CHAPTER 7
CORPORATE DEBT INSTRUMENTS
ANSWERS TO QUESTIONS FOR CHAPTER 7
(Questions are in bold print followed by answers.)
2. Answer the following questions.
(a) What is meant by a make-whole premium provision?
Instead of a specified fixed premium that must be paid by the issuer if the bond is called, a bond
may have a make-whole premium provision, also called a yield-maintenance premium provision.
The provision specifies a formula for determining the premium that the issuer must pay to call an
issue and is such that the amount of the premium, when added to the principal amount and
reinvested at the redemption date in U.S. Treasury securities having the same remaining life,
would provide a yield equal to the original yield. The premium plus the principal at which the
issue is called is referred to as the make-whole redemption price.
(b)What is the purpose of this provision?
The purpose of the make-whole premium is to protect the yield of those investors who purchased
the issue at issuance.
4. Answer the following questions.
(a)What is a bullet bond?
Beginning in early 1986 a number of industrial companies issued long-term debt with extended
call protection, not refunding protection. In Wall Street, these noncallable-for-life issues are
referred to as bullet bonds.
(b) Can a bullet bond be redeemed prior to the stated maturity date?
Some bullet bonds are noncallable for the issue’s life as the prospectus expressly prohibits
redemption prior to maturity. Other issues carry limited call protection and can be called after a
period of time.
6. Who are the companies that assign ratings to debt obligations?
A number of nationally recognized rating companies perform credit analysis and issue their
conclusions in the form of ratings. The three commercial rating companies are Moody’s
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Investors Service, Standard & Poor’s Corporation, and Fitch Ratings.
While some large institutional investors and many investment banking firms have their own
credit analysis departments, most institutional bond investors and individual investors rely
primarily on the nationally recognized rating companies to perform their credit analysis.
8. Answer the following questions.
(a) What is event risk?
Event risk refers to the possibility of an event occurring that will lead investors to doubt the
ability of an issuer to make interest and principal payments. Event risk can occur because of (i) a
natural or industrial accident or some regulatory change, or (ii) a takeover or corporate
restructuring. Event risk can have spillover effects on other firms. A nuclear accident, for
example, will affect all utilities producing nuclear power.
(b) Give two examples of event risk.
The first type of event risk is a natural or industrial accident or regulatory change. Examples of
this type are a change in the accounting treatment of loan losses for commercial banks or
cancellation of nuclear plants by public utilities.
A second type of event risk is a takeover or corporate restructuring. An example of this type is
the 1988 takeover of RJR Nabisco through a leveraged buyout. The new company took on a
substantial amount of debt incurred to finance the acquisition of the firm causing its bond quality
rating to be reduced. The yield spread to a benchmark Treasury increased from about 100 basis
points to 350 basis points.
10. Answer the following questions.
(a) What is a payment-in-kind bond?
In an 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. 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.
(b) An investor who purchases a payment-in-kind bond will find that increased interest
rate volatility will have an adverse economic impact. If interest rates rise substantially,
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there will be an adverse consequence. So too will a substantial decline in interest rates have
adverse consequences. Why?
In general, increased interest rate volatility causes problems for companies who base projections
on expectations of changes in interest rates. Investors can observe that an increase in interest
rates will cause borrowing rates to increase for companies who go to the debt market to obtain
funds. Investors can also observe the problems that deflation will cause since it becomes more
difficult for firms to increase prices even though they have locked in higher rates of borrowing.
For someone who purchases a payment-in-kind bond (called a PIK bond for short), economic
stability is important since the company issuing payment-in-kind bonds needs a stable economic
environment. Due to the design of payment-in-kind bonds, the adverse interest rate volatility
may not actually impact the payments promised to payment-in-kind bond owners. However, the
long-run economic well-being of the company is jeopardized and this can impact the probability
that payment-in-kind bond owners will be paid in a timely fashion.
12. Answer the following questions pertaining to the private-placement corporate debt
market.
(a) Do you agree or disagree with the following statement? “Since Rule 144A became
effective, all privately placed issues can be bought and sold in the market.”
As seen in the discussion that follows, one would disagree with the statement because not all
privately placed issues are Rule 144A private placements (which are the only private placements
eligible for trading).
Securities privately placed are exempt from registration with the SEC because they are issued in
transactions that do not involve a public offering. The private-placement market has undergone a
major change since the adoption of SEC Rule 144A in 1990, which allows the trading of
privately placed securities among qualified institutional buyers. However, not all private
placements are Rule 144A private placement. Consequently, the private-placement market can
be divided into two sectors. First is the traditional private-placement market, which includes non144A securities. For this market privately placed issues cannot be bought and sold in the market
among qualified institutional buyers. Second is the market for 144A securities. For this market
privately placed issues can be bought and sold in the market among qualified institutional
buyers.
(b) Do you agree or disagree with the following statement? “Traditionally privately placed
issues are now similar to publicly offered securities.”
The private-placement market includes the Rule 144A private placements and the traditional
private-placement market (which includes non-144A securities). Thus, any changes in the
differences and similarities between the private-placement and the publicly offered securities
market largely concern the Rule 144A private placement. While there are now more similarities,
significant differences still exist today between the Rule 144A privately placed issues and
publicly offered securities. The similarities and differences are described below.
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Rule 144A private placements are now underwritten by investment bankers on a firm
commitment basis, just as with publicly issued bonds. The features in these issues are similar to
those of publicly issued bonds. For example, the restrictions imposed on the borrower are less
onerous than for traditional private-placement issues. For underwritten issues, the size of the
offering is comparable to that of publicly offered bonds.
However, unlike publicly issued bonds, the issuers of privately placed issues tend to be less well
known. In this way, the private-placement market shares a common characteristic with the bank
loan market. Borrowers in the publicly issued bond market are typically large corporations.
Issuers of privately placed bonds tend to be medium-sized corporations. Those corporations that
borrow from banks tend to be small corporations.
Although the liquidity of privately placed issues has increased since Rule 144A became
effective, it is still not comparable to that of publicly offered issues. Yields on privately placed
debt issues are still higher than those on publicly offered bonds. However, one market observer
reports that the premium that must be paid by borrowers in the private placement market has
decreased as investment banking firms have committed capital and trading personnel to making
markets for securities issued under Rule 144A.10.
14. What is meant by a default loss rate and how is it computed?
The default loss rate attempts to measure the sum of the default loss of principal and the default
loss of coupon. It is a better measure of loss than simply looking at default rates where most of
the research on the high-yield-bond sector focuses. From an investment perspective, default rates
by themselves are not of paramount significance: It is perfectly possible for a portfolio of highyield bonds to suffer defaults and to outperform Treasuries at the same time, provided that the
yield spread of the portfolio is sufficiently high to offset the losses from default. Furthermore,
because holders of defaulted bonds typically recover a portion of the par amount of their
investment, the default loss rate is lower than the default rate. Therefore, focusing exclusively on
default rates merely highlights the worst possible outcome that a diversified portfolio of highyield bonds would suffer, assuming that all defaulted bonds would be totally worthless.
The methodology for computing the default loss rate, developed by Edward Altman, is as
follows. First, the default loss of principal is computed by multiplying the default rate for the
year by the average loss of principal. The average loss of principal is computed by first
determining the recovery per $100 of par value. The recovery per $100 of par value uses the
weighted average price of all issues after default. The difference between par value of $100 and
the recovery of principal is the default loss of principal. Next the default loss of coupon is
computed. This is found by multiplying the default rate by the weighted average coupon rate
divided by 2 (because the coupon payments are semiannual).The default loss rate is then the sum
of the default loss of principal and the default loss of coupon.
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16. What is meant by an issue or issuer being placed on a credit watch?
Being placed on a credit watch means the issue or issuer is under review for a possible change in
rating. Rating agencies monitor the bonds and issuers that they have rated, and they can issue a
watch at any time while reviewing a particular credit rating. It may go even further and state that
the outcome of the review may result in a downgrade (i.e., a lower credit rating being assigned)
or upgrade (i.e., a higher credit rating being assigned).
18. What is the difference between a credit rating and recovery rating?
Recovery ratings were developed in response to the market’s need for more information for
particular bond issues than could be supplied by a credit rating. While a credit rating can provide
guidance on recovery if a firm is in default, a recovery rating corresponds to a specific range of
recovery values. More details are given below.
While credit ratings provide guidance for the likelihood of default and recovery given default,
the market needed better recovery information for specific bond issues. In response to this need,
two ratings agencies, Standard & Poor’s and Fitch, developed recovery rating systems for
corporate bonds. Standard & Poor’s introduced recovery ratings in December 2003 for secured
debt using an ordinal scale of 1+ through 5.
In July 2005, Fitch introduced a recovery rating system for corporate bonds rated single B and
below. The factors considered in assigning a recovery rating to an issue by Fitch are (1) the
collateral, (2) the seniority relative to other obligations in the capital structure, and (3) the
expected value of the issuer in distress. The recovery rating system does not attempt to precisely
predict a given level of recovery. Rather, the ratings are in the form of an ordinal scale and
referred to accordingly as a Recovery Ratings Scale. Despite the recovery ratings being in
relative terms, Fitch also provides recovery bands in terms of securities that have characteristics
in line with securities historically recovering current principal and related interest.
20. Answer the following questions.
(a) In what ways does an MTN differ from a corporate bond?
There are four ways that an MTN differs from a corporate bond. First, corporate bonds generally
have a longer maturity than a medium-term note (MTN). With shorter maturities and an upward
sloping yield curve, MTNs tend to have lower coupon rates if everything else is equal.
Second, medium-term notes differ from corporate bonds in the manner in which they are
distributed to investors when they are initially sold. Although some investment-grade corporate
bond issues are sold on a best-efforts basis, typically they are underwritten by investment
bankers. Traditionally, MTNs have been distributed on a best-efforts basis by either an
investment banking firm or other broker/dealers acting as agents.
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Third, MTNs are usually sold in relatively small amounts on a continuous or an intermittent
basis, whereas corporate bonds are sold in large, discrete offerings. MTNs are offered
continuously to investors by an agent of the issuer. Investors can select from several maturity
ranges: 9 months to 1 year, more than 1 year to 18 months, more than 18 months to 2 years, and,
on rare occasions, up to 30 years and even longer.
Fourth, on occasion, MTNs can offer advantages in terms of cost and flexibility. When the
treasurer of a corporation is contemplating an offering of either an MTN or corporate bonds,
there are two factors that affect the decision. The most obvious is the cost of the funds raised
after consideration of registration and distribution costs. This cost is referred to as the all-in-cost
of funds. The second is the flexibility afforded to the issuer in structuring the offering. The
tremendous growth in the MTN market is evidence of the relative advantage of MTNs with
respect to cost and flexibility for some offerings. However, the fact that there are corporations
that raise funds by issuing both bonds and MTNs is evidence that there is no absolute advantage
in all instances and market environments.
(b) What derivative instrument is commonly used in creating a structured MTN?
The most common derivative instrument used in creating structured notes is a swap. More details
on MTNs and their relationship with the derivative markets are given below.
At one time the typical MTN was a fixed-rate debenture that was noncallable. It is common
today for issuers of MTNs to couple their offerings with transactions in the derivative markets
(options, futures/forwards, swaps, caps, and floors) so as to create debt obligations with more
interesting risk-return features than are available in the corporate bond market. Specifically, an
issue can be floating-rate over all or part of the life of the security, and the coupon reset formula
can be based on a benchmark interest rate, equity index or individual stock price, a foreign
exchange rate, or a commodity index. Inverse floaters are created in the structured MTN market.
MTNs can have various embedded options included.
MTNs created when the issuer simultaneously transacts in the derivative markets are called
structured notes. As stated above, the most common derivative instrument used in creating
structured notes is a swap. The development of the MTN market has been fostered by
commercial banks involved in the swap market. By using the derivative markets in combination
with an offering, borrowers are able to create investment vehicles that are more customized for
institutional investors to satisfy their investment objectives, even though they are forbidden from
using swaps for hedging. Moreover, it allows institutional investors who are restricted to
investing in investment-grade debt issues the opportunity to participate in other asset classes to
make a market play. For example, an investor who buys an MTN whose coupon rate is tied to the
performance of the S&P 500 is participating in the equity market without owning common stock.
If the coupon rate is tied to a foreign stock index, the investor is participating in the equity
market of a foreign country without owning foreign common stock. In exchange for creating a
structured note product, borrowers can reduce their funding costs.
Because of the small size of an offering and the flexibility to customize the offering in the swap
market, investors can approach an issuer through its agent about designing a security for their
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needs. This process of customers inquiring of issuers or their agents to design a security is called
a reverse inquiry. Transactions that originate from reverse inquiries account for a significant
share of MTN transactions.
22. What is reverse inquiry?
In a typical offering of a corporate bond, the sales force of the underwriting firm will solicit
interest in the offering from its customer base. That is, the sales force will make an inquiry. In
the structured note market, the process is often quite different. Because of the small size of an
offering and the flexibility to customize the offering in the swap market, investors can approach
an issuer through its agent about designing a security for their needs. This process of customers
inquiring of issuers or their agents to design a security is called a reverse inquiry. Transactions
that originate from reverse inquiries account for a significant share of MTN transactions.
24. What is the difference between directly placed paper and dealer-placed paper?
Commercial paper is classified as either direct paper or dealer-placed paper. Directly placed
paper is sold by the issuing firm directly to investors without the help of an agent or an
intermediary. (An issuer may set up its own dealer firm to handle sales.) A large majority of the
issuers of direct paper are financial companies. These entities require continuous funds in order
to provide loans to customers. As a result, they find it cost-effective to establish a sales force to
sell their commercial paper directly to investors. Dealer-placed paper requires the services of an
agent to sell an issuer’s paper. The agent distributes the paper on a best efforts underwriting basis
by commercial banks and securities houses.
26. Why does commercial paper have a maturity of less than 270 days?
In the United States, commercial paper ranges in maturity from 1 day to 270 days. The reason
that the maturity of commercial paper does not exceed 270 days is as follows. The Securities Act
of 1933 requires that securities be registered with the SEC. Special provisions in the 1933 act
exempt commercial paper from registration as long as the maturity does not exceed 270 days.
Hence, to avoid the costs associated with registering issues with the SEC, firms rarely issue
commercial paper with maturities exceeding 270 days. Another consideration in determining the
maturity is whether the commercial paper would be eligible collateral for a bank that wanted to
borrow from the Federal Reserve Bank’s discount window. To be eligible, the maturity of the
paper may not exceed 90 days. Because eligible paper trades at lower cost than paper that is not
eligible, issuers prefer to issue paper whose maturity does not exceed 90 days.
28. Answer the following questions.
(a) What is the difference between a liquidation and a reorganization?
First, there is a difference in how the absolute priority rule holds. A corporate debt obligation can
be secured or unsecured. In the case of a liquidation, proceeds from a bankruptcy are distributed
to creditors based on the absolute priority rule. However, in the case of a reorganization, the
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absolute priority rule rarely holds. That is, an unsecured creditor may receive distributions for the
entire amount of his or her claim and common stockholders may receive something, while a
secured creditor may receive only a portion of its claim. The reason is that a reorganization
requires approval of all the parties. Consequently, secured creditors are willing to negotiate with
both unsecured creditors and stockholders in order to obtain approval of the plan of
reorganization.
Second, there is a difference in outcome as to what happens to the company being liquidated
versus the company being reorganized. The liquidation of a corporation means that all the assets
will be distributed to the holders of claims of the corporation and no corporate entity will
survive. In a reorganization, a new corporate entity will result. Some holders of the claim of the
bankrupt corporation will receive cash in exchange for their claims; others may receive new
securities in the corporation that results from the reorganization; and still others may receive a
combination of both cash and new securities in the resulting corporation.
(b)What is the difference between a Chapter 7 and Chapter 11 bankruptcy filing?
The law governing bankruptcy in the United States is the Bankruptcy Reform Act of 1978. The
bankruptcy act is composed of 15 chapters, each chapter covering a particular type of
bankruptcy. Of particular interest are two chapters, Chapter 7 and Chapter 11. Chapter 7 deals
with the liquidation of a company; Chapter 11 deals with the reorganization of a company. Thus,
for a Chapter 7 bankruptcy filing, the spotlight is on rules governing liquidations; for a Chapter
11 bankruptcy filing, the focus is on rules governing reorganizations.
30. What is the principle of absolute priority?
When a company is liquidated, creditors receive distributions based on the absolute priority rule
to the extent that assets are available. The absolute priority rule is the principle that senior
creditors are paid in full before junior creditors are paid anything. For secured creditors and
unsecured creditors, the absolute priority rule guarantees their seniority to equity holders.
In liquidations, the absolute priority rule generally holds. In contrast, there is a good body of
literature that argues that strict absolute priority has not been upheld by the courts or the SEC.
Studies of actual reorganizations under Chapter 11 have found that the violation of absolute
priority is the rule rather the exception.
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32. Give three reasons to explain why absolute priority might be violated in a
reorganization.
When a company is liquidated, creditors receive distributions based on the absolute priority rule
to the extent that assets are available. The absolute priority rule is the principle that senior
creditors are paid in full before junior creditors are paid anything. There are four hypotheses that
have been suggested as to why in a reorganization the distribution made to claimholders will
diverge from that required by the absolute priority principle. Each of these hypothesis suggests a
reason for why absolute priority might be violated in a reorganization. These hypotheses are
described below.
The incentive hypothesis argues that the longer the negotiation process among the parties, the
greater the bankruptcy costs and the smaller the amount to be distributed to all parties.
The recontracting process hypothesis argues that the violation of absolute priority reflects a
recontracting process between stockholders and senior creditors that give recognition to the
ability of management to preserve value on behalf of stockholders.
According to the stockholders’ influence on the reorganization plan hypothesis, creditors are less
informed about the true economic operating conditions of the firm than management. This leads
to violation of the absolute priority rule.
The strategic bargaining process hypothesis advocates that the increasing complexity of firms
that declare bankruptcy will accentuate the negotiating process and result in an even higher
incidence of violation of the absolute priority rule.
Consequently, although investors in the debt of a corporation may feel that they have priority
over the equity owners and priority over other classes of debtors, the actual outcome of a
bankruptcy may be far different from what the terms of the debt agreement state.
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