Long Term Debt

A bond is any long term (ten years or more) promissory note issued by the firm. In examining bonds we will first acquaint ourselves with bond terminology and features, then examine types of bonds (both secured and unsecured), methods of retiring debt, bond refunding, and advantages and disadvantages of financing with long term debt.

The par value of a bond is the face value appearing on it that is returned to the bondholder at maturity. In general, most corporate bonds are issued in denomina¬tions of $1000, although there are some exceptions to this rule. When bond prices are quoted by financial managers, or in the financial press, prices are generally expressed as a percentage of the bond's par value. For example, a Detroit Edison bond that pays $90 per year interest, and matures in 1999, was recently quoted in the Wall St. journal as selling for 573/4. That does not mean that you can buy the bond for $57 75. It does mean that this bond is selling for 573/4 percent of its par value, which happens to be $1000. Hence, the market price of this bond is actually $577.50, and, at maturity in 1999, the bondholder will receive the $1000.

The coupon interest rate on a bond indicates what percentage of the par value of the bond will be paid out annually in the form of interest. Thus, regardless of what happens to the price of a bond with an 8 percent coupon interest rate and a $1000 par value, it will pay out $80 annually in interest until maturity.

The maturity of a bond indicates the length of time until the bond issuer returns the par value to the bondholder and terminates the bond.

An indenture is the legal agreement between the firm issuing the bonds and the bond trustee who represents the bondholders. The indenture provides the specificterms of the loan agreement, including a description of the bonds, the rights of the bondholders, the rights of the issuing firm, and the responsibilities of the trustees. This legal document may run 100 pages or more in length, with the majority of it devoted to defining protective provisions for the bondholder. The bond trustee, usually a banking institution or trust company, is then assigned the task of overseeing the relationship between the bondholder and the issuing firm, protecting the bondholder, and seeing that the terms of the indenture are carried out.

Typically, the restrictive provisions included in the indenture attempt to protect the bondholder's position relative to that of other outstanding securities. Common provisions involve (1) prohibitions on the sale of accounts receivable, (2) constraints on the issuance of common stock dividends, (3) restrictions on the purchase or sale of fixed assets, and (4) constraints on additional borrowing. Prohibitions on the sale of accounts receivable result because such sales would benefit the firm's short run liquidity position at the expense of its future liquidity position. Constraints on the issuance of common stock dividends generally take the form of limiting them when working capital falls below a specified level, or simply limiting the maximum dividend payout to 50 or 60 percent of earnings under any circumstance. Fixed asset restrictions generally require lender permission before the liquidation of any fixed asset or prohibit the use of any existing fixed asset as collateral on new loans. Constraints on additional borrowing are usually in the form of restrictions or limitations on the amount and type of additional long term debt that can be issued. All these restrictions have one thing in common: They attempt to prohibit action that would improve the status of other securities at the expense of bonds and to protect the status of bonds from being weakened by any managerial action.