Corporate Bonds

A Corporate bond is a security issued by a corporation.

It represents a promise to pay bondholders a fixed sum of money (called the bond’s principal, or par or face value) at a future maturity date, along with periodic payments of interest (called coupons).

Bonds issued with a standard, relatively simple set of features are popularly called Plain Vanilla Bonds (or “bullet” bonds).

Debentures are unsecured bonds issued by a corporation.

Mortgage bonds are debt secured with a property lien.

Collateral trust bonds are debt secured with financial collateral.

Equipment trust certificates are shares in a trust with income from a lease contract.

A Bond indenture is a formal written agreement between the corporation and the bondholders.

This agreement spells out, in detail, the obligations of the corporation, the rights of the corporation, and the rights of the bondholders (with respect to the bond issue.)

In practice, few bond investors read the original indenture. Instead, they might refer to an indenture summary provided in the prospectus of the bond issue.

Different bond issues can usually be differentiated according to the seniority of their claims on the firm’s assets in case of default.

Senior Debentures are the bonds paid first in case of default. Subordinated Debentures are paid after senior debentures.

Bond seniority may be protected by a negative pledge clause.

A negative pledge clause prohibits a new debt issue that would have seniority over existing bonds.

A traditional, fixed-price call provision allows the issuer to buy back all or part of its outstanding bonds at a specified call price sometime before the bonds mature.

When interest rates fall, bond prices increase.

The corporation can “call-in” the existing bonds, i.e., pay the call price.

The corporation can then issue new bonds with a lower coupon. This process is called bond refunding.

No matter how low market interest rates fall, the maximum price of an unprotected fixed-price callable bond is most likely its call price.

Like a fixed-price call provision, a make-whole call provision allows the issuer to pay off the remaining debt early. However,

The issuer must pay the bondholders a price equal to the present value of all remaining payments.

The discount rate used to calculate this present value is equal to: The yield of a comparable maturity U.S. Treasury security A fixed, pre-specified make-whole premium

As interest rates decrease:

the make-whole call price increases But, even in the region of low yields, these bonds still exhibit the

standard convex price-yield relationship in all yield regions.

A bond with a put provision can be sold back to the issuer at a pre-specified price (normally set at par value) on any of a sequence of pre-specified dates.

Bonds with put provisions are often called extendible bonds.

Convertible bonds are bonds that can be exchanged for common stock according to a pre-specified conversion ratio (i.e., the number of shares acquired).

Suppose the conversion ratio for a $1,000 par value bond is 20 shares.

Conversion Price = Bond Par Value / Conversion Ratio

Then, the conversion price is $50 ($1,000 / 20).

Conversion Value = Price Per Share X Conversion Ratio

If the market price per share of stock is currently $40, the conversion value is $800 ($40 x 20).

Bond maturity and principal payment provisions - Term bonds are issued with a single maturity date, while serial bonds are issued with a regular sequence of maturity dates.

Term bonds normally have a sinking fund, which is an account used to repay some bondholders before maturity.

Money paid into a sinking fund can only be used to pay bondholders. Some bondholders are repaid before the stated maturity of their

bonds, whether they want to be repaid or not. At maturity, only a portion of the original bond issue will still be

outstanding.

Coupon payment provisions - An exact schedule of coupon payment dates is specified.

If a company suspends payment of coupon interest, the company is said to be in default:

Bondholders have the unconditional right to timely repayment. Bondholders have the right to bring legal action to get paid. Companies in default have the right to seek protection from

inflexible bondholders in bankruptcy court.

If there is default, it is often in the best interests of the bondholders and the company to avoid court and negotiate a new bond issue to replace the existing one.

A bond indenture is likely to contain a number of protective covenants.

Protective Covenants are restrictions designed to protect bondholders.

Negative covenant (“thou shalt not”) example - The firm cannot pay dividends to stockholders in excess of what is allowed by a formula based on the firm’s earnings.

Positive covenant (“thou shalt”) example - Proceeds from the sale of assets must be used either to acquire other assets of equal value or to redeem outstanding bonds.

A Private placement is a new bond issue sold privately to one or more parties. That is, this new bond issue is not available to the general public.

Private placements are exempt from registration requirements with the SEC, although they often have formal indentures.

Debt issued without an indenture is basically a simple IOU of the corporation.

A corporation usually subscribes to several bond rating agencies for a credit evaluation of a new bond issue.

Each contracted rating agency will then provides a credit rating - an assessment of the credit quality of the bond issue based on the issuer’s financial condition.

The best known rating agencies in the U.S. are Moody’s Investors Services and Standard & Poors Corporation.

Rating agencies in the U.S. also include Duff and Phelps; Fitch Investors Service; and McCarthy, Crisanti, and Maffei.

A bond’s credit rating helps determine its yield spread.

The yield spread is the extra return (increased yield to maturity) that investors demand for buying a bond with a lower credit rating (and higher risk).

Yield spreads are often quoted in basis points over Treasury notes and bonds. That is,

Suppose we see a 5-year Aaa/AAA yield spread equal to 59. This means the YTM on this bond is 59 basis points (0.59%) greater

than 5-year U.S. Treasury notes.

High-yield bonds are bonds with a speculative credit rating (Moody’s Ba , S&P BB).

As a result of this poor credit rating, a yield premium must be offered on these bonds to compensate investors for higher credit risk.

High-yield bonds are also called junk bonds.

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 are now reported on more than 4,000 bonds That is, about 75% of market volume for investment grade bonds. More bonds will be added to TRACE over time.

www.investinginbonds.com

(for more information on corporate bonds)w

ww.sec.gov

(U.S. Securities and Exchange Commission)w

ww.convertbond.com (for more information about convertible bonds)w

ww.bondsonline.com (follow the "corporate bond spreads" link)w

ww.nasdbondinfo.com (for TRACE data on bond trades)

Websites for companies in this chapter:

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:

www.duffllc.com (Duff and Phelps, LLC.) www.fitchibca.com (Fitch Investors Service) www.moodys.com (Moody’s) www.standardpoor.com (Standard & Poor’s) www.mcmwatch.com (MCM)

Corporate Bond Basics

Types of Corporate Bonds

Bond Indentures

Bond Seniority Provisions Call Provisions

Fixed-Price Make-Whole

Put Provisions Bond-to-Stock Conversion Provisions Graphical Analysis of Convertible Bond Prices Bond Maturity and Principal Payment Provisions Sinking Fund Provisions Coupon Payment Provisions

Protective Covenants

Bonds Without Indentures

Preferred Stock

Adjustable-Rate Bonds and Adjustable-Rate Preferred Stock

Corporate Bond Credit Ratings

High-Yield (Junk) Bonds

Bond Market Trading, TRACE

Homework: 2, 7, 14

Government Bonds

In 2005, the gross public debt of the U.S. government was more than $4 trillion, making it the largest single borrower in the world.

The U.S. Treasury finances government debt by issuing marketable as well as non-marketable securities.

Municipal government debt is also a large debt market.

In the U.S., there are more than 80,000 state and local governments. Together, they contribute about $2 trillion of outstanding debt.

Marketable securities can be traded among investors.

Marketable securities issued by the U.S. Government include T-bills, T-notes, and T-bonds.

Non-marketable securities must be redeemed by the issuer.

Non-marketable securities include U.S. Savings Bonds, Government Account Series, and State and Local Government Series.

T-bills are Short-term obligations with maturities of 13, 26, or 52 weeks (when issued).

T-bills pay only their face value (or redemption value) at maturity.

Face value denominations for T-bills are as small as $1,000.

T-bills are sold on a discount basis (the discount represents the imputed interest on the bill).

T-notes are medium-term obligations, usually with maturities of 2, 5, or 10 years (when issued).

T-notes pay semiannual coupons (at a fixed coupon rate) in addition to their face value (at maturity).

T-notes have face value denominations as small as $1,000.

T-bonds are long-term obligations with maturities of more than 10 years (when issued).

T-bonds pay semiannual coupons (at a fixed coupon rate) in addition to their face value (at maturity).

T-bonds have face value denominations as small as $1,000.

STRIPS: Separate Trading of Registered Interest and Principal of Securities

STRIPS were originally derived from 10-year T-notes and 30-year T-bonds

A 30-year T-bond can be separated into 61 strips - 60 semiannual coupons + a single face value payment

STRIPS are effectively zero coupon bonds (zeroes).

The YTM of a STRIP is the interest rates the investors will receive if the STRIP is held until maturity.

What is the price of a STRIPS maturing in 20 years with a face value of $10,000 and a semiannual YTM of 7%?

The STRIPS price is calculated as the present value of a single cash flow. That is,

$2,525.72

20.071

$10,000PRICE STRIPS

40

Recall: The price of a bond is found by adding together the present value of the bond’s coupon payments and the present value of the bond’s face value.

The formula is:

In the formula, C represents the annual coupon payments (in $), FV is the face value of the bond (in $), and M is the maturity of the bond, measured in years.

2M2M

2YTM1

FV

2YTM1

11

YTM

CPriceBond

In recent years, the U.S. Treasury has issued securities that guarantee a fixed rate of return in excess of realized inflation rates.

These inflation-indexed U.S. Treasury securities:

Pay a fixed coupon rate on their current principal, and Adjust their principal semiannually according to the most

recent inflation rate

The Federal Reserve Bank conducts regularly scheduled auctions for T-bills, notes, and bonds.

4-week, 13-week, and 26-week T-bills are auctioned weekly.

2-year T-notes are auctioned monthly.

5-year and 10-year T-bonds auctions occur about four times per year for each maturity.

The U.S. Treasury posts auction FAQs, results, and other details at:

www.publicdebt.treas.gov

At each Treasury auction, the Federal Reserve accepts sealed bids of two types.

Competitive bids specify a bid price/yield and a bid quantity. Such bids can only be submitted by Treasury securities dealers.

Noncompetitive bids specify only a bid quantity, and may be submitted by individual investors.

The price and yield of the issue is determined by the results of the competitive auction process.

All noncompetitive bids are accepted automatically and are subtracted from the total issue amount.

Then, a stop-out bid is determined. This is the price at which all competitive bids are sufficient to finance the remaining amount.

Since 1998, all U.S. Treasury auctions have been single-price auctions in which all accepted bids pay the stop-out bid.

The U.S. Treasury offers an investment opportunity for individual investors by issuing two types of Savings Bonds:

Series EE Savings Bonds:

Have face value denominations ranging from $50 to $10,000, Are sold at exactly half the face value. Treasury guarantees the bond will double in value in no more

than twenty years Fixed interest rate (known at time of purchase) Earn interest for up to thirty years Accrue interest semiannually Must be held at least one year 3-month interest penalty if held for less than 5 years

Series I Savings Bonds:

Have face value denominations ranging from $50 to $10,000.

Are sold at face value. Earn interest for up to thirty years Accrue interest semiannually (the interest rate is set at a

fixed rate plus the recent inflation rate), and Can be redeemed after 12 months At redemption, the investor receives the original price plus

interest earned But, investors redeeming Series I bonds within the first 5

years of purchase incur a three-month earnings penalty

Most U.S. government agencies consolidate their borrowing through the Federal Financing Bank, which obtains funds directly from the U.S. Treasury.

However, several federal agencies are authorized to issue securities directly to the public. Examples include:

The Resolution Trust Funding Corporation The World Bank The Tennessee Valley Authority

Bonds issued by U.S. government agencies share an almost equal credit quality with U.S. Treasury issues.

They are attractive in that they offer higher yields than comparable U.S. Treasury securities.

However, the market for agency debt is less active than the market for U.S. Treasury debt.

Compared to T-bonds, agency bonds have a wider bid-ask spread.

Municipal notes and bonds, or munis, are intermediate- to long-term interest-bearing obligations of state and local governments, or agencies of those governments.

Because their coupon interest is usually exempt from federal income tax, the market for municipal debt is commonly called the tax-exempt market.

The federal income tax exemption makes municipal bonds attractive to investors in the highest income tax brackets.

However, yields on municipal debt are less than yields on corporate debt with similar features and credit quality.

The risk of default is also real despite their usually-high credit ratings.

Bonds issued by a municipality that are secured by the full faith and credit (general taxing powers) of the issuer are known as general obligation bonds (GOs).

Municipal bonds secured by revenues collected from a specific project or projects are called revenue bonds.

Example: Airport and seaport development bonds that are secured by user fees and lease revenues.

Hybrid bonds are municipal bonds secured by project revenues with some form of general obligation credit guarantees.

A common form of hybrid is the moral obligation bond.

Suppose you are trying to decide whether to buy:

A corporate bond paying an annual coupon interest of 8%, or

A municipal bond paying an annual coupon interest of 5%

How do you decide?

If the purchase was for a tax-exempt retirement account, the corporate bond is preferred because the coupon is higher.

But, if the purchase is not tax-exempt, the decision should be made on an after-tax basis.

That is, you must calculate an equivalent taxable yield oryou must calculate an aftertax yield Rate)Tax Marginal - (1 YieldTaxable ieldAftertax y

RateTax Marginal - 1

YieldExemptTax YieldTaxable Equivalent

19-47

Suppose you are in the 35% marginal tax bracket:

You would choose the corporate bond in this case (8% > 7.69%).

Instead, suppose you are in the 40% marginal tax bracket:

You would choose the municipal bond in this case (5% > 4.8%).

7.69%0.35 - 1

5%

RateTax Marginal - 1

YieldExemptTax YieldTaxable Equivalent

4.8% .40) - (1 8% ieldAftertax Y

The Tax Reform Act of 1986 imposed notable restrictions on the types of municipal bonds that qualify for federal tax exemption of interest payments.

In particular, the act expanded the definition of private activity bonds, which are taxable municipal bonds used to finance facilities used by private businesses.

The yields on such bonds are often similar to the yields on corporate bonds.

www.publicdebt.treas.gov (lots of information on Treasuries) www.investinginbonds.com (information on bonds, bonds,

bonds) www.ustreas.gov (visit the U.S. Treasury) www.savingsbonds.com (for the latest on Savings Bonds) www.bondmarkets.com (Bond Market Association) www.municipalbonds.com (check out munis) www.firstmiami.com (First Miami - muni bonds purchasable

on-line) www.lebenthal.com (buy muni bonds on-line) www.muniauction.com (Muni Bond Auction on-line)

Government Bond Basics

U.S. Treasury Bills, Notes, Bonds, and STRIPS

Treasury Bond and Note Prices Inflation-Indexed Treasury Securities

U.S. Treasury Auctions

U.S. Savings Bonds

Series EE Savings Bonds Series I Savings Bonds

Federal Government Agency Securities

Municipal Bonds

Municipal Bond Features Types of Municipal Bonds Municipal Bond Credit Ratings Municipal Bond Insurance

Equivalent Taxable Yield

Taxable Municipal Bonds

Homework: 2, 3, 8, 17