Question

1. a)            What are the cash flows associated with a bond?

2.             What are the distinguishing features of debt as compared to equity?

3.             What is the indenture? What are protective covenants. Give some examples.

4.            Define the following types of Bonds:

                –   Euro Bond

                –   Zero-Coupon Bond

                –   Samurai Bond

                –   Equipment Obligation Bond

2. a)            Differentiate between term Loans and Bonds.

Answer 1

a) The following are the cash flows associated with a bond:

Cash flows are the actual or virtual transfer of cash into (Cash inflow) and out (Cash outflow) of the business at a particular period of time. Since a bond is a form of borrowing, the cash flows involved are the interest and the principal which are known to be the coupon/yield and face/par value, respectively.

b) The following are the distinguishing features of debt as compared to equity:

Debt: Debt is an amount that is payable to a person or organization for the amount of funds that has been borrowed.

Equity: Equity is the ownership interest of shareholders in a corporation in the form of common stock or preferred stock.

Debt:	Equity
1)The debt has less or no impact on control of the company.	1) Equity requires controlling collectively and also involves imposed restrictions.
2) Debt requires regular interest payments. Company must generate cash flow to pay.	2) Here no payment requirements it may receive dividends but only out of retained earnings.
3) Debt allows beverage of company projects.	3) Shareholders share the company projects.
4) Debt must be repaid or refinanced.	4) It can be usually kept permanently.
5) Debt providers are conservative and they cannot share any profits. Therefore they want to eliminate all possible losses or risks.	5) Equity providers are aggressive and can accept risks because they fully share the upside as well.

​​​​​3) Indenture:

The indenture is the written agreement between the corporation (the borrower) and its creditors. "Deed of trust". Legal document made for tedious reading, but includes, the basic terms of bonds, total amount of bonds issued, description of property used as security, the repayment arrangements, the call provisions, details of the protective covenants.
Protective Covenant- part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the term of the loan.
Negative covenant: limits or prohibits actions the company might take.. limit the amount of dividends it pays according to some formula, firm cannot pledge any assets to other lenders, the firm cannot merge with another firm, the firm cannot sell or lease any major assets without approval by the lender, and the firm cannot issue additional long-term debt
Positive covenant: specifies an action the company agrees to take or a condition the company must abide by... the company must maintain its working capital at or above some specified minimum level, the company must periodically furnish audited financial statements to the lender, the firm must maintain any collateral or security in good condition.

4) Definitions of bonds:

Euro bond: Denominated in one currency, usually that of the issuer, but sold in other national markets.

Zero Coupon bond: A bond paying no coupons, that sells at a discount, and provides only a payment of Par value at maturity.

Samurai bond: Yen dominated bonds, sold in Japan, by non-Japanese issuers.

Equipment obligation bond: Yen dominated bonds, sold in Japan, by non-Japanese issuers.

e) Differentiate between term loans and bonds:

1) The key difference between a loan and bond is that a bond is highly tradeable. If you purchase a bond, there is usually a market place where you can trade the bonds. This means you can even sell the bond, rather than waiting for the end of the thirty-year period. In practical, people purchase bonds when they wish to increase their portfolio in that way. Loans tend to be the agreements between borrowers and the banks. Loans are generally non-tradeable, and the bank will be obliged to see out the entire term of the loan.

2) In the case of repayments, Bonds tend to be only repaid in full at the maturity of the bond – e.g. 10, 20 or 30 years. Banks perhaps expect the repayment of both principal and interest during the repayment period at regular intervals.

3) Interest rates on the government bonds are generally lower. The US and the UK Government bonds are perhaps treated as low-risk. Private loans on unsecured debt, on the other hand, are likely to attract a higher rate of interest. Corporate bonds are mostly somewhere in between – depending upon the reputation of the corporate.

4) Issuing bonds give the corporates significantly greater freedom to operate as they deem fit because it frees them from the restrictions that are often attached to the loans that are lent by the banks. Consider, for example, that lenders or the creditors often require corporates to agree to a variety of limitations, such as not to issue more debt or not to make corporate acquisitions until their loans are repaid entirely.

5) The rate of interest that the companies pay the bond investors is often less than the rate of interest that they would be required to pay to obtain the loan from the bank.

6) Bonds that are traded in the market do possess credit rating which are issued by the credit rating agencies which starts from investment grade to speculative grade where investment grade bonds are considered to be of low risk and usually have low yields whereas speculative bonds are considered of higher risk and hence they are traded at higher yields to compensate the investors for the risk premium. To the contrary, Loan doesn’t have any such concept instead the creditworthiness is checked by the creditor.