Long-term bonds are the most common type of long-term debt. They can have many different characteristics, including the amount of interest, whether the company can elect to repay them before their maturity date, and whether they can be converted to common stock.
Bonds payable represents a major source of borrowed capital for U.S. firms. Bonds are notes, sold to individual investors as well as to financial institutions. For a variety of reasons, managers may prefer to issue bonds to investors rather than borrowing directly from financial institutions. Bond financing can also offer advantages in terms of the availability and cost of borrowing and the managers’ subsequent flexibility in making business decisions. For example, the amount that financial institutions are willing to loan to a single firm may be limited because the lender aims to diversify its risks by loaning smaller amounts to many different borrowers. The sale of bonds, on the other hand, enables the borrower to obtain access to much larger amounts of loanable funds from large institutional investors and also from thousands of individual investors.
In addition, for some firms, bond financing may be less expensive. The interest rates that prevail in the bond market can be less than the rate available from financial institutions. Finally, bond financing may also offer managers greater flexibility in the future. A direct lending agreement often imposes various restrictions on managers’ investing and financing activities until the loan is repaid. As examples, a lending agreement can restrict the firm’s dividend payments or limit the amounts that the firm can borrow from other lenders until the debt is repaid. Although bond issuances can also entail similar restrictions, they can be less onerous than the restrictions imposed by financial institutions.
A bond is also a contract that is sold to investors. Bonds obligate the borrower (the issuing corporation) to make periodic interest payments, usually every six months, and to pay the principal or face value of the bond at a specified maturity date. Prior to issuing bonds, managers meet with financial advisers to decide on the maturity value and other terms of the bond contract, as well as to predict the market interest rate at which the bonds can be sold. The predicted interest rate usually becomes the coupon rate (also called the face rate or nominal rate) that is contained in the bond contract. This rate, in conjunction with the face value, determines the cash interest to be paid periodically to bondholders.
The market rate of interest cannot be known with certainty until the date on which the bonds are sold. Market interest rates are the “cost of money” and are determined by the forces of supply and demand in the financial markets. The federal government, through the actions of the Federal Reserve, also influences interest rates. Because the market rate constantly changes, and the coupon rate is fixed when the bonds are printed, it is rare that the bond coupon rate will coincide exactly with the market interest rate when the bonds are sold. The following sections illustrate the issuance and reporting for bonds when the market interest rate in turn equals, exceeds, or falls below the coupon rate of interest.
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