Corporations and Corporate Bonds
Bonds can also be used to finance a corporation's ongoing business activities. In addition, corporations often sell bonds when it is difficult or impossible to sell stock. The sale of bonds can also improve a corporation's financial leverage-the use of bon-owed funds to increase the corporation's retum on investment. Finally, the interest paid to bond owners is a tax-deductible expense and thus can be used to reduce the taxes the corporation must pay to the federal and state governments.
While a corporation may use both bonds and stocks to finance its activities, there are important distinctions between the two. Corporate bonds are a form of debt financing, whereas stock is a form of equity financing. Bond owners must be repaid at a future date; stockholders do not have to be repaid. Interest payments on bonds are required: dividends are paid to stockholders at the discretion of the board of director. Finally, in the event of bankruptcy. bondholders have a claim to the assets of the corporation prior to that of stockholders.
Before issuing bonds, a corporation must decide what type of bond to issue and hm the bond issue will be repaid.
Types of Bonds
Most corporate bonds are debentures. A debenture is a bond that is backed only by the reputation of the issuing corporation. If the corporation fails to make either intere-payments or repayment at maturity. debenture bondholders become general creditors_ much like the firm's suppliers. In the event of corporate bankruptcy. general creditors. including debenture bondholders. can claim any asset not specifically used as collatera.: for a loan or other financial obligation.
To make a bond issue more appealing to conservative investors. a corporation ma. issue a mortgage bond. A mortgage bond (sometimes refened to as a secured bond) a corporate bond secured by various assets of the issuing firm. A first mortgage bon may be backed by a lien on a specific asset. usually real estate. A corporation can al issue bonds that are backed by stocks and other bonds that it owns and. in some caseeven its operating equipment. A general mortgage bond is secured by all the fixe assets of the firm that are not pledged as collateral for other financial obligations A secured bond is safer than a debenture because corporate assets or collateral may be sold to repay the bondholders if the corporation defaults on interest or repaymenBecause of this added security. interest rates on mortgage bonds are usually lower thar interest rates on debentures.
A third type of bond a corporation may issue is called a subordinated debenture. A subordinated debenture is an unsecured bond that gives bondholders a claim secondary to that of other designated bondholders with respect to interest paymenb repayment. and assets. Investors who purchase subordinated debentures usually enjoy higher interest rates than other bondholders because of the increased risk associate with this type of bond.
A special type of bond a corporation may issue is a convertible bond. A convertibl bond can be exchanged. at the owner's option. for a specified number of shares of th corporation's common stock. This conversion feature allows investors to enjoy t& lower lisk of a corporate bond but also take advantage of the speculative nature of common stock. For example. Westinghouse Electric Corporation's $1.000 bond issue wit: a 2007 maturity date is convertible. Each bond can be converted to 64.5 shares of the company's common stock. This means you could convert the bond to common stoe. whenever the price of the company's common stock is $15.50 ($1,000 / 64.5 == $15.50) or higher.
In reality, there is no guarantee that Westinghouse bondholders will convert to common stock even if the market val ue of the common stock does increase to $15.50 0higher. The reason for choosing not to exercise the conversion feature in this example is quite simple. As the market value of the common stock increases, the market value of the convertible bond also increases. By not converting to common stock, bondholders enjoy the added safety of the bond and interest income in addition to the increased market value of the bond caused by the price movement of the common stock.
The corporation gains three advantages by issuing convertible bonds. First, the interest rate on a convertible bond is often 1 to 2 percent lower than that on tradition a] bonds. Second, the conversion feature attracts investors who are interested in the speculative gain that conversion to common stock may provide. Third, if the bondholder converts to common stock, the corporation no longer has to redeem the bond at maturity.
Convertible bonds, like all potentia] investments, must be carefully evaluated.
Remember, not all convertible bonds are quality investments.