The term debt structure refers to the duration and timing of principal and interest payments. The structure typically refers to characteristics such as the maturity dates, whether a bond issue includes serial bonds or term bonds, and the provisions for calling the bonds.
The maturity of a bond is the date on which the principal of the bond must be repaid. Until this date, there usually are periodic payments of interest made, usually every six months, at a specified percentage of the face value of the bond.
The maturity of a bond issue can be structured either as a serial bond, a term bond, or a combination of serial and term bonds.
A call provision gives the issuer an opportunity to retire a bond prior to the stated maturity.
The maturity of a bond is the date on which the principal of the bond must be repaid. Until this date, there are periodic payments of interest made, usually every six months, at a specified percentage of the face value of the bond. A fundamental tenet of public finance is that the debt maturity approximately coincide with the useful life of the project being financed. This maturity-matching principle helps ensure that the people benefiting from a public project are the ones paying for it.
Usually, a single bond issue will consist of a series of bonds with different maturities. The further away the maturity of a bond, generally the higher the risk of the investment and the higher the interest rate associated with the bond. Generally, this relationship between the maturity of a bond and the interest rate it carries is embodied graphically by the yield curve. A longer term bond is riskier due to uncertainty about future interest rates -- rates might be higher for other investment instruments and the investor would have foregone potential earnings. There is also uncertainty about future inflation rates. Additionally, longer term rates are higher because the possibility of default is greater.
The maturity of an issue can be quite important in an investor's decision-making process. Many investors prefer shorter term tax-exempt investments. There are several factors which influence these considerations: investors are more certain about tax rates in the near future, tax laws favor institutional investment in short-term securities, and there is less danger of illiquidity due to price fluctuations.
There are two approaches to structuring the maturity of bonds. A serial bond issue is an issue consisting of a series of bonds that mature in a regular pattern, usually annually over the entire life of the issue. The interest on each maturity is paid at regular intervals until that particular bond matures. Serial bonds allow the investor a variety of maturities to fit his or her specific needs.
A term bond issue has a single final maturity date when the entire principal will be repaid for all the bonds in the issue. A term bond is usually financed through the use of a sinking fund. A sinking fund is a fund into which the issuer makes payments so that when the maturity date of the term bond arrives, there will be sufficient funds available to repay the bonds. The benefit of a sinking fund is that a period of revenue shortfall can be compensated by another period of revenue surplus.
Term bonds allow for greater flexibility for the issuer than the prearranged payment schedule of serial bonds. Because of their flexibility, term bonds are often used for entities with fluctuating revenue sources. Furthermore, term bonds are popular with some investors due to the active secondary market for them. Municipal bond issues often will have both serial and term securities in the same issue to benefit from their respective advantages.
Bonds can be structured so that the issuer has the option to buy back the bond prior to the stated maturity date. This option is called a call provision and is the mechanism that allows refunding to occur. Callable bonds typically will carry a higher interest rate (10 to 50 basis points) to offset the risk to the bondholders of having their investment cashed out. If an investor must sell back a higher-yield bond during a period of low interest rates, then he or she will have to reinvest the money in other investments that carry a lower yield than the bond he or she had been holding.
Call premiums will typically be higher when interest rates approach cyclical peaks because the rates are bound to fall and there is a much greater chance for early redemption. Often the bond indenture includes a call protection period of five to ten years after the sale date. During this period, the bonds cannot be called. After the call protection period has expired, the issuer must decide if it is in its best interest to call the debt.
Timing is an important consideration in calling a bond because it becomes harder to attain significant savings as the call option ages due to a shorter period in which savings can be obtained. Calling debt is not cost-free. Most call provisions require the issuer to pay a call premium to compensate the investor for an early retirement of the debt. The call premium is usually 2% to 5% above the par value of a bond and will often decrease as the bond ages. Therefore, the issuer must weigh the cost of the call premium, the magnitude of the difference in interest rates, and the length of interest savings when analyzing the decision to call debt.
| Back To Topics | To Previous Section: Financial and Legal Preparation | To Next Section: Bond Rating |