fabozzi_ch07_.ppt

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

Chapter 7

Corporate Debt

Instruments


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Learning Objectives

Understanding the key provisions of a corporate bond issue, including

provisions for repaying a bond issue prior to the stated maturity

date

corporate bond ratings and what investment-grade bonds and

noninvestment-grade (also called high-yield or junk) bonds are event risk

bond structures used in the high-yield bond market

empirical evidence concerning historical risk and return patterns

in the corporate bond market

what recovery ratings are the secondary market for corporate bonds


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Learning Objectives (continued)

Understanding the private-placement market for corporate bonds medium-term notes

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


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Corporate Bonds

Corporate bonds are issued by utilities, transportation,industrial, and bank/finance companies.

Bond terms are stated in the prospectus, including date(s)

when principal will be repaid and dates and amounts of

interest payments. The prospectus includes any other terms,such as security for the bond, embedded options, alternatives

for interest payments and so on.

Failure to pay either the principal or interest when due

constitutes legal default; investors can go to court to enforcethe contract.


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Corporate Bond Maturities (Terms)

Most corporate bonds are term bonds, due and payable at a

set maturity date (generally called notes if original maturity

is less than 10 years).

Serial bonds have specified principal amounts due on

specified dates before the final maturity date.


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Corporate Bond Security

Mortgage bonds are secured by a specific asset or assets.

Debenture bonds are general obligations, not secured by aspecific pledge of property.

Subordinated debenture bonds rank after secured debt anddebenture bonds for receipt of principal repayment.

Guaranteed bonds are guaranteed by another entity, usuallyan insurance company, which substitutes its own (higher)credit rating for that of the issuing company.

Mortgage bonds typically have lower rates than debenture

bonds, and debenture bonds typically have lower rates thansubordinated debenture bonds.


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Corporate Bond Repayment

Call provisions allow the company to buy back all or part of

the issue prior to the stated maturity date, often at a premiumover face value (especially in the first few years after the

bonds are issued). Refunding protection prevents calls

funded by lower cost debt; call protection prevents calls for

any reason or for a specified period of time.

Sinking fund bonds will be partially redeemed early, either

through calls determined by lottery or through open market

purchases of bonds which the company makes to satisfy its

obligation to retire some of the issue earlier than the statedmaturity.



Exhibit 7-1 Redemption Schedule for Anheuser-Busch Cos., Inc., 10%

Sinking Fund Debentures Due July 1, 2018 (callable bonds)

The 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 thedate 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.



Corporate Bond Ratings

The SEC requires that all publically traded bonds be rated by

an approved ratings agency, which analyzes the companys

credit and the terms of each of its debt issues to estimate the

companys ability to pay its future contractual obligations.

The best known of those agencies are Moodys Investors

Service, Standard & Poors Corporation, and Fitch Ratings

though there are a few other firms on the approved list.

Although all investors pay some attention to rating agency

ratings, professional money managers also independently

analyze credit information on companies and bond issues.



Corporate Bond Ratings (continued)

Ratings range from AAA (best) through AA and A to BBB(with + andratings) for companies judged very likely to

fulfill all their contractual obligations when due. Debt fromsuch companies is considered investment grade, suitable forall investors.

Debt which is rated lower than BBB- (BB, B, CCC, CC, C,D) is considered speculative, best owned by sophisticated

investors. Such debt is called non-investment grade, highyield or junk. Debt may be rated below-investment grade atissue or may be downgraded later (fallen angels).

Exhibit 7-3 (see slide 7-11) gives a rating transition matrix,showing the likelihood that a rating will change (either up or

down) within one calendar year. (Note: does not include theexperience of 2007-8 when record numbers of issues weredowngraded.)



Exhibit 7-3Hypothetical One-Year Rating Transition Matrix

Rating at End of Year

Rating at Start

of Year Aaa Aa A Baa Ba B C or D Total

Aaa 91.00 8.30 0.70 0.00 0.00 0.00 0.00 100.00

Aa 1.50 91.40 6.60 0.50 0.20 0.00 0.00 100.00

A 0.10 3.00 91.20 5.10 0.40 0.20 0.00 100.00



Corporate Bond Defaults and Losses

The next two slides show data on the numbers of bond issues

that defaulted between 1985 and 2006, broken out between

investment grade and high yield companies (slide 7-13) and

on the total dollar amount of defaulted high yield debt

(slide 7-14)

Note that defaults increase during recessions and that more

high yield issues default than investment grade issues but

also that the volume of high yield issues has risen steadily

over this time period (until 2006).



Exhibit 7-4Defaults by Original Ratings (Investment Grade VersusNon-Investment Grade) by Year, 19852006

Year

Total # Defaulted

Issues

% Originally Rated

Investment Grade

% Originally Rated

Non-Investment Grade

2006 52 13 87

2005 184 49 51

2004 79 19 81

2003 203 33 672002 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 Default Rate

for Corporate Bonds in the U.S. and Canada 19852006

Year

Par Value Outstanding

($ millions)

Par Value Defaults

($ millions)

Default Rate

(%)

2006 993,600 7,559 0.761

2005 1,073,000 36,209 3.375

2004 933,100 11,657 1.249

2003 825,000 38,451 4.6612002 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

C t B d D f lt d L



Corporate Bond Defaults and Losses(continued)

A bond is in default when the issuer fails to make an interest

or principal payment when due. However, the bond holderoften recovers at least part of the investment despite the

default.

The recoveryrate is the percentage of the face amount of thebond recovered by the holder.

The default loss rate is a measure of the actual investment

loss following a default:

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



Corporate Bond Event Risk

Event risk is a serious, unexpected change in the ability of a

company to make interest and principal payments.

Event risk usually happens because of a natural or industrial

accident, regulatory change or a takeover/corporate

restructuring (often involving the addition of significantamounts of new debt). Event risk may lead to a ratings

downgrade.


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Corporate Bond Event Risk(continued)

Leveraged buyouts (LBOs) or recapitalizations with a lot of

new debt are a common event risk. Interest payments on thenew debt can cause severe cash flow constraints. Companiesmay structure debt issues to ease these constraints.

Deferred-interest bonds do not pay interest for an initial period,

typically from three to seven years, and sell at a deep discount. Step-up bonds do pay coupon interest, but the coupon rate is low

for an initial period and then increases (steps up). Payment-in-kind (PIK or PIK toggle) bonds give the company an

option at each coupon payment date to pay cash or give thebondholder a similar bond for the amount of interest due (called a

toggle if on each coupon payment date the company can chooseeither form of payment depending on its cash flow at that time).


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Corporate Bond Event Risk(continued)

Extendable reset bonds reflect both the level of interest rates

at the reset date, and the credit spread the market wants on

the issue.

Companies that issue extendable reset bonds have a long-

term source of funds based on short-term rates.

Investors who own these bonds have a coupon rate and a

credit spread which reset periodically to the market rate .


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High Yield Corporate Bonds

High-yield corporate bonds (also called below investment

grade or junk bonds) have outperformed both investment

grade corporate bonds and Treasuries over the long term,

although they have underperformed common stock.


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Corporate Bond Trading

Secondary Market: Over-the-counter (OTC)Traditionally, corporate bond traded on an OTC market

conducted via telephone and based on broker-dealer trading

desks.

Electronic bond trading now makes up the majority of

corporate bond trading, still done via trading desks, not

exchanges.

Private-Placement Market for Corporate BondsCompanies may also issue bonds privately. Such bond issues

are not registered with SEC, have a limit on the number of

buyers and are restricted to sophisticated investors. These

bonds typically carry higher interest rates; trading is very

limited and may not be possible at all.


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Corporate Bonds(continued)

Bond purchasers must pay sellers accrued interest as well as

the bond price in the secondary market.

Corporate bonds use a 30/360 calendar.

Example: 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.


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Medium-Term Notes (MTN)

MTN are corporate debt instruments offered continuously to

investors by an agent of the company. Investors can selectfrom 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 give companies maximum flexibility forissuing securities: fixed or floating rates, US dollar or other

currency. Companies often add swaps (or options, futures/

forwards, caps, and floors) to create structured notes with

more interesting risk-return features than are otherwiseavailable in the corporate bond market.


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Commercial Paper

Commercial paper is short-term unsecured borrowing issued

in the open market to provide short-term funds for seasonaland working capital needs.

Corporations sometimes use commercial paper for other

purposes such as bridge financing. For example, if a

corporation needs long-term funds to build a plant or acquireequipment but thinks that capital market conditions are

unattractive, it may use commercial paper to finance the

project temporarily.

If companies have raised funds in the commercial papermarket for long term uses, they typically replace that paper

with a later sale of longer-term securities.


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Commercial Paper(continued)In the United States, most commercial paper is sold withmaturities ranging from 1 day to 270 days (paper with original

maturity within 270 days does not need to be registered with theSEC).

Companies generally roll over commercial paper at maturity, i.e.,use the proceeds from selling new commercial paper to pay thematuring debt.

Companies may sell directly to buyers (direct placement) orthrough dealers (dealer placed). Paper from less well-knowncompanies may carry a guarantee from a third party or may havecollateral (asset-backed paper)

Commercial paper is rated by rating agencies just as longer termdebt is; almost all marketable commercial paper carries the highestcredit rating (there are strict limits on the amount of paper withlower ratings institutional investors may hold).


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Exhibit 7-12Commercial Paper Ratings

Category Fitch Moodys S&P

Investment grade F-1+ A-1+

F-1 P-1 A-1

F-2 P-2 A-2

F-3 P-3 A-3

Noninvestment grade F-S NP (not prime) B

C

In default D D


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Commercial Paper Trading

There is a small secondary market for commercial paper

although there is a large amount outstanding (most buyershold to maturity).

Commercial paper is a discount instrument, with higher rates

than similar Treasuries because: Commercial paper has credit risk. Interest on commercial paper is taxable (states/cities

do not tax interest on Treasuries).

Commercial paper is (significantly) less liquid than

Treasury bills.


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Bank Loans

Bank loans to corporate borrowers are divided into two

categories: investment-grade loans (made to corporate

borrowers that have investment-grade ratings) and leveraged

loans (made to below-investment grade borrowers). They

trade in securities markets in several forms.

Syndicated bank loans are provided by a group (or syndicate)

of banks, generally used when borrowers seek a large loan.

Lenders assign loans (transfer all ownership rights) to other

banks or participate in loans (no rights transfer).

Bank loans are senior to bondholders for repayment of

interest and principal; generally the principal is due at

maturity (bullet loans.)


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Bank Loan Trading

Syndicated loans can be traded in the secondary market or

securitized to create collateralized loan obligations; they

require periodic marking to market.

Non investment grade borrowers may use either leveragedloans or high-yield bonds as sources of debt financing.

B k t d C dit Ri ht


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Bankruptcy and Creditor Rights

When companies are liquidated in bankruptcy, all company assets aredistributed to creditors following creditor priority rules clearlyestablished by law.

However, if a company files for reorganization under Chapter XI of

the Bankruptcy Code, the focus is on restructuring its debt so thecompany can emerge as a going concern. Creditor priority breaksdown and equity holders often receive some value for their claims.Explanations for this phenomenon include:


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Bankruptcy and Creditor Rights (continued)

Incentive hypothesis: longer negotiations incur greater costs and a smallerdistribution to all parties; equity holders participate so negotiations cansettle more quickly.

Recontracting process hypothesis: senior creditors recognize the ability ofmanagement (which holds equity) to preserve value for all claimants.

Stockholders influence on the reorganization plan hypothesis: creditorsmay be less informed about the firms true economic operating conditionsthan management, which presents data to reinforce its position.

Strategic bargaining process hypothesis: more complex bankrupt firmshave more claimants, therefore risk longer negotiations. These firms havehigher incidences of violation of the absolute priority rule, which supportsthis hypothesis.


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