The following types of long-term debt are covered here:
- 1. Term loans
- 2. Bonds
- 3. Debentures
- 4. Mortgage bonds
- 5. Convertible bonds
- 6. Senior debt
- 7. Subordinated debt
- 8. Junk bonds
Term Loans. This is the form of long-term debt most frequently
used by businesses. It is a loan from a bank to acompany
that is used to finance expansion efforts. It has afixed maturity
date, frequently five to seven years from the date ofthe loan. The
company will repay the loan in monthly installments ofprincipal
and interest. Spreading the payments of the principalover the
life of the loan is called loan amortization. The monthly payments
of principal and interest are called debt service. The amortization
of the principal can take place over a period that islonger
than the loan period. With this arrangement, theremaining principal
is due at the end of the loan period. That endingbalance is
called a balloon payment.
Bonds. A bond has many characteristics similar to those of a
term loan. The differences are:
- 1. A bond is a negotiable instrument that can bebought and
sold like common stock.
- 2. A bond is usually sold to the public through apublic offering
registered with the Securities and ExchangeCommission.
Bonds are usually sold in units of $1,000. A bond thatis selling at
its face value is said to be selling at par. The interest rate is called
the coupon. After these securities are issued, their prices fluctuate
in accordance with economic conditions. The prices ofmany
of these securities are quoted daily in all majorfinancial publications.
Bonds are usually interest payments only withprincipal
repaid at maturity.
Debentures. A debenture is a bond with only ‘‘the full faith
and credit’’ of the company as collateral. Other thanthe credit
rating and creditworthiness of the debtor, there is nospecific collateral.
The owners of these bonds, therefore, are classifiedas
Mortgage Bonds. A mortgage bond differs from a debenture
only in that there is specific collateral to back upthe security.
Owners of these bonds are known as secured lenders.Because of
this collateral, the interest rate should be lowerthan that on a
Convertible Bonds. This is a type of debenture with a very
interesting feature. If a company does not have a highcredit rating
and therefore does not qualify for a reasonableinterest rate, it
would be prohibitively expensive for that company tosell bonds.
Remember that investors and lenders have verydifferent risk/
reward relationships. An investor may take a very highrisk in the
hope of experiencing a very high reward. A lender cannever
make more that the interest rate, and thus a lenderthat takes a
very high risk may lose everything without having theprospect
of a high reward. The convertible bond changes therisk/reward
relationship for the lender.
The bond is sold at a relatively low interest rate,perhaps
7 percent rather than the 12 percent that the companywould
otherwise have to pay. The owner of the bond has theright to
convert the bond into shares of common stock at alater date.
The company enjoys an affordable interest rate and cannow expand
its business. The owners of the convertible bonds getsome
interest and share in the rewards of success if thecompany does
well and the price of the stock increases to above apredeter190
mined threshold price called the strike price. Prices of convertible
bonds are listed in the bond price tables in majorfinancial publications
with the extra symbol CV.
Senior Debt. This is a debenture issue that gives its holders
priority over the holders of all other debentureissues in receiving
interest payments and access to the company’s assetsin case of
Subordinated Debt. Holders of this type of debt have priority
below that of the holders of senior debt. Because ofthis secondary
position and the resulting higher risk position,holders of
this debt will receive a higher interest rate than theholders of
Junk Bonds. The creditworthiness of most companies and
their securities is rated by various agencies such asStandard &
Poor’s and Moody’s. Generally bonds with the three orfour highest
ratings are classified as investment grade. Bonds inthis category
are recommended for pension funds and veryconservative
Bonds that do not qualify for these high ratings havea much
smaller pool of available buyers. As a result, theymust pay considerably
higher interest rates, and so they are classified as ‘‘high
yield.’’ As a company’s creditworthiness declines, theyield on its
bonds increases at an increasing rate because of the incrementally
greater risk. When bonds reach a very-high-yield,lowerquality
status, they are known as ‘‘junk’’ bonds.