© 2009 McGraw-Hill Ryerson Limited Chapter 18 Corporate Bonds Prepared by Ayşe Yűce Ryerson University

© 2009 McGraw-Hill Ryerson Limited Chapter eighteen outline Corporate bond basics Corporate bond basics Types of corporate bonds Types of corporate bonds Bond indentures Bond indentures Protective covenants Protective covenants Event risk Event risk Bonds without indentures Bonds without indentures

© 2009 McGraw-Hill Ryerson Limited Chapter eighteen outline Preferred stock Preferred stock Adjustable-rate bonds and adjustable-rate preferred stock Adjustable-rate bonds and adjustable-rate preferred stock Corporate bond ratings Corporate bond ratings Junk Bonds Junk Bonds Bond market trading Bond market trading

© 2009 McGraw-Hill Ryerson Limited Corporate Bonds Our goal in this chapter is to introduce the specialized knowledge concerning trading corporate bonds. Our goal in this chapter is to introduce the specialized knowledge concerning trading corporate bonds. Money managers who buy and sell corporate bonds possess this kind of knowledge. Money managers who buy and sell corporate bonds possess this kind of knowledge.

© 2009 McGraw-Hill Ryerson Limited Corporate Bond Basics A Corporate bond is a security issued by a corporation. A Corporate bond is a security issued by a corporation. It represents a promise to pay bondholders a fixed sum of money (called the bond’s principal, or par or face value) at a future maturity date, along with periodic payments of interest (called coupons). It represents a promise to pay bondholders a fixed sum of money (called the bond’s principal, or par or face value) at a future maturity date, along with periodic payments of interest (called coupons).

© 2009 McGraw-Hill Ryerson Limited Corporate Bond Basics Corporate bonds differ from common stock in three fundamental ways. Corporate bonds differ from common stock in three fundamental ways. Corporate Bonds Common Stock Represent a creditor’s claim on the corporation Represents an ownership claim on the corporation Promised cash flows (coupons and principal) are stated in advance Amount and timing of dividends may change at any time Mostly callable Almost never callable

© 2009 McGraw-Hill Ryerson Limited Corporate Bond Basics In Canada the corporate bond market is illiquid, however there are several trillion dollars of corporate bonds outstanding in the United States. In Canada the corporate bond market is illiquid, however there are several trillion dollars of corporate bonds outstanding in the United States. More than half of these are owned by life insurance companies and pension funds. More than half of these are owned by life insurance companies and pension funds. These institutions can eliminate much of their financial risk via cash flow matching. These institutions can eliminate much of their financial risk via cash flow matching. They can also diversify away most default risk by including a large number of different bond issues in their portfolios. They can also diversify away most default risk by including a large number of different bond issues in their portfolios.

© 2009 McGraw-Hill Ryerson Limited Corporate Bond Basics Table 18.1

© 2009 McGraw-Hill Ryerson Limited Types of Corporate Bonds Bonds issued with a standard, relatively simple set of features are popularly called Plain Vanilla Bonds (or “bullet” bonds). Bonds issued with a standard, relatively simple set of features are popularly called Plain Vanilla Bonds (or “bullet” bonds). Debentures are unsecured bonds issued by a corporation. Debentures are unsecured bonds issued by a corporation. Mortgage bonds are debt secured with a property lien. Mortgage bonds are debt secured with a property lien. Collateral trust bonds are debt secured with financial collateral. Collateral trust bonds are debt secured with financial collateral. Equipment trust certificates are shares in a trust with income from a lease contract. Equipment trust certificates are shares in a trust with income from a lease contract.

© 2009 McGraw-Hill Ryerson Limited Bond Offering Figure 18.1

© 2009 McGraw-Hill Ryerson Limited Bond Indentures A Bond indenture is a formal written agreement between the corporation and the bondholders. A Bond indenture is a formal written agreement between the corporation and the bondholders. This agreement spells out, in detail, the obligations of the corporation, the rights of the corporation, and the rights of the bondholders (with respect to the bond issue.) This agreement spells out, in detail, the obligations of the corporation, the rights of the corporation, and the rights of the bondholders (with respect to the bond issue.) In practice, few bond investors read the original indenture. Instead, they might refer to an indenture summary provided in the prospectus of the bond issue. In practice, few bond investors read the original indenture. Instead, they might refer to an indenture summary provided in the prospectus of the bond issue.

© 2009 McGraw-Hill Ryerson Limited Seniority Provisions Different bond issues can usually be differentiated according to the seniority of their claims on the firm’s assets in case of default. Different bond issues can usually be differentiated according to the seniority of their claims on the firm’s assets in case of default. Senior Debentures are the bonds paid first in case of default. Senior Debentures are the bonds paid first in case of default. Subordinated Debentures are paid after senior debentures. Subordinated Debentures are paid after senior debentures. Bond seniority may be protected by a negative pledge clause. Bond seniority may be protected by a negative pledge clause. A negative pledge clause prohibits a new debt issue that would have seniority over existing bonds. A negative pledge clause prohibits a new debt issue that would have seniority over existing bonds.

© 2009 McGraw-Hill Ryerson Limited Call Provisions A call provision allows the issuer to buy back all or part of its outstanding bonds at a specified call price sometime before the bonds mature. A call provision allows the issuer to buy back all or part of its outstanding bonds at a specified call price sometime before the bonds mature. When interest rates fall, bond prices increase. When interest rates fall, bond prices increase. The corporation can “call-in” the existing bonds, i.e., pay the call price. The corporation can “call-in” the existing bonds, i.e., pay the call price. The corporation can then issue new bonds with a lower coupon. The corporation can then issue new bonds with a lower coupon. This process is called bond refunding. This process is called bond refunding.

© 2009 McGraw-Hill Ryerson Limited Bond Indentures, Make-Whole Call Provisions Make-whole call provisions have recently become common Make-whole call provisions have recently become common Like a fixed-price call provision, a make-whole call provision allows the issuer to pay off the remaining debt early. However, Like a fixed-price call provision, a make-whole call provision allows the issuer to pay off the remaining debt early. However, The issuer must pay the bondholders a price equal to the present value of all remaining payments. The issuer must pay the bondholders a price equal to the present value of all remaining payments. As interest rates decrease: As interest rates decrease: the make-whole call price increases the make-whole call price increases But, even in the region of low yields, these bonds still exhibit the standard convex price-yield relationship in all yield regions. But, even in the region of low yields, these bonds still exhibit the standard convex price-yield relationship in all yield regions.

© 2009 McGraw-Hill Ryerson Limited Maximum Price of a Callable Bond No matter how low market interest rates fall, the maximum price of an unprotected callable bond is most likely its call price. No matter how low market interest rates fall, the maximum price of an unprotected callable bond is most likely its call price.

© 2009 McGraw-Hill Ryerson Limited Put Provisions A bond with a put provision can be sold back to the issuer at a pre-specified price (normally set at par value) on any of a sequence of pre- specified dates. A bond with a put provision can be sold back to the issuer at a pre-specified price (normally set at par value) on any of a sequence of pre- specified dates. Bonds with put provisions are often called extendible bonds. Bonds with put provisions are often called extendible bonds.

© 2009 McGraw-Hill Ryerson Limited Bond-to-Stock Conversion Provisions Convertible bonds are bonds that can be exchanged for common stock according to a pre-specified conversion ratio (i.e., the number of shares acquired). Convertible bonds are bonds that can be exchanged for common stock according to a pre-specified conversion ratio (i.e., the number of shares acquired). Suppose the conversion ratio for a $1,000 par value bond is 20 shares. Suppose the conversion ratio for a $1,000 par value bond is 20 shares.

© 2009 McGraw-Hill Ryerson Limited Bond-to-Stock Conversion Provisions Conversion Price = Bond Par Value / Conversion Ratio Conversion Price = Bond Par Value / Conversion Ratio Then, the conversion price is $50 ($1,000 / 20). Then, the conversion price is $50 ($1,000 / 20). Conversion Value = Price Per Share X Conversion Ratio Conversion Value = Price Per Share X Conversion Ratio If the market price per share of stock is currently $40, the conversion value is $800 ($40 x 20). If the market price per share of stock is currently $40, the conversion value is $800 ($40 x 20).

© 2009 McGraw-Hill Ryerson Limited Tombstone Ad, Convertible Notes Issue Figure 18.4

© 2009 McGraw-Hill Ryerson Limited Convertible Bond Prices and Conversion Values

© 2009 McGraw-Hill Ryerson Limited Exchangeable Debenture Issue

© 2009 McGraw-Hill Ryerson Limited Bond Maturity Provisions Bond maturity and principal payment provisions - Term bonds are issued with a single maturity date, while serial bonds are issued with a regular sequence of maturity dates. Bond maturity and principal payment provisions - Term bonds are issued with a single maturity date, while serial bonds are issued with a regular sequence of maturity dates. Term bonds normally have a sinking fund, which is an account used to repay some bondholders before maturity. Term bonds normally have a sinking fund, which is an account used to repay some bondholders before maturity.

© 2009 McGraw-Hill Ryerson Limited Bond Maturity Provisions Money paid into a sinking fund can only be used to pay bondholders. Money paid into a sinking fund can only be used to pay bondholders. Some bondholders are repaid before the stated maturity of their bonds, whether they want to be repaid or not. Some bondholders are repaid before the stated maturity of their bonds, whether they want to be repaid or not. At maturity, only a portion of the original bond issue will still be outstanding. At maturity, only a portion of the original bond issue will still be outstanding.

© 2009 McGraw-Hill Ryerson Limited Principal Payment Provisions Coupon payment provisions - An exact schedule of coupon payment dates is specified. Coupon payment provisions - An exact schedule of coupon payment dates is specified. If a company suspends payment of coupon interest, the company is said to be in default, a serious matter. If a company suspends payment of coupon interest, the company is said to be in default, a serious matter. Bondholders have the unconditional right to timely repayment. Bondholders have the right to bring legal action to get paid. Bondholders have the unconditional right to timely repayment. Bondholders have the right to bring legal action to get paid. Companies in default have the right to seek protection from inflexible bondholders in bankruptcy court. Companies in default have the right to seek protection from inflexible bondholders in bankruptcy court. If there is default, it is often in the best interests of the bondholders and the company to avoid court and negotiate a new bond issue to replace the existing one. If there is default, it is often in the best interests of the bondholders and the company to avoid court and negotiate a new bond issue to replace the existing one.

© 2009 McGraw-Hill Ryerson Limited Protective Covenants A bond indenture is likely to contain a number of protective covenants. A bond indenture is likely to contain a number of protective covenants. Protective Covenants are restrictions designed to protect bondholders. Protective Covenants are restrictions designed to protect bondholders. Negative covenant - The firm cannot pay dividends to stockholders in excess of what is allowed by a formula based on the firm’s earnings. Negative covenant - The firm cannot pay dividends to stockholders in excess of what is allowed by a formula based on the firm’s earnings. Positive covenant - Proceeds from the sale of assets must be used either to acquire other assets of equal value or to redeem outstanding bonds. Positive covenant - Proceeds from the sale of assets must be used either to acquire other assets of equal value or to redeem outstanding bonds.

© 2009 McGraw-Hill Ryerson Limited Event Risk Event risk is the possibility that the issuing corporation will experience a significant change in its bond credit quality. Event risk is the possibility that the issuing corporation will experience a significant change in its bond credit quality. Example: In October 1992, Marriott Corporation announced its intention to spin off part of the company. Example: In October 1992, Marriott Corporation announced its intention to spin off part of the company. The spinoff, called Host Marriott, would acquire most of the parent company’s debt and its poorly performing real estate holdings. The spinoff, called Host Marriott, would acquire most of the parent company’s debt and its poorly performing real estate holdings. Holding bonds in Host Marriott is more risky than holding bonds in Marriott Corporation. Holding bonds in Host Marriott is more risky than holding bonds in Marriott Corporation.

© 2009 McGraw-Hill Ryerson Limited Bonds Without Indentures A Private placement is a new bond issue sold privately to one or more parties. That is, this new bond issue is not available to the general public. A Private placement is a new bond issue sold privately to one or more parties. That is, this new bond issue is not available to the general public. Private placements are exempt from registration requirements with the SEC, although they often have formal indentures. Private placements are exempt from registration requirements with the SEC, although they often have formal indentures. Debt issued without an indenture is basically a simple IOU of the corporation. Debt issued without an indenture is basically a simple IOU of the corporation.

© 2009 McGraw-Hill Ryerson Limited Preferred Stock Preferred stockholders have a claim to dividend payments that is senior to the claim of common stockholders. Preferred stockholders have a claim to dividend payments that is senior to the claim of common stockholders. However, their claim is junior (subordinate) to the claims of bondholders and other creditors. However, their claim is junior (subordinate) to the claims of bondholders and other creditors.

© 2009 McGraw-Hill Ryerson Limited Preferred Stock Preferred stock has some of the features of both bonds and common stock. Preferred stock has some of the features of both bonds and common stock. Typically, preferred stock issues Typically, preferred stock issues Do not grant voting rights to their holders, Do not grant voting rights to their holders, Promise a stream of fixed dividend payments, Promise a stream of fixed dividend payments, Have no specified maturity but are often callable, Have no specified maturity but are often callable, May have their dividends suspended without setting off a bankruptcy process (as long as common stock dividends are also suspended), May have their dividends suspended without setting off a bankruptcy process (as long as common stock dividends are also suspended), Cumulate unpaid preferred dividends, and Cumulate unpaid preferred dividends, and May be convertible. May be convertible.

© 2009 McGraw-Hill Ryerson Limited Adjustable Rate Bonds and Preferred Stock Adjustable Rate Bonds and Preferred Stock Many bond, note, and preferred stock issues allow the issuer to adjust the annual coupon according to a rule or formula based on current market interest rates. Many bond, note, and preferred stock issues allow the issuer to adjust the annual coupon according to a rule or formula based on current market interest rates. These securities are called adjustable-rate or floating-rate securities. These securities are called adjustable-rate or floating-rate securities.

© 2009 McGraw-Hill Ryerson Limited Corporate Bond Credit Ratings A corporation usually subscribes to several bond rating agencies for a credit evaluation of a new bond issue. A corporation usually subscribes to several bond rating agencies for a credit evaluation of a new bond issue. Each contracted rating agency will then provides a credit rating - an assessment of the credit quality of the bond issue based on the issuer’s financial condition. Each contracted rating agency will then provides a credit rating - an assessment of the credit quality of the bond issue based on the issuer’s financial condition. Established rating agencies are Moody’s Investors Services,Standard & Poors Corporation, Dominion Bond Rating Service, Duff and Phelps, and Fitch Investors Service. Established rating agencies are Moody’s Investors Services,Standard & Poors Corporation, Dominion Bond Rating Service, Duff and Phelps, and Fitch Investors Service.

© 2009 McGraw-Hill Ryerson Limited Corporate Bond Credit Rating Symbols Table 18.2

© 2009 McGraw-Hill Ryerson Limited The Importance of Corporate Bond Credit Ratings Only a few institutional investors have the resources and expertise necessary to evaluate correctly the credit quality of a particular bond. Only a few institutional investors have the resources and expertise necessary to evaluate correctly the credit quality of a particular bond. Many financial institutions have prudent investment guidelines stipulating that only securities with a certain level of investment safety may be included in their portfolios. Many financial institutions have prudent investment guidelines stipulating that only securities with a certain level of investment safety may be included in their portfolios.

© 2009 McGraw-Hill Ryerson Limited The Yield Spread A bond’s credit rating helps determine its yield spread. A bond’s credit rating helps determine its yield spread. The yield spread is the extra return (increased yield to maturity) that investors demand for buying a bond with a lower credit rating (and higher risk). The yield spread is the extra return (increased yield to maturity) that investors demand for buying a bond with a lower credit rating (and higher risk).

© 2009 McGraw-Hill Ryerson Limited The Yield Spread

© 2009 McGraw-Hill Ryerson Limited High Yield Bonds (aka "Junk" Bonds) High-yield bonds are bonds with a speculative credit rating. High-yield bonds are bonds with a speculative credit rating. As a result of this poor credit rating, a yield premium must be offered on these bonds to compensate investors for higher credit risk. As a result of this poor credit rating, a yield premium must be offered on these bonds to compensate investors for higher credit risk. High-yield bonds are also called junk bonds. High-yield bonds are also called junk bonds.

© 2009 McGraw-Hill Ryerson Limited High Yield Bonds Quotes Figure 18.7

© 2009 McGraw-Hill Ryerson Limited Bond Market Trading An active secondary market with a substantial volume of bond trading exists, thus satisfying most of the liquidity needs of investors. An active secondary market with a substantial volume of bond trading exists, thus satisfying most of the liquidity needs of investors. Corporate bond trading is characteristically an OTC activity. Corporate bond trading is characteristically an OTC activity. Nevertheless, bond trading on the New York Stock Exchange is watched by bond investors and traders throughout the world. Nevertheless, bond trading on the New York Stock Exchange is watched by bond investors and traders throughout the world.

© 2009 McGraw-Hill Ryerson Limited Canadian Bond Trading Figure 18.8

© 2009 McGraw-Hill Ryerson Limited Trade Reporting and Compliance Engine At the request of the SEC, corporate bond trades are now reported through TRACE. At the request of the SEC, corporate bond trades are now reported through TRACE. TRACE provides a means for bond investors to get accurate, up-to-date price information. TRACE provides a means for bond investors to get accurate, up-to-date price information. TRACE has dramatically improved the information available about bond trades. TRACE has dramatically improved the information available about bond trades. Transaction prices are now reported on more than 4,000 bonds Transaction prices are now reported on more than 4,000 bonds That is, about 75% of market volume for investment grade bonds. That is, about 75% of market volume for investment grade bonds.

© 2009 McGraw-Hill Ryerson Limited Useful Websites (for more information on corporate bonds) (for more information on corporate bonds) (U.S. Securities and Exchange Commission) (U.S. Securities and Exchange Commission) (for more information about convertible bonds) (for more information about convertible bonds) (follow the "corporate bond spreads" link) (follow the "corporate bond spreads" link)

© 2009 McGraw-Hill Ryerson Limited Useful Websites Websites for companies in this chapter: Websites for companies in this chapter: (Advanced Micro Devices) (Advanced Micro Devices) (Marriott International, Inc.) (Marriott International, Inc.) (Host Marriott Corporation) (Host Marriott Corporation) Websites for Ratings Agencies: Websites for Ratings Agencies: (Dominion Bond Rating Service) (Dominion Bond Rating Service) (Fitch Investors Service) (Fitch Investors Service) (Moody’s) (Moody’s) (Standard & Poor’s) (Standard & Poor’s)

© 2009 McGraw-Hill Ryerson Limited Chapter Review Corporate Bond Basics Corporate Bond Basics Types of Corporate Bonds Types of Corporate Bonds Bond Indentures Bond Indentures Bond Seniority Provisions Bond Seniority Provisions Call Provisions Call Provisions Graphical Analysis of Callable Bond Prices Graphical Analysis of Callable Bond Prices Put Provisions Put Provisions Bond-to-Stock Conversion Provisions Bond-to-Stock Conversion Provisions

© 2009 McGraw-Hill Ryerson Limited Chapter Review Graphical Analysis of Convertible Bond Prices Graphical Analysis of Convertible Bond Prices Bond Maturity and Principal Payment Provisions Bond Maturity and Principal Payment Provisions Sinking Fund Provisions Sinking Fund Provisions Coupon Payment Provisions Coupon Payment Provisions Protective Covenants Protective Covenants Event Risk Event Risk Bonds Without Indentures Bonds Without Indentures Preferred Stock Preferred Stock

© 2009 McGraw-Hill Ryerson Limited Chapter Review Adjustable-Rate Bonds and Adjustable-Rate Preferred-Stock Adjustable-Rate Bonds and Adjustable-Rate Preferred-Stock Corporate Bond Credit Ratings Corporate Bond Credit Ratings Junk Bonds Junk Bonds Bond Market Trading Bond Market Trading