Notes

In this chapter we will discuss how companies raise money from investors by issuing debt securities in the bond markets. The bond markets are where companies go to sell debt securities and where investors go to purchase and trade debt securities. The debt securities purchased and traded in the bond markets are generically referred to as "bonds" by the press and investors. The companies issuing debt securities in the bond markets, however, almost always refer to these securities as "notes" in their financial statements.

Once again, we focus on the liabilities and equity side of the balance sheet. In the previous chapters, we discussed the Stockholders' equity. Today we will focus on the bonds included in the long-term debt.

Firms need financial resources to carry on their operating and investing activities. When they lack internal resources, they look for debt. In this case, firms can ask financial resources to banks (loans) or they may issue debt securities that are traded in the bond market. If bank loans represent a private type of debt financing characterized by a close relation between the firm and the bank, bonds represent a public type of debt financing. Like firms' shares, bonds are traded in the market and the possibility for investors to sell firms' bonds increases their willingness to finance the firm.

From the point of view of investors, bonds differ with respect to equity because are safer. The issuance of bonds implies the payment of interests on a regular basis and the repayment of the principal at the end. Instead, in the case of equity financing, owners have the right to receive dividends, but the payment of dividends is not scheduled (as in the case of bonds). Moreover, equity holders are residual claimants. Thus, they will be paid after all the others are paid.

From the point of view of the firm, a company can prefer to issue bonds rather than equity for several reasons:

• Existing owners keep their control over the firm, avoidance of control dilution that takes place when I issue new shares.
• The presence of debt can discipline managers and avoid that they act at detriment of shareholders.
• The presence of debt gives a tax benefit to shareholders. Indeed, the presence of interest expenses decreases the pre-tax income and, hence, the taxes that the company would pay. As a result, shareholders may obtain a greater return from their investment in the firm.

At the same time, a company can prefer to issue equity rather than bonds because:

• Bonds increase the bankruptcy risk of the firm, higher level of distress.
• They imply the periodical payment of interests that reduces the financial resources available to the firm to make new investments.

Bonds' Characteristics Bonds are obligations that the firm owes to creditors. The obligation is twofold:

• Regular payment of interests at a given date and at a given rate.
• Payment of the principal (usually at the end of the contract).

Thus, at the moment of the issuance, the firm receives financial resources in exchange for the regular payment of interests and the repayment of the principal at the end.

The important elements that we should consider are:

• Maturity Date, date at which the firm has to pay back the principal (or face value).
• Face Value, Par Value or Principal, amount that the firm has to pay back at the maturity date.
• Coupon Rate, rate to determine the interest that the firm should pay. The coupon rate is applied to the principal amount. (Interest Payment = Coupon Rate x Principal Value).
• Frequency of Interest Payment.

Such information are determined at the moment of the issuance by the company and are reported in the bond certificate, also called Bond Prospectus. However, the price that bondholders are willing to pay for the bond is determined in the market and, hence, it can differ from the par value.

In order to determine if the company is a good investment, the investor will compare the Coupon Rate included in the Bond Prospectus with the interest rate of another company with similar characteristics, which is the Effective Market Rate.

The Price of the Bond is the amount of cash that the company will receive from the Bond Issuance. The price is equal to the Present Value of all the future obligations. This means the value today of all the future interest payments + value today of the payment of the principal amount. To obtain the value today of these obligations I have to apply a discount.

The discounted amount will be equal to (interest payment)/(1 + effective market rate)^n. This is the value today of an interest payment at time t+n. While the value today of the payment of the principal amount is (Principal Amount)/(1 + effective market rate)^n where n is the years range in which occur the maturity date (e.g. 10 years, n = 10).

Therefore Price = Discounted Amount (Interest Payments) + Discounted Amount (Payment of the Principal Amount).

In particular, the price is determined on the basis of the present value of interest expenses and principal amount. In order to determine the present value, bondholders will use a discount rate that it is equal to the return that bondholders expect to get from a firm with similar characteristics.

If the bondholders believe that the return from the investment in the firm is equal to the coupon rate, then, the price will be equal to the principal amount.

If bondholders believe that the return from the investment in the firm is higher than the coupon rate, then, the price will be lower than the principal amount and the bond is issued at the discount. Hence, the firm will receive less financial resources than it will pay at the end. Bondholders provide less financial resources because they believe that the coupon rate offered by the firm is lower than the return that the market will offer for a similar firm. Thus, we can identify three cases:

• Bond issued at Par Value (Effective Market Rate = Coupon Rate), then Amount received at the bond issuance is equal to Face Value.
• Bond issued at the Discount (Effective Market Rate > Coupon Rate), then Amount received at the bond issuance is lower than Face Value.
• Bond issued at a Premium (Effective Market Rate < Coupon Rate), then Amount received at the bond issuance is higher than Face Value.

Note that in all the 3 cases, the return earned is the effective interest rate that determined the price paid by the firm.

Types of Bonds

• Secured Bonds, the bond is secured by the issuer's pledge of a specific asset, which is a form of collateral on the loan. In the event of the default, the title of the asset passes from the bond issuer (that is, the firm) to the bondholders. (Higher Price)
• Callable Bonds, the callable bond is a bond that can be redeemed by the issuer prior to its maturity. (Higher Price)
• Convertible Bonds, the bond gives the owner the option to convert bonds into equity, therefore, to become a shareholder. (Not clear the effect).