Bondholders are concerned that payments of interest and repayments of principal are made on time and without problems. The willingness of bondholders to provide funds to companies depends upon the risks and returns that they face, including the companies, expected cash flows, assets, (including security on assets), and credit ratings shareholders, in theory, seek to maximize the value of their shares. This is not necessarily consistent with the interests of bondholders, or the incentive to maximize the total value of the company (the value of equity plus debt).
Shareholders seeking to maximize their wealth, might use the finance provided by bondholders to invest in very risky projects, which change the character of the risk that the bondholders face. If the risky projects are successful, then the rewards flow primarily to the shareholders. If the projects fail, then much of the cost of failure will fall on the bondholders. If there are no constraints on shareholders, the shareholders might have a natural incentive to take such risks.
Management, acting on behalf of shareholders, might also reduce the wealth, and/or increase the risk of bondholders by:
a. Selling off assets of the company
b. Paying large dividends
c. Borrowing additional funds that rank above existing bonds in terms of prior payment upon liquidation.
The incentive for shareholders to take on risks at bondholders’ expense is especially strong when the company is in financial difficulties and in danger of failing. In such circumstances the shareholders may believe that they have little to lose by undertaking risky projects. In the case of corporate failure, significant ‘bankruptcy costs’ normally exist. Direct costs of bankruptcy include receivers and lawyers’ fees, whilst indirect costs might include loss of cash flow prior to failure through loss of sales, worse credit terms etc. When corporate failure occurs most of the firm’s value will be transferred to its debt holders who ultimately bear most of the bankruptcy costs.