chapter 10 Bonds Lonni Steven Wilson Medaille College

chapter 10 Bonds Lonni Steven Wilson, Medaille College

Key Chapter Objectives • Understand how issuing bonds creates a fixed-cost solution to raising funds. • Describe the types of bonds that are available and how they are secured. • Understand how a company repays bondholders. • Understand the dynamics of government-issued bonds to finance sports facilities.

Key Terms bond—An obligation that needs to be repaid with interest, similar to a loan from a bank. corporate bonds—Another name for bonds, because bonds can normally be issued only by the largest corporations. mortgage bond—A bond backed by specified real estate. bondholder—The owner of the bond covenants—The restrictions attached to a bond; every bond has restrictions.

Characteristics of Bonds • Typically issued by larger corporations or government entities with a good repayment history • Sought after by investors because of either favorable interest rates or tax benefits • High desirability creates a market for their purchase and sale that is similar to the stock market • Similar to a long-term loan in that they are contracts under which a borrower agrees to make specified interest and principal payments on specified dates for a specified time period

Junk Bonds • A junk bond is a high-yield bond with a low credit rating. • Smaller or new companies without a significant financial track record of sales or earnings often issue these bonds. • They were particularly popular is the 1970 s and 1980 s.

Advantages of Bond Financing • Interest on bonds is tax deductible (versus stock dividends, which are not deductible). • Bond financing can be reasonably inexpensive for an established company with a good credit rating. • There is a strong, established market for trading and issuing bonds.

Disadvantages of Bond Financing • Interest is a fixed charge that needs to be paid regardless of whether income was or was not earned. • The principal loaned amount must be paid in full when the bond matures. • Issuing bonds can harm a company’s credit rating and make it more difficult for the company to borrow money in the future. • If the bond is secured by collateral, a corporation might not be able to sell or otherwise dispose of the asset without bondholder approval. • Bondholders have the upper hand whenever a company declares bankruptcy.

Secured versus Unsecured Bonds • A secured bond is a bond secured by a specific item, or collateral, that can be sold if the bond is not repaid. – If an asset is secured, by the terms of the security agreement the corporation does not have exclusive use of the asset and might need to obtain approval before using the asset for various activities. • A debenture is an unsecured bond, meaning there are no assets to secure the bond (guarantee repayment) if the bond issuer defaults. – Unsecured bonds provide the greatest flexibility for the issuing corporation but minimal protection for the bond purchaser.

Suppliers for Long-Term Funds • • • Life insurance companies Savings and loan associations Mutual savings banks Commercial banks that might acquire bonds Insurance companies (fire, property, casualty) Corporate pension funds State and local government retirement funds Union retirement plans Mutual funds that purchase bonds

Cost of Issuing Bonds Although bonds can raise substantial funds, they are very expensive to issue. The primary cost is the required interest payments. • Such payments are due on a semiannual basis for as long as the bond is outstanding. • A 20 -year $100 million bond issued with 10% interest would require semiannual payments of $5 million for 20 years. (continued)

Cost of Issuing Bonds (continued) A second cost is the discount or risk premium at which they are sold. • The discount for the $100 million bond issue might be $5 million, which means that the issuing or selling entity for the bonds would take $5 million (5%) as a fee to process and help sell the bonds. • This affects the interest cost. In this example the interest rate would move to 10. 25% so that the full $100 million would be received, not just $95 million ($100 million - $5 million setup fee).

Key Terms sinking funds—A fund in which moneys are set aside either in preset amounts or on a variable basis. serial bonds—A series of bonds issued with maturity dates at predetermined redemption dates. convertible bonds—Bonds that can be redeemed when the bondholder converts the bonds to stocks.

Factors Influencing Bond Ratings • The level of coverage (ability to repay the loan with existing revenue streams) • The strength, breadth, and reliability of the tax base • The historical performance of the revenue stream • The risk associated with the project • The underlying economic strength of the stadium or arena or the community • Political volatility • Whether or not the project is economically viable (Greenberg & Gray, 1996)

Sources of Funding Bonds Government resources for paying a bond’s debt service • • • Utility taxes Ticket surcharges Car rental taxes Real estate taxes Specific sales taxes Possessory interest taxes • Tourist development taxes • Restaurant sales taxes • Excise or sin taxes • Lottery and gaming revenue • Nontax fees such as permits • General appropriations • General sales and use taxes (Greenberg & Gray, 1996)

Questions for In-Class Discussion 1. Should the general population pay the debt service for bonds issued to pay for a stadium or arena that is used primarily by a privately owned professional team? Debate the topic, citing all the pros and cons associated with the question. What innovative ideas could be used to help repay the bonds? 2. What is the value of bonds versus stocks? 3. Is a bond a safer investment for an investor than other investing options such as stocks? 4. Besides the various backings for bonds highlighted in this chapter, what other resources can be tapped to help repay government-backed bonds to build stadiums and arenas?