LongTerm Debt

1
Chapter 16

• Long-Term Debt

2
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

3
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

4
Bond Indenture

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

5
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

6
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)

7
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

8
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

9
Bond Ratings

• An external assessment of a firms 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)

10
Bond Ratings cont

• Rating are based on 6 Cs 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

11
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

12
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
  firms economic position
• Burdensome indenture restrictions
• Too much debt increases bankruptcy risk

13
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
  issuers obligations
• Secured Debt specific asset is pledged to secure
  the loan
• Debenture Long-term unsecured corporate bond

14
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)

15
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 ?