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Issuing Securities to the Public

Issuing Securities to the Public. Key Concepts and Skills. Understand the characteristics and terms of a standard bond. Understand callable bonds and the process of bond refunding. Compare and contrast different types of bonds such as floating rate, deep discount, and income bonds.

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Issuing Securities to the Public

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  1. Issuing Securities to the Public

  2. Key Concepts and Skills • Understand the characteristics and terms of a standard bond. • Understand callable bonds and the process of bond refunding. • Compare and contrast different types of bonds such as floating rate, deep discount, and income bonds.

  3. Chapter Outline 20.1 Long-Term Debt: A Review 20.2 The Public Issue of Bonds 20.3 Bond Refunding 20.4 Bond Ratings 20.5 Some Different Types of Bonds 20.6 Direct Placement Compared to Public Issues 20.7 Long-Term Syndicated Bank Loans

  4. 20.1 Long-Term Debt: A Review • Corporate debt can be short-term (maturity less than one year) or long-term. • Different from common stock: • Creditor’s claim on corporation is specified • Promised cash flows • Most are callable • Over half of outstanding bonds are owned by life insurance companies & pension funds. • Plain vanilla bonds vs. “kitchen sink” bonds

  5. Features of a Cisco Systems Bond

  6. 20.2 The Public Issue of Bonds • The general procedure is similar to the issuance of stock, as described in the previous chapter. • The indenture, which is specific to bonds, is a written agreement between the borrower and a trust company. The indenture usually lists: • Amount of Issue, Date of Issue, Maturity • Denomination (Par value) • Annual Coupon, Dates of Coupon Payments • Security • Sinking Funds • Call Provisions • Covenants

  7. Protective Covenants • Agreements to protect bondholders • Negative covenant: Thou shalt not: • pay dividends beyond specified amount • sell more senior debt & amount of new debt is limited • refund existing bond issue with new bonds paying lower interest rate • buy another company’s bonds • Positive covenant: Thou shalt: • use proceeds from sale of assets for other assets • allow redemption in event of merger or spinoff • maintain good condition of assets • provide audited financial information

  8. Principal Repayment • Term bonds versus serial bonds • Sinking funds–how do they work? • Fractional repayment each year • Good news—security • Bad news—unfavorable calls • How trustee redeems

  9. The Sinking Fund • There are many different kinds of sinking-fund arrangements: • Most start between 5 and 10 years after initial issuance. • Some establish equal payments over the life of the bond. • Most high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue. • Sinking funds provide extra protection to bondholders. • Sinking funds provide the firm with an option.

  10. 20.3 Bond Refunding • Replacing all or part of a bond issue is called refunding. • Bond refunding raises two questions: • Should firms issue callable bonds? • Given that callable bonds have been issued, when should the bonds be called?

  11. Callable Bonds versus Noncallable Bonds Most bonds are callable. Some sensible reasons for call provisions include: taxes, managerial flexibility and the fact that callable bonds have less interest rate risk.

  12. 20.4 Bond Ratings • What is rated: • The likelihood that the firm will default • The protection afforded by the loan contract in the event of default • Who pays for ratings: • Firms pay to have their bonds rated. • The ratings are constructed from the financial statements supplied by the firm. • Ratings can change, and raters can disagree.

  13. Moody's Duff & S&P's Credit Rating Phelps Description Aaa 1 AAA Highest credit rating, maximum safety Aa1 2 AA+ Aa2 3 AA High credit quality, investment - grade bonds Aa3 4 AA - A1 5 A+ A2 6 A Upper - medium quality, inve stment grade bonds A3 7 A - Baa1 8 BBB + Baa2 9 BBB Lower - medium quality, investment grade bonds Baa3 10 BBB - Bond Ratings: Investment Grade

  14. Moody's Duff & S&P's Credit Rating Phelps Description Speculative - Grade Bond Ratings Ba1 11 BB+ Low credit quality, speculative - grade bonds Ba2 12 BB Ba3 13 BB - B1 14 B+ Very low credit quality, speculative - grade bonds B2 15 B B3 16 B - Extrem ely Speculative - Grade Bond Ratings Caa 17 CCC Extremely low credit + standing, high - risk bonds CCC CCC - Ca CC Extremely speculative C C D Bonds in default Bond Ratings: Below Investment Grade

  15. Junk Bonds • Anything less than an S&P “BB” or a Moody’s “Ba” is a junk bond. • A polite euphemism for junk is high-yield bond. • There are two types of junk bonds: • Original issue junk—possibly not rated • Fallen angels—rated • Current status of junk bond market • Private placement • Yield premiums versus default risk

  16. 20.5 Different Types of Bonds • Callable Bonds • Put Bonds • Convertible Bonds • Deep Discount Bonds • Income Bonds • Floating-Rate Bonds

  17. Put Bonds • Put provisions • Put price • Put date • Put deferment • Extendible bonds • Value of the put feature • Cost of the put feature

  18. Convertible Bonds • Why are they issued? • Why are they purchased? • Conversion ratio: • Number of shares of stock acquired by conversion • Conversion price: • Bond par value / Conversion ratio • Conversion value: • Price per share of stock x Conversion ratio • In-the-money versus out-the-money

  19. Convertible Bond Prices

  20. More on Convertibles • Exchangeable bonds • Convertible into a set number of shares of a third company’s common stock • Minimum (floor) value of convertible is the greater of: • Straight or “intrinsic” bond value • Conversion value • Conversion option value • Bondholders pay for the conversion option by accepting a lower coupon rate on convertible bonds versus otherwise- identical nonconvertible bonds.

  21. 20.6 Direct Placement Compared to Public Issues • A directly placed long-term loan avoids the cost of registration with the SEC. • Direct placement is likely to have more restrictive covenants. • In the event of default, it is easier to “work out” a private placement.

  22. 20.7 Long-Term Syndicated Bank Loans • Large money-center banks frequently have more demand for loans than they have supply. • Small regional banks are often in the opposite situation. • As a result, a lager money center bank may arrange a loan with a firm or country and then sell portions of the loan to a syndicate of other banks. • A syndicated loan may be publicly traded. • Syndicated loans are always rated investment grade. • However, a leveraged syndicated loan is junk.

  23. Quick Quiz • What details are provided in the bond indenture? • Explain the significance of protective covenants. • Many corporate bonds are callable. Compare these to a “plain vanilla” bond—how do they work, who is at risk, how do yields differ.

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