Finance 4330

Advanced Corporate Finance Corporate Long-Term Debt Lecture 27 Fall 2010 Ronald F. Singer

Long-Term Debt
1. Long Term Debt: A Review 2. The Public Issue of Bonds 3. Bond Refunding

4. Bond Ratings
5. Some Different Types of Bonds 6. 7. Direct Placement Compared to Public Issues Summary and Conclusions

1. Long Term Debt: A Review

Corporate debt can be short-term (maturity less than one year) or long-term. Different from common stock:
Creditors 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 to kitchen sink bonds

Features of a Typical Bond

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

Features that may change over time

Rating Yield-to-Maturity Market price

Features of a Hypothetical Bond

Issue amount Issue date Maturity date Face value Coupon interest Coupon dates Offering price Yield to maturity Call provision Call price Trustee Security Rating $20 million 12/15/98 12/31/18 Bond issue total face value is $20 million Bonds offered to the public in December 1998 Remaining principal is due December 31, 2018 $1,000 Face value denomination is $1,000 per bond $100 per annum Annual coupons are $100 per bond 6/30, 12/31 Coupons are paid semiannually 100 Offer price is 100% of face value 10% Based on stated offer price Callable after 12/31/03 Bonds are call protected for 5 years after issuance 110 before 12/31/08, Callable at 110 percent of par value through 100 thereafter 2008. Thereafter callable at par. United Bank of Trustee is appointed to represent Florida bondholders None Bonds are unsecured debenture Moody's A1, S&P A+ Bond credit quality rated upper medium grade by Moody's and S&P's rating

2. The Public Issue of Bonds

The general procedure is similar to the issuance of stock, as described in the previous chapter. Indentures and covenants are not relevant to stock issuance. The indenture 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

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

Protective Covenants
Agreements to protect bondholders Negative covenant: Thou shalt not:

Positive covenant: Thou shalt:

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 companys bonds 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

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 funs provide extra protection to bondholders. Sinking funs provide the firm with an option.

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?

Callable Bonds versus Noncallable Bonds Most bonds are callable;

200 175

Noncallable bond

Bond price (% of par)

150

125

100

some sensible reasons for call provisions include: taxes, managerial flexibility and the fact that callable bonds have less interest rate risk.

75

Callable bond
50

25 0 4 8 12 16 20

Yield to maturity (%)

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. Raters can disagree.

Bond Ratings: Investment Grade

Moody's Duff & Phelps
Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 1 2 3 4 5 6 7 8 9 10

S&P's
AAA AA+ AA AAA+ A ABBB + BBB BBB-

Credit Rating Description

Highest credit rating, maximum safety High credit quality, investment-grade bonds

Upper-medium quality, investment grade bonds

Lower-medium quality, investment grade bonds

Bond Ratings: Below Investment Grade

Moody's Duff & Phelps
Ba1 Ba2 Ba3 B1 B2 B3 Caa 11 12 13 14 15 16 17

S&P's

Credit Rating Description

Speculative-Grade Bond Ratings

BB+ BB BBB+ B BCCC + CCC CCCCC C D Extremely low credit standing, high-risk bonds Low credit quality, speculative-grade bonds

Very low credit quality, speculative-grade bonds

Extremely Speculative-Grade Bond Ratings

Ca C

Extremely speculative Bonds in default

Junk bonds
Anything less than an S&P BB or a Moodys Ba is a junk bond. A polite euphemism for junk is high-yield bond. There are two types of junk bonds:
Original issue junkpossibly not rated Fallen angelsrated

Current status of junk bond market

Private placement

Yield premiums versus default risk

5. Different Types of Bonds

Callable Bonds Puttable Bonds Convertible Bonds Deep Discount Bonds Income Bonds Floating-Rate Bonds

Puttable bonds
Put provisions
Put price Put date Put deferment

Extendible bonds Value of the put feature Cost of the put feature

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

150 140 130

Convertible Bond Prices

Convertible bond price

Bond price (% of par)

120 110 100 90 80 70 60 50 50 70 90 110 130 150

Stock price

Nonconvertible bond price

Conversion value (% of par)

Example of a Convertible Bond

More on Convertibles
Exchangeable bonds
Convertible into a set number of shares of a third companys 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.

Example of an Exchangeable Bond

6. Direct Placement Compared to Public Issues

A direct 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.

7. Summary and Conclusions

The details of the long-term debt contract are contained in the indenture. The main provisions are: security, repayment, protective covenants and call provisions. Protective covenants are designed to protect bondholders from management decisions that favor stockholders at bondholders expense. Most public industrial bonds are unsecured they are general claims on the companys value. Most utility bonds are secured. If the firm defaults on secured bonds, the trustee can repossess the asset.

7. Summary and Conclusions (cont.)

Long-term bonds usually provide for repayment of principal before maturity. This is usually accomplished with a sinking fund whereby a firm retires a certain number of bonds each year. Most publicly issued bonds are callable. There is no single reason for call provisions. Some sensible reasons include taxes, greater flexibility, and the fact that callable bonds are less sensitive to interest-rate changes. There are many different types of bonds, including floating-rate bonds, deep-discount bonds, and income bonds.