berk chapter 24: debt financing

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter 24

Debt Financing

Copyright © 2011 Pearson Prentice Hall. All rights reserved.24-2

Chapter Outline

24.1 Corporate Debt

24.2 Other Types of Debt

24.3 Bond Covenants

24.4 Repayment Provisions


Learning Objectives

1. Identify typical sources of debt for corporations.

2. Describe the bond indenture.

3. Define the following terms: notes, debentures, mortgage bonds, and asset-backed bonds. Identify which of these are secured, and which are senior.

4. Identify and define the four broadly defined categories that comprise international bonds.

5. Define term loan and private placement, and contrast the two forms of private debt.


Learning Objectives (cont'd)

6. Identify four different types of security issued by the U.S. Treasury.

7. Identify the characteristics of municipal bonds.

8. Define the term asset-backed security and give several examples of issuers and types of such securities.

9. Define the following bond terminology: covenants, call provision, callable bond, yield to call, sinking fund, and convertible bonds.

10. Compare and contrast convertible and callable bonds with straight debt.


24.1 Corporate Debt

• Leveraged Buyout (LBO)

– When a group of private investors purchase all the equity of a public corporation and finances the purchase primarily with debt

• For example, Hertz was taken private through an LBO.


Table 24.1 New Debt Issued as Part of the Hertz LBO


Public Debt

• The Prospectus

– A public bond issue is similar to a stock issue.

– Indenture• Included in a prospectus, it is a formal contract

between a bond issuer and a trust company.– The trust company represents the bondholders and

makes sure that the terms of the indenture are enforced.

– In the case of default, the trust company represents the interests of the bond holders.


Figure 24.1 Front Cover of the Offering Memorandum of the Hertz Junk Bond Issue

Source: Courtesy Hertz Corporation


Public Debt (cont'd)

• Corporate bonds almost always pay coupons semiannually, although a few corporations have issued zero-coupon bonds.

• Most corporate bonds have maturities of 30 years or less.



• The face value or principal amount of a bond is denominated in standard increments, most often $1000.– The face value does not always correspond to

the actual money raised because of underwriting fees and/or if the bond is issued at a discount.

• Original Issue Discount Bond– Describes a bond that is issued at a discount



• Bearer Bonds and Registered Bonds

– Bearer Bonds• Similar to currency in that whoever physically holds

the bond certificate owns the bond

• To receive a coupon payment, the holder of a bearer bond must provide explicit proof of ownership by literally clipping a coupon off the bond certificate and remitting it to the paying agent.



• Bearer Bonds and Registered Bonds

– Registered Bonds• The issuer of this type of bond maintains a list of all

holders of its bonds.

• Coupon and principal payments are made only to people on this list.

– Almost all bonds today are registered bonds.



• Types of Corporate Debt

– Unsecured Debt• A type of corporate debt that, in the event of

bankruptcy, gives bondholders a claim to only the assets of the firm that are not already pledged as collateral on other debt




– Notes• A type of unsecured corporate debt

• Notes typically are coupon bonds with maturities shorter than 10 years.

– Debentures• A type of unsecured corporate debt

• Debentures typically have longer maturities than notes.




– Secured Debt• A type of corporate debt in which specific assets are

pledged as collateral.




– Mortgage Bonds• A type of secured corporate debt

• Real property is pledged as collateral that bondholders have a direct claim to in the event of bankruptcy.

• All classes of securities are paid from the same cash flow source.




– Asset-Backed Bonds• A type of secured corporate debt

• Specific assets are pledged as collateral that bondholders have a direct claim to in the event of bankruptcy.

• Can be secured by any kind of asset


Table 24.2 Types of Corporate Debt




– Tranches• Different classes of securities that comprise a single

bond issue

• All classes of securities are paid from the same cash flow source.


Table 24.3 Hertz’s December 2005 Junk Bond Issues



• Seniority

– Seniority• A bondholder’s priority in claiming assets not already

securing other debt

• Most debenture issues contain clauses restricting the company from issuing new debt with equal or higher priority than existing debt.



• Seniority

– Subordinated Debentures• Debt that, in the event of a default, has a lower

priority claim to the firm’s assets than other outstanding debt



• Bond Markets

– International Bonds

• Domestic Bonds– Bonds issued by a local entity and traded in a local

market, but purchased by foreigners

– They are denominated in the local currency.

• Foreign Bonds– Bonds issued by a foreign company in a local market

and intended for local investors

– They are denominated in the local currency.



• Bond Markets

– International Bonds

• Foreign Bonds

– Yankee Bonds

» Foreign bonds in the United States

– Samurai Bonds

» Foreign bonds in Japan

– Bulldogs

» Foreign bonds in the United Kingdom



• Bond Markets

– International Bonds• Eurobonds

– International bonds that are not denominated in the local currency of the country in which they are issued

• Global Bonds– Bonds that are offered for sale in several different

markets simultaneously

– Global bonds can be offered for sale in the same currency as the country of issuance (unlike Eurobonds).


Private Debt

• Private Debt

– Debt that is not publicly traded• Has the advantage that it avoids the cost of

registration but has the disadvantage of being illiquid


Private Debt (cont'd)

• Term Loans

– Term Loan• A bank loan that lasts for a specific term

– Syndicated Bank Loan• A single loan that is funded by a group of banks

rather than just a single bank

– Revolving Line of Credit• A credit commitment for a specific time period,

typically two to three years, which a company can use as needed


Private Debt (cont'd)

• Private Placements

– Private Placement

• A bond issue that is sold to a small group of investors rather than the general public

– Because a private placement does not need to be registered, it is less costly to issue than public debt.

» In 1990, the SEC issued Rule 144A, which allows private debt issued under this rule to be traded by large financial institutions among themselves.

» Because this debt is tradeable between financial institutions, it is only slightly less liquid than public debt.


24.2 Other Types of Debt

• Sovereign Debt

– Sovereign Debt• Debt issued by national governments

– U.S. Treasury securities represents the single largest sector of the U.S. bond market.


Sovereign Debt

• The U.S. Treasury issues:

– Treasury Bills• Pure discount bonds with maturities up to 26 weeks

– Treasury Notes• Semi-annual coupon bonds with maturities of 2 to 10

years


Sovereign Debt (cont'd)

• The U.S. Treasury issues:

– Treasury Bonds• Semi-annual coupon bonds with maturities longer

than 10 years

• Long Bonds– Bonds issued by the U.S. Treasury with the longest

outstanding maturities (currently 30 years)

• All income from Treasury securities is taxable at the federal level, but not taxable at the state and local level


Table 24.4 Existing U.S.Treasury Securities



• TIPS (Treasury-Inflation-Protected Securities)

– An inflation-indexed bond issued by the U.S. Treasury with maturities of 5, 10, and 20 years

– They are standard fixed-rate coupon bonds with one difference: The outstanding principal is adjusted for inflation.


Textbook Example 24.1


Textbook Example 24.1 (cont'd)


Alternative Example 24.1

• Problem

– On April 15, 1998, the U.S. Treasury issued a thirty-year inflation-indexed note with a coupon

of 3 5/8%.

– On the date of issue, the consumer price index (CPI) was 161.74000.

– On April 18, 2007, the CPI had increased to 203.02970.

– What coupon payment was made on April 18, 2007?



• Solution

– Between the issue date and April 18, 2007, the CPI appreciated by:

• 203.02970 ÷ 161.74000 − 1 = 25.528%

– Consequently, the principal amount of the bond increased to:

• $1,000 × 1.25528 = $1,255.28

– The semi-annual coupon payment was:• $1,255.28 × .03625 ÷ 2 = $22.75.



• Treasury securities are sold by auction.

– Two types of bids are allowed.• Competitive

– Competitive bidders submit sealed bids in terms of yields and the amount of bonds they are willing to purchase. The Treasury then accepts the lowest-yield (highest-price) competitive bids up to the amount required to fund the deal.



• Treasury securities are sold by auction.

– Two types of bids are allowed.• Non-Competitive

– Noncompetitive bidders (usually individuals) just submit the amount of bonds they wish to purchase and are guaranteed to have their orders filled at the auction.



• Stop-Out Yield

– The highest yield competitive bid that will fund a particular U.S. Treasury security issue when all successful bidders (including the non-competitive bidders) are awarded this yield



• STRIPS (Separate Trading of Registered Interest and Principal Securities)

– Zero-coupon Treasury securities with maturities longer than one year that trade in the bond market

• The Treasury itself does not issue STRIPS. Instead, investment banks purchase Treasury notes and bonds and then resell each coupon and principal payment separately as a zero-coupon bond.


Municipal Bonds

• Municipal Bonds (Munis)

– Bonds issued by state and local governments

– They are not taxable at the federal level (and sometimes at the state and local level as well).

– Sometimes referred to as tax-exempt bonds


Municipal Bonds (cont'd)

• Municipal Bonds (Munis)

– Most pay semi-annual interest• Fixed Rate

– Has the same coupon over the life of the bond

• Floating Rate– The coupon of the bond is adjusted periodically



• Serial Bonds– A single issue of municipal bonds that are

scheduled to mature serially over a period of years

• General Obligation Bonds– Bonds backed by the full faith and credit of the

local government



• Revenue Bonds– Municipal bonds for which the local or state

government can pledge as repayment revenues generated by specific projects

• Double-Barreled– Describes municipal bonds for which the

issuing local or state government has strengthened its promise to pay by committing itself to using general revenue to pay off the bonds


Asset-Backed Securities

• Securities made up of other financial securities

– Security’s cash flows come from the cash flows of the underlying financial securities that “back” it.

• Asset securitization

– The process of creating an asset-backed security


Asset-Backed Securities (cont'd)

• Mortgage-backed security

– Largest sector of the asset-backed security market

– Backed by home mortgages

– Largest issuers are U.S. government agencies and sponsored enterprises, such as the Government National Mortgage Association (GNMA).



• GNMA-issued mortgage-backed securities are explicitly guaranteed against default risk by the U.S. government.

• Investors still have pre-payment risk– The risk that the bond will be partially (or

wholly) repaid earlier than expected.



• Other government sponsored enterprises issuing mortgage backed securities:– Federal National Mortgage Association (FNMA)– Federal Home Loan Mortgage Corporation

(FHLMC or “Freddie Mac”)

• Student Loan Marketing Association (“Sallie Mae”)– Asset-backed securities backed by student

loans



• The entities on the previous slide are not explicitly backed by the full faith and credit of the U.S. government, but many believe there is an implicit guarantee.



• Private organizations, such as banks, also issue asset-backed securities.– Backed by home mortgages, auto loans, credit

card receivables, and other consumer loans.

• Collateralized debt obligation (CDO)– A re-securitization of other asset-backed

securities.– Often divided into tranches that are assigned

different repayment priority.


24.3 Bond Covenants

• Covenants

– Restrictive clauses in a bond contract that limit the issuers from undercutting their ability to repay the bonds

• For example, covenants may

– Restrict the ability of management to pay dividends

– Restrict the level of further indebtedness

– Specify that the issuer must maintain a minimum amount of working capital


24.4 Repayment Provisions

• A bond issuer typically repays its bonds by making coupon and principal payments as specified in the bond contract. However, the issuer can:

– Repurchase a fraction of the outstanding bonds in the market

– Make a tender offer for the entire issue

– Exercise a call provision


24.4 Repayment Provisions (cont'd)

• Callable Bonds

– Bonds that contain a call provision that allows the issuer to repurchase the bonds at a predetermined price


Call Provisions

• A call feature allows the issuer of the bond the right (but not the obligation) to retire all outstanding bonds on (or after) a specific date (the call date), for the call price.

– The call price is generally set at or above, and expressed as a percentage of, the bond’s face value.


Call Provisions (cont'd)

• A firm may choose to call a bond issue if interest rates have fallen.

– The issuer can lower its borrowing costs by exercising the call on the callable bond and then immediately refinancing the issue at a lower rate.

• Note: If rates rise after a bond is originally issued, there is no need to refinance.



• Holders of callable bonds understand that the issuer will exercise the call option only when the coupon rate of the bond exceeds the prevailing market rate.

– If a bond is called, investors must reinvest the proceeds when market rates are lower than the coupon rate they are currently receiving.

• This makes callable bonds relatively less attractive to bondholders than identical non-callable bonds.

– A callable bond will trade at a lower price (and therefore a higher yield) than an otherwise equivalent non-callable bond.



• Consider what happens to a bond that is callable at par on only one specific date. On the call date:

– If the yield of the callable bond is less than the coupon, the callable bond will be called, so its price is its par value.

– If this yield is greater than the coupon, then the callable bond will not be called, so it has the same price as the non-callable bond.

• Note: The callable bond price is capped at par: The price can be low when yields are high, but does not rise above the par value when the yield is low.


Figure 24.2 Prices of Callable and Non-callable Bonds on the Call Date



• Prior to the call date

– When market yields are high relative to the bond coupon, investors anticipate that the likelihood of exercising the call is low and the bond price is similar to an otherwise identical non-callable bond.



• Prior to the call date

– When market yields are low relative to the bond coupon, investors anticipate that the bond will likely be called, so its price is close to the price of a non-callable bond that matures on the call date.


Figure 24.3 Prices of Callable and Non-callable Bonds Prior to the Call Date



• Yield to Call (YTC)

– The yield of a callable bond calculated under the assumption that the bond will be called on the earliest call date


Textbook Example 24.2


Textbook Example 24.2 (cont'd)



• Problem

– Antec has just issued a callable (at par) five-year, 6% coupon bond with annual coupon payments.

– The bond can be called at $1,050 in one year or anytime thereafter on a coupon payment date.

– It has a current price of $1,000.

– What is the bond’s yield to call?



• Solution

– Yield to Maturity

N I/YR PV PMT FV

1

11

-1,000 1,05060


Sinking Funds

• Sinking Fund

– A method of repaying a bond in which a company makes regular payments into a fund administered by a trustee over the life of the bond

• These payments are then used to repurchase bonds.

– This allows the firm to retire some of the outstanding debt without affecting the cash flows of the remaining bonds.


Sinking Funds (cont'd)

• If the bonds are trading at a discount, the company will repurchase the bonds in the market.

• If the bonds are trading above its face value, the bonds are repurchased at par.– Which bonds are repurchased is decided by a

lottery.


Sinking Funds (cont'd)

• Balloon Payment

– A large payment that must be made on the maturity date of a bond

– Some sinking funds require equal payments over the life of the bond. In other cases, the sinking fund payments are not sufficient to retire the entire issue and the company must make a balloon payment.


Convertible Provisions

• Convertible Bond– A corporate bond with a provision that gives

the bondholder an option to convert each bond owned into a fixed number of shares of common stock

• Conversion Ratio– The number of shares received upon

conversion of a convertible bond, usually stated per $1000 of face value


Convertible Provisions (cont'd)

• Conversion Price

– The face value of a convertible bond divided by the number of shares received if the bond is converted



• Assume you have a convertible bond with a $1000 face value and a conversion ratio of 15.

– If you convert the bond into stock, you will receive 15 shares.

– If you do not convert, you will receive $1000. • By converting you essentially “pay” $1000 for 15

shares, implying a price per share of $66.67. – If the price of the stock exceeds $66.67, you will choose

to convert; otherwise, you will take the cash.



• Often companies issue convertible bonds that are callable.

– With these bonds, if the issuer calls them, the holder can choose to convert rather than let the bonds be called.


Figure 24.4 Convertible Bond Value



• Warrant

– A call option written by the company itself on new stock

• When a holder of a warrant exercises it and thereby purchases stock, the company delivers this stock by issuing new stock.

• Convertible debt carries a lower interest rate because it has an embedded warrant.


Discussion of Key Data Case Topic

• Compare the yields on Home Depot’s bonds with Lowe’s bonds of similar maturities.

• Are the differences consistent with what you might expect, given differences in bond ratings, callability, etc.?

• www.finra.org


Chapter Quiz

1. List four types of corporate debt that are typically issued.2. What are the four categories of international bonds?3. What is the distinguishing characteristic of municipal

bonds?4. What is an asset-backed security?5. What happens if an issuer fails to live up to a bond

covenant?6. Do callable bonds have a higher or lower yield than

otherwise identical bonds without a call feature? Why?7. Why does a convertible bond have a lower yield than an

otherwise identical bond without the option to convert?

berk chapter 24: debt financing

Economy & Finance

types of debt

new debt

type of corporate debt

straight debt

existing debt

outstanding debt

debt financing

public debt contd bearer