1、Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-1Chapter 7 Corporate Debt Instruments Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-2Learning ObjectivesAfter reading this chapter, you will understand the different types of securities issued by the Treasury t
2、he key provisions of a corporate bond issue provisions for paying off a bond issue prior to the stated maturity date corporate bond ratings and what investment-grade bonds and noninvestment-grade (or high-yield) bonds are event risk bond structures that have been used in the high-yield bond market e
3、mpirical evidence concerning the historical risk and return pattern in the corporate bond market what a recovery rating is the secondary market for corporate bondsCopyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-3Learning Objectives (continued)After reading this chapter, you will
4、understand the different types of securities issued by the Treasury the private-placement market for corporate bonds a medium-term note the difference between the primary offering of a medium-term note and a corporate bond what a structured medium-term note is and the flexibility it affords issuers
5、what commercial paper is and why it is issued the credit ratings of commercial paper the difference between directly placed and dealer-placed commercial paper what a bank loan is and the difference between an investment-grade bank loan and a leveraged bank loan the market for leveraged loansCopyrigh
6、t 2010 Pearson Education, Inc. Publishing as Prentice Hall7-4Corporate Bonds Features of a Corporate Bond Issue Corporate bonds are classified by the type of issuer.o The four general classifications used by bond information services are utilities, transportations, industrials, and banks and finance
7、 companies. The essential features of a corporate bond are straightforward. The corporate issuer promises to pay a specified percentage of par value (the coupon payments) on designated dates and to repay par or principal value of the bond at maturity. Failure to pay either the principal or interest
8、when due constitutes legal default, and investors can go to court to enforce the contract.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-5Corporate Bonds (continued) Features of a Corporate Bond Issue Corporate bonds are classified by the type of issuer. The indenture is made ou
9、t to the corporate trustee as a representative of the interests of bondholders; that is, a trustee acts in a fiduciary capacity for investors who own the bond issue. Most corporate bonds are term bonds; that is, they run for a term of years, then become due and payable. Generally, obligations due in
10、 under 10 years from the date of issue are called notes. Serial bonds are arranged so that specified principal amounts become due on specified dates.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-6Corporate Bonds (continued) Security for Bonds Some companies own securities of ot
11、her companies; they are holding companies, and the other companies are subsidiaries. Debenture bonds are debt securities not secured by a specific pledge of property. Subordinated debenture bonds rank after secured debt, after debenture bonds, and often after some general creditors in their claim on
12、 assets and earnings. For a given corporation, secured debt (such as mortgage bonds) will cost less than debenture bonds, and debenture bonds will cost less than subordinated debenture bonds. Guaranteed bonds are obligations guaranteed by another entity.Copyright 2010 Pearson Education, Inc. Publish
13、ing as Prentice Hall7-7Corporate Bonds (continued) Provisions for Paying off Bonds Most corporate issues have a call provision allowing the issuer an option to buy back all or part of the issue prior to the stated maturity date. The premium plus the principal at which the issue is called is referred
14、 to as the make-whole redemption price. The prices shown in Exhibit 7-1 are called the regular or general redemption prices. (See truncated version of Exhibit 7-1 in Overhead 7-8.) There are also special redemption prices for debt redeemed through the sinking fund and through other provisions, and t
15、he proceeds from the confiscation of property through the right of eminent domain.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-8Exhibit 7-1 Redemption Schedule for Anheuser-Busch Cos., Inc., 10% Sinking Fund Debentures Due July 1, 2018The Debentures will be redeemable at the o
16、ption of the Company at any time in whole or in part, upon not fewer than 30 nor more than 60 days notice, at the following redemption prices (expressed in percentages of principal amount) in each case together with accrued interest to the date fixed for redemption: If redeemed during the 12 months
17、beginning July 1,Redemption1999104.5%2000104.0%2001103.5%2002103.0%2003102.5%2004102.0%2005101.5%2006101.0%2007100.5%2008 and thereafter 100.0%Provided, however, that prior to July 1, 1998, the Company may not redeem any of the Debentures pursuant to such option, directly or indirectly, from or in a
18、nticipation of the proceeds of the issuance of any indebtedness for money borrowed having an interest cost of less than 10% per annum.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-9Corporate Bonds (continued) Provisions for Paying off Bonds Call protection is much more absolute
19、 than refunding protection. Refunding means to replace an old bond issue with a new one, often at a lower interest cost. Bonds can be called in whole (the entire issue) or in part (only a portion). When less than the entire issue is called, the specific bonds to be called are selected randomly or on
20、 a pro rata basis. A sinking fund requirement requires the issuer to retire a specified portion of an issue each year.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-10Corporate Bonds (continued)Accrued InterestIn addition to the agreed-upon price, the buyer must pay the seller a
21、ccrued interest.Each month in a corporate bond year is 30 days, whether it is February, April, or August.A 12% coupon corporate bond pays $120 per year per $1,000 par value, accruing interest at $10 per month or $0.33333 per day.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-11C
22、orporate Bonds (continued) Corporate Bond Ratings Professional money managers use various techniques to analyze information on companies and bond issues in order to estimate the ability of the issuer to live up to its future contractual obligations.o This activity is known as credit analysis. Indivi
23、dual investors and institutional bond investors rely primarily on nationally recognized rating companies that perform credit analysis and issue their conclusions in the form of ratings. The three commercial rating companies are Moodys Investors Service, Standard & Poors Corporation, and Fitch Rating
24、s.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-12Corporate Bonds (continued) Corporate Bond Ratings In all rating systems the term high grade means low credit risk, or conversely, high probability of future payment. Bonds rated triple A are said to be prime; double A are of hi
25、gh quality; single A issues are called upper medium grade, and triple B are medium grade. Bond issues that are assigned a rating in the top four categories are referred to as investment-grade bonds. Issues that carry a rating below the top four categories are referred to as noninvestment-grade bonds
26、, or more popularly as high-yield bonds or junk bonds. Thus, the corporate bond market can be divided into two sectors: the investment-grade and noninvestment-grade markets. Exhibit 7-3 (see Overhead 7-13) gives a rating transition matrix, which specifies how ratings change over various periods of t
27、ime.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-13Exhibit 7-3Hypothetical One-Year Rating Transition MatrixRating at End of YearRating at Startof YearAaaAaABaaBaBC or DTotalAaa91.00 8.30 0.70 0.000.000.000.00100.00Aa 1.5091.40 6.60 0.500.200.000.00100.00A 0.10 3.00 91.20 5.10
28、0.400.200.00100.00Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-14Corporate Bonds (continued) Default Rates and Default Loss Rates Exhibit 74 shows the number of defaulted issues each year from 1985 to 2006 for all corporate bonds and then broken down by their original rating f
29、or investment-grade and noninvestment-grade bonds. (See truncated version of Exhibit 7-4 in Overhead 7-15.) As expected, a higher percentage of defaults are for non-investment-grade rated bonds. Exhibit 7-5 provides information about default rates for high-yield corporate bonds by year from 1985 to
30、2006. (See truncated version of Exhibit 7-5 in Overhead 7-16.)Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-15Exhibit 7-4 Defaults by Original Ratings (Investment Grade Versus Non-Investment Grade) by Year, 19852006YearTotal # Defaulted Issues% Originally Rated Investment Grade
31、% Originally Rated Non-Investment Grade2006 5213 87200518449 512004 7919 81200320333 67200232239 61200125814 86200014216 841999 8713 871998 3931 691997 20 01001996 2413 88Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-16Exhibit 7-5 Historical High-Yield Dollar-Denominated Rate f
32、or Corporate Bonds in the U.S. and Canada 19852006YearPar Value Outstanding ($ millions)Par Value Defaults ($ millions)Default Rate (%)2006 993,600 7,559 0.76120051,073,00036,209 3.3752004 933,10011,657 1.2492003 825,00038,451 4.6612002 757,00096,85812.7952001 649,00063,609 9.8012000 597,20030,295 5
33、.0731999 567,40023,532 4.1471998 465,500 7,464 1.6031997 335,400 4,200 1.2521996 271,000 3,336 1.231Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-17Corporate Bonds (continued) Default Rates and Default Loss Rates A higher percentage of defaults are for non-investment-grade rate
34、d bonds. To evaluate the performance of the corporate bond sector, more than just default rates are needed. It is perfectly possible for a portfolio of corporate bonds to suffer defaults and to outperform Treasuries at the same time, provided the yield spread of the portfolio is sufficiently high to
35、 offset the losses from default. The recovery rate is the percentage of the face amount of the bond recovered by the holder. An important measure in studying the performance of the corporate bond sector is the default loss rate, defined as:Default loss rate = Default rate (100% Recovery rate)Copyrig
36、ht 2010 Pearson Education, Inc. Publishing as Prentice Hall7-18Corporate Bonds (continued)Event RiskOccasionally, the ability of an issuer to make interest and principal payments changes seriously and unexpectedly because of:i. a natural or industrial accident or some regulatory changeii. a takeover
37、 or corporate restructuringThese risks are referred to generically as event risk.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-19Corporate Bonds (continued)Event RiskOccasionally, the ability of an issuer to make interest and principal payments changes seriously and unexpectedl
38、y because of:i. a natural or industrial accident or some regulatory changeii. a takeover or corporate restructuringThese risks are referred to generically as event risk.Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-20Corporate Bonds (continued) High-Yield Corporate Bond Sector
39、High-yield bonds, commonly called junk bonds, are issues with quality ratings below triple B. Bond issues in this sector of the market may have been downgraded to noninvestment-grade, or they may have been rated noninvestment-grade at the time of issuance, called original-issue high-yield bonds. Bon
40、ds that have been downgraded fall into two groups:i. issues that have been downgraded because the issuer voluntarily significantly increased their debt as a result of a leveraged buyout or a recapitalizationii. issues that have been downgraded for other reasonsCopyright 2010 Pearson Education, Inc.
41、Publishing as Prentice Hall7-21Corporate Bonds (continued) High-Yield Corporate Bond Sector In leveraged buyout (LBO) or a recapitalization, the heavy interest payment burden that the corporation assumes places severe cash flow constraints on the firm.oTo reduce this burden, firms have issued bonds
42、with deferred coupon structures that permit the issuer to avoid using cash to make interest payments for a period of three to seven years. As given below, there are three types of deferred coupon structures:i.Deferred-interest bonds sell at a deep discount and do not pay interest for an initial peri
43、od, typically from three to seven years.ii. Step-up bonds do pay coupon interest, but the coupon rate is low for an initial period and then increases (“steps up”).iii. Payment-in-kind (PIK) bonds give the issuer an option to pay cash at a coupon payment date or give the bondholder a similar bond.Cop
44、yright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-22Corporate Bonds (continued) High-Yield Corporate Bond Sector In late 1987, a junk bond came to market with a structure allowing the issuer to reset the coupon rate. The new rate will then reflect both the level of interest rates at t
45、he reset date, and the credit spread the market wants on the issueoThis structure is called an extendable reset. In a floating-rate issue, the coupon rate resets according to a fixed spread over some benchmark.oThe spread reflects market conditions on the issue date. The advantage to issuers of exte
46、ndable reset bonds is that they can be assured of a long-term source of funds based on short-term rates. For investors, the advantage of these bonds is that the coupon rate will reset to the market rate (both the level of interest rates and the credit spread, in principle keeping the issue at par).C
47、opyright 2010 Pearson Education, Inc. Publishing as Prentice Hall7-23Corporate Bonds (continued) Performance of High-Yield Bonds There have been several studies of the risk and return in the high-yield bond market.oIn the long run, high-yield corporate bonds have outperformed both investment grade c
48、orporate bonds and Treasuries but have been outperformed by common stock. Recovery Ratings While credit ratings provide guidance for the likelihood of default and recovery given default, the market needed better recovery information for specific bond issues. In response to this need, two ratings age
49、ncies, Fitch and Standard & Poors, developed recovery rating systems for corporate bonds. S&P recovery ratings for secured debt are given in Exhibit 7-10 (see Overhead 7-24) and the FitchRating recovery rating system is given in Exhibit 7-11 (see Overhead 7-25).Copyright 2010 Pearson Education, Inc.
50、 Publishing as Prentice Hall7-24Exhibit 7-10S&P Recovery Ratings for Secured DebtRecovery RateUltimate Recovery of PrincipalIndicative Recovery Expectation 1+Highest expectation of fullrecovery of principal100% of principal1High expectation of fullrecovery of principal100% of principal2Substantial r
