A bond is a long-term debt, or liability, owed by its issuer. Physical evidence of the debt lies in a negotiable bond certificate. In contrast to long-term notes, which usually mature in 10 years or less, bond maturities often run for 20 years or more.
Generally, a bond issue consists of a large number of $1,000 bonds rather than one large bond. For example, a company seeking to borrow $100,000 would issue one hundred $1,000 bonds rather than one $100,000 bond. This practice enables investors with less cash to invest to purchase some of the bonds.
Bonds derive their value primarily from two promises made by the borrower to the lender or bondholder. The borrower promises to pay (1) the face value or principal amount of the bond on a specific maturity date in the future and (2) periodic interest at a specified rate on face value at stated dates, usually semiannually, until the maturity date.
Large companies often have numerous long-term notes and bond issues outstanding at any one time. The various issues generally have different stated interest rates and mature at different points in the future. Companies present this information in the footnotes to their financial statements. Promissory notes, debenture bonds, and foreign bonds are shown with their amounts, maturity dates, and interest rates.
A bond differs from a share of stock in several ways:
•A bond is a debt or liability of the issuer, while a share of stock is a unit of ownership.
•A bond has a maturity date when it must be paid. A share of stock does not mature; stock remains outstanding indefinitely unless the company decides to retire it.
•Most bonds require stated periodic interest payments by the company. In contrast, dividends to stockholders are payable only when declared; even preferred dividends need not be paid in a particular period if the board of directors so decides.
•Bond interest is deductible by the issuer in computing both net income and taxable income, while dividends are not deductible in either computation.
A company seeking to borrow millions of dollars generally is not able to borrow from a single lender. By selling (issuing) bonds to the public, the company secures the necessary funds.
Usually companies sell their bond issues through an investment company or a banker called an underwriter. The underwriter performs many tasks for the bond issuer, such as advertising, selling, and delivering the bonds to the purchasers. Often the underwriter guarantees the issuer a fixed price for the bonds, expecting to earn a profit by selling the bonds for more than the fixed price.
When a company sells bonds to the public, many purchasers buy the bonds. Rather than deal with each purchaser individually, the issuing company appoints a trustee to represent the bondholders. The trustee usually is a bank or trust company. The main duty of the trustee is to see that the borrower fulfills the provisions of the bond indenture. A bond indenture is the contract or loan agreement under which the bonds are issued. The indenture deals with matters such as the interest rate, maturity date and maturity amount, possible restrictions on dividends, repayment plans, and other provisions relating to the debt. An issuing company that does not adhere to the bond indenture provisions is in default. Then, the trustee takes action to force the issuer to comply with the indenture.
Bonds may differ in some respects; they may be secured or unsecured bonds, registered or unregistered (bearer) bonds, and term or serial bonds. We discuss these differences next but first watch this video about the different bond types.
Certain bond features are matters of legal necessity, such as how a company pays interest and transfers ownership. Such features usually do not affect the issue price of the bonds. Other features, such as convertibility into common stock, are sweeteners designed to make the bonds more attractive to potential purchasers. These sweeteners may increase the issue price of a bond.
Several advantages come from raising cash by issuing bonds rather than stock. First, the current stockholders do not have to dilute or surrender their control of the company when funds are obtained by borrowing rather than issuing more shares of stock. Second, it may be less expensive to issue debt rather than additional stock because the interest payments made to bondholders are tax deductible while dividends are not. Finally, probably the most important reason to issue bonds is that the use of debt may increase the earnings of stockholders through favorable financial leverage.
A company has favorable financial leverage when it uses borrowed funds to increase earnings per share (EPS) of common stock. An increase in EPS usually results from earning a higher rate of return than the rate of interest paid for the borrowed money. For example, suppose a company borrowed money at 10 per cent and earned a 15 per cent rate of return. The 5 per cent difference increases earnings.
Several disadvantages accompany the use of debt financing. First, the borrower has a fixed interest payment that must be met each period to avoid default. Second, use of debt also reduces a company’s ability to withstand a major loss. A third disadvantage of debt financing is that it also causes a company to experience unfavorable financial leverage when income from operations falls below a certain level. Unfavorable financial leverage results when the cost of borrowed funds exceeds the revenue they generate; it is the reverse of favorable financial leverage. The fourth disadvantage of issuing debt is that loan agreements often require maintaining a certain amount of working capital (Current assets – Current liabilities) and place limitations on dividends and additional borrowings.
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