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Chapter 18Chapter 18

Corporate BondsCorporate Bonds

Prepared byPrepared by

AyAyşşe Ye Yűűcece

Ryerson UniversityRyerson University

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Chapter eighteen outlineChapter eighteen outline

Corporate bond basicsCorporate bond basics Types of corporate bondsTypes of corporate bonds Bond indenturesBond indentures Protective covenantsProtective covenants Event riskEvent risk Bonds without indenturesBonds without indentures

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Chapter eighteen outlineChapter eighteen outline

Preferred stockPreferred stock Adjustable-rate bonds and adjustable-rate Adjustable-rate bonds and adjustable-rate

preferred stockpreferred stock Corporate bond ratingsCorporate bond ratings Junk BondsJunk Bonds Bond market tradingBond market trading

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Corporate BondsCorporate Bonds

Our goal in this chapter is to introduce the Our goal in this chapter is to introduce the specialized knowledge concerning trading specialized knowledge concerning trading corporate bonds.corporate bonds.

Money managers who buy and sell corporate Money managers who buy and sell corporate bonds possess this kind of knowledge.bonds possess this kind of knowledge.

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Corporate Bond BasicsCorporate Bond Basics

A A Corporate bond Corporate bond is a security issued by a is a security issued by a corporation.corporation.

It represents a promise to pay bondholders a It represents a promise to pay bondholders a fixed sum of money (called the bond’s fixed sum of money (called the bond’s principalprincipal, or par or face value) at a future , or par or face value) at a future maturity date, along with periodic payments of maturity date, along with periodic payments of interest (called interest (called couponscoupons).).

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Corporate Bond BasicsCorporate Bond Basics Corporate bonds differ from common stock in Corporate bonds differ from common stock in

three fundamental ways.three fundamental ways.

Corporate BondsCorporate Bonds Common StockCommon Stock

Represent a creditor’s Represent a creditor’s claim on the corporationclaim on the corporation

Represents an ownership Represents an ownership claim on the corporationclaim on the corporation

Promised cash flows Promised cash flows (coupons and principal) (coupons and principal) are stated in advanceare stated in advance

Amount and timing ofAmount and timing ofdividends may changedividends may changeat any timeat any time

Mostly callableMostly callable Almost never callableAlmost never callable

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Corporate Bond BasicsCorporate Bond Basics In Canada the corporate bond market is In Canada the corporate bond market is

illiquid, however there are several trillion illiquid, however there are several trillion dollars of corporate bonds outstanding in the dollars of corporate bonds outstanding in the United States.United States.

More than half of these are owned by life More than half of these are owned by life insurance companies and pension funds.insurance companies and pension funds. These institutions can eliminate much of their These institutions can eliminate much of their

financial risk via financial risk via cash flow matchingcash flow matching.. They can also diversify away most default risk by They can also diversify away most default risk by

including a large number of different bond issues including a large number of different bond issues in their portfolios.in their portfolios.

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Corporate Bond BasicsCorporate Bond BasicsTable 18.1

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Types of Corporate BondsTypes of Corporate Bonds Bonds issued with a standard, relatively simple set of Bonds issued with a standard, relatively simple set of

features are popularly called features are popularly called Plain Vanilla Bonds (or Plain Vanilla Bonds (or “bullet” bonds)“bullet” bonds)..

DebenturesDebentures are unsecured bonds issued by a corporation. are unsecured bonds issued by a corporation. Mortgage bondsMortgage bonds are debt secured with a property lien. are debt secured with a property lien. Collateral trust bondsCollateral trust bonds are debt secured with financial are debt secured with financial

collateral.collateral. Equipment trust certificatesEquipment trust certificates are shares in a trust with are shares in a trust with

income from a lease contract.income from a lease contract.

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Bond OfferingBond OfferingFigure 18.1

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Bond IndenturesBond Indentures A A Bond indenture Bond indenture is a formal written agreement is a formal written agreement

between the corporation and the bondholders.between the corporation and the bondholders. This agreement spells out, in detail, the obligations of This agreement spells out, in detail, the obligations of

the corporation, the rights of the corporation, and the the corporation, the rights of the corporation, and the rights of the bondholders (with respect to the bond rights of the bondholders (with respect to the bond issue.)issue.)

In practice, few bond investors read the original In practice, few bond investors read the original indenture. Instead, they might refer to an indenture. Instead, they might refer to an indenture indenture summarysummary provided in the provided in the prospectusprospectus of the bond of the bond issue.issue.

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Seniority ProvisionsSeniority Provisions Different bond issues can usually be differentiated Different bond issues can usually be differentiated

according to the according to the seniority seniority of their claims on the of their claims on the

firm’s assets in case of firm’s assets in case of default.default. Senior DebenturesSenior Debentures are the bonds paid first in case of are the bonds paid first in case of

default.default. Subordinated Debentures Subordinated Debentures are paid after senior are paid after senior

debentures. debentures. Bond seniority may be protected by a Bond seniority may be protected by a negative pledge negative pledge

clauseclause.. A negative pledge clause prohibits a new debt issue A negative pledge clause prohibits a new debt issue

that would have seniority over existing bonds. that would have seniority over existing bonds.

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Call ProvisionsCall Provisions A A call provisioncall provision allows the issuer to buy back allows the issuer to buy back

all or part of its outstanding bonds at a all or part of its outstanding bonds at a specified call price sometime before the bonds specified call price sometime before the bonds mature.mature.

When interest rates fall, bond prices increase.When interest rates fall, bond prices increase. The corporation can “call-in” the existing bonds, The corporation can “call-in” the existing bonds,

i.e., pay the call price.i.e., pay the call price. The corporation can then issue new bonds with a The corporation can then issue new bonds with a

lower coupon.lower coupon. This process is called This process is called bond refundingbond refunding..

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Bond Indentures, Make-Whole Call ProvisionsBond Indentures, Make-Whole Call Provisions

Make-whole call provisionsMake-whole call provisions have recently become have recently become commoncommon

Like a fixed-price call provision, a Like a fixed-price call provision, a make-whole call make-whole call provisionprovision allows the issuer to pay off the remaining allows the issuer to pay off the remaining debt early. However,debt early. However, The issuer must pay the bondholders a price equal to the The issuer must pay the bondholders a price equal to the

present value of all remaining payments.present value of all remaining payments. As interest rates decrease:As interest rates decrease:

the make-whole call price increasesthe make-whole call price increases But, even in the region of low yields, these bonds still But, even in the region of low yields, these bonds still

exhibit the standard exhibit the standard convex price-yield relationship convex price-yield relationship in all in all yield regions.yield regions.

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Maximum Price of a Callable BondMaximum Price of a Callable Bond No matter how low market interest rates fall, No matter how low market interest rates fall,

the maximum price of an unprotected callable the maximum price of an unprotected callable bond is most likely its call price.bond is most likely its call price.

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Put ProvisionsPut Provisions

A bond with a A bond with a put provisionput provision can be sold back can be sold back to the issuer at a pre-specified price (normally to the issuer at a pre-specified price (normally set at par value) on any of a sequence of pre-set at par value) on any of a sequence of pre-specified dates. specified dates.

Bonds with put provisions are often called Bonds with put provisions are often called extendible bondsextendible bonds..

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Bond-to-Stock Conversion Bond-to-Stock Conversion ProvisionsProvisions

Convertible bondsConvertible bonds are bonds that can be are bonds that can be exchanged for common stock according to a exchanged for common stock according to a pre-pre-specifiedspecified conversion ratio (i.e., the number of conversion ratio (i.e., the number of shares acquired).shares acquired).

Suppose the conversion ratio for a $1,000 par Suppose the conversion ratio for a $1,000 par value bond is 20 shares.value bond is 20 shares.

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Bond-to-Stock Conversion Bond-to-Stock Conversion ProvisionsProvisions

Conversion Price = Bond Par Value / Conversion Price = Bond Par Value / Conversion RatioConversion Ratio Then, the conversion price is $50 ($1,000 / 20).Then, the conversion price is $50 ($1,000 / 20).

Conversion Value = Price Per Share X Conversion Value = Price Per Share X Conversion RatioConversion Ratio If the market price per share of stock is currently If the market price per share of stock is currently

$40, the conversion value is $800 ($40 x 20).$40, the conversion value is $800 ($40 x 20).

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Tombstone Ad, Convertible Notes Tombstone Ad, Convertible Notes IssueIssue

Figure 18.4

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Convertible Bond Prices Convertible Bond Prices and Conversion Valuesand Conversion Values

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Exchangeable Debenture IssueExchangeable Debenture Issue

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Bond Maturity ProvisionsBond Maturity Provisions

Bond maturity and principal payment Bond maturity and principal payment provisionsprovisions - - Term bondsTerm bonds are issued with a are issued with a single maturity datesingle maturity date, while , while serial bondsserial bonds are are issued with a regular issued with a regular sequence of maturity sequence of maturity datesdates..

Term bonds normally have a Term bonds normally have a sinking fundsinking fund, , which is an account used to repay some which is an account used to repay some bondholders before maturity.bondholders before maturity.

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Bond Maturity ProvisionsBond Maturity Provisions

Money paid into a sinking fund can only be Money paid into a sinking fund can only be used to pay bondholders.used to pay bondholders.

Some bondholders are repaid before the stated Some bondholders are repaid before the stated maturity of their bonds, whether they want to maturity of their bonds, whether they want to be repaid or not.be repaid or not.

At maturity, only a portion of the original At maturity, only a portion of the original bond issue will still be outstanding.bond issue will still be outstanding.

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Principal Payment ProvisionsPrincipal Payment Provisions Coupon payment provisionsCoupon payment provisions - An - An exact exact schedule of schedule of

coupon payment dates is specified.coupon payment dates is specified. If a company suspends payment of coupon interest, If a company suspends payment of coupon interest,

the company is said to be the company is said to be inin defaultdefault,, a serious matter.a serious matter. Bondholders have the Bondholders have the unconditionalunconditional right to timely right to timely

repayment. Bondholders have the right to bring legal action repayment. Bondholders have the right to bring legal action to get paid.to get paid.

Companies in default have the right to seek protection from Companies in default have the right to seek protection from inflexible bondholders in bankruptcy court.inflexible bondholders in bankruptcy court.

If there is default, it is often in the best interests of the If there is default, it is often in the best interests of the bondholders and the company to avoid court and bondholders and the company to avoid court and negotiate a new bond issue to replace the existing negotiate a new bond issue to replace the existing one.one.

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Protective CovenantsProtective Covenants A bond indenture is likely to contain a number A bond indenture is likely to contain a number

of of protective covenantsprotective covenants.. Protective CovenantsProtective Covenants are restrictions designed are restrictions designed

to protect bondholders.to protect bondholders. Negative covenant Negative covenant - The firm cannot pay dividends - The firm cannot pay dividends

to stockholders in excess of what is allowed by a to stockholders in excess of what is allowed by a formula based on the firm’s earnings.formula based on the firm’s earnings.

Positive covenant Positive covenant - Proceeds from the sale of - Proceeds from the sale of assets must be used either to acquire other assets of assets must be used either to acquire other assets of equal value or to redeem outstanding bonds.equal value or to redeem outstanding bonds.

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Event RiskEvent Risk Event riskEvent risk is the possibility that the issuing is the possibility that the issuing

corporation will experience a significant change corporation will experience a significant change in its bond credit quality.in its bond credit quality.

Example:Example: In October 1992, Marriott In October 1992, Marriott Corporation announced its intention to spin off Corporation announced its intention to spin off part of the company.part of the company. The spinoff, called Host Marriott, would acquire The spinoff, called Host Marriott, would acquire

most of the parent company’s debt and its poorly most of the parent company’s debt and its poorly performing real estate holdings.performing real estate holdings.

Holding bonds in Host Marriott is more risky Holding bonds in Host Marriott is more risky than holding bonds in Marriott Corporation.than holding bonds in Marriott Corporation.

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Bonds Without IndenturesBonds Without Indentures A A Private placement Private placement is a new bond issue sold is a new bond issue sold

privately to one or more parties. That is, this privately to one or more parties. That is, this new bond issue is not available to the general new bond issue is not available to the general public.public.

Private placements are exempt from Private placements are exempt from registration requirements with the SEC, registration requirements with the SEC, although they often have formal indentures.although they often have formal indentures.

Debt issued without an indenture is basically a Debt issued without an indenture is basically a simple IOU of the corporation.simple IOU of the corporation.

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Preferred StockPreferred Stock

Preferred stockholders have a claim to Preferred stockholders have a claim to dividend payments that is dividend payments that is seniorsenior to the claim to the claim of common stockholders. of common stockholders.

However, their claim is However, their claim is junior (subordinate)junior (subordinate) to the claims of bondholders and other to the claims of bondholders and other creditors.creditors.

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Preferred StockPreferred Stock Preferred stock has some of the features of Preferred stock has some of the features of

both bonds and common stock.both bonds and common stock. Typically, preferred stock issuesTypically, preferred stock issues

Do not grant voting rights to their holders,Do not grant voting rights to their holders, Promise a stream of fixed dividend payments,Promise a stream of fixed dividend payments, Have no specified maturity but are often callable,Have no specified maturity but are often callable, May have their dividends suspended without setting off May have their dividends suspended without setting off

a bankruptcy process (as long as common stock a bankruptcy process (as long as common stock dividends are also suspended),dividends are also suspended),

Cumulate unpaid preferred dividends, andCumulate unpaid preferred dividends, and May be convertible.May be convertible.

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Adjustable Rate Bonds and Preferred StockAdjustable Rate Bonds and Preferred Stock

Many bond, note, and preferred stock issues Many bond, note, and preferred stock issues allow the issuer to adjust the annual coupon allow the issuer to adjust the annual coupon according to a rule or formula based on current according to a rule or formula based on current market interest rates. market interest rates.

These securities are called These securities are called adjustable-rateadjustable-rate or or floating-ratefloating-rate securities. securities.

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Corporate Bond Credit RatingsCorporate Bond Credit Ratings A corporation usually subscribes to several A corporation usually subscribes to several

bond rating agencies for a credit evaluation of bond rating agencies for a credit evaluation of a new bond issue.a new bond issue.

Each contracted rating agency will then Each contracted rating agency will then provides a provides a credit ratingcredit rating - an assessment of the - an assessment of the credit quality of the bond issue based on the credit quality of the bond issue based on the issuer’s financial condition.issuer’s financial condition. Established rating agencies are Moody’s Investors Established rating agencies are Moody’s Investors

Services ,Standard & Poors Corporation, Services ,Standard & Poors Corporation, Dominion Bond Rating Service, Duff and Phelps, Dominion Bond Rating Service, Duff and Phelps, and Fitch Investors Service.and Fitch Investors Service.

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Corporate Bond Credit Rating Corporate Bond Credit Rating SymbolsSymbols

Table 18.2

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The Importance of Corporate Bond Credit RatingsThe Importance of Corporate Bond Credit Ratings

Only a few institutional investors have the Only a few institutional investors have the resources and expertise necessary to evaluate resources and expertise necessary to evaluate correctly the credit quality of a particular correctly the credit quality of a particular bond.bond.

Many financial institutions have Many financial institutions have prudent prudent investment guidelinesinvestment guidelines stipulating that only stipulating that only securities with a certain level of investment securities with a certain level of investment safety may be included in their portfolios.safety may be included in their portfolios.

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The Yield SpreadThe Yield Spread

A bond’s credit rating helps determine its A bond’s credit rating helps determine its yield spreadyield spread..

The yield spread is the extra return (increased The yield spread is the extra return (increased yield to maturity) that investors demand for yield to maturity) that investors demand for buying a bond with a lower credit rating (and buying a bond with a lower credit rating (and higher risk).higher risk).

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The Yield SpreadThe Yield Spread

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High Yield Bonds (aka "Junk" Bonds)High Yield Bonds (aka "Junk" Bonds) High-yield bondsHigh-yield bonds are bonds with a are bonds with a speculative speculative

credit rating.credit rating.

As a result of this poor credit rating, a yield As a result of this poor credit rating, a yield premium must be offered on these bonds to premium must be offered on these bonds to compensate investors for higher credit risk. compensate investors for higher credit risk.

High-yield bonds are also called High-yield bonds are also called junk bondsjunk bonds..

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High Yield Bonds QuotesHigh Yield Bonds QuotesFigure 18.7

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Bond Market TradingBond Market Trading An active secondary market with a An active secondary market with a

substantial volume of bond trading exists, substantial volume of bond trading exists, thus satisfying most of the liquidity needs of thus satisfying most of the liquidity needs of investors.investors.

Corporate bond trading is characteristically Corporate bond trading is characteristically an OTC activity. an OTC activity.

Nevertheless, bond trading on the New York Nevertheless, bond trading on the New York Stock Exchange is watched by bond Stock Exchange is watched by bond investors and traders throughout the world.investors and traders throughout the world.

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Canadian Bond TradingCanadian Bond TradingFigure 18.8

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Trade Reporting and Compliance EngineTrade Reporting and Compliance Engine

At the request of the SEC, corporate bond At the request of the SEC, corporate bond trades are now reported through TRACE.trades are now reported through TRACE.

TRACE provides a means for bond investors TRACE provides a means for bond investors to get accurate, up-to-date price information.to get accurate, up-to-date price information.

TRACE has dramatically improved the TRACE has dramatically improved the information available about bond trades.information available about bond trades. Transaction prices are now reported on more than Transaction prices are now reported on more than

4,000 bonds4,000 bonds That is, about 75% of market volume for That is, about 75% of market volume for

investment grade bonds.investment grade bonds.

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Useful WebsitesUseful Websites www.investinginbonds.comwww.investinginbonds.com (for more (for more

information on corporate bonds)information on corporate bonds) www.sec.govwww.sec.gov (U.S. Securities and Exchange (U.S. Securities and Exchange

Commission)Commission) www.convertbond.comwww.convertbond.com (for more information (for more information

about convertible bonds)about convertible bonds) www.bondsonline.comwww.bondsonline.com (follow the "corporate (follow the "corporate

bond spreads" link)bond spreads" link)

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Useful WebsitesUseful Websites

Websites for companies in this chapter:Websites for companies in this chapter: www.amd.comwww.amd.com (Advanced Micro Devices) (Advanced Micro Devices) www.marriott.comwww.marriott.com (Marriott International, Inc.) (Marriott International, Inc.) www.hostmarriott.comwww.hostmarriott.com (Host Marriott Corporation) (Host Marriott Corporation)

Websites for Ratings Agencies:Websites for Ratings Agencies: www.dbrs.comwww.dbrs.com (Dominion Bond Rating Service) (Dominion Bond Rating Service) www.fitchibca.comwww.fitchibca.com (Fitch Investors Service) (Fitch Investors Service) www.moodys.comwww.moodys.com (Moody’s) (Moody’s) www.standardpoor.comwww.standardpoor.com (Standard & Poor’s) (Standard & Poor’s)

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Chapter ReviewChapter Review Corporate Bond BasicsCorporate Bond Basics

Types of Corporate BondsTypes of Corporate Bonds Bond IndenturesBond Indentures

Bond Seniority ProvisionsBond Seniority Provisions Call ProvisionsCall Provisions Graphical Analysis of Callable Bond PricesGraphical Analysis of Callable Bond Prices Put ProvisionsPut Provisions Bond-to-Stock Conversion ProvisionsBond-to-Stock Conversion Provisions

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Chapter ReviewChapter Review Graphical Analysis of Convertible Bond PricesGraphical Analysis of Convertible Bond Prices Bond Maturity and Principal Payment Bond Maturity and Principal Payment

ProvisionsProvisions Sinking Fund ProvisionsSinking Fund Provisions Coupon Payment ProvisionsCoupon Payment Provisions

Protective CovenantsProtective Covenants Event RiskEvent Risk Bonds Without IndenturesBonds Without Indentures Preferred StockPreferred Stock

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Chapter ReviewChapter Review Adjustable-Rate Bonds and Adjustable-Rate Adjustable-Rate Bonds and Adjustable-Rate

Preferred-StockPreferred-Stock

Corporate Bond Credit RatingsCorporate Bond Credit Ratings Junk BondsJunk Bonds

Bond Market TradingBond Market Trading