Page 595 - Accounting Principles (A Business Perspective)

15. Long-term financing: Bonds

Unregistered (bearer) bonds An unregistered (bearer) bond is the property of its holder or bearer
because the owner's name does not appear on the bond certificate or in a separate record. Physical delivery of the
bond transfers ownership.

Coupon bonds A coupon bond is a bond not registered as to interest. Coupon bonds carry detachable
coupons for the interest they pay. At the end of each interest period, the owner clips the coupon for the period and
presents it to a stated party, usually a bank, for collection.
Term bonds and serial bonds A term bond matures on the same date as all other bonds in a given bond
issue. Serial bonds in a given bond issue have maturities spread over several dates. For instance, one-fourth of
the bonds may mature on 2011 December 31, another one-fourth on 2012 December 31, and so on.
Callable bonds A callable bond contains a provision that gives the issuer the right to call (buy back) the

bond before its maturity date. The provision is similar to the call provision of some preferred stocks. A company is
likely to exercise this call right when its outstanding bonds bear interest at a much higher rate than the company
would have to pay if it issued new but similar bonds. The exercise of the call provision normally requires the
company to pay the bondholder a call premium of about USD 30 to USD 70 per USD 1,000 bond. A call premium is
the price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity
date.
Convertible bonds A convertible bond is a bond that may be exchanged for shares of stock of the issuing
corporation at the bondholder's option. A convertible bond has a stipulated conversion rate of some number of
shares for each USD 1,000 bond. Although any type of bond may be convertible, issuers add this feature to make

risky debenture bonds more attractive to investors.
Bonds with stock warrants A stock warrant allows the bondholder to purchase shares of common stock at
a fixed price for a stated period. Warrants issued with long-term debt may be nondetachable or detachable. A bond
with nondetachable warrants is virtually the same as a convertible bond; the holder must surrender the bond to
acquire the common stock. Detachable warrants allow bondholders to keep their bonds and still purchase shares of
stock through exercise of the warrants.
Junk bonds Junk bonds are high-interest rate, high-risk bonds. Many junk bonds issued in the 1980s

financed corporate restructurings. These restructurings took the form of management buyouts (called leveraged
buyouts or LBOs), hostile takeovers of companies by outside parties, or friendly takeovers of companies by outside
parties. In the early 1990s, junk bonds lost favor because many issuers defaulted on their interest payments. Some
issuers declared bankruptcy or sought relief from the bondholders by negotiating new debt terms.
Several advantages come from raising cash by issuing bonds rather than stock. First, the current stockholders do
not have to dilute or surrender their control of the company when funds are obtained by borrowing rather than
issuing more shares of stock. Second, it may be less expensive to issue debt rather than additional stock because the
interest payments made to bondholders are tax deductible while dividends are not. Finally, probably the most
important reason to issue bonds is that the use of debt may increase the earnings of stockholders through favorable

financial leverage.
Favorable financial leverage A company has favorable financial leverage when it uses borrowed funds
to increase earnings per share (EPS) of common stock. An increase in EPS usually results from earning a higher
rate of return than the rate of interest paid for the borrowed money. For example, suppose a company borrowed
money at 10 per cent and earned a 15 per cent rate of return. The 5 per cent difference increases earnings.

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