Methods of Repayment
The method of repayment for bond issues may not always call for one lump-sum disbursement at the maturity date. Some Canadian and British government bonds are perpetual in nature. In 1951, West Shore Railroad Company issued bonds that were scheduled to mature in 2361 (410 years later). More recently, the Coca-Cola Company and the Walt Disney Company have issued “century” bonds that mature in 100 years. Nevertheless most bonds have some orderly or preplanned system of repayment. In addition to the simplest arrangement—a single-sum payment at maturity—bonds may be retired by serial payments, through sinking-fund provisions, through conversion, or by a call feature.
Serial Payments Bonds with serial payment provisions are paid off in installments over the life of the issue. Each bond has its own predetermined date of maturity and receives interest only to that point. Although the total issue may span over 20 years, 15 or 20 different maturity dates may be assigned specific dollar amounts.
Sinking-Fund Provision A less structured but more popular method of debt retirement is through the use of a sinking fund. Under this arrangement semiannual or annual contributions are made by the corporation into a fund administered by a trustee for purposes of debt retirement. The trustee takes the proceeds and purchases bonds from willing sellers. If no willing sellers are available, a lottery system may be used among outstanding bondholders.
Conversion A more subtle method of reducing debt outstanding is to provide for debt conversion into common stock. Although this feature is exercised at the option of the bondholder, a number of incentives or penalties may be utilized to encourage conversion. The mechanics of convertible bond trading are discussed at length in Chapter 19, “Convertibles, Warrants, and Derivatives.”
Call Feature A call provision allows the corporation to retire or force in the debt issue before maturity. The corporation will pay a premium over par value of 5 to 10 percent—a bargain value to the corporation if bond prices are up. Modern call provisions usually do not take effect until the bond has been outstanding at least 5 to 10 years. Often the call provision declines over time, usually by 0.5 to 1 percent per year after the call period begins. A corporation may decide to call in outstanding debt issues when interest rates on new securities are considerably lower than those on previously issued debt (let’s get the high-cost, old debt off the books).
An Example: Eli Lilly’s 6.77 Percent Bond
Now that we have covered the key features of the bond indenture, let us examine an existing bond. More specific features of this bond are found in Table 16-1, which provides material from the Mergent Industrial Manual. In April 2015, we find that Eli Lilly & Co., one of the largest drug companies in the world, has a 6.77 percent bond due in 2036. The bond carried a Moody’s rating of A1.
As we can see in Table 16-1, the 6.77 percent bond had an original authorized offering of $300 million (third line). The trustee is Citibank, and it is the trustee’s obligation to make sure that Eli Lilly adheres to the terms of the offering. The information in Table 16-1 also provides other pertinent information found in the indenture, such as the interest payment dates (January 1 and July 1), denomination of each bond, security provisions, call features, and high and low bond prices.
Notice that the bond trades above its face value. Corporate bond prices are quoted as a percentage of par value, which is almost always $1,000. This table shows an important relationship between interest rates and bond prices. As interest rates went down after 1996, the price of this long-term bond went up.
Bond Prices, Yields, and Ratings
The financial manager must be sensitive to interest rate changes and price movements in the bond market. For example, the treasurer’s interpretation of market conditions will influence the timing of new issues, the coupon rate offered, and the maturity date. In case you may think bonds maintain stable long-term price patterns, you need merely consider bond pricing during the five-year period 1967–72. When the market interest rate on outstanding 30-year, Aaa corporate bonds went from 5.10 percent to 8.10 percent, the average price of existing bonds dropped 36 percent. A conservative investor would be quite disillusioned to see a $1,000, 5.10 percent bond now quoted at $640.1 Though most bonds are virtually certain to be redeemed at their face value at maturity ($1,000 in this case), this is small consolation to the bondholder who has many decades to wait. At times, bonds also greatly increase in value, such as they did in 1984–85, 1990–92, 1994–95, 2007–08, and 2011–12 when interest rates declined.
Table 16-1 Eli Lilly’s bond offering
|Eli Lilly Bonds Due January 1, 2036|
|Moody’s Rating: A1|
|Indenture Date: January 5, 1996|
|Securing of Obligation: A direct unsecured obligation|
|Interest Payable: January 1, July 1|
|Grace Period: 30 days|
|Call Feature: None|
|Trading Exchange: OTC|
|Price Range Year||High||Low|
Source: Mergent Industrial Manual, 2014 and Nasdaq TRACE.
As indicated in the paragraph above and in Chapter 10, the price of a bond is directly tied to current interest rates. One exception to this rule was discussed at the beginning of the chapter; that is, when bankruptcy becomes a key factor in pricing and valuation. We will look at the more normal case where interest rates are the key factor in determining price.
A bond paying 5.10 percent ($51 a year) will fare quite poorly when the going market rate is 8.10 percent ($81 a year). To maintain a market in the older issue, the price is adjusted downward to reflect current market demands. The longer the life of the issue, the greater the influence of interest rate changes on the price of the bond. The same process will work in reverse if interest rates go down. A 30-year, $1,000 bond initially issued to yield 8.10 percent would go up to almost $1,500 if interest rates declined to 5.10 percent (assuming the bond is not callable). A further illustration of interest rate effects on bond prices is presented in Table 16-2 (on the next page) for a bond paying 12 percent interest. Observe that not only interest rates in the market but also years to maturity have a strong influence on bond prices.
Table 16-2 Interest rates and bond prices (face value is $1,000 and annual coupon rate is 12%)
Prices are based on semiannual payments. Thus, the annual rate is divided by two and the periods are multiplied by 2. Cash flow inputs are entered as negative values as required by Excel’s PV function.
From 1945 through the early 1980s, the pattern had been for long-term interest rates to move upward (Figure 16-3). However, long-term interest rates have generally been declining since 1982. The figure shows both Moody’s Aaa bond yields for the highest quality corporate bonds and Moody’s Baa bonds, which are three notches lower than the highest investment-grade bonds. The graph does illustrate the pattern of rates over time but also that the highest-quality bonds always have a lower interest rate than lower quality bonds. See the bond rating section for more details on bond quality.
Figure 16-3 Long-term yields on debt
Source: St. Louis Federal Reserve, research.stlouisfed.org
Bond yields are quoted three different ways: coupon rate, current yield, and yield to maturity. We will apply each to a $1,000 par value bond paying $100 per year interest for 10 years. The bond is currently priced at $900.
Nominal Yield (Coupon Rate) Stated interest payment divided by the par value.
Current Yield Stated interest payment divided by the current price of the bond.
Yield to Maturity The yield to maturity is the interest rate that will equate future interest payments and the payment at maturity (principal payment) to the current market price. This represents the concept of the internal rate of return. In the present case, an interest rate of 11.75 percent will equate interest payments of $100 for 10 years and a final payment of $1,000 to the current price of $900. Calculating yield to maturity is discussed in detail in Chapter 10 beginning on page 303.2
When financial analysts speak of bond yields, the general assumption is that they are speaking of yield to maturity. This is deemed to be the most significant measure of return.