Bondholders are providers or lenders of long term debt capital. They will usually give debt capital to the firm on the strength of the following factors:
- The existing asset structure of the firm
- The expected asset structure of the firm
- The existing capital structure or gearing level of the firm
- The expected capital structure of gearing after borrowing the new debt.
- In raising capital, the borrowing firm will always issue the financial securities in form of debentures, ordinary shares, preference shares, bond etc.
- In case of shareholders and bondholders the agent is the shareholder who should ensure that the debt capital borrowed is effectively utilized without reduction in the wealth of the bondholders. The bondholders are the principal whose wealth is influenced by the value of the bond and the number of bonds held.
- Wealth of bondholders = Market value of bonds x No. of bonds /debentures held.
- An agency problem or conflict of interest between the bondholders (principal) and the shareholders (agents) will arise when shareholders take action which will reduce the market value of the bond and by extension, the wealth of the bondholders. These actions include:
a) Disposal of assets used as collateral for the debt in this.
In this case the bondholder is exposed to more risk because he may not recover the loan extended in case of liquidation of the firm.
b) Assets/investment substitution
In this case, the shareholders and bond holders will agree on a specific low risk project. However, this project may be substituted with a high risk project whose cash flows have high standard deviation. This exposes the bondholders because should the project collapse, they may not recover all the amount of money advanced.
c) Payment of High Dividends
Dividends may be paid from current net profit and the existing retained earnings. Retained earnings are an internal source of finance. The payment of high dividends will lead to low level of capital and investment thus reduction in the market value of the shares and the bonds.
A firm may also borrow debt capital to finance the payment of dividends from which no returns are expected. This will reduce the value of the firm and bond.
d) Under investment
This is where the firm fails to undertake a particular project or fails to invest money/capital in the entire project if there is expectation that most of the returns from the project will benefit the bondholders. This will lead to reduction in the value of the firm and subsequently the value of the bonds.
e) Borrowing more debt capital
A firm may borrow more debt using the same asset as a collateral for the new debt. The value of the old bond or debt will be reduced if the new debt takes a priority on the collateral in case the firm is liquidated. This exposes the first bondholders/lenders to more risk.
Solutions to agency problem
The bondholders might take the following actions to protect themselves from the actions of the shareholders which might dilute the value of the bond. These actions include:
1. Restrictive Bond/Debt Covenant
In this case the debenture holders will impose strict terms and conditions on the borrower. These restrictions may involve:
a) No disposal of assets without the permission of the lender.
b) No payment of dividends from retained earnings
c) Maintenance of a given level of liquidity indicated by the
amount of current assets in relation to current liabilities.
d) Restrictions on mergers and organisations
e) No borrowing of additional debt, before the current debt is
f) The bondholders may recommend the type of project to be
undertaken in relation to the riskness of the project.
2. Callability Provisions
These provisions will provide that the borrower will have to pay the debt before the expiry of the maturity period if there is breach of terms and conditions of the bond covenant.
3. Transfer of Asset
- The bondholder or lender may demand the transfer of asset to him on giving debt or loan to the company. However the borrowing company will retain the possession of the asset and the right of utilization.
- On completion of the repayment of the loan, the asset used as a collateral will be transferred back to the borrower.
The lender or bondholder may demand to have a representative in the board of directors of the borrower who will oversee the utilization of the debt capital borrowed and safeguard the interests of the lender or bondholder.
5. Refuse to lend
If the borrowing company has been involved in un-ethical practices associated with the debt capital borrowed, the lender may withhold the debt capital hence the borrowing firm may not meet its investments needs without adequate capital.
The alternative to this is to charge high interest on the borrower as a deterrent mechanism.
6. Convertibility: On breach of bond covenants, the lender may have the right to convert the bonds into ordinary shares.