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

2. Corporate Bonds
Risk Structures
Convertibles

3. Risk Structures

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

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

6. Expected Yield to Maturity
% * 1% = 6.19 %

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

8. 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.

9. 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
0.24
Even a bond in bankruptcy can yield a positive yield
© Oltheten & Waspi 2012

10. 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

11. 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

12. 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%

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

14. 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%

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

16. 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

17. 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)

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

19. Convertible Bonds

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

21. 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

22. Questions & Problems
Astrologer Question (19-9)

23. Corporate Bonds II