Chapter 18

Corporate Bonds

18-2

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

18-3

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.

18-4

Corporate Bond Basics

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

Corporate Bonds Common StockRepresent a creditor’s claim on the corporation

Represents an ownership claim on the corporation

Promised cash flows (coupons and principal) are stated in advance

Amount and timing ofdividends may changeat any time

Mostly callable Almost never callable

18-5

Corporate Bond Types

• “Plain vanilla bonds” or “bullet” bonds• “Bullet” bonds• Issued with standard, simple features

Corporate Bond Type Secured byDebentures UnsecuredMortgage Bonds Lien on specific propertyCollateral trust bonds Pledge of financial assetsEquipment trust certificates Trustee owned equipment

18-6

Tombstone Ad, Equipment Trust Notes Issue

18-7

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

18-8

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

18-9

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

18-10

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.

18-11

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.

18-12

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 20 bp > U.S. T-notes• Ratings BBB

18-13

Make-Whole Call Example• 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)

N 10

I/Y 4.7625/2

PV CPT=-1010.4571

PMT 25

FV 1000

18-14

Tombstone Ad, Convertible Notes Issue

18-15

Convertible Bond Prices and Conversion Values

18-16

Tombstone Ad, Exchangeable Debenture Issue

18-1718-17

Convertible Bonds• Can be exchanged for common stock • Conversion ratio:

# shares acquired by conversionFixed at originationNormally set = 10-20% less than par

• Conversion price:Bond par value/Conversion ratio

• Conversion value:Stock price/share x conversion ratio

18-18

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

18-19

Convertible Bond Example

• Suppose you own a convertible bond with the following features:

Par value $1,000Call premium $25Conversion ratio 25 sharesConversion price $1,000/25=$40Current stock price $35

Conversion value/bond $35 x 25 = $875

• At what stock price should you expect a call?• If called at 10%>par, convert or surrender?

18-20

Convertible Bond ExamplePar value $1,000Call 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

18-21

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

18-22

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

18-23

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”

18-2418-24

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.

18-2518-25

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

18-26

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

18-27

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

18-28

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.

18-29

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”

18-30

Corporate Bond Credit Rating Symbols

18-31

Investment-Grade Bond Ratings

Moody's D&P S$P Credit Rating Description

Aaa 1 AAA Highest credit rating; maximum safetyAa1 2 AA+Aa2 3 AA High credit quality, investment-grade bondsAa3 4 AA-A1 5 A+A2 6 A Upper medium quality, investment-grade bondsA3 7 A-

Baa1 8 BBB+Baa2 9 BBB Lower medium quality, investment-grade bondsBaa3 10 BBB-

Rating Agency

Investment-Grade Bond Ratings

18-32

Speculative-Grade Bond Ratings

Moody's D&P S$P Credit Rating Description

Ba1 11 BB+ Low credit quality, speculative-grade bondsBa2 12 BBBa3 13 BB-B1 14 B+ Very low credit quality, speculative-grade bondsB2 15 BB3 16 B-

Caa 17 CCC+ Extremely low credit standing, high-risk bondsCCC CCC-

Ca CC Extremely speculativeCa C

D Bonds in default

Rating Agency

Speculative-grade Bond Ratings

Extremely Speculative-Grade Bond Ratings

18-33

“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

18-3418-34

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

18-35

The Yield Spread

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

.

18-36

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

18-37

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.

18-38

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)