Corporate Debt Instruments

Chapter 7--Fabozzi

Corporate DebtSecurities

Corporate Bonds Medium-TermNotes (MTNs) Commercial Paper

Directly-Placed Dealer PlacedSecured Bonds Unsecured Bonds(Debenture Bonds)

Credit-EnhancedBond

guaranteed by aThird Party

guaranteed by aBank Letter of Credit

Mortgage Debt

Collateral TrustBonds

secured by real propertyor personal property

secured byfinancial assets

Corporate Debt Instruments

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

Corporate bonds are classified by issuer type: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 covenant – 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 BondsA 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.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%.The call premium declines over time as the bond approaches maturity.

Instead of a fixed premium that must be paid by the issuer if the bond is called, a bond may have a Make-Whole Premium Provision:

The provision specifies a formula for determining the premium that the issuer must pay to call an issue.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 RatingsMoney 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 ServiceStandard & Poor’s Fitch Ratings

M oody's S& P Fitch Brief Definition Investment Grade: High Credit Worthiness Aaa AAA AAA Gilt edge, prime, maximum safety Aa1 AA+ AA+ Aa2 AA AA Very high grade, high quality Aa3 AA– AA– A1 A+ A+ A2 A A Upper medium grade A3 A– A– Baa1 BBB+ BBB+ Baa2 BBB BBB Lower medium grade Baa3 BBB2 BBB2 Distinctly Speculative: Low Creditworthiness Ba1 BB+ BB+ Ba2 BB BB Low grade, speculative Ba3 BB– BB– B1 B+ B+ B2 B B Highly speculative B3 B– B–2 Predominantly Speculative: Substantial Risk or in Default

CCC+ Caa CCC CCC Substantial risk, in poor standing

CCC– Ca CC CC M ay be in default, extremely speculative C C C Even more speculative than those above

CI CI = Income bonds; no interest is being paid DDD Default DD

D D

High Yield Bond PerformanceFrom 1978-2004, promised yields on junk bonds ranged from 281 bps to 1050 bps above Treasuries and averaged 490 bps above Treasuries.Are these yields justified given the greater default risk of the bonds?Junk bonds have had both strong advocates and harsh critics in the press. Claims:

Advocates: Junk bonds exhibit significantly superior performance as a class.Critics: Junk bonds exhibit significantly inferior performance as a class.

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.

Issuers of privately placed 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.

Commercial Paper

A low-cost source of cash for companies to meet short-term financial needs.A key advantage is that it's cheaper than tapping a line of credit from a bank.Typical uses of commercial paper are:

Finance seasonal or working capital needs.PayrollBridge financing—using short-term funds to temporarily finance a long-term project until more favorable market conditions prevail for issuing long-term debt.

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 collatral 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.

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 Motor Credit, GMAC, Harley Davidson 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.

The lower credit rating paper has ceased due to defaults and changes in regulation.

Default risk for high grade CP has traditional been very low.

CP Credit Ratings

CP is rated by the same agencies that rate bonds:CP is categorized as investment grade and noninvestment grade.

Fitch Moody’s S&P

Investment Grade

F-1+ A-1+

F-1 P-1 A-1

F-2 P-2 A-2

F-3 P-3 A-3

Noninvestment Grade

F-S NP B

C

In Default D D

Placement of Commercial Paper

Commercial paper is placed in one of two ways:Directly placedDealer 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 intermediary.

Secondary Markets and Yields in CP

The CP market is one of the largest type of money market instruments:

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 the 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 ‘healthier’ corporate entity emerges:

Some security holders receive cash for their claims.Others may receive new securities in the new firm.Others 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.