Interest In the United States, interest is typically paid twice a year at six month

Interest In the United States, interest is typically paid twice a year at six month

intervals. For example, a bond may pay interest on January 1 and July 1. Bonds issued in many other countries pay interest annually. A bond can

be designed to pay interest quarterly, monthly, or even daily, any way the

FINANCING DECISIONS

corporation desires. The objective is to design the interest payments to

be attractive to the investors, but, at the same time minimize the costs of administering the bonds—writing and mailing interest payments. Interest is also referred to as a coupon. The reference to coupons originates with bearer bonds. If you owned a bearer bond, you received the interest by clipping coupons off the side of the bond and redeeming them for cash. But over time, the interest received on both registered and bearer debt has come to be referred to as the coupon payment.

Interest is generally stated as a percentage of the par value of the bond and the rate or interest is referred to as the interest rate or the cou- pon rate. The coupon rate can be either a fixed coupon rate (fixed rate) or a floating coupon rate (floating rate). Most bonds have a fixed cou- pon rate and such issues are said to have a straight coupon.

In the past 25 years, there have been many innovations in the type of debt interest payments, so there is no longer any “typical” bond. These innovations include zero-coupon, deferred interest, floating rate, and dual coupon debt. Below we discuss the various types of coupon payments.

Zero-Coupon Zero-coupon bonds do not have a coupon. Since there are no coupons, the only return an investor gets by holding the bond until it matures is the difference between what was paid for the bond and its maturity value. This is why zero-coupon bonds are issued and trade at a discount from their maturity value. That is, they are issued and trade at

a price below 100. Effectively, the investor in a zero-coupon bond earns interest, but the investor does not receive it until the maturity date—the interest is part of the maturity value. Consider The Walt Disney Co. Zero-coupon Subordi- nated Notes, due 2005. These notes were issued in June 1990 at 41.199 (41.199% of their maturity value). An investor buying a $1,000 maturity value note in June 1990 would pay $411.99. If that investor held on to the bond until the maturity date, she would not receive interest during the life of the bond, but she would receive $1,000 in June 2005.

Zero-coupon bonds were first issued by corporations in 1981 and rapidly became popular. As with interest paid on any kind of debt, the issuer may deduct the implicit interest to determine taxable income. Investors are taxed on the bond’s interest income—the implicit inter- est—even though they receive no cash.

Consider the Disney notes. If you bought a note for $411.99 in June 1990 and hold it until maturity, you earn an annual return of 6.09%:

Present value of the investment = $411.99 Future value of the investment = $1,000.00 Number of periods

Intermediate and Long-Term Debt

Return = -------------------------- $1,000.00 – 1 = 6.09%

Implied interest for the first year is 6.09% multiplied by $411.99, or $25.09. Implied interest for the second year is 6.09% multiplied by $411.99 + $25.09 = $437.08, or $26.62. As time passes, the value of the note increases and the implicit interest on the note in any period is the 6.09% multiplied by the increased value. Implicit interest on the Disney note over its life is shown for each year in Exhibit 15.3.

EXHIBIT 15.3 Implied Interest on Disney Zero-Coupon Subordinated Notes, Due

2005, that were Issued June 1990 at 41.199 or $411.99 per Bond Beginning

End of Year Value = For the year

Implied Interest =

Beginning Value + ended June …

of the

Yield ××××

Year Value

Beginning Value

Implied Interest

57.40 1,000.00 Total implied interest

$588.01 Note:

Yield calculation:

$1,000.00 -------------------------- – 1 = 6.0899% Present value

Yield = ---------------------------------- Future value – 1 =

Check on the calculations:

Total implied interest + price when issued = Face value

FINANCING DECISIONS

Floating Rate In the 1970s, when bond issuers were reluctant to be locked into paying the high interest rates that prevailed in the United States, corporations began to issue bonds whose coupon rate changed as inter- est rates changed. Corporations thus ended up paying the “market rate” instead of a fixed rate.

Different interest rate benchmarks for floating rates include: ■ The London Interbank Offered Rate (LIBOR)

■ The rate on a money market instrument such a Treasury bill (T-bill) or the rate on commercial paper 2

A rate fixed by an auction process (specifically, a Dutch auction) As explained earlier when we discussed the floating rate for term

loans, there is an interest rate reset formula (called a coupon reset for- mula) that is used to determine the coupon rate for the reset period. The floating rate changes periodically, such as annually, semiannually, or quarterly, as specified. Many bonds with a floating rate will have a cap, the maximum coupon rate that the issuer pays. Some issues may have a floor, the minimum coupon rate.

By using derivatives and other types of derivative instruments, differ- ent types of coupon bonds can be created. Consider for example bonds that are issued in which the interest rate changes in the opposite direction from the benchmark rates. These bonds are referred to as inverse floaters. For example, in 1996 BMW issued 10-year bonds denominated in deut- schemarks. The bonds pay interest of 9% in the first year, reverting there- after to a semiannual interest payment that floats at 12% minus the prevailing six-month LIBOR for deutschemark. If the LIBOR falls, the coupon rate on these bonds rises. By issuing such a bond it would seem that BMW is accepting the risk that if interest rates fall, it will have to pay

a higher interest rate. While not demonstrated here, this risk may be elim- inated by using an interest rate swap. Later in this chapter, we will see how swaps are used to create a bond whose coupon payment depends on the performance of a stock market index.

Deferred Interest Somewhere between a zero-coupon bond and a straight bond lies a deferred interest bond—a bond whose interest payments do not start until some time after it is issued. Most deferred interest bonds have no interest for the first three to seven years and sell at a discount from their face value.

2 Money market instruments are debt obligations that mature in one year or less. We describe these instruments in Chapter 19.

Intermediate and Long-Term Debt

Deferred interest debt is usually used where cash flow problems are anticipated. For example, if a firm borrows heavily to restructure its oper- ations, deferred interest debt offers time to turn its operations around.

Income Bonds An income bond pays interest only when there are sufficient earnings to pay it. If earnings are not sufficient, the firm need not pay the interest to its income bondholders. Unlike other types of debt, failure to pay interest on an income bond is not necessarily an act of default.

Income bonds and notes are seldom issued, for two reasons. First, since they do not carry a fixed interest obligation, they are issued by companies that foresee financial difficulties—so this stigma is attached to income bonds. Second, since paying interest depends on accounting earnings, which can be manipulated, there is a potential problem—a possible conflict of interests between management, who represent share- holders, and the bondholders, who are the creditors.

Moreover, the Internal Revenue Service (IRS) is not naive. It recog- nizes that a firm may attempt to disguise preferred stock by packaging it as an income bond. If the IRS believes that an income bond has all of the characteristics of preferred stock, it will seek to reclassify the interest rate payments that were deducted by the firm so that they are treated as divi- dend payments which are not tax deductible.