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CORPORATE DEBT INSTRUMENTS
USINFO | 2014-01-03 10:41
CHAPTER SUMMARY
Corporate debt instruments are financial obligations of a corporation that have priority over its common stock and preferred stock in the case of bankruptcy. In this chapter we discuss the following corporate debt instruments: corporate bonds, medium-term notes, commercial paper, and asset-backed securities. The discussion of convertible corporate bonds and asset-backed securities come in later chapters.
CORPORATE BONDS
Corporate bonds are classified by the type of issuer. The four general classifications used by bond information services are utilities, transportations, industrials, and banks and finance companies.
Features of a Corporate Bond Issue
The essential features of a corporate bond are straightforward. The corporate issuer promises to pay a specified percentage of par value (the coupon payments) on designated dates and to repay par or principal value of the bond at maturity. Failure to pay either the principal or interest when due constitutes legal default, and investors can go to court to enforce the contract.
The promises of corporate bond issuers and the rights of investors who buy them are set forth in great detail in contracts called bond indentures. The indenture is made out to the corporate trustee as a representative of the interests of bondholders; that is, a trustee acts in a fiduciary capacity for investors who own the bond issue.
Most corporate bonds are term bonds; that is, they run for a term of years, then become due and payable. Generally, obligations due in under 10 years from the date of issue are called notes. Some corporate bond issues are arranged so that specified principal amounts become due on specified dates. Such issues are called serial bonds.
Security for Bonds
Some companies own securities of other companies; they are holding companies, and the other companies are subsidiaries. To satisfy the desire of bondholders for security, they will pledge stocks, notes, bonds or whatever other kind of obligations they own. These assets are termed collateral (or personal property); bonds secured by such assets are called collateral trust bonds.
Debenture bonds are debt securities not secured by a specific pledge of property. Debenture bondholders have the claim of general creditors on all assets of the issuer not pledged specifically to secure other debt. Subordinated debenture bonds rank after secured debt, after debenture bonds, and often after some general creditors in their claim on assets and earnings. For a given corporation, secured debt (such as mortgage bonds) will cost less than debenture bonds, and debenture bonds will cost less than subordinated debenture bonds.
Guaranteed bonds are obligations guaranteed by another entity. The safety of a guaranteed bond depends upon the guarantor’s financial capability as well as the financial capability of the issuer.
Provisions for Paying Off Bonds
Most corporate issues have a call provision allowing the issuer an option to buy back all or part of the issue prior to the stated maturity date. Issuers generally want the right to call because they recognize that at some time in the future the general level of interest rates may fall sufficiently below the issue’s coupon rate that redeeming the issue and replacing it with another issue with a lower coupon rate would be attractive.
Many investors are confused by the terms noncallable and nonrefundable. Call protection is much more absolute than refunding protection. Refunding means to replace an old bond issue with a new one, often at a lower interest cost.
Bonds can be called in whole (the entire issue) or in part (only a portion). When less than the entire issue is called, the specific bonds to be called are selected randomly or on a pro rata basis. Corporate bond indentures may require the issuer to retire a specified portion of an issue each year. This is referred to as a sinking fund requirement.
Accrued Interest
In addition to the agreed-upon price, the buyer must pay the seller accrued interest. Each month in a corporate bond year is 30 days, whether it is February, April, or August. A 12% coupon corporate bond pays $120 per year per $1,000 par value, accruing interest at $10 per month or $0.33333 per day.
Corporate Bond Ratings
Professional money managers use various techniques to analyze information on companies and bond issues in order to estimate the ability of the issuer to live up to its future contractual obligations. This activity is known as credit analysis. Individual investors and institutional bond investors rely primarily on nationally recognized rating companies that perform credit analysis and issue their conclusions in the form of ratings. The three commercial rating companies are Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch Ratings.
In all rating systems the term high grade means low credit risk, or conversely, high probability of future payment. Bonds rated triple A are said to be prime; double A are of high quality; single A issues are called upper medium grade, and triple B are medium grade. Lower rated bonds are said to have speculative elements or to be distinctly speculative.
Bond issues that are assigned a rating in the top four categories are referred to as investment-grade bonds. Issues that carry a rating below the top four categories are referred to as noninvestment-grade bonds, or more popularly as high-yield bonds or junk bonds. Thus, the corporate bond market can be divided into two sectors: the investment-grade and noninvestment-grade markets.
Default Rates and Default Loss Rates
Historically, a higher percentage of defaults are for non-investment-grade rated bonds. To evaluate the performance of the corporate bond sector, more than just default rates are needed. The reason is that default rates by themselves are not of paramount significance. It is perfectly possible for a portfolio of corporate bonds to suffer defaults and to outperform Treasuries at the same time, provided the yield spread of the portfolio is sufficiently high to offset the losses from default. Furthermore, because holders of defaulted bonds typically recover a percentage of the face amount of their investment, this is called the recovery rate. Therefore, an important measure in studying the performance of the corporate bond sector is the default loss rate, which is defined as: Default loss rate = Default rate * (100% - Recovery rate).
Event Risk
Occasionally, the ability of an issuer to make interest and principal payments changes seriously and unexpectedly because of (i) a natural or industrial accident or some regulatory change, or (ii) a takeover or corporate restructuring. These risks are referred to generically as event risk.
High-Yield Corporate Bond Sector
High-yield bonds, commonly called junk bonds, are issues with quality ratings below triple B. Bond issues in this sector of the market may have been downgraded to noninvestment-grade, or they may have been rated noninvestment-grade at the time of issuance, called original-issue high-yield bonds. Bonds that have been downgraded fall into two groups: (i) issues that have been downgraded because the issuer voluntarily significantly increased their debt as a result of a leveraged buyout or a recapitalization, and (ii) issues that have been downgraded for other reasons.
In a leveraged buyout (LBO) or a recapitalization, the heavy interest payment burden that the corporation assumes places severe cash flow constraints on the firm. To reduce this burden, firms involved in LBOs and recapitalizations have issued bonds with deferred coupon structures that permit the issuer to avoid using cash to make interest payments for a period of three to seven years. There are three types of deferred coupon structures: deferred-interest bonds, step-up bonds, and payment-in-kind bonds.
Deferred-interest bonds sell at a deep discount and do not pay interest for an initial period, typically from three to seven years. Step-up bonds do pay coupon interest, but the coupon rate is low for an initial period and then increases (“steps up”) to a higher coupon rate. Payment-in-kind (PIK) bonds give the issuer an option to pay cash at a coupon payment date or give the bondholder a similar bond (i.e., a bond with the same coupon rate and a par value equal to the amount of the coupon payment that would have been paid). The period during which the issuer can make this choice varies from 5 to 10 years.
In late 1987, a junk bond came to market with a structure allowing the issuer to reset the coupon rate so that the bond will trade at a predetermined price. The coupon rate may reset annually or even more frequently, or reset only one time over the life of the bond. Generally, the coupon rate at reset time will be the average of rates suggested by two investment banking firms. The new rate will then reflect both the level of interest rates at the reset date, and the credit spread the market wants on the issue at the reset date. This structure is called an extendable reset.
In a floating-rate issue, the coupon rate resets according to a fixed spread over some benchmark, with the spread specified in the indenture. The amount of the spread reflects market conditions at the time the issue is offered. The coupon rate on an extendable reset bond by contrast is reset based on market conditions (as suggested by several investment banking firms) at the time of the reset date. Moreover, the new coupon rate reflects the new level of interest rates and the new spread that investors seek.
The advantage to issuers of extendable reset bonds is again that they can be assured of a long-term source of funds based on short-term rates. For investors, the advantage of these bonds is that the coupon rate will reset to the market rate—both the level of interest rates and the credit spread, in principle keeping the issue at par.
Corporate debt instruments are financial obligations of a corporation that have priority over its common stock and preferred stock in the case of bankruptcy. In this chapter we discuss the following corporate debt instruments: corporate bonds, medium-term notes, commercial paper, and asset-backed securities. The discussion of convertible corporate bonds and asset-backed securities come in later chapters.
CORPORATE BONDS
Corporate bonds are classified by the type of issuer. The four general classifications used by bond information services are utilities, transportations, industrials, and banks and finance companies.
Features of a Corporate Bond Issue
The essential features of a corporate bond are straightforward. The corporate issuer promises to pay a specified percentage of par value (the coupon payments) on designated dates and to repay par or principal value of the bond at maturity. Failure to pay either the principal or interest when due constitutes legal default, and investors can go to court to enforce the contract.
The promises of corporate bond issuers and the rights of investors who buy them are set forth in great detail in contracts called bond indentures. The indenture is made out to the corporate trustee as a representative of the interests of bondholders; that is, a trustee acts in a fiduciary capacity for investors who own the bond issue.
Most corporate bonds are term bonds; that is, they run for a term of years, then become due and payable. Generally, obligations due in under 10 years from the date of issue are called notes. Some corporate bond issues are arranged so that specified principal amounts become due on specified dates. Such issues are called serial bonds.
Security for Bonds
Some companies own securities of other companies; they are holding companies, and the other companies are subsidiaries. To satisfy the desire of bondholders for security, they will pledge stocks, notes, bonds or whatever other kind of obligations they own. These assets are termed collateral (or personal property); bonds secured by such assets are called collateral trust bonds.
Debenture bonds are debt securities not secured by a specific pledge of property. Debenture bondholders have the claim of general creditors on all assets of the issuer not pledged specifically to secure other debt. Subordinated debenture bonds rank after secured debt, after debenture bonds, and often after some general creditors in their claim on assets and earnings. For a given corporation, secured debt (such as mortgage bonds) will cost less than debenture bonds, and debenture bonds will cost less than subordinated debenture bonds.
Guaranteed bonds are obligations guaranteed by another entity. The safety of a guaranteed bond depends upon the guarantor’s financial capability as well as the financial capability of the issuer.
Provisions for Paying Off Bonds
Most corporate issues have a call provision allowing the issuer an option to buy back all or part of the issue prior to the stated maturity date. Issuers generally want the right to call because they recognize that at some time in the future the general level of interest rates may fall sufficiently below the issue’s coupon rate that redeeming the issue and replacing it with another issue with a lower coupon rate would be attractive.
Many investors are confused by the terms noncallable and nonrefundable. Call protection is much more absolute than refunding protection. Refunding means to replace an old bond issue with a new one, often at a lower interest cost.
Bonds can be called in whole (the entire issue) or in part (only a portion). When less than the entire issue is called, the specific bonds to be called are selected randomly or on a pro rata basis. Corporate bond indentures may require the issuer to retire a specified portion of an issue each year. This is referred to as a sinking fund requirement.
Accrued Interest
In addition to the agreed-upon price, the buyer must pay the seller accrued interest. Each month in a corporate bond year is 30 days, whether it is February, April, or August. A 12% coupon corporate bond pays $120 per year per $1,000 par value, accruing interest at $10 per month or $0.33333 per day.
Corporate Bond Ratings
Professional money managers use various techniques to analyze information on companies and bond issues in order to estimate the ability of the issuer to live up to its future contractual obligations. This activity is known as credit analysis. Individual investors and institutional bond investors rely primarily on nationally recognized rating companies that perform credit analysis and issue their conclusions in the form of ratings. The three commercial rating companies are Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch Ratings.
In all rating systems the term high grade means low credit risk, or conversely, high probability of future payment. Bonds rated triple A are said to be prime; double A are of high quality; single A issues are called upper medium grade, and triple B are medium grade. Lower rated bonds are said to have speculative elements or to be distinctly speculative.
Bond issues that are assigned a rating in the top four categories are referred to as investment-grade bonds. Issues that carry a rating below the top four categories are referred to as noninvestment-grade bonds, or more popularly as high-yield bonds or junk bonds. Thus, the corporate bond market can be divided into two sectors: the investment-grade and noninvestment-grade markets.
Default Rates and Default Loss Rates
Historically, a higher percentage of defaults are for non-investment-grade rated bonds. To evaluate the performance of the corporate bond sector, more than just default rates are needed. The reason is that default rates by themselves are not of paramount significance. It is perfectly possible for a portfolio of corporate bonds to suffer defaults and to outperform Treasuries at the same time, provided the yield spread of the portfolio is sufficiently high to offset the losses from default. Furthermore, because holders of defaulted bonds typically recover a percentage of the face amount of their investment, this is called the recovery rate. Therefore, an important measure in studying the performance of the corporate bond sector is the default loss rate, which is defined as: Default loss rate = Default rate * (100% - Recovery rate).
Event Risk
Occasionally, the ability of an issuer to make interest and principal payments changes seriously and unexpectedly because of (i) a natural or industrial accident or some regulatory change, or (ii) a takeover or corporate restructuring. These risks are referred to generically as event risk.
High-Yield Corporate Bond Sector
High-yield bonds, commonly called junk bonds, are issues with quality ratings below triple B. Bond issues in this sector of the market may have been downgraded to noninvestment-grade, or they may have been rated noninvestment-grade at the time of issuance, called original-issue high-yield bonds. Bonds that have been downgraded fall into two groups: (i) issues that have been downgraded because the issuer voluntarily significantly increased their debt as a result of a leveraged buyout or a recapitalization, and (ii) issues that have been downgraded for other reasons.
In a leveraged buyout (LBO) or a recapitalization, the heavy interest payment burden that the corporation assumes places severe cash flow constraints on the firm. To reduce this burden, firms involved in LBOs and recapitalizations have issued bonds with deferred coupon structures that permit the issuer to avoid using cash to make interest payments for a period of three to seven years. There are three types of deferred coupon structures: deferred-interest bonds, step-up bonds, and payment-in-kind bonds.
Deferred-interest bonds sell at a deep discount and do not pay interest for an initial period, typically from three to seven years. Step-up bonds do pay coupon interest, but the coupon rate is low for an initial period and then increases (“steps up”) to a higher coupon rate. Payment-in-kind (PIK) bonds give the issuer an option to pay cash at a coupon payment date or give the bondholder a similar bond (i.e., a bond with the same coupon rate and a par value equal to the amount of the coupon payment that would have been paid). The period during which the issuer can make this choice varies from 5 to 10 years.
In late 1987, a junk bond came to market with a structure allowing the issuer to reset the coupon rate so that the bond will trade at a predetermined price. The coupon rate may reset annually or even more frequently, or reset only one time over the life of the bond. Generally, the coupon rate at reset time will be the average of rates suggested by two investment banking firms. The new rate will then reflect both the level of interest rates at the reset date, and the credit spread the market wants on the issue at the reset date. This structure is called an extendable reset.
In a floating-rate issue, the coupon rate resets according to a fixed spread over some benchmark, with the spread specified in the indenture. The amount of the spread reflects market conditions at the time the issue is offered. The coupon rate on an extendable reset bond by contrast is reset based on market conditions (as suggested by several investment banking firms) at the time of the reset date. Moreover, the new coupon rate reflects the new level of interest rates and the new spread that investors seek.
The advantage to issuers of extendable reset bonds is again that they can be assured of a long-term source of funds based on short-term rates. For investors, the advantage of these bonds is that the coupon rate will reset to the market rate—both the level of interest rates and the credit spread, in principle keeping the issue at par.
