INVESTMENT BANKING LESSON 12 APPLYING INVESTMENT BANKING TO FIXED INCOME Investment Banking (2 nd edition) Beijing Language and Culture University Press, 2013 Investment Banking for Dummies, Matthew Krantz, Robert R. Johnson,Wiley & Sons, 2014

WHAT’S IN THE NEWS OR WHAT’S THERE TO LEARN? CHINA USED MORE CEMENT IN 3 YEARS THAN THE UNITED STATES USED IN ALL OF THE 20 TH CENTURY!

VOCABULARY REVIEW AND PREVIEW – WHAT DO THESE WORDS MEAN? equity securities stock symbol market value or market capitalization enterprise value dividend common stock preferred stock

VOCABULARY REVIEW AND PREVIEW – WHAT DO THESE WORDS MEAN? stock options puts calls warrants

VOCABULARY REVIEW & PREVIEW Equity = stock, investments, capital Securities - Can be either stock or bonds. investment security = stock debt security = bond Stock symbol = DIS–Disney, BABA-Alibaba. AAPL-Apple Market value or capitalization = The value of a company. Take # of shares x stock price

VOCABULARY REVIEW & PREVIEW Enterprise value = A better way IB value, or to measure a company’s total value. Enterprise value = equity value (market value) + liabilities (debt) – cash Dividend = a distribution, or pay out of a part of a company’s earnings. Common stock = a security that means ownership, voting rights and last in line to get paid Preferred stock = ownership, but no voting rights. Dividends paid before common stock.

VOCABULARY REVIEW & PREVIEW Stock options = gives owners right but not obligation to buy or sell a stock in the future Puts = Gives the owner the right to sell Calls = Gives a right to buy

A. INTRODUCTION – What are bonds? B. TYPES OF BONDS C. THE POSITION OF BONDHOLDERS D. UNDERSTANDING BOND PRICING E. HOW DO COMPANIES CHOOSE TO ISSUE DEBT OR EQUITY

This lesson looks at bonds and how IB deal with the debt side when a company is bought or restructured. The holders of debt are called bondholders. Whenever there is a company that is a target for acquisition and bonds are issued, they are usually the first ones in line because their claims are ahead of stockholders’ claims.

What are bonds? A bond is a financial security an investor loans to a company – an IOU. In return for the money, the corporation makes periodic interest payments and to repay the loan when the term ends. Terms of the bond include: Maturity – the length of the loan Coupon rate of interest – interest rate on bond Denomination – the amount of the loan

The terms of the bond are made in the bond indenture, which is a legal document that lays out all the rights of the bondholder and the obligations of the issuer. The amounts, or denominations, of corporate bonds are $1,000 or $5,000, and the typical bond pays interest every 6 months (semiannually).

Unlike stocks, the holder has no ownership interest in the company. A bondholder only receives what is promised. That’s why bonds are referred to as fixed-income securities. Why are bonds bought and sold?

To build or fix up facilities Purchase new equipment Buy other companies Grow a business Issuing bonds is a way of raising capital – another option to selling stock.

Returns are easy to measure but risk is much more difficult. Standard deviation is a measure and that tells how much an asset swings in price. Annual returns for assets ( ) Asset classReturnStandard deviation Large stocks11.77%20.30% Small stocks16.51%32.51% Long-term Corp bonds 6.36% 8.35% Long-term Govt bonds 6.14% 9.78% Medium-term Govt bonds 5.54% 5.67% Treasury bills 3.62% 3.10%

1. CONVERTIBLE 2. CALLABLE 3. PUTTABLE 4. FLOATING-RATE BONDS 5. ZERO-COUPON BONDS Let’s look at these!

1. CONVERTIBLE – Bondholder can exchange the bond for a fixed number of shares of stock. The bondholder gets to decide whether to change or not. And agrees to receive a lower interest payment to have the option.

2. CALLABLE – Gives the issuer – the company – the right to pay the bondholder back earlier than the full term. They have a call premium, which means the company pays a higher interest rate. Corporations will call bonds when market rates have fallen since they can re-issue debt at a lower interest rate.

3. PUTTABLE BONDS – Gives the investor the right to demand early payment of the principal cancelling the loan. Interest rates are lower because of this right. Investors may demand early repayment if rates rise so they can get better interest rates on current issues.

4. FLOATING-RATE BONDS – These are the bonds where the interest rate can change, adjustible- rate bonds. The contract states the rate can change several times a year. The holder will receive higher interest payments and the corporations borrowing costs will increase.

5. ZERO-COUPON BONDS – No periodic interest payments. All the cash comes at maturity. The big disadvantage is that the holder must pay annual taxes.

The capital structure of a firm tells who has supplied the funds and where those suppliers are in seniority terms of being paid back. The capital structure tells how the money, stocks or bonds, is being used in the firm. If a firm has to sell assets, bondholders will be paid first.

What happens to bondholders in mergers and acquisitions? A bond trustee (acts as the manager of bondholders) is responsible for keeping the agreements in the indenture. With M & A there are covenants which safeguard interests of the bondholders and protect against actions that could benefit stockholders. The goal of covenants is to put restrictions on management to not take on higher levels of debt.

In the example, the bond is selling at a discount from par or principle value of $1,000, because the stated interest rate on the bond (coupon rate) of 4% is less than the yield to maturity of 6%.

If the coupon rate is greater than the yield to maturity, the bond would be selling at a premium. If the same bond had a yield to maturity of 3%, it would sell for $1, – a premium of $46.39 to par value. If the bond were selling at 4% it would be selling at par, for exactly $1,000.

There is an inverse relationship between interest rates and bond prices: as interest rates rise, the price falls. Corporate bonds are issued at or near par value, so when a bond is selling at discount, interest rates have fallen. On the other side, if a bond is selling at a premium to par value, the bond was issued in a higher interest rate environment.

Bonds can be subject to default risk. Bonds with higher default risk sell at higher yields to maturity (interest rate). Credit spreads are defined as the risk premium over similar securities. For example: Comparing 10-year Treasury bond yielding 3% and a corporate bond yielding 5%, The credit spread is 2% or 200 basis points. A basis point is 1/100 of 1%, or.01% (.00001)

Credit spreads get wider, or larger during economic downturns, but are narrower, or smaller during “boom” times, or good economic times.

Both debt and equity are issued by companies who need money to grow. The goal is always to raise capital in a most efficient way. Companies will choose based on the cost of the debt versus equity.

Scenarios for choosing the capital: 1. Interest rates are low and will rise in the future. What kind of debt should you choose? 2. Interest rates are high and will be going down in the future. 3. Equity is under-valued but debt financing is too expensive cause interest rates are too high?

1. Interest rates are low and will rise in the future. What kind of debt should you choose? A: Long-term debt at a fixed interest rate If rates do rise, the market value of the debt will decline thus the liability of the company will decline.

2. Interest rates are high and will be going down in the future. A: short-term debt, callable debt, or debt with an adjustable, floating rate. This way the company is not locked into paying a high interest rate for a long time. They can refinance when the rates fall.

3. Equity is under-valued but debt financing is too expensive A: A company may choose convertible bonds. If the value of the equity rises, the bondholders will convert to stock and pay off the debt.

Other considerations: Companies do not want to issue equity if their stock is under-valued. This form of financing is expensive and dilutes the ownership of the current stockholders. Companies can increase their leverage without using debt. They can buyback (or repurchase) company stock in the market increasing it’s debt-to-equity ratio (reduces shares)

A company may do a stock buyback when it has extra cash and the stock is under-valued. This increases the stock price of the company because each stockholder has a higher percentage of ownership in the company. Buybacks are often preferred over dividends as stockholders are gaining more ownership in the company.