Chapter 20 Fixed-Income Financing and Pension Liability

Features of Debt Coupon rate is fixed return of long-term debt Trustee represents the interests of bondholders Indenture contains the terms of the bond issue and the restrictions placed on the company (protective covenants) Bond ratings reflect a rating agency’s opinion as to the creditworthiness of publicly traded debt High-yield debt is rated Ba/BB or below Sinking funds retire a portion of the bonds prior to maturity Issuer’s option Nasty accumulators

Floating-Rate Notes (FRNs) The interest rate can float with some short-term rate, such as the (LIBOR), Treasury bill, or commercial paper rate Used in a volatile interest rate environment to reduce risk Special features Options Declining spread Fixed-rate provision

European Corporate Bond Issuance Lacked depth and breadth necessary to be attractive before Euro Bond issue denominated in the Euro has become the vehicle of choice in cross-border financing Viable European corporate bond market has developed

Types of Debt Financing Debentures Subordinated debentures Mortgage bonds Income bonds Equipment trust certificates Equity-linked debt Debt + warrants Convertible bond Project financing Nonrecourse basis Sharing rules

Call Feature and Refunding Embedded options Sinking fund Call feature Gives the issuer the option to buy back a debt instrument at a specific price (call price) before maturity Forms of the provision Immediately callable Deferred for a period of time Gives the company flexibility Call the bonds and refinance if interest rates decline significantly Unduly restrictive protective covenants

Refunding Versus Redemption Refunding means refinancing the bond issue with a new bond issue at a lower interest cost Many bond issues can be redeemed provided the source of the redemption is not a refunding Investor has no call protection Redemption price often is the face value The line of demarcation between a call and a redemption is blurred

Value of Call Privilege Determined by supply and demand forces in the market for callable securities Investors are unwilling to invest in callable bonds unless such bonds yield more than noncallable bonds Borrower has to be able to refund at a profit

Valuation in an Option Pricing Context More volatility increases the value of the call option Equilibrium pricing Callable bond = Noncallable bond - Call option Level and volatility of interest rates are key factors in giving value to the call feature Identifies arbitrage opportunities

Refunding a Bond Issue in a Capital Budget Framework A riskless investment project after new bonds are sold Calculate the net investment Net cash outflow at time 0 Calculate the interest savings Cash inflows Calculate the net present value of refunding Timing of refunding Based on expectations of future interest rates

Problems With Analyzing Bond Refunding Longer maturity of new issue Sinking-fund bonds or serial bonds Decrease in the leverage of the firm

Private Placement Features Speed of the commitment Terms tailored to the needs of the borrower Renegotiation is possible Actual borrowing does not have to take place all at once No registration with SEC Company avoids making certain detailed information available to the public Slightly higher interest rate Lower floatation costs

Developments in the Market for Private Placements Considerable popularity over the last two decades Allowance for secondary trading Distinction between private placement and public market has blurred

Preferred Stock A form of fixed-income security, but the dividend is at the discretion of the company’s board Adds to the equity base of the company and enhances the ability of the company to borrow in the future Cumulative feature provides for unpaid dividends to be carried forward Voting power Normally not given unless management defaults

Retirement of Preferred Stock Call feature affords the company flexibility to retire the issue Sinking fund partially assures an orderly retirement of the stock Convertibility Convertible into common stock at the option of the holder Force conversion by calling the preferred stock

Tax Treatment of Preferred Dividend Taxed as ordinary income for individual investors If the investor is a corporation, 70% is not subject to taxation (intercorporate dividend exclusion) Preferred stock dividend paid is not tax deductible

Tax-Deductible Preferred Stock Instrument devised to be tax-deductible A special-purpose vehicle (SPV) is created Most widely used instruments MIPS QUIPS TOPrS

Auction-Rate Preferred Stock An instrument whose interest rate floats with money market rates 70% intercorporate dividend exclusion does apply Money market preferred stock (MMP) Rate is set by auction every 49 days, the effective maturity date Tax arbitrage involved in the instrument benefits both investor and issuer at the expense of the federal government

Pension Fund Liability Binding claim under (ERISA) Types of pension plans Defined benefit plans are a liability of the employer to provide retirement benefits Flat benefit formula Unit benefit formula Defined contribution plans are not a liability of the employer

Funded and Unfunded Liabilities of a Defined Benefit Plan Liability to currently retired employees depends on their average life expectancy and the discount rate used Liability to employees not yet retired Past employment Future service Total pension liability of a company must be valued The present value of liabilities is calculated by discounting to present value likely future benefits to be paid based on past service and expected future service

Unfunded Liability PV of pension liabilities - PV of pension assets Reported on the balance sheet as a liability FASB No. 87 Matter of concern to creditors Pension Benefit Guarantee Corporation (PBGC) makes good on most of the total obligations for a bankrupt company

Accounting for Pensions FASB No. 87 brought a consistent treatment of pension expense accounting together with bringing pension liability firmly onto the balance sheet Expenses Interest cost Service cost for additional benefits that employees earn during the year Amortization of any accumulated deficit Expected investment return (offset expenses)