TYPES OF BONDS
We've been examining corporate bonds issued by commercial entities to raise debt funding. Let's look at some additional features of corporate bonds as well as some of the other entities that issue bonds.
Objectives of this lesson are:
- Learn about some alternative forms of bonds: callable, convertible, and zero-coupon bonds.
- Understand the different entities that issue bonds and the risk associated with each.
TYPES OF BONDS
Corporate bonds may have a call provision that allows the bond to be called, or, repurchased, before maturity. Such a bond is callable. To compensate the bond owners for their lost interest payments, the bonds will need to be purchased at a premium—that is, above par value. The bondholders may have been expecting to collect interest payments for several more years. The premium will make that loss less painful.
Callable bonds allow corporations to refinance their debt at lower interest rates. Suppose a company issued callable bonds with a 6% coupon and a 20-year maturity. After 8 years, interest rates have dropped to 3%. The company can halve its interest payments by calling those bonds and reissuing new ones with a 3% coupon. It's just like refinancing a mortgage on your house.
Our hypothetical investor, Uche, is a little worried that you'll think he's been misleading you when he says that some bonds don't actually come with regular interest payments. Zero-coupon bonds are sold at a discount, that is, below par value. The purchaser is compensated by receiving the full par value when the bond matures instead of interest payments along the way. For example, investor Uche purchases a zero-coupon bond from a company with a five-year maturity and a par value of $1,000. He bought the bond for $750.After five years, the company pays Uche $1,000 for a profit of $250.
Like some preferred shares, some bonds are convertible into a set number of common shares. Owning a convertible bond would allow Uche to transition from creditor to investor should it advance his investing goals. Converting a debt instrument to an equity instrument changes Uche from a creditor to an owner.
If the bond were about to mature and the price of the several stocks exceed the face value of the bond, Uche should convert to stock. Uche can then sell the stocks and make more than he'd have gotten from receiving the par value of the bond. Or, he can hold the stocks if he thinks they'll appreciate.
A company might issue convertible bonds when it wants equity funding but without an immediate decline in its share price. Issuing a huge amount of shares at once will dilute the value of each individual share. Convertible bonds delay this dilution until the bondholders make the switch.
Advantage of convertible bond
The greatest advantage of convertible bonds from a company's standpoint is the savings on interest payments. Because the conversion option is valuable to investors, a company can issue convertible bonds with lower coupons than non-convertible bonds. Essentially investors are paying for the conversion option by accepting lower interest payments. Let's review the key terms.
|Callable bond||Can be repurchased before maturity|
|Convertible bond||Can be traded in for common stock
|Zero-coupon bond||Issued below par with no interest payments|
|Premium||Price paid above par value|
|Discount||Price paid below par value|
So much for bond features. Let's turn now to the other big bond issuers: governments. Government bonds are known by different names depending on their maturities:
- Bills mature in less than one year.
- Notes mature in one to ten years.
- Bonds mature in more than ten years.
Debt securities issued by the Nigerian government are known as treasuries (Treasury bills or T-bills). Treasuries are considered some of the safest of all investments, and their interest rates are often quoted as the risk-free rate. Despite possible shutdowns making headlines every few years, the Nigerian government has always made its interest payments. State and local governments can also issue bonds, called municipal bonds, or, munis. However, cities have been known to go bankrupt, making munis a higher risk investment than treasuries.
Corporations are more likely to default on payments than governments (well, stable governments at any rate). Therefore, corporate bonds are higher risk investments than government bonds. Because of the higher risk, corporate bonds must offer higher coupons to compensate their investors. Never forget the risk-reward relationship. The riskier the investment, the more reward that's demanded.
When an investor (Uche) says that corporate bonds are riskier than government bonds, he is referring specifically to credit risk—the chance the bond issuer fails to make its payments. If the issuer of Uche's bond starts to have cash flow issues, the bond will decrease in value.
A drop in a bond's market value due to increased credit risk isn't necessarily a problem if Uche is holding the bond to maturity. Rather, it's the potential loss in interest payments and principal repayment at maturity that worries him. What would you do if you held a bond with a credit risk that suddenly increased? It's either you hold out and hope the issuer rebounds or cut your losses and sell it at a discount.
To help investors understand credit risk, several agencies rate bonds. The highest-rated bonds (those with the lowest credit risk) are Aaa or AAA, depending on the agency. Bonds rated Baa/BBB or higher are investment grade. Most ratings can be further divided. For example, Moody's Aa can be subcategorized as Aa1, Aa2, and Aa3, whereas Fitch's and Standard & Poor's AA can be divided as AA+, AA, and AA-.
All other things being equal, which would have a higher coupon, a AAA bond or a BBB bond? Of cause it's BBB bond. Classic risk-reward. No one would take on additional risk without an additional enticement such as a higher coupon payment.
The lowest-rated bonds—those with the highest credit risk—carry a rating of C or D. Bonds on the bottom end of the scale (below Baa or BBB) are called junk bonds also known as speculative grade or high-yield bonds.
A drop of a single rating from Baa or BBB moves a bond from investment grade to junk status, which will significantly reduce the number of willing lenders, forcing the demanded yields up significantly. A company will have to offer a significant reward to encourage bond investors to purchase a junk bond.
Let's reward ourselves with a second round of key term review!
|Bills||Government-issued debt securities that mature in less than one year|
|Notes||Government-issued debt securities that mature in between one and ten years|
|Bonds (in the context of bills and notes)||Government-issued debt securities that mature in more than ten years|
|Treasuries||Debt securities issued by the Nigerian government|
|Junk bonds||Debt securities with very high credit risk|
|investment-grade bonds||Debt securities with relatively low credit risk|
You've got all the basics down. It's time to change perspective and see how all this looks to a company's accounting team.