Learning Objectives Identify different types of debt financing available to a firm Understand limits within bond contracts that protect the interests of bondholders Describe the various options available to firms for the early repayment of debt
15.1 Corporate Debt Corporate dent can be private debt, which is negotiated directly with a bank or a small group of investors, or public debt, which trades in a public market. The private bank is larger than public debt market. Private debt has advantage that it avoids the cost and delay of registration with the U.S. SEC. the disadvantage is that because it is not publicly traded, it is illiquid, meaning that it is hard for a holder of the firm’s private debt to sell it in a timely manner.
15.1 Corporate Debt Private Debt Bank Loans Term Loan: A bank loan that lasts for a specific term. Syndicated Bank Loan: A single loan that is funded by a group of banks rather than just a single bank. Revolving Line of Credit: A credit commitment for a specific time period, typically two to three years, which a company can use as needed. Asset-Backed Line of Credit: A type of credit commitment, where the borrower secures a line of credit by pledging an asset as collateral. Private Placements: A bond issue that does not trade on a public market but rather is sold to a small group of investors.
15.1 Corporate Debt Public Debt The Prospectus Indenture Included in a prospectus, it is a formal contract between a bond issuer and a trust company, which represents the bondholders’ interests Original Issue Discount (OID) Bond A coupon bond issued at a discount
Figure 15.1 Front Cover of the Offering Memorandum for the Hertz Junk Bond Issue
15.1 Corporate Debt Public Debt Unsecured Corporate Debt: A type of corporate debt that, in the event of a bankruptcy, gives bondholders a claim to only the assets of the firm that are not already pledged as collateral on other debt. Notes: A type of unsecured corporate debt with maturities shorter than ten years. Debentures : A type of unsecured corporate debt with maturities of ten years or longer. Secured Corporate Debt: A type of corporate loan or debt security in which specific assets are pledged as a firm’s collateral that bondholders have a direct claim to in the event of a bankruptcy. Mortgage Bonds: A type of secured corporate debt in which real property is pledged as collateral. Asset-Backed Bonds: A type of secured corporate debt in which specific assets are pledged as collateral.
Table 15.1 Types of Corporate Debt
15.1 Corporate Debt Public Debt Seniority: A bondholder’s priority, in the event of a default, in claiming assets not already securing other debt Subordinated Debenture: A debenture issue that has a lower priority claim to the firm’s assets than other outstanding debt Tranches: Different classes of securities that comprise a single bond issuance
Table 15.2 Hertz’s December 2005 Junk Bond Issues
15.1 Corporate Debt Public Debt International Bonds Domestic Bonds Issued by a local entity and traded in a local market, but purchased by foreigners Denominated in the local currency Foreign Bonds Issued by a foreign company in a local market and are intended for local investors Denominated in the local currency
15.1 Corporate Debt Public Debt International Bonds Foreign Bonds Yankee bonds Foreign bonds issued in the United States Eurobonds International bonds that are not denominated in the local currency of the country in which they are issued
15.1 Corporate Debt Public Debt International Bonds Global Bonds Combines the features of domestic, foreign, and Eurobonds, and are offered for sale in several different markets simultaneously Can be offered for sale in the same currency as the country of issuance
Table 15.3 Summary of New Debt Issued as Part of the Hertz LBO
15.2 Bond Covenants Covenants Restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds Advantages of Covenants With more covenants, a firm firms can reduce its costs of borrowing. The reduction in the firm’s borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants
Table 15.4 Typical Bond Covenants
15.3 Repayment Provisions Call Provisions Callable Bond: Bonds containing a call provision that allows the issuer to repurchases the bonds at a predetermined price. Call Date: The date in the call provision on or atfer which the bond issuer has the right to retire the bond. Call Price: A price specified at the issuance of a bond for which the issuer can redeem the bond. Call Premium: the difference between the call price and the par value.
15.3 Repayment Provisions Call Provisions Call Provisions and Bond Prices Investors will pay less for a callable bond than for an otherwise identical noncallable bond A firm raising capital by issuing callable bonds instead of non-callable bonds will either have to pay a higher coupon rate or accept lower proceeds
15.3 Repayment Provisions Call Provisions Yield to Call The yield of a callable bond calculated under the assumption that the bond will be called on the earliest call date Yield to Worst Quoted by bond traders as the lower of the yield to call or yield to maturity
Table 15.6 Bond Calls and Yields
Example 15.1 Calculating the Yield to Call Problem: IBM has just issued a callable (at par) five-year, 8% coupon bond with annual coupon payments. The bond can be called at par in one year or anytime thereafter on a coupon payment date. It has a price of $103 per $100 face value, implying a yield to maturity of 7.26%. What is the bond’s yield to call?
Example 15.1 Calculating the Yield to Call Solution: Plan: The timeline of the promised payments for this bond (if it is not called) is:
Example 15.1 Calculating the Yield to Call Solution: Plan: (cont’d) If IBM calls the bond at the first available opportunity, it will call the bond at year 1. At that time, it will have to pay the coupon payment for year 1 ($8 per $100 of face value) and the face value ($100). The timeline of the payments if the bond is called at the first available opportunity (at year 1) is:
Example 15.1 Calculating the Yield to Call Solution: Plan: (cont’d) To solve the YTC, we use these cash flows, set the price equal to the bond’s current price and solve for the discount rate.
Example 15.1 Calculating the Yield to Call Execute: For the YTC, setting the present value of these payments equal to the current price gives : Given: Solve for:4.85 Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(1,8,-103,100)
Example 15.1 Calculating the Yield to Call Evaluate: The YTM is higher than the YTC because it assumes that you will continue receiving your coupon payments for 5 years, even though interest rates have dropped below 8%. While under the YTC assumptions, you are repaid the face value sooner, you are deprived of the extra 4 years of coupon payments, so your total return is lower.
15.3 Repayment Provisions Sinking Fund A company makes regular payments into a fund administered by a trustee over the life of the bond. These payments are then used to repurchase bonds, usually at par. Balloon Payment A large payment that must be made on the maturity date of a bond when the sinking fund payments are not sufficient to retire the entire bond issue.
15.3 Repayment Provisions Convertible Provisions Convertible Bonds: Corporate bonds with a provision that gives the bondholder a option to convert each bond owned into a fixed number of shares of common stock. Conversion Ratio
15.3 Repayment Provisions Convertible Provisions Convertible Bond Pricing Consider a convertible bond with a $1000 face value and a conversion ratio of 20 If you converted the bond into stock on its maturity date, you would receive 20 shares If you did not convert, you would receive $1000 Conversion Price By converting the bond you essentially “paid” $1000 for 20 shares, implying a conversion price per share of $1,000/20 = $50.
15.3 Repayment Provisions Convertible Provisions Convertible Bond Pricing Straight (Plain-Vanilla) Bond A non-callable, non-convertible bond Convertible Bonds and Stock Prices When a firm’s stock price is much higher than the conversion price, conversion is very likely and the convertible bond’s price is close to the price of the converted shares
Figure 15.2 Convertible Bond Value
15.3 Repayment Provisions Convertible Provisions Combining Features Companies have flexibility in setting the features of the bonds they issue Leveraged Buyout (LBO) When a group of private investors purchases all the equity of a public corporation and finances the purchase primarily with debt.