The Debt Contract
The corporate bond represents the basic long-term debt instrument for most large U.S. corporations. The bond agreement specifies such basic items as the par value, the coupon rate, and the maturity date.
Par Value This is the initial value of the bond. The par value is sometimes referred to as the principal or face value. Most corporate bonds are initially traded in $1,000 units.
Coupon Rate This is the actual interest rate on the bond, usually payable in semi-annual installments. To the extent that interest rates in the market go above or below the coupon rate after the bond has been issued, the market price of the bond will change from the par value.
Maturity Date The maturity date is the final date on which repayment of the bond principal is due.
The bond agreement is supplemented by a much longer document termed a bond indenture. The indenture, often containing over 100 pages of complicated legal wording, covers every detail surrounding the bond issue—including collateral pledged, methods of repayment, restrictions on the corporation, and procedures for initiating claims against the corporation. The corporation appoints a financially independent trustee to administer the provisions of the bond indenture under the guidelines of the Trust Indenture Act of 1939. Let’s examine two items of interest in any bond agreement: the security provisions of the bond and the methods of repayment.
A secured debt is one in which specific assets are pledged to bondholders in the event of default. Only infrequently are pledged assets actually sold and the proceeds distributed to bondholders. Typically the defaulting corporation is reorganized and existing claims are partially satisfied by issuing new securities to the participating parties. The stronger and better secured the initial claim, the higher the quality of the new security to be received in exchange. When a defaulting corporation is reorganized for failure to meet obligations, existing management may be terminated and, in extreme cases, held legally responsible for any imprudent actions.
A number of terms are used to denote collateralized or secured debt. Under a mortgage agreement, real property (plant and equipment) is pledged as security for the loan. A mortgage may be senior or junior in nature, with senior requiring satisfaction of claims before payment is given to junior debt. Bondholders may also attach an after-acquired property clause, requiring that any new property be placed under the original mortgage.
You should realize not all secured debt will carry every protective feature, but rather represents a carefully negotiated position including some safeguards and rejecting others. Generally, the greater the protection offered a given class of bondholders, the lower is the interest rate on the bond. Bondholders are willing to assume some degree of risk to receive a higher yield.
A number of corporations issue debt that is not secured by a specific claim to assets. In Wall Street jargon, the name debenture refers to a long-term, unsecured corporate bond. Among the major participants in debenture offerings are such prestigious firms as ExxonMobil, IBM, Dow Chemical, and Intel. Because of the legal problems associated with “specific” asset claims in a secured bond offering, the trend is to issue unsecured debt—allowing the bondholder a general claim against the corporation—rather than a specific lien against an asset.
Even unsecured debt may be divided between high-ranking and subordinated debt. A subordinated debenture is an unsecured bond in which payment to the holder will occur only after designated senior debenture holders are satisfied. The hierarchy of creditor obligations for secured as well as unsecured debt is presented in Figure 16-2, along with consideration of the position of stockholders.
Figure 16-2 Priority of claims
A classic case of the ranking of bondholders (debtholders) and stockholders took place on June 1, 2009, when General Motors went into bankruptcy. The government provided over $50 billion in funds to GM to help them survive and ultimately come out of bankruptcy as a stronger company. The U.S. government owned 60 percent of the common stock of General Motors in early 2010 and was able to sell a $13.6 billion stake when GM came to the market with an IPO in November of 2010. By December 2013, the U.S government had sold all of its shares in GM.
When GM went into bankruptcy, the common stockholders (with the lowest priority of claims, as shown at the bottom of Figure 16-2) received nothing for their shares. This was quite a disappointment to the stockholders who only two years earlier held shares that were valued at $40 and paying a $2 annual dividend.
Preferred stockholders also received nothing—the next major class, reading up the scale in Figure 16-2, were the unsecured debtholders. They unhappily received 10 cents on the dollar (in this case, there was no distinction between senior and subordinated unsecured debt).
Finally, the secured debtholders (whether senior or junior) were paid off in full with the sell-off of secured assets. The unsecured bondholders were given 10 percent of the new company’s common stock with warrants to purchase another 15 percent in the future.
For a further discussion of payment of claims and the hierarchy of obligations, the reader should see Appendix 16A, “Financial Alternatives for Distressed Firms,” which also covers other bankruptcy considerations.