© 2000 John Petroff
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© 2000 John Petroff |
Essentially, a bond is a debt instrument with stated interest and maturity. Actually, there is a great variety of bonds, not only because interest, maturity and company risk vary, but also because bonds contain different types of safety features and sweeteners. Even for one given company, the bonds it has issued, most certainly have different provisions. This is true for the simple reason that if a firm issued a bond, it made certain promises that it cannot usually duplicate in another bond (with the exception of the case when it refunds one bond by another).
Just as preferred shares, bonds
are temporary funds. Bonds can be used in cases where preferred
stock is also a choice. In many respects, bonds are very similar
to preferred stock (fixed income, retirement, convertibility),
except for one important right of the bondholder. That is: the
bondholder can put the company in default as soon as a payment
is late. This is the financial risk which took up a large part
of the previous chapter, and which makes preferred stock more
desirable if cash flows are not assured. The rates of return on
bonds and preferred stock are also close, but for the corporation
the deductibility of interest for tax purpose is at the heart
of financial leverage. And that make bonds superior to preferred
stock whenever cash flows can be expected to be sufficiently stable.
That is most often the case when the projects to be financed are
in the cost saving, equipment replacement and modest sales expansion
category.
When compared to other forms of borrowing,
bonds are the cheapest and most flexible form of long term financing.
To float a bond, an investment banker would normally be used by
a corporation, but bonds do not require SEC registration, there
is much less of a problem with timing of the issue as in the case
of stocks, and placing the bonds with institutional investors
avoids much of the administrative work involved in common stock
subscription. The bottom line is that the commission charged by
an investment banker is usually less than half of one percent,
which is many times less than the commission on stock issues.
Bond financing is more flexible because the corporation can tailor
the provisions of the bond indenture to its needs, as outlined
below. Whereas when debt financing is contracted with a bank,
the borrower has to comply with all the bank's demand.
See review questions Q-12D.1 through Q-12D.4.
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