Describe what bond provisions exist

Answer 1

BOND PROVISIONS

Bond issues vary with respect to their specific provisions. For example, particular collateral might back up bonds (a secured borrowing), or firms might issue bonds based only on their credit worthiness as an entity. Such unsecured borrowing means that lenders must rely on assets not pledged as collateral for other loans in the event the firm cannot repay the bonds. Unsecured borrowing might carry senior rights or subordinated rights in the event of bankruptcy. Senior debt holders have a higher priority for payment in the event of bankruptcy than subordinated (junior) unsecured lenders.

Bonds also vary in terms of their payment provisions. The typical debenture bond pays interest periodically, usually every six months, during the life of the bond and repays the principal amount borrowed at maturity. A serial bond requires periodic payments of interest plus a portion of the principal throughout the life of the bond. A zero coupon bond provides for no periodic payments of interest while the bond is outstanding; the bond requires payment of all principal and interest at maturity.

Convertible bonds permit the holder to exchange the bonds for shares of the firm's common stock under certain conditions. This conversion option has value because the holder can benefit from some of the later increases in the market value of the firm's common stock after issuance of the bonds. If holders do not convert the bonds into common stock prior to maturity, the issuing firm repays the debt at maturity, the same as for nonconvertible bonds.

Some bonds are callable, which means the issuing firm has the right to repurchase the bonds prior to maturity at a specified price. An issuing firm might exercise this call provision if interest rates decline after the initial issuance of the bonds. The firm can borrow at the lower interest rate and use the proceeds to finance the repurchase of the bonds initially issued.

Investors in bonds sometimes hold a put option, meaning they can force the issuing company to repay the bonds prior to maturity under specified contractual conditions. Investors might exercise this put option if interest rates increase, and investors can reinvest the cash proceeds in debt securities with a higher yield.

Bonds can carry either fixed interest rates or variable interest rates. Bonds with fixed interest rates pay interest at that fixed rate throughout the life of the bond. Bonds with variable interest rates pay interest at rates that change during the life of the bond. The bond indenture specifies the formula for the periodic calculation of the variable interest rate.

Industry economic characteristics, the financial health of a firm, and the particular provisions of a bond issue combine to determine the risk of investing in the bond, which in turn affects the interest rate investors demand and therefore the bond's price.