Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall7-1 Chapter 7 Corporate Debt...

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 7-1

Chapter 7

Corporate Debt

Instruments


Learning ObjectivesAfter reading this chapter, you will understand the different types of securities issued by the Treasury the key provisions of a corporate bond issue provisions for paying off a bond issue prior to the stated maturity date corporate bond ratings and what investment-grade bonds and noninvestment-grade (or high-yield) bonds are event risk bond structures that have been used in the high-yield bond market empirical evidence concerning the historical risk and return pattern in the corporate bond market what a recovery rating is the secondary market for corporate bonds


Learning Objectives (continued)

After reading this chapter, you will understand the different types of securities issued by the Treasury the private-placement market for corporate bonds a medium-term note the difference between the primary offering of a medium-term note and a corporate bond what a structured medium-term note is and the flexibility it affords issuers what commercial paper is and why it is issued the credit ratings of commercial paper the difference between directly placed and dealer-placed commercial paper what a bank loan is and the difference between an investment-grade bank loan and a leveraged bank loan the market for leveraged loans


Corporate Bonds Features of a Corporate Bond Issue Corporate bonds are classified by the type of issuer.o The four general classifications used by bond information services

are utilities, transportations, industrials, and banks and finance companies.

The essential features of a corporate bond are straightforward. The corporate issuer promises to pay a specified percentage of

par value (the coupon payments) on designated dates and to repay par or principal value of the bond at maturity.

Failure to pay either the principal or interest when due constitutes legal default, and investors can go to court to enforce the contract.


Corporate Bonds (continued)

Features of a Corporate Bond Issue Corporate bonds are classified by the type of issuer. The indenture is made out to the corporate trustee as a

representative of the interests of bondholders; that is, a trustee acts in a fiduciary capacity for investors who own the bond issue.

Most corporate bonds are term bonds; that is, they run for a term of years, then become due and payable.

Generally, obligations due in under 10 years from the date of issue are called notes.

Serial bonds are arranged so that specified principal amounts become due on specified dates.



Security for Bonds Some companies own securities of other companies; they are

holding companies, and the other companies are subsidiaries. Debenture bonds are debt securities not secured by a specific

pledge of property. Subordinated debenture bonds rank after secured debt, after

debenture bonds, and often after some general creditors in their claim on assets and earnings.

For a given corporation, secured debt (such as mortgage bonds) will cost less than debenture bonds, and debenture bonds will cost less than subordinated debenture bonds.

Guaranteed bonds are obligations guaranteed by another entity.



Provisions for Paying off Bonds Most corporate issues have a call provision allowing the

issuer an option to buy back all or part of the issue prior to the stated maturity date.

The premium plus the principal at which the issue is called is referred to as the make-whole redemption price.

The prices shown in Exhibit 7-1 are called the regular or general redemption prices. (See truncated version of Exhibit 7-1 in Overhead 7-8.)

There are also special redemption prices for debt redeemed through the sinking fund and through other provisions, and the proceeds from the confiscation of property through the right of eminent domain.


Exhibit 7-1 Redemption Schedule for Anheuser-Busch Cos., Inc., 10% Sinking Fund Debentures Due July 1, 2018The Debentures will be redeemable at the option of the Company at any time in whole or in part, upon not fewer than 30 nor more than 60 days’ notice, at the following redemption prices (expressed in percentages of principal amount) in each case together with accrued interest to the date fixed for redemption: If redeemed during the 12 months beginning July 1,

Redemption1999 104.5%2000 104.0%2001 103.5%2002 103.0%2003 102.5%2004 102.0%2005 101.5%2006 101.0%2007 100.5%2008 and thereafter 100.0%

Provided, however, that prior to July 1, 1998, the Company may not redeem any of the Debentures pursuant to such option, directly or indirectly, from or in anticipation of the proceeds of the issuance of any indebtedness for money borrowed having an interest cost of less than 10% per annum.



Provisions for Paying off Bonds Call protection is much more absolute than refunding

protection. Refunding means to replace an old bond issue with a

new one, often at a lower interest cost. Bonds can be called in whole (the entire issue) or in

part (only a portion). When less than the entire issue is called, the specific

bonds to be called are selected randomly or on a pro rata basis.

A sinking fund requirement requires the issuer to retire a specified portion of an issue each year.



Accrued Interest In addition to the agreed-upon price, the buyer

must pay the seller accrued interest.Each month in a corporate bond year is 30

days, whether it is February, April, or August.A 12% coupon corporate bond pays $120 per

year per $1,000 par value, accruing interest at $10 per month or $0.33333 per day.


Corporate Bonds (continued) Corporate Bond Ratings Professional money managers use various techniques to

analyze information on companies and bond issues in order to estimate the ability of the issuer to live up to its future contractual obligations.

o This activity is known as credit analysis. Individual investors and institutional bond investors rely

primarily on nationally recognized rating companies that perform credit analysis and issue their conclusions in the form of ratings.

The three commercial rating companies are Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch Ratings.


Corporate Bonds (continued) Corporate Bond Ratings In all rating systems the term high grade means low credit risk, or

conversely, high probability of future payment. Bonds rated triple A are said to be prime; double A are of high

quality; single A issues are called upper medium grade, and triple B are medium grade.

Bond issues that are assigned a rating in the top four categories are referred to as investment-grade bonds.

Issues that carry a rating below the top four categories are referred to as noninvestment-grade bonds, or more popularly as high-yield bonds or junk bonds.

Thus, the corporate bond market can be divided into two sectors: the investment-grade and noninvestment-grade markets.

Exhibit 7-3 (see Overhead 7-13) gives a rating transition matrix, which specifies how ratings change over various periods of time.


Exhibit 7-3Hypothetical One-Year Rating Transition Matrix

Rating at End of Year

Rating at Startof Year

Aaa Aa A Baa Ba B C or D Total

Aaa 91.00 8.30 0.70 0.00 0.00 0.00 0.00100.0

0

Aa 1.50 91.40 6.60 0.50 0.20 0.00 0.00100.0

0

A 0.10 3.00 91.20 5.10 0.40 0.20 0.00100.0

0


Corporate Bonds (continued) Default Rates and Default Loss Rates Exhibit 7–4 shows the number of defaulted issues each

year from 1985 to 2006 for all corporate bonds and then broken down by their original rating for investment-grade and noninvestment-grade bonds. (See truncated version of Exhibit 7-4 in Overhead 7-15.)

As expected, a higher percentage of defaults are for non-investment-grade rated bonds.

Exhibit 7-5 provides information about default rates for high-yield corporate bonds by year from 1985 to 2006. (See truncated version of Exhibit 7-5 in Overhead 7-16.)


Exhibit 7-4 Defaults by Original Ratings (Investment Grade Versus Non-Investment Grade) by Year, 1985–2006

YearTotal # Defaulted

Issues% Originally Rated Investment Grade

% Originally Rated Non-Investment Grade

2006 52 13 872005 184 49 51

2004 79 19 81

2003 203 33 67

2002 322 39 61

2001 258 14 86

2000 142 16 84

1999 87 13 87

1998 39 31 69

1997 20 0 100

1996 24 13 88


Exhibit 7-5 Historical High-Yield Dollar-Denominated Rate for Corporate Bonds in the U.S. and Canada 1985–2006

YearPar Value Outstanding

($ millions)Par Value Defaults

($ millions)Default Rate

(%)

2006 993,600 7,559 0.7612005 1,073,000 36,209 3.375

2004 933,100 11,657 1.249

2003 825,000 38,451 4.661

2002 757,000 96,858 12.795

2001 649,000 63,609 9.801

2000 597,200 30,295 5.073

1999 567,400 23,532 4.147

1998 465,500 7,464 1.603

1997 335,400 4,200 1.252

1996 271,000 3,336 1.231


Corporate Bonds (continued) Default Rates and Default Loss Rates A higher percentage of defaults are for non-investment-grade

rated bonds. To evaluate the performance of the corporate bond sector, more

than just default rates are needed. It is perfectly possible for a portfolio of corporate bonds to

suffer defaults and to outperform Treasuries at the same time, provided the yield spread of the portfolio is sufficiently high to offset the losses from default.

The recovery rate is the percentage of the face amount of the bond recovered by the holder.

An important measure in studying the performance of the corporate bond sector is the default loss rate, defined as:

Default loss rate = Default rate × (100% – Recovery rate)



Event RiskOccasionally, the ability of an issuer to make

interest and principal payments changes seriously and unexpectedly because of:

i. a natural or industrial accident or some regulatory change

ii. a takeover or corporate restructuringThese risks are referred to generically as

event risk.



Event RiskOccasionally, the ability of an issuer to make

interest and principal payments changes seriously and unexpectedly because of:

i. a natural or industrial accident or some regulatory change

ii. a takeover or corporate restructuringThese risks are referred to generically as

event risk.



High-Yield Corporate Bond Sector High-yield bonds, commonly called junk bonds, are issues

with quality ratings below triple B. Bond issues in this sector of the market may have been

downgraded to noninvestment-grade, or they may have been rated noninvestment-grade at the time of issuance, called original-issue high-yield bonds.

Bonds that have been downgraded fall into two groups:i. issues that have been downgraded because the issuer

voluntarily significantly increased their debt as a result of a leveraged buyout or a recapitalization

ii. issues that have been downgraded for other reasons


Corporate Bonds (continued) High-Yield Corporate Bond Sector In leveraged buyout (LBO) or a recapitalization, the heavy interest

payment burden that the corporation assumes places severe cash flow constraints on the firm.

o To reduce this burden, firms have issued bonds with deferred coupon structures that permit the issuer to avoid using cash to make interest payments for a period of three to seven years.

As given below, there are three types of deferred coupon structures:i. Deferred-interest bonds sell at a deep discount and do not pay interest

for an initial period, typically from three to seven years.ii. Step-up bonds do pay coupon interest, but the coupon rate is low for

an initial period and then increases (“steps up”).iii. Payment-in-kind (PIK) bonds give the issuer an option to pay cash at

a coupon payment date or give the bondholder a similar bond.


Corporate Bonds (continued) High-Yield Corporate Bond Sector In late 1987, a junk bond came to market with a structure allowing

the issuer to reset the coupon rate. The new rate will then reflect both the level of interest rates at the

reset date, and the credit spread the market wants on the issueo This structure is called an extendable reset. In a floating-rate issue, the coupon rate resets according to a fixed

spread over some benchmark.o The spread reflects market conditions on the issue date. The advantage to issuers of extendable reset bonds is that they can be

assured of a long-term source of funds based on short-term rates. For investors, the advantage of these bonds is that the coupon rate

will reset to the market rate (both the level of interest rates and the credit spread, in principle keeping the issue at par).


Corporate Bonds (continued) Performance of High-Yield Bonds There have been several studies of the risk and return in the high-

yield bond market.o In the long run, high-yield corporate bonds have outperformed both

investment grade corporate bonds and Treasuries but have been outperformed by common stock.

Recovery Ratings While credit ratings provide guidance for the likelihood of default

and recovery given default, the market needed better recovery information for specific bond issues.

In response to this need, two ratings agencies, Fitch and Standard & Poor’s, developed recovery rating systems for corporate bonds.

S&P recovery ratings for secured debt are given in Exhibit 7-10 (see Overhead 7-24) and the FitchRating recovery rating system is given in Exhibit 7-11 (see Overhead 7-25).


Exhibit 7-10S&P Recovery Ratings for Secured Debt

Recovery Rate

Ultimate Recovery of Principal

Indicative Recovery Expectation

1+Highest expectation of fullrecovery of principal 100% of principal

1High expectation of fullrecovery of principal 100% of principal

2 Substantial recovery of principal 80%–100% of principal

3 Meaningful recovery of principal 50%–80% of principal

4 Marginal recovery of principal 25%–50% of principal

5 Negligible recovery of principal 0%–25% of principal


Exhibit 7-11FitchRating Recovery Rating System

Recovery Rating Recovery Prospect Recovery Band

R1 Outstanding 91%–100%

R2 Superior 71%–90%

R3 Good 51%–70%

R4 Average 31%–50%

R5 Below 11%–30%

R6 Poor 0%–10%


Corporate Bonds (continued) Secondary Market As with all bonds, the principal second market for corporate bonds

is the over-the-counter (OTC) market. Efforts to increase price transparency in the U.S. corporate debt

market resulted in the introduction in July 2002 by the National Association of Securities Dealers (NASD) in a mandatory reporting of OTC secondary market transactions for corporate bonds.

The Trade Reporting and Compliance Engine (“TRACE”) requires that all broker/dealers who are NASD member firms report transactions in corporate bonds to them.

Traditionally, corporate bond trading has been an OTC market conducted via telephone and based on broker-dealer trading desks.

Electronic bond trading now makes up about 30% of corporate bond trading.



Private-Placement Market for Corporate Bonds Securities privately placed are exempt from the

registration with the SEC because they are issued in transactions that do not involve a public offering.

The private-placement market has undergone a major change since the adoption of SEC Rule 144A in 1990, which allows the trading of privately placed securities among qualified institutional buyers.

Unlike publicly issued bonds, the issuers of privately placed issues tend to be less well known.

Yields on privately placed debt issues are still higher than those on publicly offered bonds.


Medium-Term Notes A medium-term note (MTN) is a corporate debt instrument,

with the unique characteristic that notes are offered continuously to investors by an agent of the issuer.

Investors can select from several maturity ranges: 9 months to 1 year, more than 1 year to 18 months, more than 18 months to 2 years, and so on up to 30 years.

Medium-term notes are registered with the SEC under Rule 415 (the shelf registration rule), which gives a corporation the maximum flexibility for issuing securities on a continuous basis.

Borrowers have flexibility in designing MTNs to satisfy their own needs.

They can issue fixed- or floating-rate debt. The coupon payments can be denominated in U.S. dollars or in a

foreign currency.


Medium-Term Notes (continued)

Primary Market Medium-term notes differ from corporate bonds in the manner in

which they are distributed to investors when they are initially sold.

Although some investment-grade corporate bond issues are sold on a best-efforts basis, typically they are underwritten by investment bankers.

Traditionally, MTNs have been distributed on a best-efforts basis by either an investment banking firm or other broker/dealers acting as agents.

Another difference between corporate bond and MTNs when they are offered is that MTNs are usually sold in relatively small amounts on a continuous or an intermittent basis, whereas corporate bonds are sold in large, discrete offerings.


Medium-Term Notes (continued)

Structured MTNs At one time the typical MTN was a fixed-rate debenture

that was noncallable. It is common today for issuers of MTNs to couple their

offerings with transactions in the derivative markets (options, futures/forwards, swaps, caps, and floors) so as to create debt obligations with more interesting risk-return features than are available in the corporate bond market.

MTNs created when the issuer simultaneously transacts in the derivative markets are called structured notes.

The most common derivative instrument used in creating structured notes is a swap.


Commercial Paper Commercial paper is a short-term unsecured

promissory note that is issued in the open market and that represents the obligation of the issuing corporation.

The primary purpose of commercial paper was to provide short-term funds for seasonal and working capital needs.

Corporations now use commercial paper for other purposes such as bridge financing.

For example, suppose that a corporation needs long-term funds to build a plant or acquire equipment.

Rather than raising long-term funds immediately, the corporation may elect to postpone the offering until more favorable capital market conditions prevail.

The funds raised by issuing commercial paper are used until longer-term securities are sold.


Commercial Paper (continued) Characteristics of Commercial Paper In the United States, commercial paper ranges in maturity

from 1 day to 270 days. Special provisions in the 1933 act exempt commercial

paper from registration as long as the maturity does not exceed 270 days.

To avoid the costs associated with registering issues with the SEC, firms rarely issue commercial paper with maturities exceeding 270 days.

To pay off holders of maturing commercial paper, issuers generally use the proceeds obtained by selling new commercial paper.

o This process is often described as rolling over short-term paper.


Commercial Paper (continued) Issuers of Commercial Paper There are more than 1,700 issuers of commercial papers

in the United States. Corporate issuers of commercial paper can be divided

into financial companies and nonfinancial companies. Although the issuers of commercial paper typically have

high credit ratings, smaller and less well-known companies with lower credit ratings have been able to issue commercial paper .

o They have been able to do so by means of:i. credit support from a firm with a high credit rating (such paper is

called credit-supported commercial paper)ii. collateralizing the issue with high-quality assets (such paper is

called asset-backed commercial paper).


Commercial Paper (continued)

Default Risk and Credit Ratings With one exception, between 1971 and mid-1989 there

were no defaults on commercial paper. The three companies that rate corporate bonds and

medium-term notes also rate commercial paper.o The ratings assigned by these three rating companies are

shown in Exhibit 7-12 (see Overhead 7-35).o As with the ratings on other securities, commercial paper

ratings are categorized as either investment grade or non-investment grade.

o As with corporate bond ratings, rating agencies publish rating transition matrices for commercial paper ratings.


Exhibit 7-12FitchRating Recovery Rating System

Category Fitch Moody’s S&P

Investment grade F-1+ A-1+

F-1 P-1 A-1

F-2 P-2 A-2F-3 P-3 A-3

Noninvestment grade F-S NP (not prime) B

C

In default D D


Commercial Paper (continued) Directly Placed Versus Dealer-Placed Paper Commercial paper is classified as either direct paper or dealer-

placed paper.i. Directly placed paper is sold by the issuing firm directly to investors

without the help of an agent or an intermediary.ii. Dealer-placed commercial paper requires the services of an agent to

sell an issuer’s commercial paper Tier 1 and Tier 2 Papers A major investor in commercial paper is money market mutual

funds. However, there are restrictions imposed on money market mutual

funds by the SEC. To be eligible commercial paper , the issue must carry one of the

two highest ratings (“Tier-1” or “Tier-2”) from at least two of the nationally recognized statistical ratings agencies.


Commercial Paper (continued) Secondary Market Despite the fact that the commercial paper market is larger than

markets for other money market instruments, secondary trading activity is much smaller.

Yields on Commercial Paper Like Treasury bills, commercial paper is a discount instrument. The commercial paper rate is higher than that on Treasury bills

for the same maturity.o There are three reasons for this.i. The investor in commercial paper is exposed to credit risk.ii. The interest earned from investing in Treasury bills is exempt from

state and local income taxes.iii. Commercial paper is less liquid than Treasury bills.


Bank Loans Bank loans to corporate borrowers are divided into two

categories: investment-grade loans and leveraged loans. An investment-grade loan is a bank loan made to corporate

borrowers that have an investment-grade rating. A leveraged loan is a bank loan to a corporation that has a

below-investment-grade rating. A syndicated bank loan is one in which a group (or syndicate)

of banks provides funds to the borrower. A syndicated bank loan is used by borrowers who seek to raise a

large amount of funds in the loan market.o These bank loans are called senior bank loans because of their

priority position over subordinated lenders (bondholders) with respect to repayment of interest and principal.

o Structures in which no repayment of the principal is made until the maturity date can be arranged and are called bullet loans.


Bank Loans (continued) Syndicated loans are distributed by two methods:

assignment or participation. Each method has its relative advantages and disadvantages,

with the method of assignment being the more desirable of the two.

The holder of a loan who is interested in selling a portion can do so by passing the interest in the loan by the method of assignment.

o In this procedure, the seller transfers all rights completely to the holder of the assignment, now called the assignee.

o The assignee is said to have privity of contract with the borrower.

A participation involves a holder of a loan “participating out” a portion of the holding in that particular loan.


Bank Loans (continued) Secondary Market for Syndicated Bank Loans While at one time, a bank or banks who originated loans

retained them in their loan portfolio, today those loans can be traded in the secondary market or securitized to create collateralized loan obligations and require periodic marking to market.

High-Yield Bond versus Leveraged Loans Leveraged loans are bank loans in which the borrower is

a non-investment-grade borrower. Hence, leverage loans and high-yield bonds are

alternative sources of debt by noninvestment- grade borrowers.


Bankruptcy and Creditor Rights The holder of a corporate debt instrument has

priority over the equity owners in the case of bankruptcy of a corporation, and there are creditors who have priority over other creditors.

The law governing bankruptcy in the United States is the Bankruptcy Reform Act of 1978.

One purpose of the act is to set forth the rules for a corporation to be either liquidated or reorganized.

The liquidation of a corporation means that all the assets will be distributed to the holders of claims of the corporation and no corporate entity will survive.

In a reorganization, a new corporate entity will result.


Bankruptcy and Creditor Rights (continued) Absolute Priority: Theory and Practice The absolute priority rule is the principle that senior creditors are paid

in full before junior creditors are paid anything. The incentive hypothesis argues that the longer the negotiation process

among the parties, the greater the bankruptcy costs and the smaller the amount to be distributed to all parties.

The recontracting process hypothesis argues that the violation of absolute priority reflects a recontracting process between stockholders and senior creditors that give recognition to the ability of management to preserve value on behalf of stockholders.

According to the stockholders’ influence on the reorganization plan hypothesis, creditors are less informed about the true economic operating conditions of the firm than management.

The essence of the strategic bargaining process hypothesis is that the increasing complexity of firms that declare bankruptcy will accentuate the negotiating process and result in an even higher incidence of violation of the absolute priority rule.


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