VI: Debt Market Instruments
19: Corporate Bonds
Corporate Bonds
 Risk Structures
 Convertibles
Chapter 19: Corporate Bonds
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Risk Structures
Promised Yield to Maturity
 Not all bonds pay as promised.
 Enron filed for bankruptcy
December 2, 2001
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
Enron
$100
On December 14,
the promised YTM
was 618.755%
700%
102.4134
Price
Yield
$80
500%
400%
$60
300%
$40
200%
$20
$0
1-Oct
600%
17.7177
31-Oct
30-Nov
100%
0%
30-Dec
6.5% Enron August 1, 2002
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
Expected Yield to Maturity
 618.755% * 1% = 6.19 %
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
Enron
$100
Why would anyone
pay 17.7177 for a
bond in bankruptcy?
700%
102.4134
Price
Yield
$80
500%
400%
$60
300%
$40
200%
$20
$0
1-Oct
Chapter 19: Corporate Bonds
600%
17.7177
31-Oct
30-Nov
100%
0%
30-Dec
© Oltheten & Waspi 2012
Enron
 Buy a $1,000,000 bond flat December 14,
2001 at 17.7177
 The invoice price is $177,177.00
 Assume the bond pays nothing until
December 14, 2006 when it pays off at 24¢
on the dollar.
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
The recovery
rate is 24¢
Dec 14, 01
Aug 1, 02
Aug 1, 03
Aug 1, 04
32,500
1,032,500
0.24
10
 Y
1  
2

17.7177
 0.177177
Aug 1, 05
Aug 1, 06
Dec 14, 06
Enron
0.24
Y  6.16%
Even a bond in bankruptcy can yield a positive yield
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
Risk Structures
 The Yield on a Corporate Bond depends on






Term to Maturity  This dimension gives us
the term structure or yield
Coupon Rate
curve
Call Provisions
Liquidity
Default Risk This dimension gives us the risk
structure
Tax Status
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
Yield Spread
 6% 2023 IBM Bond YTM=8 ½%
 6% 2023 T-Bond YTM=6
Coupon
Rate is
the
same.
Maturity
is the
same
The Yield
Spread is 2½%
or 250 basis
points
So any difference in yield is due to the
difference in risk
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
Risk of Default - IBM
 There is a 6% probability that IBM will
default on its bond.
 6% probability of 0.00%
 94% probability of 8.50%
 Risk adjusted Expectation of 7.99%
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
IBM
8.50% (Promised YTM)
Spread
= 250 bp
7.99% (Expected YTM)
6.00% T-Bond YTM
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
Risk of Default – Fly-By-Night
 Fly-By-Night trades at 9.99%. There is a 20%
probability that will default on its bond.
 20% probability of 0.00%
 80% probability of 9.99%
 Risk adjusted Expectation of 7.99%
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
Fly-By-Night
9.99% (Promised YTM)
Spread
= 399 bp
7.99% (Expected YTM)
6.00% T-Bond YTM
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
Market Forces
 IBM



6% * 0.00%
94% * 8.50%
E[Y] = 7.99%
 Fly-By-Night
 20% * 0.00%
 80% * 12.00%
 E[Y] = 9.60%
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
IBM & Fly-By-Night
9.99%
(Fly-By-Night)
Default
Premium
=
8.50%
(IBM)
7.99%
(Expected YTM)
Risk
Premium
=
6.00%
(T-Bond YTM)
Chapter 19: Corporate Bonds
Default
Premium
=
Risk
Premium
=
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Speculative Ventures
 If the Speculative Ventures 6% 2023 bond
trades at 12% yield what does the market
think is the probability of default?
Chapter 19: Corporate Bonds
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Convertible Bonds
Convertible
 Convertible Bonds may be turned into the
issuer in exchange for other assets –
generally common shares
Chapter 19: Corporate Bonds
© Oltheten & Waspi 2012
Fly By Night
 The indenture specifies that Fly By Night
bonds may be converted to common shares
at $50 per share
 The common share currently trades at
$51.50
 $1000 bond -> 20 shares
 20 shares * $51.50/share = $1,030.00
 The conversion value of the bond is
$1,030.00
Chapter 19: Corporate Bonds
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Questions & Problems
 Astrologer Question (19-9)
Chapter 19: Corporate Bonds
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Corporate Bonds II