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Chapter Twenty
Long-Term Debt
Corporate Finance
Ross  Westerfield  Jaffe
20
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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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
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20.1 Long Term Debt: A Review
• Corporate debt can be short-term (maturity less than
one year) or long-term.
• Different from common stock:
– 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
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Features of a Typical Bond
• The indenture usually lists
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–
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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
– Rating
– Yield-to-Maturity
– Market price
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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
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$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
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20.2 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
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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
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Principal Repayment
• Term bonds versus serial bonds
• Sinking funds: How do they work?
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Fractional repayment each year
Good news---security
Bad news---unfavourable calls
How trustee redeems
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Protective Covenants
• Agreements to protect bondholders
• Negative covenant: Thou shalt not:
– pay dividends beyond specified amount
– sell more senior debt and 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
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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 funds provide extra protection to
bondholders.
• Sinking funds provide the firm with an option.
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The Call Provision
• A call provision lets the company repurchase or call the
entire bond issue at a predetermined price overa specified
period.
• The difference between the call price and the face value is
the call premium.
• Many long-term corporate bonds outstanding in Canada have
call provisions.
• New corporate debt features a different call provision
referred to as a Canada plus call.
• The Canada plus call is designed to replace the traditional
call feature by making it unattractive for the issuer ever to
call the bonds.
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20.3 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?
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Should firms issue callable bonds?
•
•
•
•
•
Common sense tells us that call provisions have
value.
A call works to the advantage of the issuer.
If interest rates fall and bond prices go up, the
option to buy back the bonds at the call price is
valuable.
In bond refunding, firms will typically replace the
called bonds with a new bond issue.
The new bonds will have a lower coupon rate than
the called bonds.
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Why are callable bonds issued in the real world?
•
1.
2.
3.
4.
Four specific reasons why a company might use a
call provision:
Superior interest rate predictions
Taxes
Financial flexibility for future investment
opportunities
Less interest-rate risk
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Callable Bonds versus Noncallable Bonds
200
175
Bond price (% of par)
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.
Noncallable
bond
150
125
100
75
Callable bond
50
25
0
4
8
12
16
Yield to maturity (%)
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Calling Bonds: When does it make sense?
• In a world with no transaction costs, it can be shown
that the company should call its bonds whenever the
callable bond value exceeds the call price.
• This policy minimizes the value of the callable
bonds.
• The costs from issuing new bonds change the
refunding rule to allow bonds to trade at prices
above the call price.
• The objective of the company is to minimize the
sum of the value of the callable bonds plus new
issue costs.
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20.4 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.
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Bond Ratings: Investment Grade
Moody's Duff &
Phelps
DBRS
Credit Rating
Description
Aaa
1
AAA
Highest credit rating,
maximum safety
Aa1
Aa2
2
3
AA
High credit quality,
investment-grade bonds
Aa3
A1
A2
4
5
6
A
Upper-medium quality,
investment grade bonds
A3
Baa1
Baa2
7
8
9
BBB
Lower-medium quality,
investment grade bonds
Baa3
10
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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
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CCC
+
CCC
CCCCC
C
D
Extremely low credit
standing, high-risk bonds
Extremely speculative
Bonds in default
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Junk bonds
• 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:
– Original issue junk—possibly not rated
– Fallen angels—rated
• Current status of junk bond market
– Private placement
• Yield premiums versus default risk
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20.5 Different Types of Bonds
•
•
•
•
•
•
Callable Bonds
Puttable Bonds
Convertible Bonds
Zero Coupon Bonds
Floating-Rate Bonds
Other Types of Bonds
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Puttable bonds
• Put provisions
– Put price
– Put date
– Put deferment
• Extendible bonds
• Value of the put feature
• Cost of the put feature
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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
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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
130
150
Conversion value (% of par)
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Example of a Convertible Bond
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More on Convertibles
• Exchangeable bonds
– Convertible into a set number of shares of a third
company’s 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 otherwiseidentical nonconvertible bonds.
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Example of an Exchangeable Bond
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Zero-Coupon Bonds
• A bond that pays no coupons at all must be offered
at a price that is much lower than its stated value.
• For tax purposes, the issuer of a zero-coupon bond
deducts interest every year even though no interest
is actually paid.
• Zero-coupon bonds, often in the form of stripped
coupons, are attractive to individual investors for
tax-sheltered Registered Retirement Savings Plans
(RRSPs).
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Floating Rate Bonds
•
With floating rate bonds, the coupon payments are
adjustable.The adjustments are tied to the Treasury bill rate
or another short-term interest rate.
Majority of floaters have the following features:
1. The holder has the right to redeem her note at par on the
coupon payment date after some specified amount of time.
2. The coupon rate has a floor and a ceiling. i.e., a minimum
and a maximum.
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Financial Engineering and Bonds
• Income bonds: coupon payments are dependent on
company income.
• Retractable bonds: allow the holder to force the
issuer to buy the bond at the stated price. Examples
are Canada Savings Bonds (CSBs).
• A stripped real-return bond is a zero coupon bond
with inflation protection.
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20.6 Direct Placement Compared to Public Issues
1.
2.
1.
2.
3.
There are two basic forms of direct private long-term
financing:
Term loans
Private placements
Differences between direct private long-term financing and
public issues of debt are:
Registration costs are lower for direct financing.
Direct financing is likely to have more restrictive
covenants.
It is easier to renegotiate a term loan or a private placement
in the event of default.
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20.7 Long-Term Syndicated Bank Loans
• A syndicated loan is a corporate loan made by a
group (or syndicate) of banks and other institutional
investors.
• A syndicated loan may be publicly traded.
• It may be a line of credit and be “undrawn” or it
may be drawn and be used by a firm.
• Syndicated loans are always rated investment grade.
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20.8 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
favour 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.
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20.8 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 interestrate changes.
• There are many different types of bonds, including
floating-rate bonds, deep-discount bonds, and
income bonds.
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