The terminology that we use here and elsewhere in this chapter is standard in the United States. Outside the United States, these same terms can have different meanings. For example, bonds issued by the British government ("gilts") are called treasury "stock." Also, in the United Kingdom, a debenture is a secured obligation.

At the current time, almost all public bonds issued in the United States by industrial and financial companies are debentures. However, most utility and railroad bonds are secured by a pledge of assets.

Seniority In general terms, seniority indicates preference in position over other lenders, and debts are sometimes labeled as senior or junior to indicate seniority. Some debt is subordinated, as in, for example, a subordinated debenture.

In the event of default, holders of subordinated debt must give preference to other specified creditors. Usually, this means that the subordinated lenders will be paid off only after the specified creditors have been compensated. However, debt cannot be subordinated to equity.

The Bond Market Association web site is

Repayment Bonds can be repaid at maturity, at which time the bondholder will receive the stated, or face, value of the bond, or they may be repaid in part or in entirety before maturity. Early repayment in some form is more typical and is often handled through a sinking fund.

A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. The trustee does this by either buying up some of the bonds in the market or calling in a fraction of the outstanding bonds. This second option is discussed in the next section.

There are many different kinds of sinking fund arrangements, and the details would be spelled out in the indenture. For example:

1. Some sinking funds start about 10 years after the initial issuance.

2. Some sinking funds establish equal payments over the life of the bond.

3. Some high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue. As a consequence, there is the possibility of a large "balloon payment" at maturity.

The Call Provision A call provision allows the company to repurchase or "call" part or all of the bond issue at stated prices over a specific period. Corporate bonds are usually callable.

Generally, the call price is above the bond's stated value (that is, the par value). The difference between the call price and the stated value is the call premium. The amount of the call premium usually becomes smaller over time. One arrangement is to initially set the call premium equal to the annual coupon payment and then make it decline to zero as the call date moves closer to the time of maturity.

Call provisions are not usually operative during the first part of a bond's life. This makes the call provision less of a worry for bondholders in the bond's early years. For example, a company might be prohibited from calling its bonds for the first 10 years. This is a deferred call provision. During this period of prohibition, the bond is said to be call protected.

Protective Covenants A protective covenant is that part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the sinking fund

An account managed by the bond trustee for early bond redemption.

call provision

An agreement giving the corporation the option to repurchase the bond at a specified price prior to maturity.

call premium

The amount by which the call price exceeds the par value of the bond.

deferred call provision

A call provision prohibiting the company from redeeming the bond prior to a certain date.

call protected bond

A bond that, during a certain period, cannot be redeemed by the issuer.

protective covenant

A part of the indenture limiting certain actions that might be taken during the term of the loan, usually to protect the lender's interest.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

7. Interest Rates and Bond Valuation

© The McGraw-Hill Companies, 2002

PART THREE Valuation of Future Cash Flows

Want detailed information on the amount and terms of the debt issued by a particular firm? Check out their latest financial statements by searching SEC filings . at

term of the loan. Protective covenants can be classified into two types: negative covenants and positive (or affirmative) covenants.

A negative covenant is a "thou shalt not" type of covenant. It limits or prohibits actions that the company might take. Here are some typical examples:

1. The firm must limit the amount of dividends it pays according to some formula.

2. The firm cannot pledge any assets to other lenders.

3. The firm cannot merge with another firm.

4. The firm cannot sell or lease any major assets without approval by the lender.

5. The firm cannot issue additional long-term debt.

A positive covenant is a "thou shalt" type of covenant. It specifies an action that the company agrees to take or a condition the company must abide by. Here are some examples:

1. The company must maintain its working capital at or above some specified minimum level.

2. The company must periodically furnish audited financial statements to the lender.

3. The firm must maintain any collateral or security in good condition.

This is only a partial list of covenants; a particular indenture may feature many different ones.

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