Chapter 5 Corporate Debt Securities
Corporate Debt Securities • Financing of Corporate Investments:
Corporate Debt Securities Corporate Finance Issues: • Internal Verses External Financing • Capital Structure Decisions: Debt/Equity mix
General Features of Corporate Bonds General Features: • Principal • Maturity • Interest Rates • Call and Redemption Features • Security • Protective Covenants
Principal and Sinking Funds • Many corporate bonds pay a principal of $1,000 at maturity. • To minimize principal risk, many bonds have sinking fund arrangements: provision requiring the issuer to make scheduled payments into a fund. • Sinking funds can be used to call bonds or buy them up in the secondary market. • Note: An alternative to a sinking fund in reducing principal risk is a serial bond: bond issue consisting of different maturities.
Sinking Fund Features • Many sinking fund agreements have provisions requiring an orderly retirement of the issue. • In recent years, this has been commonly handled by the issuer being required to buy up a certain portion of the bond issue each year either at a stipulated call price or in the secondary market at its market price. • This sinking fund call option provision benefits the issuer and is a disadvantage to the bondholder.
Sinking Fund Features • Sinking funds are usually applied to a particular bond issue. • There are, though, nonspecific sinking funds (sometimes referred to as tunnel, funnel or blanket sinking funds) that are applied to a company’s total outstanding bonds. • For most bonds, the periodic sinking fund payments are the same each period. • Some indentures do allow the sinking fund to increase over time or to be determined by the level of earnings, and some sinking fund provisions give the issuer the option to double the stipulated amount.
Average Life • A sinking fund, SF, requires the firm to repay debt in installments rather than lump sum; it reduces the effective life of the debt. • Given a sinking fund on a bond, the average life is a better measure of the bond’s life than maturity. • The average life is the average amount of time the debt will be outstanding.
Average Life • A debt issue that matures in 10 years requiring equal SF payments at the end of years 6-10 would have an average life of 8 years: Av life = 6(.2) + 7(.2) + 8(.2) + 9(.2) + 10(.2) = 8 yrs
Maturity • Firms often choose a maturity in which the outflow obligations are in line with their expected inflows. • Original Maturity Range: 10yrs. - 30 yrs. • 1990’s average maturity = 15 yrs. • Lower maturities in 1980s and 1990s reflects changing technology. • Point of interest: In 1993, Coke issued a $150M debenture with a maturity of 100 years.
Interest Rate Features • Based on how they pay interests, there are several types of corporate bonds: • Coupon Bonds • Zero-Coupon Bonds • Deep-Discount Bonds • Floating-Rate Bonds
Coupon Bonds • Most corporate bonds are coupon bonds paying interest semiannually. • Many foreign bonds pay interest annually. • U.S. corporate bonds often used a day count convention of 30/360. • Most issuers of debt securities select a coupon rate that makes the bond sell initially at par.
Coupon Bonds • At one time, most bonds were sold with an attached coupon. They were known as bearer bonds since the bonds were paid to the person who had physical possession. • Today, U.S. bonds are registered bonds. The interest on registered bonds is paid by the issuer or trustee to all bondholders who are registered with the issuer.
Zero-Coupon Bonds • Zero-coupon corporate bonds were first introduced in the U.S. in the early 1980s. • Beatrice Foods sold a 10-year, $250M zero coupon priced at $255 per $1,000 face value.
Deep-Discount Bonds • Corporations also issue deep-discount bonds: • Low coupon rate • Bonds sell at a price below par. • Some investors, particularly pension funds, find zero and deep discount bonds attractive because they have less reinvestment risk.
Floating-Rate Bonds • Floating-Rate Bonds (FRN) or floaters pay a coupon rate that varies in relation to another bond, benchmark rate, or formula. • FRNs originated in Europe. • Introduced in U.S. in 1974 by Citicorp. • By 1990, there were approximately 500 floating-rate offerings, with two-thirds offered by banks and financial institutions.
Call and Redemption Features • The option redemption provision is a call option that gives the issuer the right to buy back the issue. • Some noncallables may have a hidden call provision written in their sinking fund agreement.
Call and Redemption Features • Many bonds have a deferred call feature that prohibits the issuer from calling the bond before a certain period of time has expired. • Nonrefundable Clause: Specifies that during a designated nonrefundable period the issuer cannot use proceeds from a debt issue that ranks superior to or in par with the bond to finance the refunding of the bond.
Call and Redemption Features • Design of Call Provisions • Example: • The first year price is equal to the public offering price plus coupon • Thereafter the call price decreases by equal amounts to equal par • Thereafter the call price is equal to par.
Call and Redemption Features • The call provision may also impose limits on the issuer’s ability to exercise the call: • Example: The debt issue is nonrefundable for 5 years or for five years the bond can only be called from proceeds coming from excess cash or equity.
Call and Redemption Features Optional Redemption Provision – Example: • A bond has a maturity of 25 years, 10% coupon • Bond issued at 95 ($950, F = $1,000) • The initial year’s redemption (or call) price is equal to the offering price plus coupon: 95 + 10 = 105 • Bond is callable at par during the last five years • Call price steps down by equal amounts in 20 steps ((105-100)/20)) to equal 100 • For the first five years the bond is not refundable out of proceeds of a debt issue that ranks senior or on par with this bond
Security: Mortgage Bonds • Mortgage Bonds are bonds secured by a lien on a specific asset of the issuer such as property or buildings. • If there is a default, the lender can seize the asset and sell it. The extra protection that the mortgage provides lowers the risk on the bond and therefore lowers its required return.
Security: Mortgage Bonds • Often in a mortgage bond, there are provisions in the indenture that allow the mortgaged asset to be sold provided it is replaced with a suitable substitute. • Some mortgage bonds also have a release and substitution provision that allows for the asset to be sold with the proceeds used to retire the bonds. • Mortgage bonds are sometimes sold in a series, similar to a serial bond issue, with the bonds of eachseries secured by the same mortgage. Generally, it is more efficient for a company to issue a series of bonds under one mortgage and one indenture than it is to arrange collateral and draw up a new indenture for each new bond issue.
Security: Equipment-Trust Bonds • Equipment-Trust Bonds are bonds secured by equipment or plants. • Equipment-trust bonds are sometimes formed through a lease-and-buy-back agreement with a third party or trustee.
Security: Equipment-Trust Bonds Lease-and-buy-back Agreement: • Under this type of agreement, a trustee (e.g., bank, leasing company, or the manufacturer) might purchase the equipment (plane, machine, etc.) and lease it to a company who would agree to take title to the equipment at the termination date of the lease. Alternatively, the company could buy the equipment and sell it the trustee who would then lease it to them. • The trustee would finance the equipment purchase from the company or the manufacturer by selling equipment trust bonds (sometime called equipment trust certificates). • Each period the trustee would then collect rent from the company and pay the interest and principal on the certificates. • At maturity, the certificates would be paid off, the trustee would transfer the title of the equipment to the company, and the lease would be terminated.
Security: Equipment-Trust Bonds • Lease-and-buy-back agreements work well when the underlying equipment is relatively standard (e.g., plane, railroad car, or computer) and therefore can be easily sold in the event the company defaults on the lease. • Airlines and railroad companies are big users of this type of financing.
Security: Collateral-Trust Bonds • A collateral-trust bond is a bond secured by a lien on the company's holdings of other company's stocks and bonds, other securities and financial claims, or the issuer’s subsidiaries. • The legal arrangements governing collateral-trust bonds generally require the issuer to deliver to the trustee the pledged securities • Note: If the securities are stock or the stock of a subsidiary, the issuer/company typically retains its voting rights.
Security: Collateral-Trust Bonds Features • The issuer is usually required to maintain the value of the securities, positing addition collateral (e.g., cash or more securities) if the collateral decreases in value. • There are also provisions in the indenture allowing for the issuer to withdraw the collateral provided there is an acceptable substitute. • Some collateral-trust bonds are sold as a series, with the same indenture and financial collateral defining each series.
Priority of Claims • Note: With secured bonds there is a need to establish a priority of claims when more than one debt obligation is secured by the same asset (senior, junior or subordinate).
Closed-End and Open-End Bonds • A closed-end bond prohibits the asset securing the bond from being used to secure any other debt. • An open-end bond allows the asset securing the bond to be used as collateral on other debt. • A typical case is an open‑end bond accompanied with an after‑acquired property clause. This clause dictates that all property or assets acquired after the issue be added to the property already pledged.
Debentures • Debentures are bonds that are not secured by a specific asset. • Unsecured debt with original maturities of 10 years or less are referred to as notes, while unsecured debt with original maturities greater than 10 years are referred to as debentures. • Both are often referred to as debentures.
Debentures • Debenture holders are general creditors. • When corporations issue a number of debentures, some may be issued that are subordinate to others (in terms of their claim on assets in the case of bankruptcy) -- subordinate debentures. • Debenture are often issued with protective covenants: restrictions on additional debt, etc. • Debenture could be sold with credit enhancements (e.g., letter of credit from a third party).
Guaranteed Bonds • Guaranteed bonds are bonds issued by one company and guaranteed by another economic entity. • The guarantee often applies to both the interest and principal. • With the guarantee, the default risk of the bond shifts from the borrower to the financial capacity of the insurer.
Guaranteed Bonds Guarantors: • The guarantor could be the parent company • The guarantor could be another company securing the issue, perhaps in return for an option on an equity interest in the project the bond is financing. • There may also be multiple guarantors. In a joint venture, for example, a limited partnership may be formed with several companies who jointly agree to guarantee the bond issue of the venture.
Guaranteed Bonds Guarantors: • For some corporate issues, a financial institution may provide the guarantee. • For example, banks for a fee provide corporations with credit enhancements in the form of letters of credit that guarantee the interest and principal payment on the corporation’s debt obligation. • Insurance companies also provide coverage of corporate bonds.
Protective Covenants • The board of directors hires the managers and officers of a corporation. • Since the board represents the stockholders, this arrangement can create a moral hazard problem in which the managers may engage in activities that could be detrimental to the bondholders. • Example: Managers might use the funds provided by creditors to finance projects different and riskier than bondholders were expecting.
Protective Covenants • Since bondholders cannot necessarily seek redress from managers after they’ve make decisions that could harm them, they need to include rules and restriction on the company in the bond indenture. • Such provisions are known as protective or restrictive covenants.
Protective Covenants • Protective Covenants impose restrictions on the borrower that are designed to protect the bondholders. • The covenants often specify the financial tests that must be met before borrowers can incur additional debt (debt limitations) or pay dividends or share repurchase (dividend limitations). • Example: a covenant that prohibits issuing long-term debt if it would cause the interest coverage ratio (EBIT/Interest) to fall below 3.
Types of Protective Covenants • Limitations on debt • Limitations on dividends • Limitations on share repurchases • Limitations that prohibit issuing long-term debt if certain ratios (e.g., interest coverage ratio) are lowered. • Limitations on liens • Limitations on borrowing from subsidiaries • Limitations on mergers, acquisitions, and asset sales • Limitations on selling assets and leasing them
Protective Covenants: Event Risk • Over the last two decades, there has been an increase in the number of mergers, corporate restructurings, and stock and bond repurchases. • Often these events benefit the stockholders at the expense of the bondholders, possibly resulting in a downgrade in a bond’s quality ratings and a lowering of its price. • Bond risk resulting from such actions is known as event risk. • Certain protective covenants such as poison puts and net worth maintenance clauses have been used to minimize event risk.
Protective Covenants: Poison Put • A poison put clause in the indenture gives the bondholders the right to sell the bonds back to the issuer at a specified price under certain conditions arising from a specific event such as a takeover, change in control, or an investment rating downgrade.
Protective Covenants: Net Worth Maintenance Clause • A net worth maintenance clause requires that the issuer redeem all or part of the debt or to give bondholders the right to sell (offer-to-redeem clause) their bonds back to the issuer if the company’s net worth falls below a stipulated level.
Income Bond Participating Bond Deferred Coupon Bond Tax-Exempt Corporate Bond Bonds with Warrants Convertible Bond Putable Bond Extendable Bond Credit-Sensitive Bond Commodity-Linked Bond Voting Bond Assumed Bond Corporate Bonds with Special Features
Income Bond • Income Bonds: Bonds that pay interest only if earnings are sufficient. • Often issued by new companies or companies that are being reorganized. • Similar to preferred stock, except that they have the tax advantage of being debt.
Participating Bond • Participating Bonds: Bonds that pay a minimum rate plus an additional rate up to a specified maximum if earnings are sufficient.
Deferred Coupon Bond • Deferred Coupon Bonds allow the issuer to defer coupon interest. Types of deferred coupon bonds: • Straight Deferred: Interest can be deferred if earnings are not sufficient; interest does accumulate -- cumulative. • Reset Bond: Bond starts with a low interest that is later increased. • Payment-in-Kind Bond: Issuer has the option at the coupon date to pay interest or issue a new bond.
Tax-Exempt Bond • Tax-Exempt Bonds: Under IRS codes, firms can issue tax-exempt bonds for specific purposes (e.g., financing solid waste disposal facilities). • Holders of the tax-exempt bond do not have to pay federal income taxes on the interest payments they receive.
Bonds with Warrants • A warrant is a security or a provision in a security that gives the holder the right to buy a specified number of shares of stock or another designated security at a specified price. • A warrant is call option issued by the corporation. • As a sweetener, some corporate bonds, such as a subordinated debenture, are sold with warrants. • A warrant that is attached to the bond can only be exercised by the bondholder. • Often, the warrant can be detached from the bond as of a particular date and sold separately.
Convertible Bond • A convertible bond is one that has a conversion provision that grants the bondholder the right to exchange the bond for a specified number of shares of the issuer's stock. • A convertible bond is similar to a bond with a non-detachable warrant. • Like a regular bond, it pays interest and principal, and like a warrant, it can be exchanged for a specified number of shares of stock. • Convertible bonds are often sold as a subordinate debenture (convertible debentures). The conversion feature of the bond, in turn, serves as a sweetener to the bond issue.