Stockholders and Bondholders

The conflict of interests between stockholders and bondholders can lead to actions that transfer wealth to the former from the latter. There are ways in which bondholders can obtain at least partial protection against some of these actions.

The Effect of Covenants

The most direct way for bondholders to protect themselves is to write in covenants in their bond agreements specifically prohibiting or restricting actions that may be wealth expropriating. Many bond (and bank loan) agreements have covenants that do the following:

(1) Restrict the firm's investment policy: Investing in riskier projects than anticipated can lead to a transfer of wealth from bondholders to stockholders.

Some bond agreements put restrictions on where firms can invest and how much risk they can take on in their new investments, specifically to provide bondholders with the power to veto actions that are not in their best interests.

(2) Restrict dividend policy: In general, increases in dividends increase stock prices while decreasing bond prices, because they reduce the cash available to the firm to meet debt payments. Many bond agreements restrict dividend policy, by tying dividend payments to earnings.

(3) Restrict additional leverage: Some bond agreements require firms to get the consent of existing lenders before borrowing more money. This is done to protect the interests of existing secured bondholders.

While covenants can be effective at protecting bondholders against some abuses, they do come with a price tag. In particular, firms may find themselves having to turn down profitable investments because of bondholder-imposed constraints and having to pay (indirectly) for the legal and monitoring costs associated with the constraints.

Taking an Equity Stake

Since the primary reason for the conflict of interests between stockholders and bondholders lies in the nature of their claims, another way that bondholders can reduce the conflict of interest is by owning an equity stake in the firm. This can take the form of buying stock in the firm at the same time as bonds, or it can be accomplished by making bonds convertible into stock at the option of the bondholders. In either case, bondholders who feel that equity investors are enriching themselves at the lenders' expense, can become stockholders and share in the spoils.

Bond Innovations

In the aftermath of several bond market debacles in the late 1980s, bondholders became increasingly creative in protecting themselves with new types of bonds. While we will consider these innovations in more detail later in this book, consider the example of puttable bonds. Unlike a conventional bond, where you are constrained to hold the bond to maturity, the holders of a puttable bond can put the bond back to the issuing company and get the face value of the bond if the company violates the conditions of the bond. For instance, a sudden increase in borrowing or a drop in bond ratings can trigger this action.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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Responses

  • asmara
    How do bondholders protect themselves?
    8 years ago
  • daniela hoover
    What can be done to protect the interests of bondholders against stockholders?
    8 years ago
  • JENNI
    How do bondholders restrict stockholder actions?
    8 years ago
  • kaija
    How do bondholders protect themselves wealth?
    4 years ago

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