Chapter 18
Corporate Bonds
Corporate Bond Basics
• Bonds = debt of a corporation
• Bond cash flows:
• Periodic interest or coupon payments
• Repayment of the principal or face value at
maturity
• Bonds = “fixed income”
• Predictable cash flows
• Most corporate bonds callable
18-2
Corporate Bond Basics
• There are several trillion dollars of corporate
bonds outstanding in the United States.
• More than half of these are owned by life
insurance companies and pension funds.
• These institutions can eliminate much of their
financial risk via cash flow matching.
• They can also diversify away most default risk by
including a large number of different bond issues
in their portfolios.
18-3
Corporate Bond Basics
• Corporate bonds differ from common stock in
three fundamental ways.
Corporate Bonds
Common Stock
Represents an
Represent a creditor’s
claim on the corporation ownership claim on the
corporation
Amount and timing of
Promised cash flows
(coupons and principal) dividends may change
at any time
are stated in advance
Mostly callable
Almost never callable
18-4
Corporate Bond Types
• “Plain vanilla bonds” or “bullet” bonds
• “Bullet” bonds
• Issued with standard, simple features
Corporate Bond Type
Debentures
Mortgage Bonds
Collateral trust bonds
Equipment trust certificates
Secured by
Unsecured
Lien on specific property
Pledge of financial assets
Trustee owned equipment
18-5
Tombstone Ad, Equipment Trust
Notes Issue
18-6
The Bond Indenture
• Formal written agreement between
corporation and the bondholders
• Legal document
• Details mutual rights and obligations
of corporation and bondholders
• “Indenture Summary” in Prospectus
18-7
Seniority Provisions
• Critical in event of bankruptcy
• Secured debt has first claim on
pledged assets
• Unsecured debt
• Senior debentures
• Protected by a negative pledge clause
• Subordinated debentures
18-8
Put and Call Provisions
• Put Provisions
• Put dates and prices
• Extendible bonds
• Call Provisions
• Bond refunding
• Traditional fixed-price call provisions
• Deferred call - Call protection period
• Call premium
• Refunding provision
18-9
Maximum Price of a Fixed-Price
Callable Bond
• No matter how low market interest rates fall, the maximum price
of an unprotected fixed-price callable bond is most likely its call
price.
18-10
Make-Whole Call Provision
• Bondholder “made-whole” if called
• Lump sum payment = present value of all
payments that will not be made as a result of
the call
• Discount rate = rate on comparable U.S.Treasury
plus a make-whole premium
• Minimum = par value of bond
• As interest rates , the make-whole call price 
• Bonds still exhibit the standard convex price-yield
relationship in all yield regions.
18-11
Make-Whole Call Example
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Settlement date
First payment
Maturity
Coupon
Price
Yield
Spread
Make-Whole call
Ratings
07/01/2008
01/01/2009
07/01/2013
5.00%
98%
5.4625%
90 bp > U.S. T-notes
20 bp > U.S. T-notes
BBB
18-12
Make-Whole Call Example
• Comparable treasury yield
5.4625% - .90% = 4.5625%
• Make-whole premium
4.5625% + .20% = 4.7625%
• Make-whole price
N
10
I/Y
4.7625/2
PV
CPT=-1010.4571
PMT
25
FV
1000
101.0457 % of par
• Make-whole $ premium
1010.46 – 980.00 = $30.46 per bond
•
Excel:
=PRICE(“07/01/2008”,”07/01/2013”,0.05,0.047625,100,2)
18-13
Tombstone Ad, Convertible
Notes Issue
18-14
Convertible Bond Prices and
Conversion Values
18-15
Tombstone Ad,
Exchangeable Debenture Issue
18-16
Convertible Bonds
• Can be exchanged for common stock
• Conversion ratio:
# shares acquired by conversion
Fixed at origination
Normally set = 10-20% less than par
• Conversion price:
Bond par value/Conversion ratio
• Conversion value:
Stock price/share x conversion ratio
18-17
18-17
Bond-to-Stock Conversions
• Timing decisions
• Delay as long as possible vs. call provision
• Normally called when conversion value is
10-15% > par
• Call immediate decision to surrender or
convert
• “In-the-money”:
• Conversion value >call price
18-18
Convertible Bond Example
• Suppose you own a convertible bond with the
following features:
Par value
Call premium
Conversion ratio
Conversion price
Current stock price
Conversion value/bond
$1,000
$25
25 shares
$1,000/25=$40
$35
$35 x 25 = $875
• At what stock price should you expect a call?
• If called at 10%>par, convert or surrender?
18-19
Convertible Bond Example
Par value
Call premium
Conversion ratio
Conversion price
$1,000
$25
25 shares
$1,000/25=$40
• At what stock price should you expect a call?
• 10-15% >par = $1,100 – 1,150
• $1,100/25 = $44
• If called at $44/share, you should convert:
• Conversion value = $44 x 25 = $1,100
• Call price = $1,025
18-20
Bond Maturity and Principal
Payment Provisions
• Term bonds
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Most common structure
All bonds in issue have same maturity date
Usually have a call provision
Sinking fund
• Serial Bonds
• Fraction of issue matures each year
• =collection of “sub-issues”
• Usually do not have a call provision
18-21
Bond Maturity and Principal
Payment Provisions
• Sinking Fund provisions
• Required periodic payments to a trusteemanaged account
• Funds used for scheduled redemptions of
outstanding bonds
• Bonds may be redeemed by
• Lottery
• Open market purchase
18-22
Bond Maturity and Principal
Payment Provisions
• Coupon payment provisions
• Schedule in bond indenture
• If payment missed, issuer in default
• Protective covenants
• Helps protect bondholders from event risk
• Negative covenant = “thou shalt not”
• Positive covenant = “thou shalt”
18-23
Protective Covenants
• Negative covenant (“thou shalt not”)
• Firm cannot pay common stock dividends
in excess of earnings formula allowance
• Positive covenant (“thou shalt”)
• Proceeds from the sale of assets must be
used either to acquire other assets of equal
value or to redeem outstanding bonds.
18-24
18-24
Event Risk
• The possibility that the issuing corporation will
experience a significant change in its bond
credit quality
• Example:
• October 1992: Marriott Corporation announced its
intention to spin off part of the company.
• Spinoff = Host Marriott = would acquire most of the
parent company’s debt and its poorly performing
real estate holdings.
• Host Marriott bonds riskier than Marriott
Corporation bonds
18-25
18-25
Private Placements
• No indenture
• Exempt from SEC registration
requirements
• Simple IOU by issuer to one ore more
financial institutions.
• Most long term debt = bonds with indentures
• Most privately-placed short-term debt =
simple IOU
18-26
Preferred Stock
• Hybrid security
• Bond-like
• Usually no voting rights
• Promised a stream of fixed dividend payments
• Stock-like
• Usually no specified maturity but often callable
• Dividends may be suspended without setting off
bankruptcy process
• Dividends usually cumulative
• Convertible preferred stock
18-27
Adjustable Rate Securities
• Allows issuer to adjust annual coupon rate
• Formula based on current market interest rates
• Bonds, notes or preferred stock =“Floaters”
• Usually putable at par value
• Examples of coupon reset formulas:
• Annually to the current rate on 180-day maturity
U.S. T-bills plus 2%
• Rate cannot be set below 105% of the YTM on
newly issued 5-year Treasury notes.
18-28
Corporate Bond Credit Ratings
• Assessment of the credit quality of a bond
issue based on the issuer’s financial
condition
• Rate new bond issues for a fee paid by
issuer
• Contractual agreement includes right to
continuing review
• “Prudent investment guidelines”
18-29
Corporate Bond Credit Rating
Symbols
18-30
Investment-Grade Bond Ratings
Rating Agency
Moody's
D&P
S$P Credit Rating Description
Investment-Grade Bond Ratings
Aaa
1
AAA Highest credit rating; maximum safety
Aa1
2
AA+
Aa2
3
AA
High credit quality, investment-grade bonds
Aa3
4
AAA1
5
A+
A2
6
A
Upper medium quality, investment-grade bonds
A3
7
ABaa1
8
BBB+
Baa2
9
BBB Lower medium quality, investment-grade bonds
Baa3
10
BBB-
18-31
Speculative-Grade Bond Ratings
Rating Agency
Moody's
D&P
S$P
Credit Rating Description
Speculative-grade Bond Ratings
Ba1
11
BB+
Low credit quality, speculative-grade bonds
Ba2
12
BB
Ba3
13
BBB1
14
B+
Very low credit quality, speculative-grade bonds
B2
15
B
B3
16
BExtremely Speculative-Grade Bond Ratings
Caa
17
CCC+ Extremely low credit standing, high-risk bonds
CCC
CCCCa
CC
Extremely speculative
Ca
C
D
Bonds in default
18-32
“Junk Bonds”
• Moody’s Ba or lower
• S&P BB or lower
• “High-yield bonds”
• “Fallen angels”
• Original-issue junk
• Yield premium high enough to accept risk
18-33
The Yield Spread
• Extra return (>yield to maturity) investors
demand for buying a bond with a lower
credit rating (and higher risk)
• Often quoted in basis points over Treasury
notes and bonds
5-year Aaa/AAA yield spread equal to 59
YTM on bond = 59 basis points
(0.59%) greater than 5-year U.S.
Treasury notes
18-34
18-34
The Yield Spread
Please insert the art from
Work the Web (pg. 602 in
First Revision) into this
slide.
.
18-35
Corporate Bond Market Trading
• Relatively low liquidity
• NYSE bond trading
• Most active issues/Large corporations
• <1% of all corporate bond trading
• Other-the-counter market (OTC)
• Limited transparency pre-2002
• TRACE – Trade Reporting and Compliance
Engine
18-36
Trade Reporting and Compliance
Engine (TRACE)
• At the request of the SEC, corporate bond trades
are now reported through TRACE.
• TRACE provides a means for bond investors to get
accurate, up-to-date price information.
• TRACE has dramatically improved the information
available about bond trades.
• Transaction prices now reported on > 4,000 bonds
• About 75% of market volume for investment grade bonds.
• More bonds will be added to TRACE over time.
18-37
Useful Websites
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www.investinginbonds.com (for more information on corporate bonds)
www.sec.gov (U.S. Securities and Exchange Commission)
www.bondsonline.com (follow the "corporate bond spreads" link)
www.nasdbondinfo.com (for TRACE data on bond trades)
Websites for companies in this chapter:
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www.nwa.com (Northwest Airlines)
www.amd.com (Advanced Micro Devices)
www.marriott.com (Marriott International, Inc.)
www.hostmarriott.com (Host Marriott Corporation)
Websites for Ratings Agencies:
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www.duffllc.com (Duff and Phelps, LLC.)
www.fitchibca.com (Fitch Investors Service)
www.moodys.com (Moody’s)
www.standardpoors.com (Standard & Poor’s)
18-38