Public debt is usually issued as a bond issue. Term bonds and serial bonds refer to the method of scheduling principal repayment and interest payments. Term bonds have a stated maturity on the last day of bond maturity. Serial bonds repay some debt as well as interest every year. Serial bonds are issued in order to take advantage of the yield curve, or interest rate differences between long and short maturity issues.
Serial Debt Service
Bonds are normally issued, along with equity, to provide a cheap but secure funding mechanism. Bonds are designed to be repaid over the useful life of a debt. If a bond issue is used for constructing plant and equipment, then the life of the bond issue should not exceed that of the asset built or purchased. For real estate, such a useful life might be 30 years; for a computer or truck, five years is more appropriate. Credit agencies base their bond ratings on the issuer's ability to pay interest and repay principal, also called debt service. Debt service credit strength is measured by a company's annual ability to repay debt. Like home mortgages, most debt is paid in installments over the life of the project. Debt issued with a series of annual maturities is considered a serial bond. Thus, a five-year serial bond issue will have approximately 20 percent of the debt due each year for five years.
Large public bond offerings are often issued as a combination of serial and term bonds. Highly rated issuers can often secure debt by pledges of assets and the likelihood that corporate cash flow, over time, will increase so that the term portion of a loan can be repaid. It is unreasonable to expect weaker companies to issue debt and have the ability to pay off existing debt from cash flow improvement alone in one large sum. Hence, smaller companies usually rely on serial debt issuance.
Sinking Fund Bonds
A sinking fund requires the bond issuer to call, or redeem prior to maturity, a fixed amount of outstanding term bonds every year. This has the practical effect of retiring a portion of outstanding debt much like a serial bond issue. Sinking funds are executed by the bond trustee, usually a bank, responsible for distributing interest and principal payments and who serves as the intermediary between issuer and investor. While reducing interest expense for the issuer, the sinking fund has a beneficial effect for the investor. As bonds approach an annual mandatory sinking fund, they tend to trade higher in value, reflecting the need for the trustee to redeem a portion of outstanding bonds at par. Par refers to the value at maturity of a bond issue. Bond calculators are readily available for investors on the Internet to compute the effects of a sinking fund on different maturities.
Term and Serial Bond Strategies
Issuers believing that interest rates are near intermediate or long-term low levels will often issue term bonds rather than serial bonds. Term issuance saves interest expense because the need to later issue additional bonds at higher rates is eliminated. Issuers believing interest rates are high will issue bonds with serial maturities but retain a call feature in the bond agreement. This agreement gives the issuer the right, but not the responsibility, to redeem outstanding debt prior to maturity. The issuer can then reissue bonds at a lower interest rate.
- Jupiterimages/Photos.com/Getty Images