VI: Debt Market Instruments 19: Corporate Bonds We have time for a pop quiz

Corporate Bonds Risk Structures Convertibles

Risk Structures

Promised Yield to Maturity Not all bonds pay as promised. Enron filed for bankruptcy December 2, 2001

Enron On December 14, the promised YTM was 618.755% 6.5% Enron August 1, 2002 © Oltheten & Waspi 2012

Expected Yield to Maturity 618.755% * 1% = 6.19 %

Enron Why would anyone pay 17.7177 for a bond in bankruptcy? © Oltheten & Waspi 2012

Enron Buy a $1,000,000 bond flat December 14, 2001 at 17.7177 The invoice price is $177,177.00 Assume the bond pays nothing until December 14, 2006 when it pays off at 24¢ on the dollar.

Even a bond in bankruptcy can yield a positive yield Enron The recovery rate is 24¢ Aug 1, 02 Aug 1, 03 Aug 1, 04 Aug 1, 05 Aug 1, 06 32,500 1,032,500 Dec 14, 01 Dec 14, 06 17.7177 0.24 Even a bond in bankruptcy can yield a positive yield © Oltheten & Waspi 2012

Risk Structures The Yield on a Corporate Bond depends on Term to Maturity Coupon Rate Call Provisions Liquidity Default Risk Tax Status  This dimension gives us the term structure or yield curve This dimension gives us the risk structure

Yield Spread 6% 2023 IBM Bond YTM=8 ½% 6% 2023 T-Bond YTM=6 The Yield Spread is 2½% or 250 basis points Coupon Rate is the same. Maturity is the same So any difference in yield is due to the difference in risk

Risk of Default - IBM There is a 6% probability that IBM will default on its bond. 6% probability of 0.00% 94% probability of 8.50% Risk adjusted Expectation of 7.99%

IBM Spread = 250 bp 8.50% (Promised YTM) 7.99% (Expected YTM) 6.00% T-Bond YTM © Oltheten & Waspi 2012

Risk of Default – Fly-By-Night Fly-By-Night trades at 9.99%. There is a 20% probability that will default on its bond. 20% probability of 0.00% 80% probability of 9.99% Risk adjusted Expectation of 7.99%

Fly-By-Night Spread = 399 bp 9.99% (Promised YTM) 7.99% (Expected YTM) 6.00% T-Bond YTM

Market Forces IBM Fly-By-Night 6% * 0.00% 94% * 8.50% E[Y] = 7.99% 20% * 0.00% 80% * 12.00% E[Y] = 9.60% © Oltheten & Waspi 2012

IBM & Fly-By-Night Default Premium = Default Premium = Risk Premium 9.99% (Fly-By-Night) Default Premium = 8.50% (IBM) Default Premium = 7.99% (Expected YTM) Risk Premium = Risk Premium = 6.00% (T-Bond YTM)

Speculative Ventures If the Speculative Ventures 6% 2023 bond trades at 12% yield what does the market think is the probability of default?

Convertible Bonds

Convertible Convertible Bonds may be turned into the issuer in exchange for other assets – generally common shares

Fly By Night The indenture specifies that Fly By Night bonds may be converted to common shares at $50 per share The common share currently trades at $51.50 $1000 bond -> 20 shares 20 shares * $51.50/share = $1,030.00 The conversion value of the bond is $1,030.00

Questions & Problems Astrologer Question (19-9)

Corporate Bonds II