Interest Rates and Bond Valuation Chapter 6 6. 2 More on Bond Features Securities issued by corporations are classified as equity securities and debt securities. A debt in very simple terms represents something that must be paid as a result of borrowing money, when corporations borrow money they make regular interest payments as well as paying the principal amount at the end of the period. There are three main differences between debt and equity, which are: Debt is not ownership; creditors don’t have any say in the firm’s decisions.
Interest is taxable, but dividends are not tax deductible. Unpaid debt is a liability on the firm; if the firm goes bankrupt creditors can legally claim assets of the firm. Debt can result to financial failure, but this is not the case when equity is issued. Is it Debt or Equity? Sometimes it is unclear if what the firm is offering is a debt or equity security. The main purpose behind doing this is so that firms offer debts that are actually equity securities so that they can obtain tax benefits from debts and the bankruptcy benefits of equity.
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Debt holders are usually paid before equity holders. The rewards for owning a debt is fixed according to the loan’s amount, but there is no limit to the available rewards that can be gained from owning equity, the higher the profit the bigger the interest amount. Long-term Debt: The Basics Even though there is no universally agreed ???upon period of distinction for debt securities but they can be classified in two categories which are short term securities which last for one year or less they are also referred to as unfunded debt, long term securities duration must be over a year.
Long-term debt securities are commonly referred to as bonds, whether they are secured or unsecured. They are also in forms of public issues are privately placed debt. The Indenture The indenture is a written agreement between the corporation and its creditors, it states the terms of the debt issue and it is also known as a deed of trust, it includes: The Basic Terms of the Bond: corporate bonds are either in registered form or bearer firm, the difference is that the first form records the bonds details and ownership.
The Total Amount of Bonds Issued A Description of Property used as Security: Securities are classified according to the collateral & mortgages used to protect the bondholder. A debenture is an unsecured bond, with a maturity of 10 years or more, but a note has the same concept but the maturity is under 10 years. Seniority indicates preference in position over other lenders and debts are sometimes labeled as juniors or seniors to indicate seniority. The Repayment Agreements: bonds can be repaid at maturity or early repayment can be managed through a sinking fund managed by the bond trustee.
Details of the Protective Covenants: is part of the in denture which limits a firm from taking certain actions during the term of the loan to protect the lender. These come in two forms, which are positive & negative covenants. 6. 3 Bond Ratings Bond Ratings are created from information supplied by the corporation. The two leading bond rating companies are Moody’s and Standard and Poor’s (S) the highest ratings that a firm can get is AAA or Aaa, this means they have the best quality and lowest degree of default risk and the lowest rating being a D. 6. 4 Some Different Types of Bonds Government Bonds When the U.
S. government wants to borrows money from the public it issues Treasury Notes and Bonds, this occurs every month. These bonds have no default risk because the treasury can always come up with money to repay their debts. These bonds are also exempt from income tax but not federal income tax so they are only taxed at one level. Municipal notes and bonds are also issued by local governments but these have a degree of risk like corporations and pay state income tax. In some cases municipal bonds are not taxed at all and that is why it is very appealing to the high income, high-tax bracket investors.
Zero Coupon Bonds Can also be called Zeroes, they are bonds that make no coupon payments and they are initially priced at a lower level than they are worth. Under the old rules these bonds were more attractive to corporations since the deduction for interest expense were larger unlike how it is now with the straight line expense. Floating-Rate Bonds These bonds are also known as Floaters, these bonds’ coupon payments are adjustable according to the interest rate index which is set by the 30 year Treasury bond rate. In most cases these adjustments occur when a lag occurs to some base rate.
There are also inflation-linked bonds, which as the name states are adjusted according to the inflation rate and this can affect the principal amount as well. Other Types of Bonds These are bonds with unusual features such as; income bonds, convertible bonds and put bonds. When buying bonds there are two prices, there is the Clean Price, which is the quoted price meaning that the accrued interest is deducted. However the price that is actually paid by the buyer is the Dirty Price, this is the price of the bond including accrued interest, this is the “full” or “invoice” price.