Chapter 16 Long-Term Debt

Long-term Debt Apart from raising capital from shareholders, start-up firms may borrow money from banks. When the firms become big and mature, they may issue corporate bonds to borrow money from the market directly. Corporate bond has become the basic long- term debt instrument for most large corporations

Continental Airline Bonds In 1987, CA issued $350 million of bonds that were secured by their planes Investors believed that the equipment listed as collateral would protect them from default So, CA could borrow money at a lower rate In reality, most of the planes were old models that had little value in the market

Bond Indenture Investors should read the indenture before buying any particular bond Indenture : legal agreement detailing the issuer’s obligations pertaining to a bond issue. The indenture is administered by an independent trustee (e.g. Montreal Trust) under the guidelines of Trust Acts

Secured Bonds Collateral bonds - specific assets are pledged to bondholders e.g. CA bonds Mortgage bonds - real property is pledged as security for loan Senior vs junior claims - first claim vs second claim on assets pledged Greater protection, lower the yield

Unsecured Bonds Debenture: an unsecured, long-term corporate bond Senior and subordinated debenture: subordinated debenture holders receive payment only after senior debenture holders are paid in full Junk bond: bonds of questionable quality and speculative in nature (with high yield)

Repayment of Principal 1. Lump-sum payment at maturity 2. Serial payments: principal is paid off in installments over the life of the bond 3. Sinking fund: bond issuer make regular contributions to a fund to accumulate the principal at maturity 4. Conversion: retirement by converting bonds into common stock

Bonds with Special Features Callable bond: the issuer has an option to retire the bond prior to maturity Retractable bond: bondholder has an option to sell the bond back to the issuer at par at a specified date before maturity Extendible bonds: bondholder has an option to extend the maturity date

Bond Ratings An external assessment of a firm’s long- term creditworthiness, or An assessment of the probability of default of the firm highest rating (AAA) means lowest risk lower rating (BB or below) means below investment grade Default rating (D)

Bond Ratings cont’ Rating are based on 6 C’s of Credit Capacity: firm size Capital (debt/equity ratio) Collateral: nature of assets pledged Condition in the economy Character of mgt: reliable/speculative Communication: healthy financial statement

Other Forms of Bond Financing Zero-Coupon Bond: no regular interest payment but sold at deep discounts Stripped Bond: similar to zero-coupon bond because coupons are stripped by investment dealer (sell to others) Floating Rate Bond: interest rate varies with market Real Return Bond: provide return over inflation

Benefits and Drawbacks of Debt Tax deductibility of interest payment Specific financial obligation Repaid with “cheaper dollars” Lower the total cost of capital Meet financial obligation regardless of the firm’s economic position Burdensome indenture restrictions Too much debt increases bankruptcy risk

Summary - Bond Terminology Par Value: principal or face value (usually $1,000) Coupon Rate: stated interest rate Maturity Date: due date for the repayment of principal Indenture: legal document detailing the bond issuer’s obligations Secured Debt: specific asset is pledged to secure the loan Debenture: Long-term unsecured corporate bond

Summary - Priority of Claims Secured Debt (Senior first, then Junior)  Unsecured Debt (Senior first, then subordinated)  Preferred Shareholders  Common Shareholders (if there is any left)

Summary - Types of Bond Yields Nominal Yield: stated yield (i.e. Coupon Rate) Current Yield or Yield-to-Maturity (YTM): discount rate that equates the future interest payments and the repayment of principal at maturity to the current market price of the bond affected by current market interest rates If mkt rates , YTM , bond price  also affected by bond rating If bond rating is high (low risk), YTM 