In addition to specifying a payment schedule, the bond indenture, which is the contract between the issuer and the bondholder, also specifies a set of restrictions that protect the rights of the bondholders. Such restrictions include provisions relating to collateral, sinking funds, dividend policy, and further borrowing. The issuing firm agrees to these so-called protective covenants in order to market its bonds to investors concerned about the safety of the bond issue.
Sinking funds Bonds call for the payment of par value at the end of the bond’s life. This payment constitutes a large cash commitment for the issuer. To help ensure that the commitment does not create a cash flow crisis, the firm may agree to establish a sinking fundto spread the payment burden over several years. The fund may operate in one of two ways:
1. The firm may repurchase a fraction of the outstanding bonds in the open market each year.
2. The firm may purchase a fraction of outstanding bonds at a special call price associated
Sinking funds Bonds call for the payment of par value at the end of the bond’s life. This payment constitutes a large cash commitment for the issuer. To help ensure that the commitment does not create a cash flow crisis, the firm may agree to establish a sinking fundto spread the payment burden over several years. The fund may operate in one of two ways:
1. The firm may repurchase a fraction of the outstanding bonds in the open market each year.
2. The firm may purchase a fraction of outstanding bonds at a special call price associated
with the sinking fund provision. The firm has an option to purchase the bonds at either
the market price or the sinking fund price, whichever is lower. To allocate the burden of
the sinking fund call fairly among bondholders, the bonds chosen for the call are selectedat random based on serial number.
the market price or the sinking fund price, whichever is lower. To allocate the burden of
the sinking fund call fairly among bondholders, the bonds chosen for the call are selectedat random based on serial number.
The sinking fund call differs from a conventional call provision in two important ways. First, the firm can repurchase only a limited fraction of the bond issue at the sinking fund call price. At best, some indentures allow firms to use a doubling option, which allows repurchase ofdouble the required number of bonds at the sinking fund call price. Second, while callable
bonds generally have call prices above par value, the sinking fund call price usually is set at the bond’s par value.
Although sinking funds ostensibly protect bondholders by making principal repayment more likely, they can hurt the investor. The firm will choose to buy back discount bonds (selling below par) at their market price, while exercising its option to buy back premium bonds (selling above par) at par. Therefore, if interest rates fall and bond prices rise, a firm will benefit from the sinking fund provision that enables it to repurchase its bonds at belowmarket prices. In these circumstances, the firm’s gain is the bondholder’s loss.
One bond issue that does not require a sinking fund is a serial bond issue in which the firm sells bonds with staggered maturity dates. As bonds mature sequentially, the principal repayment burden for the firm is spread over time just as it is with a sinking fund. Serial bonds do not include call provisions. Unlike sinking fund bonds, serial bonds do not confront security holders with the risk that a particular bond may be called for the sinking fund. The disadvantage of serial bonds, however, is that the bonds of each maturity date are different bonds, which reduces the liquidity of the issue. Trading these bonds, therefore, is more expensive.
Subordination of further debt One of the factors determining bond safety is the total outstanding debt of the issuer. If you bought a bond today, you would be understandably distressed to see the firm tripling its outstanding debt tomorrow. Your bond would be riskier than it appeared when you bought it. To prevent firms from harming bondholders in this manner, subordination clauses restrict the amount of their additional borrowing. Additional debt might be required to be subordinated in priority to existing debt; that is, in the event of bankruptcy, subordinated or junior debtholders will not be paid unless and until the prior senior debt is fully paid off.
Dividend restrictions Covenants also limit the dividends firms may pay. These limitations protect the bondholders because they force the firm to retain assets rather than pay them out to stockholders. A typical restriction disallows payments of dividends if cumulative dividends paid since the firm’s inception exceed cumulative retained earnings plus proceeds from sales of stock.
Collateral Some bonds are issued with specific collateral behind them. Collateral is a particular asset that the bondholders receive if the firm defaults. If the collateral is property, the bond is called a mortgage bond. If the collateral takes the form of other securities held by the firm, the bond is a collateral trust bond. In the case of equipment, the bond is known as an equipment obligation bond. This last form of collateral is used most commonly by firms such as railroads, where the equipment is fairly standard and can be easily sold to another firm should the firm default.
One bond issue that does not require a sinking fund is a serial bond issue in which the firm sells bonds with staggered maturity dates. As bonds mature sequentially, the principal repayment burden for the firm is spread over time just as it is with a sinking fund. Serial bonds do not include call provisions. Unlike sinking fund bonds, serial bonds do not confront security holders with the risk that a particular bond may be called for the sinking fund. The disadvantage of serial bonds, however, is that the bonds of each maturity date are different bonds, which reduces the liquidity of the issue. Trading these bonds, therefore, is more expensive.
Subordination of further debt One of the factors determining bond safety is the total outstanding debt of the issuer. If you bought a bond today, you would be understandably distressed to see the firm tripling its outstanding debt tomorrow. Your bond would be riskier than it appeared when you bought it. To prevent firms from harming bondholders in this manner, subordination clauses restrict the amount of their additional borrowing. Additional debt might be required to be subordinated in priority to existing debt; that is, in the event of bankruptcy, subordinated or junior debtholders will not be paid unless and until the prior senior debt is fully paid off.
Dividend restrictions Covenants also limit the dividends firms may pay. These limitations protect the bondholders because they force the firm to retain assets rather than pay them out to stockholders. A typical restriction disallows payments of dividends if cumulative dividends paid since the firm’s inception exceed cumulative retained earnings plus proceeds from sales of stock.
Collateral Some bonds are issued with specific collateral behind them. Collateral is a particular asset that the bondholders receive if the firm defaults. If the collateral is property, the bond is called a mortgage bond. If the collateral takes the form of other securities held by the firm, the bond is a collateral trust bond. In the case of equipment, the bond is known as an equipment obligation bond. This last form of collateral is used most commonly by firms such as railroads, where the equipment is fairly standard and can be easily sold to another firm should the firm default.
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