What it means
The distinction between a bondholder and a shareholder is the single most useful thing to understand here. A shareholder owns a slice of the business and does well when it prospers, whereas a bondholder is owed a fixed amount and does equally well whether the company makes a modest profit or a spectacular one.
That fixed claim comes with priority. If a business is wound up, bondholders are paid before shareholders receive anything, and secured bondholders with a charge over specific assets rank ahead of unsecured ones.
Bondholders are not passive. Bond documents contain covenants, meaning promises the borrower must keep, such as holding debt below a stated multiple of profit or not selling major assets without consent.
Most bondholders are institutions rather than individuals: pension funds, insurers, banks and bond funds that need predictable income to match predictable obligations. This matters to a finance team because those investors care intensely about stability and are unforgiving of surprises in results or reporting.
A bondholder does not have to wait for maturity to get money back. Bonds can be sold in the secondary market at whatever price others will pay, so a holder can realise a profit if rates have fallen or take a loss if the issuer's prospects have deteriorated.
In practice
Real-world examples
Example 1
An insurance company buys $12,000,000 of a hospital group's fifteen year bonds because the coupon dates line up with its own long term claim payments. It has no interest in the group's expansion plans, only in whether the interest arrives on time.
Example 2
A manufacturer breaches a covenant limiting net debt to three times profit after a weak year. Its bondholders waive the breach in exchange for a higher coupon and a promise to suspend dividends until the ratio recovers.
Example 3
A family office holds a retailer's bonds and its shares. When the retailer announces a large debt funded acquisition, the share price rises on growth hopes while the bonds fall, because the same deal that excites owners worries lenders.
Think of it
Being a bondholder is like being a bank that gives a mortgage to a homeowner. You do not own the kitchen or get to choose the paint colour, but you have a strict legal right to receive your monthly interest and your original loan back.
Formula
Calculation
Annual interest income = number of bonds x face value x coupon rate
Total return if held to maturity = total coupons received + (face value - purchase price)
An investor buys 20 corporate bonds with a face value of $1,000 each and a 6% coupon, six years before they mature. The bonds are bought at 95, meaning $950 per bond, so the cost is 20 x $950 = $19,000.
Annual interest income is 20 x $1,000 x 6% = $1,200, and over six years the bondholder collects 6 x $1,200 = $7,200 in coupons. At maturity the issuer repays the full face value of 20 x $1,000 = $20,000, a gain of $20,000 - $19,000 = $1,000 on the purchase price.
Total return is therefore $7,200 + $1,000 = $8,200 on an outlay of $19,000 over six years. If the issuer instead defaults after three years, the bondholder has received $3,600 of coupons and joins the queue of creditors for whatever the remaining assets cover.Case study
Seen in the real world
This is an illustrative and clearly fictional example. Larchmont Foods, an invented ready meals producer, raised $40,000,000 through a seven year bond paying 5.5%, with a covenant requiring interest cover of at least three times operating profit. The bondholders were three insurers and a pension fund, all of whom wanted steady income rather than growth.
In year four an ingredient price shock cut Larchmont's operating profit from $9,000,000 to $5,600,000 against an interest bill of $2,200,000. Interest cover fell to $5,600,000 / $2,200,000 = 2.5 times, below the agreed floor, and the bondholders were entitled to demand immediate repayment of the whole $40,000,000.
They chose not to. Repayment would have forced a fire sale of factories worth far less in a hurry than as a going concern, so the fictional bondholders agreed a waiver in return for a coupon rise to 6.25%, a ban on dividends for two years and monthly management accounts. Larchmont paid roughly $300,000 a year extra and kept control, while the bondholders swapped a legal right they could not usefully enforce for better income and better information.
Watch out
Common mistakes
- Describing bondholders as investors in the company in the same sense as shareholders, when they are lenders with a contract rather than owners with a stake.
- Believing bondholders are safe in every circumstance, when unsecured bondholders in an insolvency often recover only part of what they are owed.
- Ignoring covenants until one is breached, at which point the borrower negotiates from a very weak position.
Questions
People also ask
Do bondholders get a vote on how the business is run?
No, they have no vote at general meetings, though covenants give them a say over specific decisions such as taking on more debt or selling assets.
What happens to bondholders if the company is sold?
The bonds usually either transfer with the business or become repayable under a change of control clause, depending on what the bond documents say.
Can an individual be a bondholder?
Yes, through a broker or a bond fund, although minimum trade sizes on corporate bonds often run to $100,000 or more, which pushes most individuals towards funds.