The Many Different Kinds of Debt Principles of Corporate Finance Tenth Edition Chapter 24 The Many Different Kinds of Debt Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

Topics Covered Domestic Bonds, Foreign Bonds and Euro Bonds The Bond Contract Security and Seniority Repayment Provisions Debt Covenants Convertible Bonds and Warrants Private Placements and Project Finance Innovation in the Bond Market 2 2 2 2 3 2

Bond Terminology Foreign bonds - bonds that are sold to local investors in another country's bond market Yankee bond- a bond sold publicly by a foreign company in the United States Samurai - a bond sold by a foreign firm in Japan Eurobond market - when European and American multinationals are forced to tap into international markets for capital Global Bonds - very large bond issues that are marketed both internationally (that is, in the eurobond market) and in individual domestic markets

Bond Terminology Indenture or trust deed - the bond agreement between the borrower and a trust company* Registered bond - a bond in which the Company's records show ownership and interest and principal are paid directly to each owner Bearer bonds - the bond holder must send in coupons to claim interest and must send a certificate to claim the final payment of principal Accrued interest - the amount of accumulated interest since the last coupon payment Coupon – the annual or semiannual interest paid on a bond LIBOR - London interbank offered rate - the rate at which international banks lend to one another Indenture is the legal contract, which includes clauses to minimize the conflict of interests between the bondholders and the shareholders. A brief discussion of agency costs is required.

Bond Contract Summary of terms of 8.25% sinking fund debenture 2022 issued by J.C. Penney Notice the difference between the issued price and proceeds to the issuer. The difference is underwriting expense. As the issuing price is below 100%, this was issued as a discount bond. Explain the difference between discount (including zero-coupon) and premium bonds/notes.

Bond Terminology Debentures - long-term unsecured issues on debt Mortgage bonds - long-term secured debt often containing a claim against a specific building or property Collateral trust bonds - Bonds secured by common stocks or other securities that are owned by the borrower (e.g., holding companies whose main assets consist of subsidiary companies stocks) Equipment trust certificate - Form of secured debt generally used to finance railroad (& aircrafts, trucks, ships, etc.) equipment. The trustee retains ownership of the equipment until the debt is repaid.* Notes are short-term obligations compared with bonds. Generally mortgage bonds have a higher rating than debentures. Asset-backed securities are pooled and sold in the market. The cash flows from these are used to service the bonds. Home mortgage loans and credit card loans are examples of these. *Only when these debts have been fully paid off, the company becomes the formal owner of the equipment.

Priority Payments Senior debt is borrowed money that a company must repay first if it goes out of business. If a company goes bankrupt, senior debtholders, who are often bondholders or banks that have issued revolving credit lines, are most likely to be repaid, followed by junior debt holders, preferred stock holders and common stock holders, possibly by selling collateral held for debt repayment. Senior debt is secured by a business for a set interest rate and time period. The company provides regular principal and interest payments to lenders based on a preset schedule. Senior debt is a company’s first level of liabilities, typically secured by a lien against some type of collateral. This makes the debt less risky and provides less return for lenders. Senior debt holders may be able to voice their opinions on how much subordinated debt a company assumes. If the company becomes insolvent, carrying too much debt may mean the business cannot pay all of its creditors. For this reason, senior debt holders typically want to keep other debt at a minimum.

Secured and Unsecured Debt Secured debt is backed by an asset that was pledged as collateral. For example, lenders may place liens against equipment, vehicles or homes when issuing loans. If the loan is defaulted on, the asset may be sold to cover the debt. Unsecured debt is not backed by an asset pledged as collateral. If a business becomes insolvent, unsecured debt holders file claims against the company’s general assets.

Ultimate Percentage Recovery Rates on Defaulting Debt (1987 – 2006) Recovery Percentage A Recovery rate on defaulting debt is shown. Bank debt has the highest recovery rate. Because subordinated debts are repayable after other debts have been paid, they are more risky for the lender of the money. The debts may be secured or unsecured. Subordinated loans typically have a lower credit rating, and, therefore, a higher yield than senior debt. Senior subordinated debt is subordinated in its rights to receive its principal and interest payments from the borrower to the rights of the holders of senior debt. As a result, senior subordinated debt is riskier than senior debt. Although such loans are sometimes secured by significant collateral, we principally rely on the borrower’s cash flow for repayment. Additionally, we often receive warrants to acquire shares of stock in borrowers in connection with these loans. Structurally, junior subordinated debt is subordinate in priority of payment to senior debt (and is often unsecured), but is senior in priority to equity. Junior subordinated debt often has elements of both debt and equity instruments, having the fixed returns associated with senior debt while also providing the opportunity to participate in the future growth potential of a company through an equity component, typically in the form of warrants. Due to its higher risk profile and less restrictive covenants, loans associated with junior subordinated debt financing generally earn a higher return than senior debt or senior subordinated debt instruments.

Bond Terminology Asset backed securities (ABS) - the sale of cash flows derived directly from a specific set of bundled assets Mortgage pass through certificates - ABS backed by a package of mortgage pass-throughs* Collateralized Mortgage Obligations (CMOs) – issuer establishes several classes of security with regard to the payment priority (important protection against possible default) To illustrate: Suppose a company has made a large number of mortgage loans which will pay interests and principals when due. Instead of waiting for the cash-flows from these mortgages, the company can establish a separate special purpose vehicle companies which would purchase these loans, and sells mortgage pass-through certificates. The holders of these pas-through certificates simply receive a share of the mortgage payments.

Bond Terminology Sinking fund - a fund established to retire debt before maturity (borrowing company must make a series of payments into a sinking fund – if failed, borrowers can demand their money back) Callable bond - a bond that may be repurchased by a the firm before maturity at a specified call price. (Call/put premiums are imbedded in the bond price) Defeasance - a method of retiring corporate debt involving the creation of a trust funded with treasury bonds (In the case of J.C. Penney, the sinker starts in 2003 while the bond was issued in 1992. And the sinker covers the entire amount of bond issued over its life.) Sinking funds need not cover 100% of the face value of the bond. If the payment into sinking fund is in the form of cash, the trustee selects bonds by lottery and uses the cash to redeem them at face value. Alternatively, the company can choose to buy bonds in the market place. The latter alternative may be valuable/cheaper if the bond price is lower than the par. Call/put provisions can be seen as forms of provisions for insurance (against unwanted interest rate movements). Call provisions may be deferred also. J.C. Penney’s callability starts in 2003, which gives 10-year call protection period during which the company may not call the bonds to retire the bonds in low interest rate environment. Extendable bonds give investors the option to extend the bond’s life. Defeasance is a debt restructuring tool that allows a firm to eliminate debt from its balance sheet by establishing an irrevocable trust funded with cash - more likely, treasury securities that will generate future cash flows sufficient to service the debt. [Defeasance entails a borrower setting aside sufficient funds, often in cash and bonds, to cover his associated debts. This functions as a way to render the debt obligation null and void without the risk of prepayment penalties. Since the amounts owed and the amounts set aside offset, they are functionally removed from balance sheets as monitoring the accounts is generally unnecessary.]

Bond Terminology Restrictive covenants - Limitations set by bondholders on the actions of the Corporation Negative Pledge Clause - the processing of giving unsecured debentures equal protection and when assets are mortgaged Poison Put - a clause that obliges the borrower to repay the bond if a large quantity of stock is bought by single investor, which causes the firms bonds to beat down rated There are two types of bond covenants: negative covenants and positive covenants. Negative covenants limit or forbid actions that the firm may take, which are detrimental to the bondholders’ interests. Positive covenants specify actions that the firm must take.

Bond Terminology Pay in kind (PIK) - a bond that makes regular interest payments, but in the early years of the bonds life the issuer can choose to pay interest in the form of either cash or more bonds with an equivalent face value Puttable bond – A provision that allows the bondholder to demand immediate payment. This is the central feature in loan guarantees issued by the government. Puttable bonds exist largely because bond indentures cannot anticipate every events/actions the company may take that could harm the bondholders. If the bond value is reduced, issuers will likely be demanded for payment of debt. When Asian financial crisis occurred in 1997, those Asian issuers affected were faced with flood of lenders demanding their money back.

Straight Bond vs. Callable Bond In order to maximize the value of shareholders, the company looks to minimize debt burden. It will call its bonds if they are worth more than call price. Also, investors will not pay a price higher than the call price, as they know the bond will be called when it is above the call price. As interest rate declines and bond price increases toward call price, the value of a callable bond would be lower than the value of a straight bond

Debt Covenants Investors know that there is a default risk involved. But they still want to make sure that the company plays fair. Therefore, the loan agreement usually includes a number of default covenants that prevent the company from purposely increasing default options. Temptation to play the following games is strong particularly during financial stress: Cash-in and run: Instead of putting additional money into the company, investors want to take money out in the form of cash dividends (although there is a law called fraudulent conveyance which allows court to claw back the money into the firm and its creditors). Playing for Time: When the firm is in financial stress, creditors would like to salvage what they can by forcing the firms to settle up promptly. Naturally stockholders may want to delay this as long as they can. Firms may conceal true extent of trouble by making accounting changes, by cutting corners on maintenance, R&D, etc. in order to make the current income look better. Bait-and-Switch: Although a firm starts with a conservative debt policy at the time of issuance of its initial debt, it can suddenly raise subsequently large amount through debt, which jeopardizes creditworthiness of old bonds. RJ Reynolds Nabisco’s leveraged buy-out in 1988, where the management would buy out existing shareholders (and the company would be taken private), and the cost of buy-out be entirely financed by additional debt.

Covenants Debt ratios: Senior debt limits senior borrowing Junior debt limits senior & junior borrowing Security: Negative pledge Dividends/repurchase of stocks Event risk Positive covenants: Working capital Net worth There are two types of bond covenants: negative covenants and positive covenants. Negative covenants limit or forbid actions that the firm may take, which are detrimental to the bondholders’ interests. Positive covenants specify actions that the firm must take. Bond covenants include clauses to protect the bondholders’ interests. They are also called protective covenants. These are some of the most commonly used provisions that are normally included in the debt contract.

Covenants Covenant Restrictions Percentage of bonds with covenants Type of covenant Investment-grade bonds Other bonds Merger restrictions 92% 93% Dividends or other payment restrictions 6 44 Debt covenants 74 67 Default-related eventsa 52 71 Change in control 24 a e.g., default on other loans, rating changes, or declining net worth Percentage of sample of bonds with covenant restrictions. Sample consists of 4478 senior bonds issued between 1993 and 2007. Source: S. Chava, P. Kumar, and A. Warga, “Managerial Agency and Bond Covenants,” Review of Financial Studies These covenants matter. But, the Table above indicates that generally investment grades have less restrictions than others.

Event Risk: An Example October 1993 Marriott spun off its hotel management business worth 80% of its value. Before the spin-off, Marriott’s long-term book debt ratio was 2891/3644 = 79%. Almost all the debt remained with the parent (renamed Host Marriott), whose debt ratio therefore rose to 93%. Marriott’s stock price rose 13.8% and its bond prices declined by up to 30%. Bondholders sued and Marriott modified its spinoff plan. This is an example where bondholders were given a nasty shock called event risk. Poison put clause requires the issuing company to repay its debt if there is a change in management control and the bond ratings are down-rated.

What is a Convertible Bond? (See Section 24-6 for the case) Chiquita Brands 4.25% Convertible issued in 2008 and due in 2016 Convertible into 44.5524 shares in exchange for bond Conversion ratio 44.5524 Conversion price = 1000/44.5524 = $22.45 Lower bound of value Bond value Conversion value = conversion ratio x share price Convertible bond is equivalent to a straight bond plus an option of bond investors to acquire common stocks. [No payment is necessary, but the convertible bond is surrendered in exchange for 44.5524 common stocks.] The bond holder may remain to hold unto the bond or opt to convert into stocks. If stock price rises, it would lead into rise in convertible bond. The convertible bond will sell for at least the higher of the two values; bond value or conversion value. Before maturity a convertible is worth more than its lower bond value, because they can wait and then take a course of action that gives them the highest payoff. This is why there is a premium attached to the convertible bond (i.e., higher bond price). Convertibles are convenient and flexible - they're usually unsecured and subordinated, and cash requirements for debt service are relatively low

What is a Convertible Bond? How bond value varies with firm value at maturity Bond value ($ thousands) bond repaid in full If the firm value is at least equal to the face value of debt, the bond is paid off at face value. There is a small probability of default. If the firm value falls below the amount of bond repayment in full, the firm is in technical default. default

What is a Convertible Bond? How conversion value at maturity varies with firm value Conversion value ($ thousands) Conversion value at maturity: If converted, the value of the convertible rises in proportion to firm value.

What is a Convertible Bond? How value of convertible at maturity varies with firm value Value of convertible ($ thousands) convert bond repaid in full Before the maturity when conversion period starts, the convertible bond holder can choose to receive the payment as the bond or convert to common stocks. The value of the bond is therefore the higher of its bond value and its conversion value. By superimposing the two previous graphs we get this graph. As long as the value of the firm does not fall below $1 million, the bond is paid in full. Before maturity a convertible is worth more than its lower bound. default

Further Discussions on Convertibles Some consider convertibles as an inexpensive way to issue “delayed” common stock. Convertibles tend to be issued by smaller and more speculative firms. (from an investor’s point of view, it is difficult to assume a fair discount rate) As investor enjoys both features of debt and equity, one is less concerned about company not acting in the best interest of debt holders. Relatively low coupon rate may be attractive for small company in raising fund thru debt (alternative debt would require much higher coupon) Forcing conversion: Beginning in 2014, Chiquita has an option to buy back (or call) its convertible bonds at their face value whenever its stock price is at least 30% above the bond’s conversion price. If Chiquita announces that it will call the bonds, it makes sense for investors to convert immediately. Thus a call can force conversion.

Convertible Bond Valuation Issues Dividends Dilution Changing bond values The three type of complications in valuing bonds are presented. Each has its own unique issues that should be understood. Dividends: will not be received until conversion into stocks takes place. Dividend payment will reduce the stock value by that amount. If dividend rate is higher than the coupon, it may be worthwhile to convert before maturity. Conversion: Conversion increases the number of outstanding shares. Therefore, exercising conversion means that each shareholder is entitled to a smaller share of the firm’s net assets and profits. [Note: This is not a case of exercising of options purchased through options exchange.] Changing bond value: Bond price is also a moving target. (i) bond value will approach face value as maturity nears, and (ii) will vary with perceived credit risk and (iii) vary with interest rate changes.

Bond Warrant Package Bond Warrant and Option Warrants are usually issued privately (while most convertibles are publicly offered) Warrants can be detached (Convertibles cannot) Warrants are exercised for cash (Convertibles are not) A package of bonds and warrants may be taxed differently Warrants may also be issued on their own (can be used as a compensation for underwriting services; acts just like stock options to executives; or can be issued to investors separately) Convertible bonds consist of a package of straight bond and an option. An issue of bond-warrant package also contains a straight bond and an option. But there are a number of differences between the two. Bonds with an attached warrants which entitles the purchaser to a certain number of shares of the borrowing company for a certain period at a price fixed in advance. The coupon on the bond may be lower than that of comparable bonds without warrants because of the potential benefit of buying shares at an advantageous price. Warrant exercise dilutes the value of equity (as additional stocks are issued) while option exercise does not (as no new stocks are issued by the company).  The exercise of warrants creates new shares which increases the total number of shares that reduces the individual share value.

Private Placements Placing securities to a small group of investors with restrictions on sale to public Do not require standardization, avoid SEC registration (Rule 144A allows the avoidance) Are cheaper in issuing cost and time saving than public placements (but investors may require higher rate of return for illiquidity) Can be customized to suit the specific needs of the investors (intimacy can allow flexibility, amendment of covenants).

Project Finance Is a private investment/loan into the project - not the sponsoring company (no recourse). Project is set up as a separate company. A major proportion of equity is held by project manager or contractor, so provision of finance and management are linked. The company is highly levered. Has many stakeholders who assume various roles to make the project successful – complex/costly to arrange. Project financing in developing countries take place in infrastructure sectors such as telecom, transport, power, etc. Usually, the company is highly leveraged. The project may be executed on a build-operate-transfer (BOT) basis. There are other schemes like this. Project finance is generally provided by large international banks as well as multilateral financial institutions and export credit agencies (ECAs).

Parties In Project Finance  There are many stakeholders to a project. Their stakes in the project are specified by explicit contracts.

Risk Allocation

Bond Innovations

Bond Innovations Motives for creating new bonds To widen investor choice Government regulation and taxes Reducing agency costs Why do firms create new types on bonds? This slide provides a partial answer. Examples and illustration: 1. Axa’s mortality bond issued in 2006 where holders of the bond will lose their entire investment if death rates for 2 consecutive years exceed expectations by 10%; longevity bond which suits pension funds would pay a higher rate of interest if an unusually high proportion of the population survives to a particular age. 2. Asset Backed Securities (ABS): To reduce the likelihood of failure, banks are obliged to finance part of their loan portfolio with equity capital. Many banks have sought to reduce capital commitment by packaging their loans/receivables and selling them as bonds. 3. Investors were concerned about huge spending plans of telecom companies. So when British Telecom issued bond, it offered a step-up provision to assure investors - BT was required to increase coupon by 25 basis points if bonds were downgraded by one notch.

Web Resources Click to access web sites Internet connection required www.investinginbonds.com/ www.hbs.edu/projfinportal