Optionlinked Bonds

In recent years, firms have recognized the value of combining options with straight bonds to create bonds that more closely match the firm's specific needs. Consider two examples. In the first, commodity companies issued bonds linking the principal and even interest payments to the price of the commodity. Thus interest payments would rise if the price of the commodity increased, and vice versa. The benefit for the company was that it tailored the cash flows on the bond to the cash flows of the firm and reduced the likelihood of default. These commodity linked bonds can be viewed as a combination of a straight security and a call option on the underlying commodity. In the second example, consider insurance companies that have recently issued bonds whereby the principal on the bond is reduced in the case of a specified catastrophe, and remains unaffected in its absence. For instance, an insurance firm that has the bulk of its revenues coming from homeowners' insurance in California, might attach a provision that reduces principal and/or interest in the case of a major earthquake. Again, the rationale is to provide the firm with some breathing room when it needs it the most - when a catastrophe creates huge cash outflows for the firm.

Commodity Bonds: Commodity bonds are bonds where the interest and/or the principal payments are linked to the price of the commodity. In most cases, the payments will increase with the price of the commodity and decrease if it drops.

Illustration 7.1: Financing Choices in 2003-04 - Disney and Aracruz

Table 7.1 summarizes the existing debt and preferred stock at Disney, broken down by maturity, currency and whether the debt is fixed or floating rate.

Table 7.1: Debt Breakdown for Disney: September 2003

Type of Debt

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