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  1. 1. Fundamentals of Investments 11 C h a p t e r Corporate Bonds second edition Valuation & Management Charles J. Corrado Bradford D. Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu
  2. 2. Corporate Bonds <ul><li>Our goal in this chapter is to introduce the specialized knowledge that money managers who trade in corporate bonds possess. </li></ul>Goal
  3. 3. Corporate Bond Basics Corporate bond A security issued by a corporation that represents a promise to pay to its bondholders a fixed sum of money (called the bond’s principal , or par or face value) at a future maturity date, along with periodic payments of interest (called coupons ).
  4. 4. Corporate Bond Basics <ul><li>Corporate bonds differ from common stock in three fundamental ways. </li></ul>Corporate Bonds Common Stock Represent a creditor’s Represents an ownership claim on the corporation. claim on the corporation. Promised cash flows Amount and timing of (coupons and principal) dividends may change are stated in advance. at any time. Mostly issued as Almost never callable. callable bonds.
  5. 5. Corporate Bond Basics <ul><li>There are several trillion dollars of corporate bonds outstanding in the United States. </li></ul><ul><li>More than half of these are owned by life insurance companies and pension funds. </li></ul><ul><ul><li>These institutions can eliminate much of their financial risk via cash flow matching . </li></ul></ul><ul><ul><li>They can also diversify away most default risk by including a large number of different bond issues in their portfolios. </li></ul></ul>
  6. 6. Corporate Bond Basics
  7. 7. Corporate Bond Basics <ul><li>Bonds issued with a standard, relatively simple set of features are popularly called plain vanilla bonds . </li></ul>
  8. 8. Work the Web <ul><li>For more information on corporate bonds, visit: </li></ul><ul><ul><li>http://www. investinginbonds .com </li></ul></ul><ul><ul><li>http://www. bondresources .com </li></ul></ul>
  9. 9. Types of Corporate Bonds <ul><li>Debentures - Unsecured bonds issued by a corporation. </li></ul><ul><li>Mortgage bond - Debt secured with a property lien. </li></ul><ul><li>Collateral trust bond - Debt secured with financial collateral. </li></ul><ul><li>Equipment trust certificate - Shares in a trust with income from a lease contract. </li></ul>
  10. 10. Types of Corporate Bonds 11 - McGraw Hill / Irwin
  11. 11. Bond Indentures <ul><li>In practice, very few bond investors read the original indenture. Instead, they may refer to an indenture summary provided in the prospectus of the bond issue. </li></ul>Bond indenture A formal written agreement between the corporation and the bondholders that spells out in detail their rights and obligations with respect to the bond issue.
  12. 12. Bond Indentures <ul><li>The Trust Indenture Act of 1939 requires that any bond issue subject to regulation by the Securities and Exchange Commission (SEC) must have a trustee appointed to represent the interests of the bondholders. </li></ul><ul><li>The Act is available at the SEC website: </li></ul><ul><ul><li>http://www.sec. gov </li></ul></ul>
  13. 13. Bond Indentures <ul><li>Some of the important provisions frequently specified in bond indentures include: </li></ul><ul><ul><li>Bond seniority provisions - Different bond issues can usually be differentiated according to the seniority of their claims on the firm’s assets. Bond seniority may be protected by a negative pledge clause . </li></ul></ul><ul><ul><li>Call provisions - A call provision allows the issuer to buy back all or part of its outstanding bonds at a specified call price sometime before the bonds mature, hence facilitating bond refunding . </li></ul></ul>
  14. 14. Bond Indentures No matter how low market interest rates may fall, the maximum price of an unprotected callable bond is generally bounded above by its call price.
  15. 15. Bond Indentures <ul><ul><li>Put provisions - A bond with a put provision can be sold back to the issuer at a prespecified price (normally set at par value) on any of a sequence of prespecified dates. Such bonds are often called extendible bonds . </li></ul></ul><ul><ul><li>Bond-to-stock conversion provisions - Convertible bonds are bonds that holders can exchange for common stock according to a prespecified conversion ratio. </li></ul></ul>
  16. 16. Bond Indentures 11 - McGraw Hill / Irwin
  17. 17. Bond Indentures
  18. 18. Bond Indentures 11 - McGraw Hill / Irwin
  19. 19. Work the Web <ul><li>Find out more about convertible bonds at: </li></ul><ul><ul><li>http://www. convertbond .com </li></ul></ul>
  20. 20. Bond Indentures <ul><ul><li>Bond maturity and principal payment provisions - Term bonds are issued with a single maturity date, while serial bonds are issued with a regular sequence of maturity dates. </li></ul></ul><ul><ul><li>Sinking fund provisions - A sinking fund is an account used to provide for scheduled redemptions of outstanding bonds. </li></ul></ul><ul><ul><li>Coupon payment provisions - An exact schedule of coupon payment dates is specified in the bond indenture. </li></ul></ul>
  21. 21. Protective Covenants <ul><li>A bond indenture is likely to contain a number of protective covenants , which are restrictions designed to protect bondholders. </li></ul><ul><ul><li>Negative covenant (“thou shalt not”) example - The firm cannot pay dividends to stockholders in excess of what is allowed by a formula based on the firm’s earnings. </li></ul></ul><ul><ul><li>Positive covenant (“thou shalt”) example - Proceeds from the sale of assets must be used either to acquire other assets of equal value or to redeem outstanding bonds. </li></ul></ul>
  22. 22. Event Risk <ul><ul><li>Example: In October 1992, Marriott Corporation announced its intention to spin off part of the company. The spinoff, called Host Marriott, would acquire most of the parent company’s debt and its poorly performing real estate holdings. </li></ul></ul>Event risk The possibility that the issuing corporation will experience a significant change in its bond credit quality.
  23. 23. Bonds Without Indentures <ul><li>Private placements are exempt from registration requirements with the SEC, although they often have formal indentures. </li></ul><ul><li>Debt issued without an indenture is basically a simple IOU of the corporation. </li></ul>Private placement A new bond issue sold to one or more parties in private transactions not available to the public.
  24. 24. Preferred Stock <ul><li>Preferred stockholders have a claim to dividend payments that is senior to the claim of common stockholders. However, their claim is subordinate to the claims of bondholders and other creditors. </li></ul>
  25. 25. Preferred Stock <ul><li>Preferred stock has some of the features of both bonds and common stock. </li></ul><ul><li>Typically, preferred stock issues </li></ul><ul><ul><li>do not grant voting rights to their holders, </li></ul></ul><ul><ul><li>promise a stream of fixed dividend payments, </li></ul></ul><ul><ul><li>have no specified maturity but are often callable, </li></ul></ul><ul><ul><li>may have their dividends suspended without setting off a bankruptcy process (as long as common stock dividends are also suspended), </li></ul></ul><ul><ul><li>cumulate unpaid preferred dividends, and </li></ul></ul><ul><ul><li>may be convertible. </li></ul></ul>
  26. 26. Adjustable-Rate Bonds & Preferred Stock <ul><li>Many bond, note, and preferred stock issues allow the issuer to adjust the annual coupon according to a rule or formula based on current market interest rates. These securities are called adjustable-rate or floating-rate securities. </li></ul>
  27. 27. Corporate Bond Credit Ratings <ul><li>When a corporation sells a new bond issue to investors, it usually subscribes to several bond rating agencies for a credit evaluation of the bond issue. </li></ul><ul><li>Each contracted rating agency then provides a credit rating - an assessment of the credit quality of the bond issue based on the issuer’s financial condition. </li></ul>
  28. 28. Corporate Bond Credit Ratings 11 - McGraw Hill / Irwin
  29. 29. Corporate Bond Credit Ratings <ul><li>Why are bond ratings important? </li></ul><ul><li>Only a few institutional investors have the resources and expertise necessary to properly evaluate a bond’s credit quality on their own. </li></ul><ul><li>Many financial institutions have prudent investment guidelines stipulating that only securities with a certain level of investment safety may be included in their portfolios. </li></ul>
  30. 30. Work the Web <ul><li>Visit these rating agencies: </li></ul><ul><ul><li>Duff and Phelps: http://www. dcrco .com </li></ul></ul><ul><ul><li>Fitch: http://www. fitchibca .com </li></ul></ul><ul><ul><li>Moody’s: http://www. moodys .com </li></ul></ul><ul><ul><li>Standard & Poor’s: </li></ul></ul><ul><ul><li>McCarthy, Crisanti and Maffei: http://www. mcmwatch .com </li></ul></ul>
  31. 31. Junk Bonds <ul><li>Junk bonds are attractive investments for many institutional investors with well-diversified portfolios. </li></ul>High-yield bonds Bonds with a speculative credit rating that is offset by a yield premium offered to compensate for higher credit risk. Also called junk bonds .
  32. 32. Junk Bonds 11 - @2002 by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin
  33. 33. Bond Market Trading <ul><li>An active secondary market with a substantial volume of bond trading exists, thus satisfying most of the liquidity needs of investors. </li></ul><ul><li>Corporate bond trading is characteristically an OTC activity. Nevertheless, bond trading on the New York Stock Exchange is watched by bond investors and traders throughout the world. </li></ul>
  34. 34. Bond Market Trading 11 -
  35. 35. Bond Market Trading 11 - @2002 by the McGraw- Hill Companies Inc.All rights reserved. McGraw Hill / Irwin
  36. 36. Work the Web <ul><li>You can find current information on corporate bond prices and yields using the Bond Finder tool at Bond Resources: </li></ul><ul><ul><li>http://www. bondresources .com </li></ul></ul>
  37. 37. Chapter Review <ul><li>Corporate Bond Basics </li></ul><ul><li>Types of Corporate Bonds </li></ul>
  38. 38. Chapter Review <ul><li>Bond Indentures </li></ul><ul><ul><li>Bond Seniority Provisions </li></ul></ul><ul><ul><li>Call Provisions </li></ul></ul><ul><ul><li>Graphical Analysis of Callable Bond Prices </li></ul></ul><ul><ul><li>Put Provisions </li></ul></ul><ul><ul><li>Bond-to-Stock Conversion Provisions </li></ul></ul><ul><ul><li>Graphical Analysis of Convertible Bond Prices </li></ul></ul><ul><ul><li>Bond Maturity and Principal Payment Provisions </li></ul></ul><ul><ul><li>Sinking Fund Provisions </li></ul></ul><ul><ul><li>Coupon Payment Provisions </li></ul></ul>
  39. 39. Chapter Review <ul><li>Protective Covenants </li></ul><ul><li>Event Risk </li></ul><ul><li>Bonds Without Indentures </li></ul><ul><li>Preferred Stock </li></ul><ul><li>Adjustable-Rate Bonds and Adjustable-Rate Preferred Stock </li></ul><ul><li>Corporate Bond Credit Ratings </li></ul><ul><ul><li>Why Bond Ratings Are Important </li></ul></ul>
  40. 40. Chapter Review <ul><li>Junk Bonds </li></ul><ul><li>Bond Market Trading </li></ul>