WRITTEN

REPORT

CHAPTER 25
(SOURCES OF LONG-TERM
FINANCING)
*Advantages and Disadvantages of using Bonds
*Bonds Features and Prices
*Credit Quality Risk and Credit Ratings
*Types of Bonds
*Other Types of Bonds

To be Submitted by:
Binuya Jr., Wilfredo G.
BSA-43
To be Submitted To:
Dr. Enoe E.V. Santos

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 Table of Contents
Advantages and Disadvantages of using Bonds ...................................................... 3
Bond Features and Prices......................................................................................... 4
Par Value.......................................................................................................... 4
Coupon Interest Rate ....................................................................................... 4
Maturity ........................................................................................................... 4
Indenture .......................................................................................................... 4
Current Yield ................................................................................................... 5
Yield to Maturity ............................................................................................. 5
Credit Quality Risk .................................................................................................... 6
Junk Bonds(High-Yield Bonds) ...................................................................... 7
Credit Ratings ............................................................................................................ 7
Types of Bonds .......................................................................................................... 9
A. Unsecured Long-Term Bonds..................................................................... 9
B. Secured Long-Term Bonds ....................................................................... 10
Other Types of Bonds .............................................................................................. 12
Floating Rate or Variable Bonds ................................................................... 12
Junk or Low-Rated Bonds ............................................................................. 12
Eurobonds ...................................................................................................... 13
Treasury Bonds .............................................................................................. 13

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Advantages and Disadvantages of using Bonds

The advantages and disadvantages of using bonds can be summarized as

follows:

Advantages:
1. Long-term debt is generally less expensive than other forms of financing
because (a.) investors view debt as a relatively safe investment alternative and
demand a lower rate of return, and (b.) interest expenses are tax deductible.

2. Bondholders do not participate in extraordinary profits; the payments are

limited to interest.

3. Bondholders do not have voting rights

4. Flotation costs of bonds are generally lower than those of ordinary

(common) equity shares.

Disadvantages:
1. Debt (other than income bonds) results in interest payables that if not met,
can force the firm into bankruptcy.

2. Debt (other than income bonds) produces fixed charges increasing the
firm’s financial leverage. Although this may not be a disadvantage to all firms, it
certainly is for some firms with unstable earnings streams.

3. Debt must be repaid at maturity and thus at some point involves a major
cash outflow.

4. The typical restrictive nature of indenture covenants may limit the firm’s
future financial flexibility

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 As of May, 2015, the following are bond issuances by business firms in the
Philippines secured by Bond Funds and part of the Investment Portfolio of Mutual
Funds:

 ALFM Peso Bonds

 Grepalife Bonds
 Philam Bonds
 Philequity Peso Bonds
 Sun Life Prosperity Bonds

Bond Features and Prices

The various features of corporate bonds and some of the terminology associated with
bonds follow:

Par Value

The face value of the bond that is returned to the bondholder at maturity.

Coupon Interest Rate

The percentage of the par value of the bond that will be paid one annually in
the form of interest. Formula is: Stated interest payment divided the Par value.

Maturity

The length of time until the bond issuer returns the par value to its bondholder
and terminates the bond.

Indenture

The agreement between the firm issuing the bonds and the bond trustee who
represents the bondholders. It provides the specific terms of the loan
agreement, including the description of the bonds, the rights of the
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 bondholders, the rights of the issuing firm and the responsibilities of the
trustees.

Current Yield

This refers to the ratio of the annual interest payment to the bond’s market
place.

Yield to Maturity

This refers to the bond’s internal rate of return. It is the discount rate that
equates the present value of the interest and principal payments with the
current market price of the bond.

Formula is:

Annual Principal Payment – Price of the Bond

Approximate
Interest +
Yield to = Number of Year to Maturity
Payment
Maturity
.6 (Price of the Bond) + .4 (Principal Payment)

Example:

Par value of bond :P1,000

Interest rate :10%
Term :10 years

Current Price :P900

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 Approximate 1000 – 900
100 +
Yield to = 10
Maturity .6 (900) + .4 (1000)

110
= Or 11.70%
940

Credit Quality Risk

Credit quality risk is the chance that the bond issuer will not be able to make
timely payments.

Bond ratings involve a judgment about the future risk potential of the bond
provided by rating agencies such as Moody’s Standard and Poor’s and Fitch IBCA,
Inc. Dominition Bond Rating Services. Bond ratings are favorably affected by:

a. A low utilization of financial leverage;

b. Profitable operations;

c. A low variability of past earnings;

d. Large firm size’

e. Little use of subordinated debt.

The poorer the bond rating, the higher the rate of return demanded in the
capital markets.

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 Junk Bond

A Junk bond is a fixed-income instrument that refers to a high-yield or

noninvestment-grade bond. Junk bonds carry a credit rating of BB or
lower. Junk bonds are so called because of their higher default risk in
relation to investment-grade bonds.

High-Yield Bond

A high-yield bond is a high paying bond with a lower credit rating than
investment-grade corporate bonds, Treasury Bonds and municipal
bonds. Because of the higher risk of default, these bonds pay a higher
yield than investment grade bonds. Issuers of high-yield debt tend to be
startup companies or capital-intensive firms with high debt ratios.

Credit Ratings

For the finance manager, bond ratings are extremely important. They provide
an indicator of default risk that in turn affects the rate of return that must be paid on
borrowed funds. An example and description of these ratings follows:

Credit
Credit Risk Description
Rating
Investment Grade
The obligor’s (issuer’s) capacity to meet
Highest Quality AAA its financial commitment on the obligation
is extremely strong.

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 The obligor’s capacity to meet its financial
High Quality AA commitment on the obligation is very
strong.
The obligor’s capacity to meet its financial
commitment on the obligation is still
Upper Medium Grade A strong, though somewhat susceptible to
the adverse effects of changes in
circumstances and economic conditions.
The obligator exhibits adequate protection.
However, adequate economic conditions,
Medium Grade BBB or changing circumstances are more likely
to lead a weakened capacity to meet its
financial commitment.
Below Investment Grade
Faces major ongoing uncertainties or
exposure to adverse business, financial, or
Somewhat
BB economic conditions which could lead to
Speculative
the obligor’s inadequate capacity to meet
its financial commitment.
Adverse business, financial, or economic
conditions will likely impair the obligor’s
Speculative B
capacity or willingness to meet its
financial commitment.
Currently vulnerable to nonpayment, and
Highly Speculative CCC
is dependent upon favorable business,

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 financial, and economic conditions for the
obligor to meet its financial commitment.
Most Speculative CC Current highly vulnerable to nonpayment.
Used to cover a situation where a
bankruptcy petition has been filed or
Imminent default C
similar action taken, but payments on this
obligation are being continued.
Obligations are in default or the filing of a
Default D bankruptcy petition has occurred and
payments are jeopardized.

Types of Bonds

A. Unsecured Long-term Bonds

Debentures

These are unsecured long-term debt and backed only by the reputation
and financial stability of the corporation. Because these bonds are
unsecured, the earning ability of the issuing corporation is of great
concern to the bondholder, the issuing firm may be prohibited from
issuing future secured long-term debt that would create additional
encumbrances of assets. To the issuing firm, debentures will allow it to
incur indebtedness and still preserve some future borrowing power.

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 Subordinated Debentures

Claims of bondholders of subordinated debentures are honored only

after the claims of secured debt and unsubordinated debentures have
been satisfied.

Income Bonds

An Income bond requires interest payments only if earned and non-

payment of interest does not lead to bankruptcy. Usually issued during
the reorganization of a firm facing financial difficulties, these bonds
have longer maturity and unpaid interest is generally allowed to
accumulate for some period of time and must be paid prior to the
payment of any dividends to stockholders.

B. Secured Long-Term Bonds

Mortgage Bonds

A mortgage bond is a bond secured by a lien on real property. Typically,

the market value of a real property is greater than of the mortgage bond
issued. This provides the mortage bondholders with a margin of safety
in the event that the market value of the secured property declines.
Should the issuing firm fail to pay the bond at maturity; the trustees can
foreclose or sell the mortgaged property and use the proceeds to pay the
bondholders.

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Mortgage bonds can further be sub-classified as follows:

a. First Mortgage Bonds

The first mortgage bonds have senior claim on the secured assets
if the same property has been pledged on more than one
mortgage bond.

b. Second Mortgage Bonds

These bonds have the second claim on assets and are paid only
after the claims of the first mortgage bonds have been satisfied.

c. Blanket or General Mortgage Bonds

All the assets of the firm are used as security for this type of
bonds.

d. Closed-end Mortgage Bonds

The closed-end mortgage bonds forbid the further use of the

pledged assets security for other bonds. This protects the
bondholders from dilution of their claims on the assets by any
future mortgage bonds.

e. Open-end Mortgage Bonds

These bonds allow the issuance of additional mortgage bonds

using the same secured assets as security. However, a restriction
may be placed upon the borrower, requiring that additional assets
should be added to the secured property if new debt is issued.

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 f. Limited Open-end Mortgage Bonds

These Bonds allow the issuance of additional bonds up to a

limited amount at the same priority level using the already
mortgage assets as security.

Other Types of Bonds

1. Floating Rate or Variable Rate Bonds

A floating rate bond is one in which the interest payment changes with
the market conditions. In periods of unstable interest rates. This type of
debt offering becomes appealing to issuers and investors. To the issuers
like banks and finance companies, whose revenue go up when interest
rates rise and declines as interest rates fall, this type of debt eliminates
some of the risk and variability in earnings that accompany interest rate
swings. To the investors, it eliminates major swings in the market value
of the debt that would otherwise have occurred if interest rates had
changed.

2. Junk or Low-Rated Bonds

Junk or low rated bonds are bonds rated BB or below. The major
participants of this market are new firms that do not have an established
record of performance, although in recent years junk bonds have been
increasingly issued to finance corporate buyouts. Since junk bonds are
of speculative grade, they carry a coupon rate of between 3 to 5 percent
more than AAA grade long-term debt. As a result, there is now an active
market for these new debt instruments. Because of the acceptance of
junk or low-rated bonds, man new firms without established
performance records now have a viable financing alternative to secure
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 financing through a public offering. Rather than being forced to rely on
more costly commercial bank loans.

3. Eurobonds

These are bonds payable or denominated in the borrower’s currency,

but sold outside the country of the borrower, usually by an international
syndicate of investment bankers. This market is denominated by bonds
stated in U.S. dollars ($).

The Eurobond is usually sold by an international syndicate of

investment bankers and includes bonds sold by companies in
Switzerland, Japan, Netherlands, Germany, the United States, and
Britain, to name the most popular countries.

4. Treasury Bonds

Treasury bonds carry the “full-faith-and-credit” backing of the

government and invstors consider them among the safest fixed-income
investments in the world. The BSP (Bangko Sentral ng Pilipinas) sells
Treasury securities through public auctions usually to finance the
government’s budget defict. When the defict is large, more bonds come
to auction. In addition, the BSP uses Treasury securities to implement
monetary policy.

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 References
 Ma. Elenita Balatbat Cabrera, Financial Management 2,
2015
 http://www.investopedia.com/terms/h/high_yield_bond.asp
 http://www.investopedia.com/terms/j/junkbond.asp



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