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Chapt 11.doc

  1. 1. Chapter 11 Corporate Bonds Slides 11-1 Fundamentals of Investments 11-2 Corporate Bonds 11-3 Corporate Bond Basics 11-4 Corporate Bond Basics 11-5 Corporate Bond Basics 11-6 Corporate Bond Basics 11-7 Corporate Bond Basics 11-8 Work the Web 11-9 Types of Corporate Bonds 11-10 Types of Corporate Bonds 11-11 Bond Indentures 11-12 Bond Indentures 11-13 Bond Indentures 11-14 Bond Indentures 11-15 Bond Indentures 11-16 Bond Indentures 11-17 Bond Indentures 11-18 Bond Indentures 11-19 Work the Web 11-20 Bond Indentures 11-21 Protective Covenants 11-22 Event Risk 11-23 Bonds Without Indentures 11-24 Preferred Stock 11-25 Preferred Stock 11-26 Adjustable-Rate Bonds & Preferred Stock 11-27 Corporate Bond Credit Ratings 11-28 Corporate Bond Credit Ratings 11-29 Corporate Bond Credit Ratings 11-30 Work the Web 11-31 Junk Bonds 11-32 Junk Bonds 11-33 Bond Market Trading 11-34 Bond Market Trading 11-35 Bond Market Trading 11-36 Work the Web 11-37 Chapter Review 11-38 Chapter Review
  2. 2. A-91 Chapter 11 11-39 Chapter Review 11-40 Chapter Review Chapter Organization 11.1 Corporate Bond Basics 11.2 Types of Corporate Bonds 11.3 Bond Indentures A. Bond Seniority Provisions B. Call Provisions C. Graphical Analysis of Callable Bond Prices D. Put Provisions E. Bond-to-Stock Conversion Provisions F. Graphical Analysis of Convertible Bond Prices F. Bond Maturity and Principal Payment Provisions H. Sinking Fund Provisions I. Coupon Payment Provisions 11.4Protective Covenants 11.5 Event Risk 11.6 Bonds without Indentures 11.7 Preferred Stock 11.8 Adjustable-Rate Bonds and Adjustable-Rate Preferred Stock 11.9 Corporate Bond Credit Ratings A. Why Bond Ratings are Important 11.10 Junk Bonds 11.11 Bond Market Trading 11.12 Summary and Conclusions Selected Web Sites         
  3. 3. Corporate Bonds A-92 Annotated Chapter Outline 11.1 Corporate Bond Basics Plain Vanilla Bonds: Bonds issued with a relatively standard set of features. Unsecured Debt: Bonds, notes, or other debt issued with no specific collateral pledged as security for the bond issue. Corporate bonds represent the debt of a corporation owed to its bondholders. The fixed sum paid at maturity is the principal, par value, or face value, and the periodic interest payments are coupons. The three main differences between corporate bonds and stock are: • Common stock is an ownership claim on the corporate, whereas bonds represent a creditor's claim on the corporation. • Coupons and principal, the promised cash flows, are stated in advance, whereas the amount and timing of stock dividends may change at any time. • Most corporate bonds are callable, whereas common stock is almost never callable. There are several trillion dollars in the corporate bond market, with the largest investor being life insurance companies. Every bond issue has specific terms associated with it, from relatively simple to fairly complex. Bonds issued with standard, relatively simple features are called plain vanilla bonds. 11.2 Types of Corporate Bonds Debentures: Unsecured bonds issued by a corporation. Mortgage Bonds: Debt secured with a property lien. Equipment Trust Certificate: Shares in a trust with income from a lease contract. Debentures are the most frequently issued corporate bond and they represent an unsecured legal claim on the corporation. In the event of default, the bondholder's claim extends to all assets, although they may have to share this claim with other creditors. Mortgage bonds represent debt with a lien on specific property, and the bondholder has the legal right to foreclose on the property, although it may be more advantageous to renegotiate. Collateral trust bonds represent a pledge of financial assets as security and are usually issued by holding companies. Equipment trust certificates represent debt issued by a trustee to purchase heavy industrial equipment that is leased and used by airlines, railroads, etc. Ownership of the equipment remains with the trustee appointed to represent the certificate holders.
  4. 4. A-93 Chapter 11 11.3 Bond Indentures Indenture Summary: Description of the contractual terms of a new bond issue included in a bond's prospectus. Prospectus: Document prepared as part of a security offering detailed information about a company's financial position, its operations, and investment plans. A bond indenture is a formal written agreement between the corporation and the bondholders that spells out the rights and obligations of both parties. It is quite lengthy, so many investors refer to the indenture summary in the prospectus. The Trust Indenture Act of 1939 requires that any bond issue subject to SEC regulation must have a trustee appointed to represent the bondholders. A. Bond Seniority Provisions Senior Debentures: Bonds that have a higher claim on the firm's assets than other bonds. Subordinated Debentures: Bonds that have a claim on the firm's assets after those with a higher claim have been satisfied. Negative Pledge Clause: Bond indenture provision that prohibits new debt from being issued with seniority over an existing issue. A corporation may have several different bond issues outstanding, and these issues normally are differentiated according to the seniority of their claims on the firm's assets. Seniority usually is specified in the indenture contract. The seniority is usually protected by a negative pledge clause, which prohibits a new issue of debt with seniority over a currently outstanding issue. B. Call Provisions Bond Refunding: Process of calling an outstanding bond issue and refinancing it by a new bond issue. Most corporate bond issues have a call provision to buy back outstanding bonds at a specified price before the bonds mature. The firm may want to call high- interest bonds and replace them with lower-interest bonds when interest rates decrease. Callable bonds are not as attractive to an investor, so they should sell at a lower price. Some features that restrict an issuer's call privilege are: • Deferred call provision, • Call premium over par value, and • Refunding provision.
  5. 5. Corporate Bonds A-94 C. Graphical Analysis of Callable Bond Prices Figure 11.2 shows the relationship between interest rates and prices for comparable callable and non-callable bonds. Note the non-callable bond has the typical (positive) convex price-yield relationship, whereas the callable bond has negative convexity. D. Put Provisions Put Bonds: A bond that can be sold back to the issuer at a prespecified price on any of a sequence of prespecified dates. Also called extendible bonds. Put bonds are "putable'" on a series of designated put dates. The put feature puts a floor on the market price of the bond, and it also protects bondholders from corporate acts that may hurt credit quality. E. Bond-to-Stock Conversion Provisions Convertible Bonds: Bonds that holders can exchange for common stock according to a prespecified conversion ratio. Convertible bonds grant bondholders the right to exchange each bond for a designated number of common stock shares of the issuing firm. The important terms are: • Conversion ratio: CR = No. of stock shares acquired by conversion • Conversion price: CP = Bond par value / Conversion ratio • Conversion value: CV = Price per share of stock x Conversion ratio When is the optimum time to convert? The rational decision is to postpone converting as long as possible because the investor will want to receive as many coupon payments as possible. If the bonds are callable, the firm may force conversion by calling the bonds when the conversion value has risen 10-15%. F. Graphical Analysis of Convertible Bond Prices In-the-Money Bond: A convertible bond whose conversion value is greater than its call price.
  6. 6. A-95 Chapter 11 Intrinsic Bond Value: The price below which a convertible bond cannot fall, equal to the value of a comparable nonconvertible bond. Also called investment value. Exchangeable Bonds: Bonds that can be converted into common stock shares of a company other than the issuer's. The price of a convertible bond is closely linked to the value of the underlying shares. This relationship is shown in Figure 11.4 (PowerPoint slide 11-4). G. Bond Maturity and Bond Principal Payment Provisions Term Bonds: Bonds issued with a single maturity date. Serial Bonds: Bonds issued with a regular sequence of maturity dates. Term bonds are the most common corporate bond maturity structure, which has a single maturity date. The indenture normally stipulates a sinking fund to repay bondholders through fractional redemptions before maturity. H. Sinking Fund Provisions A sinking fund provides more security to bondholders, but since it requires periodic fractional bond issue redemptions, some bondholder will have their bonds called early. The firm's trustee either buys back the bonds in the open market, or calls the bonds by lottery, depending on the level of interest rates (bond prices). I. Coupon Payment Provisions Coupon rates are stated on an annual basis, although almost all corporate bonds pay interest semiannually. The bond indenture states exact payment dates. If a firm suspends payment of coupon interest, it is in default. In the case of default, bondholders could demand an acceleration of principal repayment and all past due interest, but it is usually best to negotiate a new debt contract. 11.4 Protective Covenants Protective Covenants: Restrictions in a bond indenture designed to protect bondholders. There are two types of protective covenants, negative and positive. Some examples include: • Negative covenants: Thou shalt not: • Pay dividends beyond specified amount.
  7. 7. Corporate Bonds A-96 • Sell more senior debt, and amount of new debt is limited. • Refund existing bond issue with new bonds paying lower interest rate. • Buy another company’s bonds. • Positive covenants: 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. 11.5 Event Risk Event Risk: The possibility that the issuing corporation will experience a significant change in its bond credit quality. Protective covenants in an indenture help protect bondholders from event risk, a structural or financial change to the firm that will cause deterioration in the credit quality of a bond issue. 11.6 Bonds Without Indentures Private Placement: A new bond issue sold to one or more parties in private transactions not available to the public. If a bond is not sold to the general public an indenture is not required (Trust Indenture Act of 1938). Private placements are sold to one or more parties in a private transaction and are exempt from SEC registration requirements. When there is no indenture, the debt is basically a simple IOU of the corporation. Many bond analysts refer to corporate debt with an indenture as a bond, and without as a note. 11.7 Preferred Stock Preferred Stock: A security with a claim to dividend payments that is senior to common stock. Preferred stock has features of both bonds and common stock and is sometimes referred to as a hybrid security. Since the preferred stockholders have a claim to dividend payments that are senior to common stockholders, it is termed "preferred." Preferred has the following typical characteristics: • Preferred stock does not grant voting rights. • Preferred stockholders are promised a stream of fixed dividend payments. • Preferred stock has not specified maturity, but is often callable. • Management can suspend preferred dividend payments, but only after suspending common dividends.
  8. 8. A-97 Chapter 11 • If dividends are suspended, all unpaid preferred dividends normally become cumulative debt that must be repaid before common dividends are paid. • Some preferred stock issues are convertible. • Preferred stock normally pays a lower interest rate than bonds. • Corporations can exclude at least 70% of the preferred dividends from income taxation. • Corporations that issue preferred must treat the dividends the same as common dividends, and they are not deductible. 11.8 Adjustable-Rate Bonds and Adjustable-Rate Preferred Stock Adjustable-Rate Bonds: securities that pay coupons that change according to a prespecified rule. Also called floating rate bonds, or simply floaters. Many bond, note, and preferred stock issues allow the issuer to adjust the annual coupon based on current interest rates. Adjustable-rate bonds are also called floating rate or floaters. Adjustable-rate bonds are often putable at par value. 11.9 Corporate Bond Credit Ratings Credit Rating: An assessment of the credit quality of a bond issue based on the issuer's financial condition. When a corporation sells a new bond issue, it usually subscribes to several bond rating agencies for a credit evaluation and credit rating. There are several established rating agencies, such as: Duff and Phelps; Fitch Investors Service; McCarthy; Crisanti and Maffei; Moody's Investors Service; and Standard and Poor's. These ratings apply to a specific bond issue and not to the issuer of the bonds. There are three broad categories of bond credit ratings: investment grade, speculative grade, and extremely speculative grade. A. Why Bond Ratings Are Important Prudent Investment Guidelines: Restrictions on investment portfolios stipulating that securities purchased must meet a certain level of safety. These credit ratings are important because only a few institutional investors have the resources and expertise to properly evaluate a bond's credit quality on their own. Many corporations and individual investors rely on these credit ratings. In fact, many financial institutions and pension funds have investment safety requirements, such that the bonds in their portfolios are limited to investment grade bonds with a minimum credit rating.
  9. 9. Corporate Bonds A-98 11.10 Junk Bonds 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. Bonds with a speculative or low credit rating, those rated Ba (Moody's) or BB (S&P) or lower, are called high-yield or junk bonds. High-yield bonds can be fallen angels or original-issue junk. Junk bonds offer a yield premium in exchange for the risk associated with their higher default rate. Even though high- yield bonds are riskier, they may still be appropriate for a diversified portfolio. 11.11 Bond Market Trading An active secondary market exists for corporate bonds to allow investors to buy and sell bonds. Bonds are traded on the New York Stock Exchange and the OTC. More than 2,300 different bond issues are listed on the NYSE, while the greatest total volume of bond trading occurs on the OTC market. Lecture Tip: It is important to walk through an example of a Wall Street Journal price quote for a corporate bond. While many students have perused the common stock pages, very few have reviewed the bond quotes. Just explaining that the interest rate is followed by the maturity year is usually informative for students. An interesting question to ask is, "what is the 's' that appears between the interest rate and the year?" You will normally get a variety of responses and the students are intrigued to hear that it is a traditional placeholder, related to referring to a bond by the interest rate, as in 8s (or eights). It is also helpful to do an example calculation of bond pricing when going over the quotes. Since you are given the coupon interest rate, maturity, and bond price, you can solve for the yield. This calculated yield can be compared to the yields presented in the WSJ under "Yield Comparisons" on the "Credit Markets" page. 11.12 Summary and Conclusions Current Topics: "Young Investors See Allure of Bonds," by Ruth Simon, The Wall Street Journal, July 30, 1999. With the current stock market movements, younger investors (in their 30s and 40s) are now showing interest in investing in bonds. They are interested in protecting their assets for the future. Many are taking money made on internet stocks and diversifying into bond investments. One investor says, "the money trickles into the account on a regular basis with little or no tax implications….it may not be a brilliant growth strategy, but the money will be there no matter what happens." Many investors are creating a ladder, a portfolio of bonds that mature sequentially in time. This diversifies the maturity points and the cash flow streams. Financial advisors recommend that investors review their whole portfolio to assure that their investments in bonds
  10. 10. A-99 Chapter 11 and equities meet their overall investment objectives and their level of risk tolerance. Current Topics: "Biggest Securities Firms Are Establishing the Leading Positions in Online Bond Trading," by Gregory Zuckerman, The Wall Street Journal, July 27, 1999. The largest Wall Street firms are playing catch-up in online trading, but they are leading the pack in online bond trading. Such firms as Merrill Lynch, Goldman Sachs, and Morgan Stanley Dean Witter are taking the lead in bond trading, and may succeed in preventing rivals from edging into their profitable world. The timing is also an advantage—Wall Street firms have employed lessons learned in online stock trading. Since bonds are such an institutional market, the large firms have had somewhat of an advantage. Some upstarts are still making progress. Muni Auction has recently hosted online auctions of 75 issues totaling $3.5 billion. This market is still at an early stage and will be changing rapidly over the next few years.