Bonds

Theory

Bonds Payable

Corporations must raise funds to finance their operations and ordinarily some of these funds must be provided by external sources. Many large corporations often choose to borrow money by issuing bonds. A bond issue breaks down a large quantity of debt into manageable parts, usually $1,000 units. By dividing their debt into smaller pieces, corporations avoid having to find a single investor that is both willing and able to lend a large amount of money at a reasonable rate of interest.

A corporation that issues bonds is obligated to repay a stated amount, usually referred to as the face amount, at a specified maturity date. In addition, the corporation agrees to pay interest to bondholders between the issue date and maturity. The periodic interest is a stated percentage of the face amount and the payments are generally made semiannually on designated dates beginning six months after the bonds are issued.

All of the specific promises made to bondholders are described in a bond indenture. This formal agreement will specify the bond issue's face amount, the stated interest rate, the method of paying interest, and whether the bonds are backed by any specified assets. The bond indenture also may provide for their redemption through a call feature, by serial payments, through sinking fund provisions, or by conversion. The bond indenture serves as a contract between the corporation and the bondholders. If the corporation fails to comply with the terms of the indenture, a trustee may bring legal action against the corporation on behalf of the bondholders.

At issuance, bonds are recorded as a liability to the corporation borrowing money and an asset to the investor. Each side of this transaction is said to be a mirror image of the other. (Spiceland)

Bonds Sold at Face Amount

On January 1, 2003, Masterwear Industries issued $700,000 of 12% bonds. Interest of $42,000 is payable semiannually on June 30 and December 31. The entire bond issue was sold in a private placement to United Intergroup, Inc. at face amount.

At Issuance (January 1)

Masterwear (Issuer)

Cash ............................................. 700,000

Bonds Payable ............................. 700,000

United (Investor)

Investment in Bonds ........................... 700,000

Cash .......................................... 700,000

However, bonds are not always issued on the same day that they are dated. In such a scenario, the buyer will pay the seller accrued interest for any time that has elapsed since the stated interest date. Consequently, when the issuer pays the investor a full six months' interest at the next interest date, the net interest paid will be correct for the time the bonds have been held.

Bonds Issued Between Interest Dates

On March 1, 2003, Masterwear Industries issued $700,000 of 12% bonds dated January 1. Interest of $42,000 is payable semiannually on June 30 and December 31. The entire issue was purchased by United Intergroup, Inc. for $700,000 plus $14,000 accrued interest.

$700,000 (face amount) x 12% (annual rate) x 2/12 = $14,000 (accrued interest)

At Issuance (March 1)

Masterwear (Issuer)

Cash ................................................... 714,000

Bonds Payable ................................... 700,000

Interest Payable ................................. 14,000

United (Investor)

Investment in Bonds ................................ 700,000

Interest receivable .................................. 14,000

Cash .............................................. 714,000

Furthermore, the price of a bond at issuance is not always equal to the face amount. Bonds frequently sell at a discount or a premium depending on the difference between the stated interest rate and the prevailing market rate for securities with similar risk and maturity. For example, if 12% bonds are trading in a market in which similar bonds are paying a 14% return, the bonds will be sold at a discount. Conversely, if the market rate is only 10%, the 12% stated rate would be relatively attractive and therefore the bonds would sell at a premium. The difference between the stated interest rate and market rate often arises due to the inevitable delay between the date the terms of the issue are established and the date the issue comes to market.

There are numerous factors that shift the supply and demand curves for bonds including riskiness, liquidity, expected inflation, and taxes. The forces of supply and demand cause a bond issue to be priced to yield the market rate of return. In other words, an investor will pay a price that will earn an effective interest rate equal to the market rate. This price is calculated as the present value of all future cash flows including the periodic interest payments plus the face amount payable at maturity, both discounted at the market rate.

Determining the Selling Price

On January 1, 2003, Masterwear issued $700,000 of 12% bonds, dated January 1. Interest is payable semiannually on June 30 and December 31. The bonds mature in three years. The market yield for bonds of similar risk and maturity is 14%.

Present value (price) of the bonds:

Interest $42,000 x 4.76654 * = $200,195

Principal $700,000 x 0.66634 ** = $466,438

Total Present value $666,663

*present value of an ordinary annuity of $1: n=6, i=7%

** present value of $1: n=6, i=7%

Corporations can determine their periodic interest expense by applying the effective interest method. "The effective interest method is the preferred method of accounting for a discount or a premium arising from a note or bond. Under the effective interest method,