to some extent by including conversion terms that only allow bond holders to convert at certain times or with the permission of company management.
- Guaranteed bond. A bond whose payments are guaranteed by another party. Corporate parents will sometimes issues this guarantee for bonds issued by subsidiaries in order to obtain a lower effective interest rate.
- Income bond. A bond that only pays interest if income has been earned. The income can be tied to total corporate earnings, or to specific projects. If the bond terms indicate that interest is cumulative, then interest will accumulate during non-payment periods, and be paid at a later date when income is available for doing so.
- Mortgage bond. A bond offering can also be backed by any real estate owned by the company (called a real property mortgage bond), or by company-owned equipment (called an equipment bond), or by all assets (called a general mortgage bond).
- Serial bond. A bond issuance where a portion of the total number of bonds are paid off each year, resulting in a gradual decline in the total amount of debt outstanding.
- Variable rate bond. A bond whose stated interest rate varies as a percentage of a baseline indicator, such as the prime rate. CFOs should be wary of this bond type, because jumps in the baseline indicator can lead to substantial increases in interest costs.
- Zero coupon bond. A bond with no stated interest rate. Investors purchase these bonds at a considerable discount to their face value in order to earn an effective interest rate.
- Zero coupon convertible bond. A bond that offers no interest rate on its face, but which allows investors to convert to stock if the stock price reaches a level higher than its current price on the open market. The attraction to investors is that, even if the conversion price to stock is marked up to a substantial premium over the current market price of the stock, a high level of volatility in the stock price gives investors some hope of a profitable conversion to equity. The attraction to a company is that the expectation of conversion to stock presents enough value to investors that they require no interest rate on the bond at all, or at least will only purchase the bond at a slight discount from its face value, resulting in a small effective interest rate. A twist on the concept is a contingent conversion clause (or “co-co” clause) that requires the stock price to surpass the designated conversion point by some fixed amount before allowing investors to actually switch to stock, thereby making the conversion even more unlikely. This concept is least useful for company whose stock has a history of varying only slightly from its current price, since investors will then see little chance to convert, and so will place little value on the conversion feature, requiring instead a higher interest rate on the bonds.
There may be a bond indenture document that itemizes all features of the bond issue. It may contain restrictions that the company is imposing on itself, such as limitations on capital expenditures or dividends, in order to make the bond issuance as palatable as possible to investors. If the company does not follow these restrictions, the bonds will be in default.
A bond is generally issued with a fixed interest rate. However, if the rate is excessively low in the current market, then investors will pay less for the face value of the bond, thereby driving up the net interest rate paid by the company. Similarly, if the rate is too high, then investors will pay extra for the bond, thereby driving down the net interest rate paid.
A number of features may be added to a bond in order to make it more attractive for investors. For example, its terms may include a requirement by the company to set up a sinking fund into which it contributes funds periodically, thereby ensuring that there will be enough cash on hand at the termination date of the bond to pay off all bond holders. There may also be a conversion feature that allows a bond holder to turn in his or her bonds in exchange for stock; this feature usually sets the conversion ratio of bonds to stock at a level that will keep an investor from making the conversion until the stock price has changed from its level at the time of bond issuance, in order to avoid watering down the ownership percentages of existing shareholders. In rare instances, bonds may be backed by personal guarantees or by a corporate parent.
There are also features that bond holders may be less pleased about. For example, it may contain a call feature that allows the company to buy back bonds at a set price within certain future time frames. This feature may limit the amount of money that a bond holder would otherwise be able to earn by holding the bond. The company may also impose a staggered buyback feature, under which it can buy back some fixed proportion of all bonds at regular intervals. When this feature is activated, investors will be paid back much sooner than the stated payback date listed on the bond, thereby requiring them to find a new home for their cash, possibly at a time when interest rates are much lower than what they would otherwise have earned by retaining the bond. The bond holder may also be positioned last among all creditors for repayment in the event of a liquidation (called a subordinated debenture), which allows the company to use its assets as collateral for other forms of debt; however, it may have to pay a higher interest rate to investors in order to offset their perceived higher degree of risk. The typical bond offering will contain a mix of these features that impact investors from both a positive and negative perspective, depending upon its perceived level of difficulty in attracting investors, its expected future cash flows, and its need to reserve assets as collateral for other types of debt.
Bonds are highly recommended for those organizations large enough to attract a group of investors willing to purchase them, since the bonds can be structured to precisely fit a company’s financing needs. Bonds are also issued directly to investors, so there are no financial intermediaries, such as banks, to whom transactional fees must be paid. Also, a company can issue long-maturity bonds at times of low interest rates, thereby locking in modest financing costs for a longer period than would normally be possible with other forms of financing. Consequently, bonds can be one of the lowest-cost forms of financing.