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Chapter 18

Chapter 18. Corporate Bonds. Corporate Bond Basics. Bonds = debt of a corporation Bond cash flows: Periodic interest or coupon payments Repayment of the principal or face value at maturity Bonds = “fixed income” Predictable cash flows Most corporate bonds callable.

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Chapter 18

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  1. Chapter 18 Corporate Bonds

  2. Corporate Bond Basics • Bonds = debt of a corporation • Bond cash flows: • Periodic interest or coupon payments • Repayment of the principal or face value at maturity • Bonds = “fixed income” • Predictable cash flows • Most corporate bonds callable

  3. Corporate Bond Basics • There are several trillion dollars of corporate bonds outstanding in the United States. • More than half of these are owned by life insurance companies and pension funds. • These institutions can eliminate much of their financial risk via cash flow matching. • They can also diversify away most default risk by including a large number of different bond issues in their portfolios.

  4. Corporate Bond Basics • Corporate bonds differ from common stock in three fundamental ways.

  5. Corporate Bond Types • “Plain vanilla bonds” or “bullet” bonds • “Bullet” bonds • Issued with standard, simple features

  6. Tombstone Ad,Equipment Trust Notes Issue

  7. The Bond Indenture • Formal written agreement between corporation and the bondholders • Legal document • Details mutual rights and obligations of corporation and bondholders • “Indenture Summary” in Prospectus

  8. Seniority Provisions • Critical in event of bankruptcy • Secured debt has first claim on pledged assets • Unsecured debt • Senior debentures • Protected by a negative pledge clause • Subordinated debentures

  9. Put and Call Provisions • Put Provisions • Put dates and prices • Extendible bonds • Call Provisions • Bond refunding • Traditional fixed-price call provisions • Deferred call - Call protection period • Call premium • Refunding provision

  10. Maximum Price of a Fixed-Price Callable Bond • No matter how low market interest rates fall, the maximum price of an unprotected fixed-price callable bond is most likely its call price.

  11. Make-Whole Call Provision • Bondholder “made-whole” if called • Lump sum payment = present value of all payments that will not be made as a result of the call • Discount rate = rate on comparable U.S.Treasury plus a make-whole premium • Minimum = par value of bond • As interest rates , the make-whole call price  • Bonds still exhibit the standard convex price-yield relationship in all yield regions.

  12. Make-Whole Call Example • Settlement date 07/01/2008 • First payment 01/01/2009 • Maturity 07/01/2013 • Coupon 5.00% • Price 98% • Yield 5.4625% • Spread 90 bp > U.S. T-notes • Make-Whole call 20bp > U.S. T-notes • Ratings BBB

  13. Make-Whole Call Example N 10 I/Y 4.7625/2 PV CPT=-1010.4571 PMT 25 FV 1000 • Comparable treasury yield 5.4625% - .90% = 4.5625% • Make-whole premium 4.5625% + .20% = 4.7625% • Make-whole price 101.0457 % of par • Make-whole $ premium 1010.46 – 980.00 = $30.46 per bond • Excel: =PRICE(“07/01/2008”,”07/01/2013”,0.05,0.047625,100,2)

  14. Tombstone Ad,Convertible Notes Issue

  15. Convertible Bond Prices and Conversion Values

  16. Tombstone Ad, Exchangeable Debenture Issue

  17. Convertible Bonds Can be exchanged for common stock Conversion ratio: # shares acquired by conversion Fixed at origination Normally set = 10-20% less than par Conversion price: Bond par value/Conversion ratio Conversion value: Stock price/share x conversion ratio 18-17

  18. Bond-to-Stock Conversions • Timing decisions • Delay as long as possible vs. call provision • Normally called when conversion value is 10-15% > par • Call immediate decision to surrender or convert • “In-the-money”: • Conversion value >call price

  19. Convertible Bond Example • Suppose you own a convertible bond with the following features: Par value $1,000 Call premium $25 Conversion ratio 25 shares Conversion price $1,000/25=$40 Current stock price $35 Conversionvalue/bond $35 x 25 = $875 • At what stock price should you expect a call? • If called at 10%>par, convert or surrender?

  20. Convertible Bond Example Par value $1,000 Call premium $25 Conversion ratio 25 shares Conversion price $1,000/25=$40 • At what stock price should you expect a call? • 10-15% >par = $1,100 – 1,150 • $1,100/25 = $44 • If called at $44/share, you should convert: • Conversion value = $44 x 25 = $1,100 • Call price = $1,025

  21. Bond Maturity and Principal Payment Provisions • Term bonds • Most common structure • All bonds in issue have same maturity date • Usually have a call provision • Sinking fund • Serial Bonds • Fraction of issue matures each year • =collection of “sub-issues” • Usually do not have a call provision

  22. Bond Maturity and Principal Payment Provisions • Sinking Fund provisions • Required periodic payments to a trustee-managed account • Funds used for scheduled redemptions of outstanding bonds • Bonds may be redeemed by • Lottery • Open market purchase

  23. Bond Maturity and Principal Payment Provisions • Coupon payment provisions • Schedule in bond indenture • If payment missed, issuer in default • Protective covenants • Helps protect bondholders from event risk • Negative covenant = “thou shalt not” • Positive covenant = “thou shalt”

  24. Protective Covenants Negative covenant (“thou shalt not”) Firm cannot pay common stock dividends in excess of earnings formula allowance Positive covenant (“thou shalt”) Proceeds from the sale of assets must be used either to acquire other assets of equal value or to redeem outstanding bonds. 18-24

  25. Event Risk The possibility that the issuing corporation will experience a significant change in its bond credit quality Example: October 1992: Marriott Corporation announced its intention to spin off part of the company. Spinoff = Host Marriott = would acquire most of the parent company’s debt and its poorly performing real estate holdings. Host Marriott bonds riskier than Marriott Corporation bonds 18-25

  26. Private Placements • No indenture • Exempt from SEC registration requirements • Simple IOU by issuer to one ore more financial institutions. • Most long term debt = bonds with indentures • Most privately-placed short-term debt = simple IOU

  27. Preferred Stock • Hybrid security • Bond-like • Usually no voting rights • Promised a stream of fixed dividend payments • Stock-like • Usually no specified maturity but often callable • Dividends may be suspended without setting off bankruptcy process • Dividends usually cumulative • Convertible preferred stock

  28. Adjustable Rate Securities • Allows issuer to adjust annual coupon rate • Formula based on current market interest rates • Bonds, notes or preferred stock =“Floaters” • Usually putable at par value • Examples of coupon reset formulas: • Annually to the current rate on 180-day maturity U.S. T-bills plus 2% • Rate cannot be set below 105% of the YTM on newly issued 5-year Treasury notes.

  29. Corporate Bond Credit Ratings • Assessment of the credit quality of a bond issue based on the issuer’s financial condition • Rate new bond issues for a fee paid by issuer • Contractual agreement includes right to continuing review • “Prudent investment guidelines”

  30. Corporate Bond Credit Rating Symbols

  31. Investment-Grade Bond Ratings

  32. Speculative-Grade Bond Ratings

  33. “Junk Bonds” • Moody’s Ba or lower • S&P BB or lower • “High-yield bonds” • “Fallen angels” • Original-issue junk • Yield premium high enough to accept risk

  34. The Yield Spread Extra return (>yield to maturity) investors demand for buying a bond with a lower credit rating (and higher risk) Often quoted in basis points over Treasury notes and bonds 5-year Aaa/AAA yield spread equal to 59 YTM on bond = 59 basis points (0.59%) greater than 5-year U.S. Treasury notes 18-34

  35. The Yield Spread Please insert the art from Work the Web (pg. 602 in First Revision) into this slide. .

  36. Corporate Bond Market Trading • Relatively low liquidity • NYSE bond trading • Most active issues/Large corporations • <1% of all corporate bond trading • Other-the-counter market (OTC) • Limited transparency pre-2002 • TRACE – Trade Reporting and Compliance Engine

  37. Trade Reporting and Compliance Engine (TRACE) • At the request of the SEC, corporate bond trades are now reported through TRACE. • TRACE provides a means for bond investors to get accurate, up-to-date price information. • TRACE has dramatically improved the information available about bond trades. • Transaction prices now reported on > 4,000 bonds • About 75% of market volume for investment grade bonds. • More bonds will be added to TRACE over time.

  38. Useful Websites • www.investinginbonds.com (for more information on corporate bonds) • www.sec.gov (U.S. Securities and Exchange Commission) • www.bondsonline.com (follow the "corporate bond spreads" link) • www.nasdbondinfo.com (for TRACE data on bond trades) • Websites for companies in this chapter: • www.nwa.com (Northwest Airlines) • www.amd.com (Advanced Micro Devices) • www.marriott.com (Marriott International, Inc.) • www.hostmarriott.com (Host Marriott Corporation) • Websites for Ratings Agencies: • www.duffllc.com (Duff and Phelps, LLC.) • www.fitchibca.com (Fitch Investors Service) • www.moodys.com (Moody’s) • www.standardpoors.com (Standard & Poor’s)

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