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Corporate Debt Instruments

Corporate Debt Instruments. Zvi Wiener Based on Chapter 7 in Fabozzi Bond Markets, Analysis and Strategies. Corporate Debt. Financial obligations of a corporation that have priority over its common stock and preferred stock in the case of bankruptcy. Corporate bonds Medium-term notes

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Corporate Debt Instruments

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  1. Corporate Debt Instruments Zvi Wiener Based on Chapter 7 in Fabozzi Bond Markets, Analysis and Strategies http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

  2. Corporate Debt • Financial obligations of a corporation that have priority over its common stock and preferred stock in the case of bankruptcy. • Corporate bonds • Medium-term notes • Commercial papers • Asset-backed securities Fabozzi Ch 7

  3. Major groups of issuers • Utilities • Transportation • Industrials • Banks and finance companies • ~communication Fabozzi Ch 7

  4. Features of Corporate Bonds (indentures) • Corporate trustee – represents bondholders • Term bonds – maturity • Under 10 years – notes • Some bonds have specific collateral • Others are debentures • Guaranteed bonds (third party’s guarantees) Fabozzi Ch 7

  5. Call provision • Company can retire the debt before maturity. • This is an option and makes the debt more expensive. • Sinking fund provision – predetermined. Fabozzi Ch 7

  6. Bond Provisions • Sinking fund provision sometimes the issuer is required to retire a portion of an issue each year. • either by cash payment to bondholders (lottery) • or by buyback bonds Fabozzi Ch 7

  7. Bond Rating • Standard and Poors • Moody’s Investor Service • Fitch • Duff and Phelps • מעלות Fabozzi Ch 7

  8. Investment Grade • Moody’s S&P=F=D&P • Aaa AAA • Aa1 AA+ • Aa2 AA • Aa3 AA- • A1 A+ • A2 A • A3 A- • Baa1 BBB+ • Baa2 BBB • Baa3 BBB- Fabozzi Ch 7

  9. Speculative Grade • Moody’s S&P=F=D&P • Ba1 BB+ • Ba2 BB • Ba3 BB- • B1 B+ • B2 B • B3 B- • CCC+ • Caa CCC • CCC- • Ca CC • C C Fabozzi Ch 7

  10. High Yield Bonds • LBO, downgrading, refinancing • fallen angels • deferred interest bonds • Step-up bonds pay initially low interest which increases with time • Spreads as a measure of risk and premium. Fabozzi Ch 7

  11. Transition Matrix • One year transition matrix (very old) • Start\end Aaa Aa A Baa Ba B C&D • Aaa 91.9 7.38 0.72 0.00 0.00 0.00 0.00 • Aa 1.13 91.26 7.09 0.31 0.21 0.00 0.00 • A 0.10 2.56 91.20 5.33 0.61 0.20 0.00 • Baa 0.00 0.21 5.36 87.94 5.46 0.82 0.21 Fabozzi Ch 7

  12. Default Rates • ?????? Fabozzi Ch 7

  13. Loss Given Default • ?????? Fabozzi Ch 7

  14. SEC rule 144A • Allows to trade private placements among qualified institutions. Fabozzi Ch 7

  15. Medium Term Notes (MTN) • Notes are registered with the SEC under Rule 415 (the shelf registration) and are offered continuously to investors by an agent of the issuer. • Maturities vary from 9 months to 30 years. • Can be either fixed or floating. • Very flexible way to raise debt! Fabozzi Ch 7

  16. Primary Market (MTN) • Issuer posts spreads over Treasuries for a variety of maturities. • Then an agent tries to find an investor. Minimal size is between $1M and $25M. • The schedule can be changed at any time! • Often structured MTNs are used (caps, floors, etc.) = structured notes. Fabozzi Ch 7

  17. Structured Notes • Many institutional investors can use swaps and structured notes to participate in markets that were prohibited. • Another use of structured notes is in risk management. • Financial Engineering is used to create securities satisfying the needs of investors. Fabozzi Ch 7

  18. Commercial Papers • Short term debt issued with less documentation typically by large and stable corporations for up to 270 days. • Much cheaper borrowing than banks. • Bridge financing. • Rollover Risk • An alternative to CD. Fabozzi Ch 7

  19. Commercial Papers • Short term unsecured promissory note • An alternative to short term bank borrowing • A typical round-lot transaction is $100,000 • In the USA maturity is up to 270 days • Requires less paperwork • Those with maturity up to 90 days can be used as collateral for FED discount window. Fabozzi Ch 7

  20. Commercial Papers • Typically rolled over • Rollover risk is backed by an unused bank credit line • In order to issue CP one need either a high rating or good collateral • Sometimes credit enhancement is used (LOC) • CP issued in the USA by foreigners are called Yankee CP Fabozzi Ch 7

  21. Commercial Papers • Between 71 an 89 there was one default on CP. • 3 defaults occurred in 89 and 4 in 90 • Direct paper is sold without an agent • Secondary market is thin • There is a special rating for CP, P-1,3, A-1,3 • discount instruments, used by money market Fabozzi Ch 7

  22. Bankruptcy and Creditor rights • Liquidation (Chapter 7) • Reorganization (Chapter 11) Fabozzi Ch 7

  23. Bankruptcy and Credit Rights • liquidation - all assets will be distributed • reorganization - a new corporate entity will result • a company that files for protection becomes a debtor in possession and continues to operate under the supervision of the court Fabozzi Ch 7

  24. Bankruptcy and Credit Rights • Absolute priority rule - senior creditors are paid in full before junior creditors are paid anything. • Works in liquidation but often does not work in reorganization. Fabozzi Ch 7

  25. Merton’s model $ firm equity debt D V Fabozzi Ch 7

  26. Home AssignmentChapter 7 • Questions 10, 21, 25 Fabozzi Ch 7

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