Previously, I mentioned about the mix of capitalization in a corporation. This brings us to the important question of how bonds affects stockholders.
In a nutshell, bonds and debentures (unsecured bonds) are debts or rather, contractual obligations. A bond agreement states the interest rate and the date the bond will be repaid. Since the bond interest rate is predetermined, their attraction as an investment tool changes over time.
There is a whole school of knowledge behind bond investments but two simple facts stand out. A bond whose interest rate is high compared to current rates will command a high market price and be traded at a premium. Conversely, if the federal bank raise interest rates, bond rates become less attractive and the bond will trade at a discount.
Given that a bond takes precedence over equity (ownership), a company has to repay bondholders at a specified date, regardless of whether there is money in the coffers or not. The greater the capitalization ratio represented by bonds, the greater the payment obligation yearly.
If a company depends exclusively on increasing bonds for its lifeblood while profits are stagnant, interest expenses will overwhelm the entire profitability structure.
A stock’s market price is determined by earnings and net profit. Burgeoning interest expenses affect a company’s prospect (insufficient money to fund operational needs, expansion or research and development), which will then restrict its market value. Not to mention, lesser money to pay dividends to stockholders.
Thus, our main interest as stockholders is to determine whether management is keeping debt capital in line with growth expectations and profitability.