Bond Contract Provisions That Influence Default Risk (2)

by Maestri

Mortgage Bonds Under a mortgage bond, the corporation pledges certain assets as security for the bond. To illustrate, in 2002 Billingham Corporation needed $10 million to build a major regional distribution center. Bonds in the amount of $4 million, secured by a first mortgage on the property, were issued. (The remaining $6 million was financed with equity capital.) If Billingham defaults on the bonds, the bondholders can foreclose on the property and sell it to satisfy their claims.

If Billingham chose to, it could issue second mortgage bonds secured by the same $10 million of assets. In the event of liquidation, the holders of these second mortgage bonds would have a claim against the property, but only after the first mortgage bondholders had been paid off in full. Thus, second mortgages are sometimes called junior mortgages, because they are junior in priority to the claims of senior mortgages, or first mortgage bonds.
All mortgage bonds are subject to an indenture. The indentures of many major corporations were written 20, 30, 40, or more years ago. These indentures are generally “open ended,” meaning that new bonds can be issued from time to time under the same indenture. However, the amount of new bonds that can be issued is virtually always limited to a specified percentage of the firm’s total “bondable property,” which generally includes all land, plant, and equipment.
For example, in the past Savannah Electric Company had provisions in its bond indenture that allowed it to issue first mortgage bonds totaling up to 60 percent of its fixed assets. If its fixed assets totaled $1 billion, and if it had $500 million of first mortgage bonds outstanding, it could, by the property test, issue another $100 million of bonds (60% of $1 billion $600 million).

Taken From : Five-Minute MBA – Corporate Finance