Legal Aspects of Corporate Bonds

-

  Legal Aspects of Corporate Bonds:

Certain legal arrangements are required to protect purchasers of bonds. Bondholders are protected primarily through the indenture and the trustee.

  • Bond Indenture: 

A bond indenture is a legal document that specifies both the rights of the bondholder's and the duties of the issuing corporation. Included in the indenture are descriptions of the amount and timing of all interest and principal payments, various standard and restrictive provisions, and, frequently, sinking-fund requirements and security interest provisions.

  • Standard Provisions:

The standard debt provisions in the bond indenture specify certain record-keeping and general business practices that the bond issuer must follow. Standard debt provisions do not normally place a burden on a financially sound business. 

The borrower commonly must: 

(1) maintain satisfactory accounting records in accordance with generally accepted accounting principles (GAAP) 

(2) periodically supply audited financial statements

(3) pay taxes and other liabilities when due 

(4) maintain all facilities in good working order. 

  • Restrictive Provisions:

Bond indentures also normally include certain restrictive covenants, which place operating and financial constraints on the borrower. These provisions help protect the bondholder against increases in borrower risk. Without them, the borrower could increase the firm’s risk but not have to pay increased interest to compensate for the increased risk.

The most common restrictive covenants do the following: 

1. Require a minimum level of liquidity, to ensure against loan default. 

2. Prohibit the sale of accounts receivable to generate cash, Selling receivables could cause a long-run cash shortage if proceeds were used to meet current obligations. 

3. Impose fixed-asset restrictions: The borrower must maintain a specified level of fixed assets to guarantee its ability to repay the bonds. 

4. Constrain subsequent borrowing:  Additional long-term debt may be prohibited, or additional borrowing may be subordinated to the original loan. Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied. 

5. Limit the firm’s annual cash dividend payments to a specified percentage or amount.

Other restrictive covenants are sometimes included in bond indentures. 

The violation of any standard or restrictive provision by the borrower gives the bondholders the right to demand immediate repayment of the debt. Generally, bondholders evaluate any violation to determine whether it jeopardizes the loan. They may then decide to demand immediate repayment, continue the loan, or alter the terms of the bond indenture. 

  • Sinking-Fund Requirements:

Another common restrictive provision is a sinking-fund requirement. Its objective is to provide for the systematic retirement of bonds prior to their maturity. To carry out this requirement, the corporation makes semiannual or annual payments that are used to retire bonds by purchasing them in the marketplace. 

  • Security Interest:

The bond indenture identifies any collateral pledged against the bond and specifies how it is to be maintained. The protection of bond collateral is crucial to guarantee the safety of a bond issue.

  • Trustee:

A trustee is a third party to a bond indenture. The trustee can be an individual, a corporation, or (most often) a commercial bank trust department. The trustee is paid to act as a “watchdog” on behalf of the bondholders and can take specified actions on behalf of the bondholders if the terms of the indenture are violated.


Comments

Post a Comment

Popular posts from this blog

Risk of a Single Asset

-
Image
 Risk of a Single Asset: The concept of risk can be developed by first considering a single asset held in isolation. We can look at expected-return behaviors to assess risk, and statistics can be used to measure it.  Risk Assessment: Sensitivity Analysis (Scenario Analysis) and Probability Distributions can be used to assess the general level of risk embodied in a given asset. Sensitivity Analysis: Sensitivity analysis uses several possible-return estimates to obtain a sense of the variability among outcomes. One common method involves making pessimistic (worst), most likely (expected), and optimistic (best) estimates of the returns associated with a given asset. In this case, the asset’s risk can be measured by the range of returns. The range is found by subtracting the pessimistic outcome from the optimistic outcome. The greater the range, the more variability, or risk, the asset is said to have. Although the use of sensitivity analysis and the range is rather crude, it does...
Read more

Types of Corporates bonds

-
Image
Types of Corporates bonds:  There are five basic categories of corporate bonds: public utilities, transportations, industrials, banks and finance companies, and international issues. The five categories can be further broken down. For example, the transportation category includes airlines, railroads, and trucking companies. Security of bonds Security for bonds suggests some kind of underlying asset that backs up the issue. This is preferable for investors, as it provides risk protection against a potential corporate  default . Assets backing the bond provide security beyond the credit of the issuer. M ortgage bond A mortgage bond is a secured bond issued by a company. With a mortgage bond, the company pledges specific assets as a collateral for the bond. The asset securing the bond is described in detail in the mortgage deed, which is a legal document giving the bondholder a lien on an asset. A company can use a specific asset as security for more than one bond issue. In the e...
Read more

Secured Bond

-
Image
What are Secured Bonds? A secured bond is a  bond  that requires the issuer to pledge specific assets as collateral in the case of default. Secured bonds are usually more popular with businesses or governments that are less likely to be able to pay their debts in the future. Interest on these bonds isn’t enough to attract investors. Companies and local governments will less than stellar past financial track records usually need to assure inventors that they will not default on their future principle and interest payments. And if they do default, ensure the investors don’t walk away empty handed.   Example A good example of a local government that will probably need to issue secured bonds in the future is the city of Detroit. Since its 2013 bankruptcy, its difficult to believe an investor would want to put his or her money at risk purchasing a bond issued by the city of Detroit. I doubt it will ever be able to issue a bond without having some kind of secured collateral agr...
Read more

Unsecured Bonds

-
Image
What are Unsecured Bonds? Unsecured bonds or debentures are bonds that are not backed by some type of collateral. In other words, the bond is only secured by the bond issuer’s good credit standing. There are no building, equipment, vehicles, or other assets backing up the bond. If the bond issuer defaults on the unsecured bond, the bond holders could receive nothing from their investment. They would be left up to the court system to sue the bond issuer for their investment.  A bond that has no specified source of collateral is considered an unsecured debt instrument. Therefore, unsecured debt often pays higher yields than secured debt due to lack of a direct collateral coverage. There are three types of unsecured debt: debentures, Income bonds and subordinated debentures. Debentures A debenture is a type of bond that does not use collateral. It's otherwise recognized as any unsecured long-term debt. Because the bonds are unsecured, it's imperative for the issue to be profitable...
Read more

Constant-Growth Model

-
Image
Constant-Growth Model The most widely cited dividend valuation approach, the constant-growth model, assumes that dividends will grow at a constant rate, but a rate that is less than the required return. The constant-growth model is commonly called the Gordon model. The Gordon Growth Model – otherwise described as the dividend discount model – is a stock valuation method that calculates a stock’s intrinsic value. Therefore, this method disregards current market conditions. Investors can then compare companies against other industries using this simplified model. The Gordon Growth Model (GGM) is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of the dividend discount model (DDM). The GGM assumes that dividends grow at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends. Because the model assumes a constant growth rate, it i...
Read more