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6.2.1 Rationale For Issuing Fixed-income Securities

Explore the rationale behind the issuance of fixed-income securities by corporations and governments, including financing operations, growth, and leveraging finances.

The Rationale for Issuing Fixed-income Securities

Corporations and governments regularly raise money to finance their operations by issuing fixed-income securities.

Governments fund their programs and other obligations largely through tax revenue. However, when a government spends more on those obligations than it receives in tax revenue, it must make up the difference by borrowing money. Most governments borrow by issuing fixed-income securities.

Unlike governments, companies have various choices available when their expenses outweigh their revenue; issuing fixed-income securities is one option. They can also raise cash by selling assets, borrowing from a bank, or issuing equity securities. The choice of financing method depends on the cost, given that companies generally prefer to raise money by the cheapest means possible.

Although companies issue fixed-income securities for various purposes, two particular reasons are commonly cited:

  • To finance operations or growth
  • To take advantage of financial leverage

Examples

Financing Operations and Growth

  1. General Corporate Purposes: A company wants to invest and expand its current operations to meet increasing demand for its product lines. It announces a new bond issue for “general corporate purposes.”

  2. Acquisition Financing: A corporation aims to purchase a company specializing in manufacturing paper bags for grocery store chains for $3 million. Instead of using its available cash, it issues $3 million in bonds. The proceeds from the bond issue fund the purchase, with borrowing costs paid from the corporation’s revenue stream.

Financial Leverage

A company wishes to open a new plant to increase production capacity. It issues $1 million in bonds at 10% interest, costing $50,000 annually after tax. The expanded capacity is expected to increase after-tax profits by over $100,000 yearly. The project proceeds because it increases the return on shareholders’ equity by borrowing the money. The expected return from investing the borrowed funds exceeds the borrowing cost, resulting in financial leverage.

The Basic Features and Terminology of Fixed-income Securities

Defining the Main Features and Terminology

When people speak of fixed-income securities, they often refer to bonds. However, other types of fixed-income securities exist. Let’s discuss some key terms and features.

Key Terms

  • Bond: A long-term, fixed-obligation debt security secured by physical assets, such as a building or railway car, owned by the issuing company.
  • Debenture: A type of bond secured by something other than a specified physical asset, typically by a general claim on residual assets.
  • Coupon Rate: The interest rate paid by the bond issuer relative to the bond’s par value over the term of the bond.
  • Maturity Date: The date at which a bond matures and the principal amount of the loan is repaid to the investor holding the bond.
  • Par Value: The principal amount that the bond issuer contracts to pay at maturity to the bondholder.
  • Yield to Maturity: The annual return on a bond held to maturity.

Bond Terminology

Par Value

The par value of a bond (also called face value) is the principle amount the bond issuer contracts to pay at maturity to the bondholder.

Coupon Rate

The coupon rate is the fixed interest rate paid by the bond issuer. For most bonds, the coupon payments are made on a semi-annual basis.

Maturity Date

The maturity date is the date at which the bond matures and the principal amount is repaid to the bondholder.

Term to Maturity

Term to maturity is the time that remains before a bond matures.

Bond Price

The bond price is the present discounted value of all future payments. Bonds can trade at a value equal to, above, or below par value.

Example

A $1,000, 6%, semi-annual coupon bond due January 10, 2034 will pay $30 to the bondholder on January 10 and July 10 each year until maturity. The semi-annual payment of $30 is a fixed obligation. The yield to maturity on January 10, 2021, is 5.2% and the bond trades at a price of 107.491 for a total cost of $1,074.91.

Key characteristics of this bond are:

  • Par Value: $1,000 (principal repayment upon maturity)
  • Coupon Rate: 6% semi-annual payments of $30
  • Maturity Date: January 10, 2034
  • Term to Maturity: 13 years as of January 10, 2021
  • Bond Price: 107.491% of face value ($1,074.91 for a $1,000 bond)
  • Yield to Maturity: 5.2%

Types of Bonds

Callable Bonds

Bond issuers can call bonds for redemption before maturity to take advantage of lower interest rates or reduce debt.

Extendible and Retractable Bonds

Extendible/debentures: Investable with the option to extend maturity. Retractable: Long maturity with the option to redeem early.

Convertible Bonds

Bond holders have the option to convert bonds into common shares of the issuing company.

Key Terms & Definitions

Term Definition
Par Value The principal amount the bond issuer contracts to pay at maturity.
Coupon Rate The fixed interest rate paid by the bond issuer.
Maturity Date The date at which the bond matures and the principal amount is repaid.
Yield to Maturity The annual return on a bond that is held to maturity.
Callable Bonds Bonds that can be redeemed by the issuer before the maturity date.
Extendible Bonds Bonds that can be extended falling short of maturity
Retractable Bonds Bonds that can be redeemed before maturity if investor choses to
Convertible Bonds Bonds that can be converted into common shares of the issuing company.

Key Takeaways

  • Fixed-income securities are critical for both corporations and governments to finance operations, expansion and reduce costs associated with borrowing.
  • Bonds generally carry a fixed income promise, providing interest payments and the return of principal upon maturity.
  • Definitions and key concepts surrounding bonds include par value, coupon rate, maturity date, and yield to maturity, all foundational to understanding the nature and risks associated with bond investments.
  • Variations of bonds, such as callable, convertibles, extendible, and retractable bonds, offer flexibility to both issuers and investors, each bearing specific investment strategies and protective covenants.

Review Questions

Test your knowledge and comprehension after advancing with Chapter 6 Review Questions.

Frequently Asked Questions

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Glossary

Par Value: The face value of a bond.

Coupon Rate: The fixed interest rate paid by the issuer on the bond’s face value.

Yield to Maturity: The total return anticipated on a bond if held until maturity.

Callable Bond: A bond that can be redeemed by the issuer prior to its maturity date.

Convertible Bond: A bond that can be converted into a predetermined number of shares of the issuing company.

Extendible Bond: A bond that allows the investor to extend the maturity date.

Retractable Bond: A bond that allows the investor to shorten the maturity date, effectively pulling back the investment earlier than the scheduled date.


CSC® Exams Practice Questions

📚✨ CSC Exam Questions ✨📚

Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck!

markdown ## Which of the following entities commonly issue fixed-income securities to finance their operations? - [ ] Only corporations - [ ] Only governments - [x] Both corporations and governments - [ ] Neither corporations nor governments > **Explanation:** Both corporations and governments issue fixed-income securities to raise funds for their operations and obligations when their revenues fall short. ## When a company’s expenses outweigh its revenues, which of the following is NOT a method it would use to raise cash? - [ ] Issuing equity securities - [ ] Borrowing from a bank - [ ] Issuing fixed-income securities - [x] Reducing its tax revenues > **Explanation:** Companies do not reduce tax revenues as they are typically entities that are taxed themselves rather than tax collectors. Methods they use include issuing equity or fixed-income securities and bank loans. ## Why do companies often issue fixed-income securities? - [ ] To gamble on market fluctuations - [ ] To diversify employee benefits - [x] To finance operations and growth or leverage financial opportunities - [ ] To comply with federal regulations > **Explanation:** Companies issue fixed-income securities primarily to finance operations, growth, and to take advantage of financial leverage when the expected return from investing borrowed funds exceeds the borrowing cost. ## What differentiates a debenture from a bond? - [x] A debenture is secured by the issuer's creditworthiness and general claim on residual assets, while a bond is typically secured by specific physical assets. - [ ] A bond is issued by corporations, while a debenture is only issued by governments. - [ ] Debentures do not involve interest payments, while bonds do. - [ ] Bonds are short-term securities, while debentures are long-term securities. > **Explanation:** Debentures are unsecured or backed by non-specific assets, relying on the issuer's creditworthiness, while bonds are often secured by specific physical assets. ## What is 'Par Value' in the context of bonds? - [ ] The total interest paid over the bond's term - [ ] The selling price of the bond on the secondary market - [x] The principal amount contracted to be paid at maturity - [ ] The market value of the bond at the time of issue > **Explanation:** Par value refers to the principal amount that the bond issuer agrees to pay the bondholder at maturity. ## How is 'Coupon Rate' defined? - [x] The fixed interest rate paid by a bond issuer relative to the bond’s par value over its term - [ ] The fluctuating market interest rate applicable to a bond - [ ] The nominal interest rate paid annually by the bondholder - [ ] The discounted rate at which a bond is issued > **Explanation:** The coupon rate is the fixed interest rate relative to the bond's par value that the bond issuer pays bondholders, usually on a semi-annual basis. ## Which of the following describes the 'Yield to Maturity'? - [x] The annual return on a bond if it is held until maturity - [ ] The current dividend yield of the bond's issuing company - [ ] The semi-annual return you receive from a bond - [ ] The face value amount received at bond maturity excluding interest > **Explanation:** Yield to maturity is the total annual return an investor can expect if the bond is held until it matures, including interest payments and final principal repayment. ## What does a 'Callable Bond' feature entail? - [ ] The bondholder can demand early repayment of principal - [x] The issuer has the right to pay off the bond before its maturity date - [ ] The bond is convertible into common stock at any time - [ ] The bond's interest rate can be adjusted based on market conditions > **Explanation:** A callable bond allows the issuer to redeem the bond before its maturity, usually to take advantage of lower interest rates or to reduce debt. ## What differentiates 'Extendible' from 'Retractable' bonds? - [ ] Both are identical and can be used interchangeably - [x] Extendible bonds allow investors to extend the bond’s maturity, while retractable bonds allow investors to shorten it. - [ ] Extendible bonds can only be issued by governments, while retractable bonds can only be issued by corporations. - [ ] Extendible bonds offer a higher interest rate compared to retractable bonds. > **Explanation:** Extendible bonds let investors extend the bond's maturity at the same or higher interest rate, while retractable bonds allow investors to redeem them early. ## What are 'Strip Bonds'? - [ ] Bonds that trade at a premium above their par value - [x] Bonds sold at a discount to face value that pay no interest until maturity - [ ] Bonds paying variable interest rates based on market performance - [ ] Bonds that can be converted into equity at multiple intervals > **Explanation:** Strip bonds, or zero-coupon bonds, are sold at a discount and do not pay periodic interest. Instead, they are redeemed at their face value at maturity, potentially giving a compounded rate of return.

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