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DEBT COMES IN MANY FORMS

Some orderly scheme of classification is essential to cope with the almost endless variety of debt issues. We will walk you through the major distinguishing characteristics.

Interest Rate. The interest payment, or coupon, on most long-term loans is fixed at the time of issue. If a $1,000 bond is issued with a coupon of 10 percent, the firm continues to pay $100 a year regardless of how interest rates change. As we pointed outearlier, you sometimes encounter zero-coupon bonds. In this case the firm does not make a regular interest payment. It just makes a single payment at maturity. Obviously, investors pay less for zero-coupon bonds.

Most loans from a bank and some long-term loans carry a floating interest rate. For example, your firm may be offered a loan at ¬1 percent over prime. ­ The prime rate is the benchmark interest rate charged by banks to large customers with good to excellent credit. (But the largest and most creditworthy corporations can, and do, borrow at less than prime.) The prime rate is adjusted up and down with the general level of interest rates. When the prime rate changes, the interest on your floating-rate loan also changes. Floating-rate loans are not always tied to the prime rate. Often they are tied to the rate at which international banks lend to one another. This is known as the London Interbank

Offered Rate, or LIBOR.

Maturity. Funded debt is any debt repayable more than 1 year from the date of issue. Debt due in less than a year is termed unfunded and is carried on the balance sheet as a current liability. Unfunded debt is often described as short-term debt and funded debt is described as long-term, although it is clearly artificial to call a 364-day debt shortterm and a 366-day debt long-term (except in leap years).

There are corporate bonds of nearly every conceivable maturity. For example, Walt Disney Co. has issued bonds with a 100-year maturity. Some British banks have issued perpetuities ¤that is, bonds which may survive forever. At the other extreme we find firms borrowing literally overnight.

Repayment Provisions. Long-term loans are commonly repaid in a steady regular way, perhaps after an initial grace period. For bonds that are publicly traded, this is done by means of a sinking fund. Each year the firm puts aside a sum of cash into a sinking fund that is then used to buy back the bonds. When there is a sinking fund, investors are prepared to lend at a lower rate of interest. They know that they are more likely to be repaid if the company sets aside some cash each year than if the entire loan has to be repaid on one specified day.

Firms issuing debt to the public sometimes reserve the right to call the debt ¤that is,issuers of callable bonds may buy back the bonds before the final maturity date. The price at which the firm can call the bonds is set at the time that the bonds are issued.

This option to call the bond is attractive to the issuer. If interest rates decline and bond prices rise, the issuer may repay the bonds at the specified call price and borrow the money back at a lower rate of interest.3

The call provision comes at the expense of bondholders, for it limits investors` capital gain potential. If interest rates fall and bond prices rise, holders of callable bonds may find their bonds bought back by the firm for the call price.

Seniority. Some debts are subordinated. In the event of default the subordinated lender gets in line behind the firm`s general creditors. The subordinated lender holds a junior claim and is paid only after all senior creditors are satisfied.

When you lend money to a firm, you can assume that you hold a senior claim unless the debt agreement says otherwise. However, this does not always put you at the front of the line, for the firm may have set aside some of its assets specifically for the protection of other lenders. That brings us to our next classification.

Security. When you borrow to buy your home, the savings and loan company will take out a mortgage on the house. The mortgage acts as security for the loan. If you default on the loan payments, the S&L can seize your home.

When companies borrow, they also may set aside certain assets as security for the loan. These assets are termed collateral and the debt is said to be secured. In the event of default, the secured lender has first claim on the collateral; unsecured lenders have a general claim on the rest of the firm`s assets but only a junior claim on the collateral.

Default Risk. Seniority and security do not guarantee payment. A debt can be senior and secured but still as risky as a dizzy tightrope walker ¤it depends on the value and the risk of the firm`s assets. Earlier, we showed how the safety of most corporate bonds can be judged from bond ratings provided by Moody`s and Standard & Poor`s. Bonds that are rated ¬triple-A ­ seldom default. At the other extreme, many speculative-grade (or ¬junk ­) bonds may be teetering on the brink.

As you would expect, investors demand a high return from low-rated bonds. We saw evidence of this in Section 3, where Figure 3.9 showed yields on default-free U.S. Treasury bonds as well as on corporate bonds in various rating classes. The lower-rated bonds did in fact offer higher promised yields to maturity.

SECURED DEBT Debt that has first claim on specified collateral in the event of default.

SUBORDINATED DEBT Debt that may be repaid in bankruptcy only after senior debt is paid.

CALLABLE BOND Bond that may be repurchased by firm before maturity at specified call price.

SINKING FUND Fund established to retire debt before maturity.

FUNDED DEBT Debt with more than 1 year remaining to maturity.

PRIME RATE Benchmark interest rate charged by banks.