Characteristics of Corporate Bonds

At one time bonds were sold with attached ______that the owner of the bond clipped and mailed to the firm to receive interest payments. These were called _______because payments were made to whoever had physical possession of the bonds. __________did not care for this method of payment, however, because it made tracking interest income difficult. Bearer bonds have now been largely replaced by_________, which do not have coupons. Instead, the owner must register with the firm to receive________. The firms are required to report the name of the person who receives interest income. Despite the fact that bearer bonds with attached coupons have been phased out, the interest paid on bonds is still called the __________ and the interest rate on bonds is the coupon interest rate.

A corporation's financial managers are hired, fired, and compensated at the direction of the board of directors, which represents_________. This arrangement implies that the managers will be more interested in protecting stockholders than they are in protecting bondholders. You should recognize this as an example of the__________. Managers may not use the funds provided by the bonds as the bondholders might prefer. Since _________cannot look to managers for protection when the firm_________, they must include rules and restrictions on managers designed to protect the bondholders' interests. These are known as__________. They usually limit the amount of dividends the firm can pay and the ability of the firm to issue additional debt. Other financial policies, such as the firm's involvement in________, may also be restricted. Restrictive covenants are included in________. Typically, the interest rate will be lower the more restrictions are placed on management through restrictive covenants because the bonds will be considered safer by investors.

5. Read the text. Explain the following word combinations. Summarize the text in 50 words.

• a call provision

• the call price

• the sinking fund

• covenants

• to retire a bond issue

• callable bonds

Call provisions

Most corporate indentures include a call provision, which states that the issuer has the right to force the holder to sell the bond back. The call provision usually requires a waiting period between the time the bond is initially issued and the time when it can be called. The price bondholders are paid for the bond is usually set at the bond's par price or slightly higher (usually by one year's interest cost). For example, a 10% coupon rate $1000 bond may have a call price of $1100.

If interest rates fall, the price of the bond will rise. If rates fall enough, the price will rise above the call price, and the firm will call the bond. Because call provisions put a limit on the amount that bondholders can earn from the appreciation of a bond's price, investors do not like call provisions.

A second reason that issuers of bonds include call provisions is to make it possible for them to buy back their bonds according to the terms of the sinking fund. A sinking fund is a requirement in the bond indenture that the firm pay off a portion of the bond issue each year. This provision is attractive to bondholders because it reduces the probability of default when the issue matures. Because a sinking fund provision makes the issue more attractive, the firm can reduce the bond's interest rate.

A third reason firms usually issue only callable bonds is that firms may have to retire a bond issue if the covenants of the issue restrict the firm from some activity that it feels is in the best interest of stockholders. Suppose that a firm needed to borrow additional funds to expand its storage facilities. If the firm's bonds carried a restriction against adding debt, the firm would have to retire its existing bonds before issuing new bonds or taking out a loan to build the new warehouse.

Finally, a firm may choose to call bonds if it wishes to alter its capital structure. A maturing firm with excess cash flow may wish to reduce its debt load if few attractive investment opportunities are available.

Because bondholders do not generally like call provisions, callable bonds must have a higher yield than comparable non callable bonds. Despite the higher cost, firms still typically issue callable bonds because of the flexibility this feature provides the firm.

5. Match the responses on the right with the questions on the left.

1.	So what exactly are bonds?	a.	Because of changes in interest rates. For example, no-one will pay the full price for a 6% bond if new bonds are paying 10%.
2.	And how do they work?	b.	Exactly. And the opposite, a bond whose market value is higher than its face value, is above par.
3.	So you have to keep them for a long time?	c.	I knew you'd finish by saying that!
4.	Why should that happen?	d.	No, not at all. Bonds are very liquid. They can be sold on the secondary market until they mature. But of course, the price might have changed.
5.	Oh, I see. Is that what they mean by below par?	e.	No, not unless it's a floating rate bond. The coupon, the amount of interest a bond pays, remains the same. But the yield will change.
6.	But the bond's interest rate doesn't change?	f.	No, those are short-term (three-month) instruments which the government sells to and buys from the commercial banks, to regulate the money supply.
7.	How's that?	g.	That's the name they use in Britain for long-term government bonds — gilts or gilt-edged securities. In the States they call them Treasury Bonds.
8.	And people talk about AAA and AAB bonds, and things like that	h.	They're securities issued by companies, governments and financial institutions when they need to borrow money.
9.	And what about gilts?	i.	Well, a bond's yield is its coupon payment expressed as a percentage of its price on the secondary market, so the yield changes if you buy or sell above or below par.
10.	Not Treasury Bills?	j.	Well, they usually pay a fixed rate of interest and are repaid after a fixed period, known as their maturity, for example five, seven, or ten years.
11.	And James Bond	k.	Yes. Bond-issuing companies are given an investment grade by private ratings companies such as Standard & Poors, according to their financial situation and performance.

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5. Work in pairs. Discuss advantages and disadvantages of different types of bonds. Make up your own dialogues using the following words and word combinations.

Repayment terms, to exempt from federal taxation, coupons, bearer, the bond indenture, unsecured bonds, speculative-grade bonds, corporate bonds, collateral, par value, market rate, the book entry method, mortgage bond, covenant, callable.

5. Complete the following.

1. Companies generally use investment banks to …..their bonds.

2. Thereafter, they can be traded on the market.

3. The amount of interest a bond pays is often called its

4. The majority of bonds have a rate of interest.

5. A bond's depends on the price it was bought at.

6. A bond priced at 104% is described as being

7. Bonds are repaid at 100% at

8. AAA is the highest

5. Answer the questions. Look at the text to help you.

1. Which is the safest for an investor?

A a corporate bond В a junk bond С a government bond

2. Which is the cheapest way for a company to raise money?

A a bank loan В an ordinary bond С a convertible bond

3. Which gives the highest potential return to an investor?

А a corporate bond B a junk bond С a government bond

4. Which is the most profitable for an investor if interest rates rise?

A a Treasury bond В a floating rate note С Treasury note

5. Translate into English.