Corporate Debt Instruments
Zvi Wiener
Based on Chapter 7 in Fabozzi
Bond Markets, Analysis and Strategies
Fall-02
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
EMBAF
Corporate Debt
Financial obligations of a corporation that have
priority over its common stock and
preferred stock in the case of bankruptcy.
A.
B.
C.
D.
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Corporate bonds
Medium-term notes
Commercial papers
Asset-backed securities
Fabozzi Ch 7
slide 2
Major groups of issuers
A.
B.
C.
D.
E.
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Utilities
Transportation
Industrials
Banks and finance companies
~communication
Fabozzi Ch 7
slide 3
Features of Corporate Bonds
(indentures)
Corporate trustee – represents bondholders
Term bonds – maturity
Under 10 years – notes
Some bonds have specific collateral
Others are debentures
Guaranteed bonds (third party’s guarantees)
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Fabozzi Ch 7
slide 4
Call provision
Company can retire the debt before maturity.
This is an option and makes the debt more
expensive.
Sinking fund provision – predetermined.
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Fabozzi Ch 7
slide 5
Bond Provisions
Sinking fund provision sometimes the issuer
is required to retire a portion of an issue each
year.
either by cash payment to bondholders (lottery)
or by buyback bonds
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Fabozzi Ch 7
slide 6
Bond Rating
Standard and Poors
Moody’s Investor Service
Fitch
Duff and Phelps
‫מעלות‬
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Fabozzi Ch 7
slide 7
Investment Grade
Moody’s
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
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S&P=F=D&P
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBBFabozzi Ch 7
slide 8
Speculative Grade
Moody’s
Ba1
Ba2
Ba3
B1
B2
B3
Caa
Ca
C
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S&P=F=D&P
BB+
BB
BBB+
B
BCCC+
CCC
CCCCC
C
Fabozzi Ch 7
slide 9
High Yield Bonds
LBO, downgrading, refinancing
fallen angels
deferred interest bonds
Step-up bonds pay initially low interest which
increases with time
Spreads as a measure of risk and premium.
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Fabozzi Ch 7
slide 10
Transition Matrix
One year transition matrix (very old)
Start\end
Aaa Aa
Aaa
91.9 7.38 0.72 0.00 0.00 0.00 0.00
Aa
1.13 91.26 7.09 0.31 0.21 0.00 0.00
A
0.10 2.56 91.20 5.33 0.61 0.20 0.00
Baa
0.00 0.21 5.36 87.94 5.46 0.82 0.21
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A
Baa
Fabozzi Ch 7
Ba
B
C&D
slide 11
Default Rates
??????
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Fabozzi Ch 7
slide 12
Loss Given Default
??????
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Fabozzi Ch 7
slide 13
SEC rule 144A
Allows to trade private placements among
qualified institutions.
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Fabozzi Ch 7
slide 14
Medium Term Notes (MTN)
Notes are registered with the SEC under Rule
415 (the shelf registration) and are offered
continuously to investors by an agent of the
issuer.
Maturities vary from 9 months to 30 years.
Can be either fixed or floating.
Very flexible way to raise debt!
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Fabozzi Ch 7
slide 15
Primary Market (MTN)
Issuer posts spreads over Treasuries for a
variety of maturities.
Then an agent tries to find an investor.
Minimal size is between $1M and $25M.
The schedule can be changed at any time!
Often structured MTNs are used (caps, floors,
etc.) = structured notes.
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Fabozzi Ch 7
slide 16
Structured Notes
Many institutional investors can use swaps
and structured notes to participate in markets
that were prohibited.
Another use of structured notes is in risk
management.
Financial Engineering is used to create
securities satisfying the needs of investors.
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Fabozzi Ch 7
slide 17
Commercial Papers
Short term debt issued with less
documentation typically by large and stable
corporations for up to 270 days.
Much cheaper borrowing than banks.
Bridge financing.
Rollover Risk
An alternative to CD.
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Fabozzi Ch 7
slide 18
Commercial Papers
Short term unsecured promissory note
An alternative to short term bank borrowing
A typical round-lot transaction is $100,000
In the USA maturity is up to 270 days
Requires less paperwork
Those with maturity up to 90 days can be
used as collateral for FED discount window.
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Fabozzi Ch 7
slide 19
Commercial Papers
Typically rolled over
Rollover risk is backed by an unused bank credit
line
In order to issue CP one need either a high rating
or good collateral
Sometimes credit enhancement is used (LOC)
CP issued in the USA by foreigners are called
Yankee CP
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Fabozzi Ch 7
slide 20
Commercial Papers
Between 71 an 89 there was one default on CP.
3 defaults occurred in 89 and 4 in 90
Direct paper is sold without an agent
Secondary market is thin
There is a special rating for CP, P-1,3, A-1,3
discount instruments, used by money market
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Fabozzi Ch 7
slide 21
Bankruptcy and Creditor rights
Liquidation (Chapter 7)
Reorganization (Chapter 11)
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Fabozzi Ch 7
slide 22
Bankruptcy and Credit Rights
liquidation - all assets will be distributed
reorganization - a new corporate entity will
result
a company that files for protection becomes a
debtor in possession and continues to operate
under the supervision of the court
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Fabozzi Ch 7
slide 23
Bankruptcy and Credit Rights
Absolute priority rule - senior creditors are
paid in full before junior creditors are paid
anything.
Works in liquidation but often does not work
in reorganization.
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Fabozzi Ch 7
slide 24
Merton’s model
$
firm
equity
debt
D
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V
Fabozzi Ch 7
slide 25
Home Assignment
Chapter 7
Questions 10, 21, 25
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Fabozzi Ch 7
slide 26