VI: Debt Market Instruments 19: Corporate Bonds. Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Corporate Bonds  Risk Structures  Convertibles.

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VI: Debt Market Instruments 19: Corporate Bonds

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Corporate Bonds  Risk Structures  Convertibles

Risk Structures

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Promised Yield to Maturity  Not all bonds pay as promised.  Enron filed for bankruptcy December 2, 2001

Chapter 19: Corporate Bonds Enron On December 14, the promised YTM was % 6.5% Enron August 1, 2002 © Oltheten & Waspi 2012

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Expected Yield to Maturity  % * 1% = 6.19 %

Chapter 19: Corporate Bonds Enron © Oltheten & Waspi 2012 Why would anyone pay for a bond in bankruptcy?

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Enron  Buy a $1,000,000 bond flat December 14, 2001 at  The invoice price is $177,  Assume the bond pays nothing until December 14, 2006 when it pays off at 32 ¢ on the dollar.

Chapter 19: Corporate Bonds Enron © Oltheten & Waspi 2012 Aug 1, 02Aug 1, 03Aug 1, 04 Aug 1, 05Aug 1, 06 Dec 14, Dec 14, Even a bond in bankruptcy can yield a positive yield 32,500 1,032,500 The recovery rate is 32 ¢

Chapter 19: Corporate Bonds © 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

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Yield Spread  6% 2023 IBM BondYTM=8 ½%  6% 2023 T-BondYTM=6 The Yield Spread is 2 ½ % 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

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 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%

Chapter 19: Corporate Bonds IBM 8.50%(Promised YTM) 7.99%(Expected YTM) 6.00%T-Bond YTM Spread = 250 bp © Oltheten & Waspi 2012

Chapter 19: Corporate Bonds © 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%

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Fly-By-Night 9.99%(Promised YTM) 7.99%(Expected YTM) 6.00%T-Bond YTM Spread = 399 bp

Chapter 19: Corporate Bonds Market Forces  IBM  6% * 0.00%  94% * 8.50%  E[Y] = 7.99% © Oltheten & Waspi 2012  Fly-By-Night  20% * 0.00%  80% * 12.00%  E[Y] = 9.60%

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 IBM & Fly-By-Night 9.99% (Fly-By-Night) 7.99% (Expected YTM) 6.00% (T-Bond YTM) Default Premium = Risk Premium = 8.50% (IBM) Default Premium = Risk Premium =

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 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

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Convertible  Convertible Bonds may be turned into the issuer in exchange for other assets – generally common shares

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 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,  The conversion value of the bond is $1,030.00

Chapter 19: Corporate Bonds © Oltheten & Waspi 2012 Questions & Problems  Astrologer Question (19-9)

Corporate Bonds II