EN.662.611 Chap.6 Corporate Bonds and Leverage Ratios
Corporate Bonds and Leverage Ratios
Why companies borrow
Week 5 compares debt with equity. Debt does not dilute owners' voting power, costs less because interest is tax deductible while dividends are not, ranks first in liquidation and provides more leverage.
A bond packages that promise: repayment of face value at maturity plus periodic interest at the coupon rate, under an indenture enforced by a trustee and described in a prospectus.
Two rates with two jobs
The coupon rate, also called the stated or nominal rate, sets the cash interest paid.
The market rate, also called the required or effective rate, is the return investors demand for the risk and sets the bond's price. Prices are quoted as a percentage of face value and equal the present value of the promised cash flows.
When the coupon beats the market rate the bond sells at a premium above 100; when it falls short it sells at a discount below 100. The syllabus directs students to work from quotes.
Accounting for the life of a bond
At issuance the company records bonds payable at face value with any premium or discount beside it.
Over the life of the bond the effective interest method charges interest expense at the carrying value times the market rate, and the difference from cash interest amortizes the premium or discount. A premium lowers interest expense to the true cost of borrowing; a discount raises it.
At maturity the carrying value equals face value and the bond is repaid.
How much debt is too much
The debt ratio and the debt-to-equity ratio measure leverage: the higher they are, the higher the risk and the potential return.
Times interest earned, pre-tax income plus interest expense divided by interest expense, tests whether the debt is affordable, against a benchmark of five times.
Why the bond market exists
The lecture frames bonds as an anchor for portfolios: an investor who holds to maturity knows the cash flows in advance.
That certainty breaks in three situations, when the bond is sold before maturity at a changed price, when the issuer calls it, or when the issuer goes bankrupt. The call feature favors the issuer when rates fall; the conversion feature favors the holder when the share price climbs above the conversion price.
What this chapter covers
- 01
Debt versus equity financing
- 02
Bond terminology and features
- 03
Call and conversion features
- 04
Coupon rate versus market rate
- 05
Premium, par and discount
- 06
Effective interest amortization
- 07
Debt ratio, debt-to-equity and times interest earned
Worked example · free
Record the first year of a premium bond
- 1Proceeds: $100,000 times 103.993% is $103,993, a $3,993 premium.
- 1Interest expense: $103,993 times 8% is $8,319.
- 1Premium amortized: cash interest $9,000 less $8,319 is $681.
- 1Carrying value: $103,993 less $681 is $103,312.
Key terms
- Coupon Rate
- The contractual interest rate on a bond, applied to face value to set the cash interest paid.
- Market Rate
- The return investors require for a bond's risk, which determines its price and the issuer's true borrowing cost.
- Bond Discount
- The amount by which a bond's issue price falls below face value, amortized as extra interest expense.
- Times Interest Earned
- Pre-tax income plus interest expense, divided by interest expense; a test of debt affordability.
- Call Feature
- A bond term that lets the issuer retire the bond before maturity, useful when interest rates fall.
Corporate Bonds and Leverage Ratios FAQ
Why would investors pay more than face value for a bond?
Because its coupon pays more than the market currently requires for that risk. Competitive bidding pushes the price up until the buyer's effective return falls to the market rate.
Does the issuer's interest expense change when market rates move after issuance?
No. Under the effective interest method expense is based on the market rate at issuance, which fixes the schedule for the whole life of the bond. Later rate changes move the bond's trading price, not the issuer's books.
When is a conversion feature attractive to bondholders?
When the company's share price rises above the conversion price. Holders can then swap their bonds for stock worth more than the set price, which builds an unrealized gain into the bond.
Exam move
Take one bond from quote to maturity: compute proceeds, build the full effective interest schedule, and check that the final carrying value equals face value. Then flip the rates to create the mirror-image case and say which way every column moves.
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