Bonds can have additives on them known as Bond Enhancements. Bond Enhancements place additional controls on the issuer and limit their potential actions. They often operate in your benefit, but you should always ensure that there are no surprises within the bond contracts. The three main bond enhancements are Covenants, Insurance, and Sinking Funds.
A Bond Covenant determines how a bond issuer can behave after an issue. Are they restricted from issuing new debt, or is there a debt limitation? Are they required to keep a specific amount of cash on hand specifically for paying their bonds? Do they have to initiate specific actions when downgraded? A covenant controls what they can do by setting limitations in writing. They protect you in specific situations and define your expectations from the firm. It also protects the firm from having to react arbitrarily to bondholder demands. They can simply point at a prospectus and say, “By contract, we don’t have to do that”. Enhancements come in two flavors: If the enhancement forbids actions it is restrictive. If it requires specific actions within a circumstance they are affirmative.
Bond Insurance allows bonds issued by firms with low credit ratings to offer safer bonds. The bond issuer insures their bonds by paying premiums to a bond insurer. In exchange, the insurer guarantees the bond purchaser that if the firm defaults, the insurer will service the bond. This reduces some of the loss suffered if the bond issuer defaults, but won’t protect you against all losses suffered. These enhancements allow risky bond issuers to sell their bonds at lower interest rates.
A Sinking Fund is used by bond issuers to retire debts constantly and before maturity. Issuers regularly deposit money into their sinking fund. The sinking fund then purchases issued bonds on a scheduled basis. They purchase these bonds at a fixed cost or market price, whichever is less, and retires those debts. By using a sinking fund, the firm constantly reduces the level of outstanding debt which makes managing long term debts easier. Paying back a portion of final maturities regularly is easier than paying a large amount of money up front at maturity. A bond covenant requirement to maintain a sinking fund provides additional security against default. You should note that it does not eliminate the risk of default.
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