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Long-Term Debt

20.1 Long Term Debt: A Review20.2 The Public Issue of Bonds

20.3 Bond Refunding

20.4 Bond Ratings

20.5 Some Different Types of Bonds

20.6 Direct Placement Compared to Public Issues

20.7 Long-Term Syndicated Bank Loans

20.8 Summary and Conclusions

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20.1 Long Term Debt: A Review

Corporate debt can be short-term (maturity less thanone year) or long-term .

Different from common stock:

Creditors claim on corporation is specified Promised cash flows Most are callable

Over half of outstanding bonds are owned by life

insurance companies & pension funds Plain vanilla bonds to kitchen sink bonds

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Features of a Typical Bond

The indenture usually lists Amount of Issue, Date of Issue, Maturity Denomination (Par value) Annual Coupon, Dates of Coupon Payments

Security Sinking Funds Call Provisions Covenants

Features that may change over time Rating Yield-to-Maturity Market price

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Features of a Hypothetical Bond

Issue amount $20 million Bond issue total face value is $20 millionIssue date 12/15/98 Bonds offered to the public in December 1998Maturity date 12/31/18 Remaining principal is due December 31,

2018Face value $1,000 Face value denomination is $1,000 per bondCoupon interest $100 per annum Annual coupons are $100 per bond

Coupon dates 6/30, 12/31 Coupons are paid semiannuallyOffering price 100 Offer price is 100% of face valueYield to maturity 10% Based on stated offer priceCall provision Callable after 12/31/03 Bonds are call protected for 5 years after

issuanceCall price 110 before 12/31/08,

100 thereafterCallable at 110 percent of par value through2008. Thereafter callable at par.

Trustee United Bank ofFlorida

Trustee is appointed to representbondholders

Security None Bonds are unsecured debentureRating Moody's A1, S&P A+ Bond credit quality rated upper medium

grade by Moody's and S&P's rating

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20.2 The Public Issue of Bonds

The general procedure is similar to the issuance of stock, asdescribed in the previous chapter.

Indentures and covenants are not relevant to stock issuance. The indenture is a written agreement between the borrower

and a trust company. The indenture usually lists Amount of Issue, Date of Issue, Maturity Denomination (Par value) Annual Coupon, Dates of Coupon Payments

Security Sinking Funds Call Provisions Covenants

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Principal Repayment

Term bonds versus serial bonds Sinking funds: How do they work?

Fractional repayment each year

Good news---security Bad news---unfavourable calls How trustee redeems

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Protective Covenants

Agreements to protect bondholders Negative covenant: Thou shalt not:

pay dividends beyond specified amount sell more senior debt and amount of new debt is limited

refund existing bond issue with new bonds paying lowerinterest rate

buy another companys bonds Positive covenant: Thou shalt:

use proceeds from sale of assets for other assets allow redemption in event of merger or spinoff maintain good condition of assets provide audited financial information

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The Sinking Fund

There are many different kinds of sinking-fundarrangements: Most start between 5 and 10 years after initial issuance. Some establish equal payments over the life of the bond. Most high-quality bond issues establish payments to the

sinking fund that are not sufficient to redeem the entireissue.

Sinking funds provide extra protection to bondholders.

Sinking funds provide the firm with an option.

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The Call Provision

A call provision lets the company repurchase or call theentire bond issue at a predetermined price overa specified

period. The difference between the call price and the face value is

the call premium. Many long-term corporate bonds outstanding in Canada have

call provisions. New corporate debt features a different call provision

referred to as a Canada plus call. The Canada plus call is designed to replace the traditional

call feature by making it unattractive for the issuer ever tocall the bonds.

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20.3 Bond Refunding

Replacing all or part of a bond issue is calledrefunding .

Bond refunding raises two questions: Should firms issue callable bonds? Given that callable bonds have been issued, when should

the bonds be called?

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Should firms issue callable bonds?

Common sense tells us that call provisions havevalue.

A call works to the advantage of the issuer.

If interest rates fall and bond prices go up, theoption to buy back the bonds at the call price isvaluable.

In bond refunding, firms will typically replace thecalled bonds with a new bond issue.

The new bonds will have a lower coupon rate thanthe called bonds.

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Why are callable bonds issued in the real world?

Four specific reasons why a company might use acall provision:

1. Superior interest rate predictions

2. Taxes3. Financial flexibility for future investment

opportunities4. Less interest-rate risk

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Callable Bonds versus Noncallable Bonds

25

50

75

100

125

150

175

200

0 4 8 12 16 20

Yield to maturity (%)

B o n

d p r i c e

( %

o f p a r )

Noncallable bond

Callable bond

Most bonds are callable;some sensible reasons for

call provisions include:taxes, managerial

flexibility, and the factthat callable bonds haveless interest rate risk.

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Calling Bonds: When does it make sense?

In a world with no transaction costs, it can be shownthat the company should call its bonds whenever thecallable bond value exceeds the call price.

This policy minimizes the value of the callable bonds.

The costs from issuing new bonds change therefunding rule to allow bonds to trade at prices

above the call price. The objective of the company is to minimize the

sum of the value of the callable bonds plus newissue costs.

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20.4 Bond Ratings

What is rated: The likelihood that the firm will default. The protection afforded by the loan contract in the event

of default.

Who pays for ratings: Firms pay to have their bonds rated. The ratings are constructed from the financial statements

supplied by the firm.

Ratings can change. Raters can disagree.

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Bond Ratings: Investment Grade

Moody' Duff &Phelps

DBRS Credit RatingDescription

Aaa 1 AAA Highest credit rating,maximum safety

Aa1 2Aa2 3 AA High credit quality,

investment-grade bondsAa3 4A1 5A2 6 A Upper-medium quality,

investment grade bondsA3 7Baa1 8Baa2 9 BBB Lower-medium quality,

investment grade bondsBaa3 10

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Moody' Duff &

Phelps

S&P's Credit Rating

Description

Speculative-Grade Bond RatingsBa1 11 BB+ Low credit quality,

speculative-grade bondsBa2 12 BB

Ba3 13 BB-B1 14 B+ Very low credit quality,speculative-grade bonds

B2 15 BB3 16 B-

Extremely Speculative-Grade Bond RatingsCaa 17 CCC

+Extremely low creditstanding, high-risk bonds

CCCCCC-

Ca CC Extremely speculativeC C

D Bonds in default

Bond Ratings: Below Investment Grade

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Junk bonds

Anything less than an S&P BB or a MoodysBa is a junk bond.

A polite euphemism for junk is high-yield bond.

There are two types of junk bonds: Original issue junk possibly not rated Fallen angels rated

Current status of junk bond market Private placement

Yield premiums versus default risk

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20.5 Different Types of Bonds

Callable Bonds Puttable Bonds Convertible Bonds

Zero Coupon Bonds Floating-Rate Bonds Other Types of Bonds

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Puttable bonds

Put provisions Put price Put date Put deferment

Extendible bonds Value of the put feature Cost of the put feature

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Convertible Bonds

Why are they issued? Why are they purchased? Conversion ratio:

Number of shares of stock acquired by conversion Conversion price:

Bond par value / Conversion ratio

Conversion value: Price per share of stock x Conversion ratio

In-the-money versus out-the-money

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Convertible Bond Prices

50

60

70

80

90

100

110

120

130

140

150

50 70 90 110 130 150

Conversion value (% of par)

B o n

d p r i c e ( %

o f p a r )

Convertible bond price

Nonconvertible bond price

Stock price

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Example of a Convertible Bond

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More on Convertibles

Exchangeable bonds Convertible into a set number of shares of a third

companys common stock.

Minimum (floor) value of convertible is the greaterof : Straight or intrinsic bond value Conversion value

Conversion option value Bondholders pay for the conversion option by accepting a

lower coupon rate on convertible bonds versus otherwise-identical nonconvertible bonds.

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Example of an Exchangeable Bond

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Zero-Coupon Bonds

A bond that pays no coupons at all must be offeredat a price that is much lower than its stated value.

For tax purposes, the issuer of a zero-coupon bonddeducts interest every year even though no interestis actually paid.

Zero-coupon bonds, often in the form of strippedcoupons, are attractive to individual investors for

tax-sheltered Registered Retirement Savings Plans(RRSPs).

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Floating Rate Bonds

With floating rate bonds, the coupon payments areadjustable.The adjustments are tied to the Treasury bill rateor another short-term interest rate.

Majority of floaters have the following features:

1. The holder has the right to redeem her note at par on thecoupon payment date after some specified amount of time.

2. The coupon rate has a floor and a ceiling. i.e., a minimumand a maximum.

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Financial Engineering and Bonds

Income bonds : coupon payments are dependent oncompany income.

Retractable bonds : allow the holder to force theissuer to buy the bond at the stated price. Examplesare Canada Savings Bonds (CSBs).

A stripped real-return bond is a zero coupon bondwith inflation protection.

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20.6 Direct Placement Compared to Public Issues

There are two basic forms of direct private long-termfinancing:

1. Term loans2. Private placements

Differences between direct private long-term financing and public issues of debt are:

1. Registration costs are lower for direct financing.2. Direct financing is likely to have more restrictive

covenants.3. It is easier to renegotiate a term loan or a private placement

in the event of default.

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20.7 Long-Term Syndicated Bank Loans

A syndicated loan is a corporate loan made by agroup (or syndicate) of banks and other institutionalinvestors.

A syndicated loan may be publicly traded. It may be a line of credit and be undrawn or it

may be drawn and be used by a firm. Syndicated loans are always rated investment grade.

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20.8 Summary and Conclusions

The details of the long-term debt contract arecontained in the indenture . The main provisions are:security, repayment, protective covenants, and call

provisions. Protective covenants are designed to protect

bondholders from management decisions thatfavour stockholders at bondholders expense.

Most public industrial bonds are unsecured they

are general claims on the companys value. Most utility bonds are secured. If the firm defaultson secured bonds, the trustee can repossess theasset.

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20.8 Summary and Conclusions (cont.)

Long-term bonds usually provide for repayment of principal before maturity. This is usuallyaccomplished with a sinking fund whereby a firmretires a certain number of bonds each year.

Most publicly issued bonds are callable . There is nosingle reason for call provisions. Some sensiblereasons include taxes, greater flexibility, and thefact that callable bonds are less sensitive to interest-rate changes.

There are many different types of bonds, includingfloating-rate bonds, deep-discount bonds, andincome bonds.