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Asset-Backed Bonds

The rock star David Bowie earns royalties from a number of successful albums such as The Rise and Fall of Ziggy Stardust and Diamond Dogs. But instead of waiting to receive these royalties, Bowie decided that he would prefer the money upfront. The solution was to issue $55 million of 10-year bonds and to set aside the future royalty payments from the singer`s albums to make the payments on these bonds. Such bonds are known as asset-backed securities; the borrower sets aside a group of assets and the income from these assets is then used to service the debt. The Bowie bonds are an unusual example of an asset-backed security, but billions of dollars of house mortgages and credit card loans are packaged each year and resold as asset backed bonds.

Reverse floaters. Floating-rate bonds that pay a higher rate of interest when other interest rates fall and a lower rate when other rates rise are called reverse floaters. They are riskier than normal bonds. When interest rates rise, the prices of all bonds fall, but the prices of reverse floaters suffer a double whammy because the coupon payments on the bonds fall as the discount rate rises. In 1994 Orange County, California, learned this the hard way, when it invested heavily in reverse floaters. Robert Citron, the treasurer, was betting that interest rates would fall. He was wrong; interest rates rose sharply and partly as a result of its investment in reverse floaters, the county lost $1.7 billion. These three examples illustrate the great variety of potential security designs. As long as you can convince investors of its attractions, you can issue a callable, subordinated, floating-rate bond denominated in euros. Rather than combining features of existing securities, you may be able to create an entirely new one. We can imagine a copper mining company issuing preferred shares on which the dividend fluctuates with the world copper price. We know of no such security, but it is perfectly legal to issue it andБІАААдwho knows?БІАААдit might generate considerable interest among investors.

Variety is intrinsically good. People have different tastes, levels of wealth, rates of tax, and so on. Why not offer them a choice? Of course the problem is the expense of designing and marketing new securities. But if you can think of a new security that will appeal to investors, you may be able to issue it on especially favorable terms and thus increase the value of your company.

Convertible Securities

We have seen that companies sometimes have the option to repay an issue of bonds before maturity. There are also cases in which investors have an option. The most dramatic case is provided by a warrant, which is nothing but an option. Companies often issue warrants and bonds in a package.

Warrants

Macaw Bill wishes to make a bond issue, which could include some warrants as a БІАААмsweetener.БІАААн Each warrant might allow you to purchase one share of Macaw stock at a price of $50 any time during the next 5 years. If Macaw`s stock performs well, that option could turn out to be very valuable. For instance, if the stock price at the end of the 5 years is $80, then you pay the company $50 and receive in exchange a share worth $80. Of course, an investment in warrants also has its perils. If the price of Macaw stock fails to rise above $50, then the warrants expire worthless.

A convertible bond gives its owner the option to exchange the bond for a predetermined number of common shares. The convertible bondholder hopes that the company`s share price will zoom up so that the bond can be converted at a big profit. But if the shares zoom down, there is no obligation to convert; the bondholder remains just that. Not surprisingly, investors value this option to keep the bond or exchange it for shares, and therefore a convertible bond sells at a higher price than a comparable bond that is not convertible.

The convertible is rather like a package of a bond and a warrant. But there is an important difference: when the owners of a convertible wish to exercise their options to buy shares, they do not pay cashБІАААдthey just exchange the bond for shares of the stock.

Companies may also issue convertible preferred stock. In this case the investor receives preferred stock with fixed dividend payments but has the option to exchange this preferred stock for the company`s common stock. The preferred stock issued by Heinz is convertible into common stock. These examples do not exhaust the options encountered by the financial manager.

CONVERTIBLE BOND Bond that the holder may exchange for a specified amount of another security.

WARRANT Right to buy shares from a company at a stipulated price before a set date.