Chapter 20 Long-Term Debt
20.1 Long Term Debt: A Review
20.2 The Public Issue of Bonds
20.3 Bond Refunding
20.4 Bond Ratings
20.5 Some Different Types of Bonds
20.6 Direct Placement Compared to Public Issues
20.7 Long-Term Syndicated Bank Loans
20.8 Summary and Conclusions
Long Term Debt: A Review
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Corporate debt can be short-term (maturity
less than one year) or long-term.
Different from common stock:
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Creditor’s 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
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The indenture usually lists
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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
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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
The Public Issue of Bonds
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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
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Amount of Issue, Date of Issue, Maturity
Denomination (Par value)
Annual Coupon, Dates of Coupon Payments
Security
Sinking Funds
Call Provisions
Covenants
Principal Repayment
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Term bonds versus serial bonds
Sinking funds--how do they work?
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Fractional repayment each year
Good news -- security
Bad news -- unfavorable calls
How trustee redeems
Protective Covenants
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Agreements to protect bondholders
Negative covenant: Thou shalt not:
 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 company’s bonds
Positive covenant: Thou shalt:
 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
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There are many different kinds of sinking-fund
arrangements:
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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.
Bond Refunding
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Replacing all or part of a bond issue is called
refunding.
Bond refunding raises two questions:
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Should firms issue callable bonds?
Given that callable bonds have been issued,
when should the bonds be called?
Callable Bonds versus Noncallable Bonds
200
Noncallable
bond
Bond price (% of par)
175
150
125
100
Most bonds are callable;
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
Yield to maturity (%)
16
20
Bond Ratings
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What is rated:
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Who pays for ratings:
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The likelihood that the firm will default.
The protection afforded by the loan contract in the
event of default.
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
S&P's
Aaa
1
AAA
Aa1
Aa2
2
3
AA+
AA
Aa3
A1
A2
4
5
6
AAA+
A
A3
Baa1
7
8
Baa2
9
ABBB
+
BBB
Baa3
10
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
S&P's
Credit Rating
Description
Speculative-Grade Bond Ratings
Ba1
11
BB+
Ba2
Ba3
B1
12
13
14
BB
BBB+
B2
B3
15
16
B
B-
Low credit quality,
speculative-grade bonds
Very low credit quality,
speculative-grade bonds
Extremely Speculative-Grade Bond Ratings
Caa
Ca
C
17
CCC
+
CCC
CCCCC
C
D
Extremely low credit
standing, high-risk bonds
Extremely speculative
Bonds in default
Junk bonds
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Anything less than an S&P “BB” or a Moody’s
“Ba” is a junk bond.
A polite euphemism for junk is high-yield
bond.
There are two types of junk bonds:
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Current status of junk bond market
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Original issue junk—possibly not rated
Fallen angels—rated
Private placement
Yield premiums versus default risk
Different Types of Bonds
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Callable Bonds
Puttable Bonds
Convertible Bonds
Deep Discount Bonds
Income Bonds
Floating-Rate Bonds
Puttable bonds
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Put provisions
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Put price
Put date
Put deferment
Extendible bonds
Value of the put feature
Cost of the put feature
Convertible Bonds
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Why are they issued?
Why are they purchased?
Conversion ratio:
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Conversion price:
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Bond par value / Conversion ratio
Conversion value:
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Number of shares of stock acquired by conversion
Price per share of stock x Conversion ratio
In-the-money versus out-the-money
Convertible Bond Prices
150
140
Convertible bond price
Bond price (% of par)
130
120
110
Stock price
100
90
80
Nonconvertible bond price
70
60
50
50
70
90
110
Conversion value (% of par)
130
150
More on Convertibles
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Exchangeable bonds
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Minimum (floor) value of convertible is the greater
of:
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Convertible into a set number of shares of a third
company’s common stock.
Straight or “intrinsic” bond value
Conversion value
Conversion option value
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Bondholders pay for the conversion option by accepting a
lower coupon rate on convertible bonds versus otherwiseidentical nonconvertible bonds.
Direct Placement Compared to Public Issues
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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.
Summary and Conclusions
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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 company’s value.
Most utility bonds are secured. If the firm defaults
on secured bonds, the trustee can repossess the
asset.
Summary and Conclusions (cont.)
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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.