Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par

value. The issuer can do so in one of following four ways: ■ Repay the entire par value in one payment at the maturity. This is the

typical mechanism for bonds issued by corporations. ■ Repay the par value based on an amortization schedule. This mechanism is the same as for the repayment of the amount borrowed for the term loans described earlier. That is, each periodic payment made by the ﬁrm to bond holders includes interest and scheduled principal repayment. Many asset-backed securities, discussed in Chapter 26, are paid off in this way.

■ Retire a speciﬁed amount of the par value of the issue periodically. This provision is called a sinking fund provision. ■ Pay off the entire amount of the face value prior to the maturity date by one of two mechanisms: “calling” the issue if permitted or “defeasing” the issue.

The ﬁrst two mechanisms are straightforward. We describe the sinking fund, call, and defeasing mechanisms next, beginning with the call mechanism.

In addition to the above mechanisms, a bond issue may give the bondholder the right to force the issuer to retire a bond issue prior to the maturity date. This right granted is referred to as a put prevision. We will also describe it below.

Call Mechanism An important question in setting the terms of a new bond issue is whether the issuer shall have the right to redeem the entire amount of bonds outstanding on one or more dates before the maturity date. Issuers generally want this right because they recognize that at some time in the future the general level of interest rates may fall sufﬁ- ciently below the issue’s coupon rate so that redeeming the issue and replacing it with another issue with a lower coupon rate would be attractive. This right is a disadvantage to the bondholder because it

Intermediate and Long-Term Debt

forces the bondholder to reinvest the proceeds received at a lower interest rate. This is the reinvestment risk that we explained in Chapter 9.

The right of the issuer to retire an issue prior to the maturity date is referred to as the right to call the issue. Effectively, it is the right of the issuer to take away the bonds from the bondholder at a speciﬁed price at speciﬁed times. Consequently, this right that the issuer has is referred to as a call option. While we described a call option in Chapter 4, those options were standalone options. That is, they were not part of any debt obligation. A call option that is part of a bond issue is referred to as an embedded option. As we discuss other features of a bond we will see other types of embedded options.

Retiring an outstanding bond issue with proceeds from the sale of another bond issue is referred to as refunding a bond issue. The usual practice is a provision that denies the issuer the right to refund a bond issue during the first five to ten years following the date of issue with proceeds received from issuing lower-cost debt obligations ranking equal to or superior to the bond issue to be retired. For example, if a bond issue has a coupon rate of 10% and the issuer could issue a new bond issue with a coupon rate of 7%, then if there is a prohibition on refunding a bond issue, the issuer could not retire the 10% coupon issue with funds received from the sale of a 7% issue. While most long-term issues have these refunding restrictions, they may be immediately callable, in whole or in part, if the source of funds comes from other than lower interest cost money. Cash flow from operations, proceeds from a common stock sale, or funds from the sale of property are examples of such sources of proceeds that a firm can use to refund a bond issue.

Sometimes there is confusion between refunding protection and call protection. Call protection is much more absolute in that bonds cannot

be redeemed for any reason. Refunding restrictions only provide protection against the one type of redemption mentioned above. Typically, corporate bonds are callable at a premium above par. Generally, the amount of the premium declines as the bond approaches maturity and often reaches par after a number of years have passed since issuance.

A framework for a ﬁrm to decide whether it will refund a bond issue will be discussed later in this chapter.

Sinking Fund Bond indentures may require the issuer to retire a speciﬁed portion of an issue each year. This is referred to as a sinking fund requirement. This kind of provision for repayment of a bond issue may

be designed to liquidate all of a bond issue by the maturity date, or it may be arranged to pay only a part of the total by the maturity date.

FINANCING DECISIONS

The purpose of the sinking fund provision is to reduce default risk. Generally, the issuer may satisfy the sinking-fund requirement by either (1) making a cash payment of the par amount of the bonds scheduled to

be retired to the trustee who then calls the bonds for redemption using a lottery, or (2) delivering to the trustee bonds with a total par value equal to the amount that must be retired from bonds the issuer purchased in the open market. Usually, the sinking-fund call price is the par value of the bonds.

Many corporate bond indentures include a provision that grants the issuer the right (i.e., option) to retire more than the required sinking fund payment. For example, suppose that the amount of the sinking fund requirement is $10 million for some year up to a speciﬁed amount. The issuer would have the right to retire more than $10 million. For some issues, the issuer may be permitted to retire twice the amount required. This is another embedded option granted to the issuer, called the acceleration option, because the issuer can take advantage of this provision if interest rates decline below the coupon rate. That is, suppose that an issue has a coupon rate of 10% and that current rates are well below 10%. Suppose further that there is a refunding restriction so that the issuer cannot refund the bond issue and that it does not have sufﬁcient funds to retire the entire issue by another means that would be permitted. If there is a sinking fund requirement with an acceleration option, the issuer can use this option to get around the refunding restriction and thereby retire part of the outstanding bond issue. There is another advantage. When bonds are purchased to satisfy the sinking fund requirement, they are called by the trustee at par value. In contrast, when they are called if the issuer has the right to call an issue, for other than to satisfy the sinking fund requirement, the call price is typically above the par value.

A sinking fund adds extra comfort to the bondholder—the presence of the sinking fund reduces the default risk associated with the bond. That is, if the issuer fails to make a scheduled payment to satisfy the sinking fund provision, the trustee may declare the bond issue in default; this has the same consequences as not paying interest or principal. However, because the inclusion of the acceleration option allows the issuer to retire more of the scheduled amount prior to the maturity date, it effectively is a call option granted to the issuer and therefore increases the reinvestment risk to the bondholders.

Defeasance Another way of effectively retiring a bond issue is to defease it by creating a trust to pay off the payments that must be made to the bondholders. To do this, the ﬁrm establishes an irrevocable trust (where the ﬁrm cannot get back any funds it puts in it), deposits risk-free securities into the trust (such as U.S. government bonds) such that the cash

Intermediate and Long-Term Debt

ﬂows from these bonds (interest and principal) are sufﬁcient to pay the obligations of the debt. The interest and principal of the defeased debt is then paid by this trust.

Defeasing debt requires that the issuer undertake the following three steps:

Step 1: Create a trust dedicated to making payments due on the bond issue. Step 2: Place in the trust U.S. government securities having cash inflows (interest and principal) that match the cash outflows on the firm’s bond (interest and principal).

Step 3: Place the securities in the trust. The bond’s interest and principal payments are made by the trust.

An issuer would employ the defeasance mechanism for several reasons:

■ If the bonds cannot be bought back from the bondholders (the issue cannot be called or refunded), defeasance provides a way of retiring bonds.

■ If interest rates on the securities in the trust is high relative to the interest rate on the defeased bond, this difference ends up increasing the ﬁrm’s reported earnings.

■ If certain requirements are met, as set forth in the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No.

76, the debt obligation is removed from the borrower’s ﬁnancial state- ments, which should lead to a an improved credit evaluation.

Owners of a bond issue that has been defeased are assured they will

be paid interest and principal as promised, so their default risk is in effect eliminated.

Put Provision

A put provision grants the bondholder the right to sell the issue back to the issuer on designated dates. Bonds with such a provision are referred to as putable bonds. The advantage to the bondholder is that if interest rates rise after the bonds are issued, thereby reducing the value of the bond, the bondholder can put the bond to the issuer for par value. The put provision, just like the call provision, is an embedded option. Consequently, the put provision is referred as a put option. Unlike a call option which is an option granted to the issuer to retire the bond issue prior to the maturity date, a put option grants the bondholder the right to have the bond issue retired prior to the maturity date.

FINANCING DECISIONS

Put provisions have been used for reasons other than to protect the bondholder against a rise in interest rates after the bond is issued. The right to sell the debt back is permitted under special circumstances. In the late 1980s, many ﬁrms took on a great deal of debt, increasing the risk of default on all their debt obligations. Many debtholders found themselves with debt whose default risk increased dramatically. Put provisions were included in bond indentures as a way of protecting bondholders. If an event affecting the bond issue took place, such as a leveraged buyout or a downgrade in the credit rating of the issuer, bondholders have the right to sell the bonds back to the issuer.

In the late 1980s, some firms issued puts designed specifically to make takeovers more expensive. Called poison puts, they take affect only under some specified change in control of the firm, such as if some- one acquires more than 20% of the common stock. By designing putable bonds with this feature, the management is able to make any takeover more expensive. Bondholders will want to sell the bonds back to the firm for more than its par value, draining the company of cash. A “change in control” put provision may state:

In the event of a change-in-control of Co., each holder will have the one-time optional right to require Co. to repur- chase such holder’s debentures at the principal amount thereof, plus accrued interest.

If there is a change in control, as deﬁned in more detail in the indenture, the bond holder can “put” the bond back to the issuer at par value.

Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par