Introduction What are corporate debt instruments? Financial obligations of a firm with priority over common and preferred shareholders in the event of bankruptcy. Types: Corporate bonds (long-term borrowing) Medium-term notes (short-, medium- and long- term) Commercial paper (short-term) Asset-backed securities (discussed in a later chapter)
Corporate Bonds 4 Major Corporate bond issuer types: Public Utilities: electric power, gas distribution, water companies, and communication companies. Transportations: airlines, railroads, and trucking. Banks/Finance: money center banks, regional banks, savings and loans, brokerage firms, insurance companies, and finance companies. Industrials: Catchall including manufacturers, mining, merchandising, retailers, energy, and service industries.
Corporate Bond Features A corporate bond contractually obligates the corporation, among other things, to pay periodic coupons and repay the principal at maturity. The contract is called an indenture : It is a detailed legal document that specifies the obligations of the corporation. An important part is called the c ovenant – a set of rules placed on the issuer designed to stabilize performance and reduce the likelihood of default. The indenture is overseen by a trustee who monitors and enforces the indenture for bondholders.
Security for Bonds A firm’s ability to pay coupons and principal as promised is supported by the firm’s cash flows and assets. Bonds are classified according to assets backing the bonds: Mortgage Bonds: bonds that are backed by specific real assets of the firm. Collateral Trust Bonds: bonds that are backed by securities (firm may have no significant real assets). Debentures: bonds backed by no specific assets. Have claim on all assets not specifically pledged to secure other debt. Subordinated Debentures: debentures that get paid third in line after secured debt and debentures. (junior securities) Guaranteed Bonds: Obligations are guaranteed by another entity. The guarantor’s creditworthiness becomes important.
Provisions for Paying Off Bonds The way in which the bond issue is ultimately paid off is outlined in the indenture. There are several ways to payoff a bond: Call Provision: Bond is called prior to maturity. Refunding: Issuer sells bonds in order to use the proceeds to redeem an earlier issue. Sinking Fund: A portion of the bond issue is retired each year. Bullet Payoff: Bond paid off at maturity.
Call Provision Bonds are callable at a premium, usually initially at par + coupon rate. E.g., a 10% coupon rate bond issued at 100 would initially be callable at 110% (of par value). The call premium declines over time as the bond approaches maturity. There is also a Make-Whole Premium Provision : The call price that when reinvested on the redemption date in a Treasury Security having the same remaining life would provide a yield equal to bond’s original yield. Also called the yield-maintenance premium provision.
Sinking Fund Provision Rather than one big balloon payment at maturity, a portion of the principal is paid off each year. Purpose: reduce credit risk. Under a sinking fund the bonds are usually retired at par value.
Corporate Bond Ratings Money managers use various techniques to estimate the ability of an issuer to make its promised payments. Although some institutions have internal credit analysis departments many do not. Those that don’t rely on nationally recognized rating agencies to perform credit analysis and summarize their findings in the form of ratings. The “big three” rating agencies are: Moody’s Investors Service Standard & Poor’s Fitch Ratings
High Yield Bond Performance From 1978-2004, promised yields on junk bonds ranged from 281 bps to 1050 bps above Treasuries and averaged 490 bps above Treasuries. (Exhibit 7-6 page 169) Are these yields justified given the greater default risk of the bonds? Evidence: Over the long run, junk bonds outperformed investment-grade bonds and Treasuries, but have been outperformed by common stock.
Secondary Markets for Publicly-Traded Corporate Bonds The main secondary market is the over-the- counter market, which can lack transparency. To increase price transparency, NASD required all NASD member broker/dealers to report all corporate bond transactions that met certain criteria. System is called “TRACE” (Trade Reporting and Compliance Engine). When introduced in 2002, 500 investment grade bond issues were reported in TRACE. By 2005, almost the entire corporate bond universe (29,000) issues were included in TRACE.
Private Placement of Corporate Bonds Not all corporate bonds are traded publicly. Instead, some issues are placed privately: These issues are exempt from SEC registration because they do not involve the public and are not actively traded. However, securities privately placed under SEC Rule 144A (1990) can be traded among institutional buyers and sellers. 144A securities tend to be more liquid than non-144A issues, but are not nearly as liquid as publicly traded bonds. Issuers of privately place bonds tend to be less well known than publicly traded issuers.
Medium-Term Notes Corporate debt instrument with a unique characteristic: It can be issued as-needed without additional SEC registration, under SEC Rule 415 (shelf-registration). Maturities range from 9 months to 30 years (so calling these “notes” is misleading). MTNs are very flexible instruments for firms: Can be fixed-rate or floating. Can be denominated in US$ or other currency. Can be issued on a continuous basis. Can be issued as structured notes —a simultaneous trade of MTNs and derivatives (as a package) to create an instrument that is more closely tailored to the needs of the issuer.
Medium-Term Notes When firms decide to raise funds, they must decide between corporate bonds on MTNs. The decision rests on two factors: The all-in-cost of funds : Cost of registration and distribution of bonds. Flexibility (refers to ability to customize structure). The tremendous growth in MTNs suggests there is a relative advantage to issuing MTNs. However, given the fact that traditional corporate bonds and MTNs are both issued by some firms suggest there is not an absolute advantage.
Commercial Paper A short-term unsecured borrowing by a corporation. Typical uses of commercial paper are: Finance seasonal or working capital needs. Bridge financing—using short-term funds to temporarily finance a long-term project until more favorable market conditions prevail for issuing long-term debt. Very little secondary market trading in CP. Most buyers hold CP to maturity so there is no need to trade.
Characteristics of Commercial Paper Maturities range from 1 day to 270 days. CP is exempt from SEC registration if not exceeding 270 days in maturity. This saves costs associated with registration. Many CP issues do not exceed 90 days: When banks borrow from the Fed discount window, they must post collateral to the Fed. CP eligible for collateral cannot exceed 90 days. CP is paid off by the firm issuing new CP issue. This is called roll-over. Creates roll-over risk: Risk that issuer will be unable to issue new paper at maturity. This would cause the original CP issue to be in default
Issuers of Commercial Paper Commercial paper issuers can be divided into financial and nonfinancial: The number of financial issuers has grown dramatically. Financial—Three types: Captive finance companies—subsidiaries of manufacturers, purpose is to secure sales for manufacturer (Ford Credit, Nissan Financial, etc). Bank-related finance companies—subsidiaries of banks, purpose is to secure financing for purchase of products by individuals and businesses. Independent finance companies—not subsidiaries, but in the business to finance the purchase of products.
CP Default Risk Most issuers of CP typically have high credit ratings. However, firms with lesser credit ratings have been able to issue paper with credit enhancements from banks: E.g., bank may issue a letter of credit, essentially guaranteeing repayment of the CP (called LOC Paper). Default risk for high grade CP is very low.
CP Credit Ratings CP is rated by the same agencies that rate bonds: CP is categorized as investment grade and noninvestment grade. FitchMoody’sS&P Investment Grade F-1+A-1+ F-1P-1A-1 F-2P-2A-2 F-3P-3A-3 Noninvestment Grade F-SNPB C In DefaultDD
Placement of Commercial Paper Commercial paper is placed in one of two ways: Directly placed Dealer placed Directly Placed: CP is sold by the issuing firm directly to investors without the help of an intermediary. Majority of directly placed deals are by financial companies. Dealer Placed: CP is sold with the services of an agent.
Secondary Markets and Yields in CP The CP market is one of the largest for in money market instruments: However, secondary trading is much smaller. Typically, investors in CP hold the paper until maturity, so there is no need to trade it. Like T-bills, CP is sold as discount instruments: CP rates track other money market instruments but trade at a spread above similar maturity T-bills. Why? (1) Credit risk, (2) CP is taxable at state and local level, and (3) CP is less liquid than T-bills.
Bankruptcy and Creditor Rights Law governing bankruptcy in the U.S. is the Bankruptcy Reform Act of 1978. One purpose of act is to set rules for a firm to be liquidated or reorganized in the event of bankruptcy. Liquidation (Chapter 7)—all assets are distributed to holders of securities and the firm ceases to exist. Reorganization (Chapter 11)—a new corporate entity emerges: Some security holders receive cash for their claims. Others may receive new securities in the new firm. Other may receive some of both.
Bankruptcy and Creditor Rights Another purpose of Bankruptcy Reform Act is to give a corporation time to decide whether to reorganize or liquidate: Firm receives bankruptcy protection from creditors who seek to collect on their claims. A firm under bankruptcy protection becomes a debtor in possession and continues to operate its business under the supervision of the court.
Absolute Priority: Theory and Practice When a company is liquidated in bankruptcy, creditors receive distributions based on the absolute priority rule to the extent that assets are available: APR—senior creditors are paid in full before junior creditors are paid anything. In liquidations the APR holds generally, but strict adherence to the APR has not been upheld by the courts or SEC. In reorganizations, violations to APR are the rule rather than the exception. (top of page 183 - end)