Chapter 20 Long-Term Debt

1
(No Transcript)
2
Chapter 20 Long-Term Debt

• 20.1 Long Term Debt A Review
• 20.2 The Public Issue of Bonds
• 20.3 Bond Refunding
• 20.4 Bond Ratings
• 20.5 Some Different Types of Bonds
• 20.6 Direct Placement Compared to Public Issues
• 20.7 Long-Term Syndicated Bank Loans
• 20.8 Summary and Conclusions

3
20.1 Long Term Debt A Review

• Corporate debt can be short-term (maturity less
  than one year) or long-term.
• Different from common stock
• Creditors claim on corporation is specified
• Promised cash flows
• Most are callable
• Over half of outstanding bonds are owned by life
  insurance companies pension funds
• Plain vanilla bonds to kitchen sink bonds

4
Features of a Typical Bond

• The indenture usually lists
• Amount of Issue, Date of Issue, Maturity
• Denomination (Par value)
• Annual Coupon, Dates of Coupon Payments
• Security
• Sinking Funds
• Call Provisions
• Covenants
• Features that may change over time
• Rating
• Yield-to-Maturity
• Market price

5
Features of a Hypothetical Bond
6
20.2 The Public Issue of Bonds

• The general procedure is similar to the issuance
  of stock, as described in the previous chapter.
• Indentures and covenants are not relevant to
  stock issuance.
• The indenture is a written agreement between the
  borrower and a trust company. The indenture
  usually lists
• Amount of Issue, Date of Issue, Maturity
• Denomination (Par value)
• Annual Coupon, Dates of Coupon Payments
• Security
• Sinking Funds
• Call Provisions
• Covenants

7
Principal Repayment

• Term bonds versus serial bonds
• Sinking funds How do they work?
• Fractional repayment each year
• Good news---security
• Bad news---unfavourable calls
• How trustee redeems

8
Protective Covenants

• Agreements to protect bondholders
• Negative covenant Thou shalt not
• pay dividends beyond specified amount
• sell more senior debt and amount of new debt is
  limited
• refund existing bond issue with new bonds paying
  lower interest rate
• buy another companys bonds
• Positive covenant Thou shalt
• use proceeds from sale of assets for other assets
• allow redemption in event of merger or spinoff
• maintain good condition of assets
• provide audited financial information

9
The Sinking Fund

• There are many different kinds of sinking-fund
  arrangements
• Most start between 5 and 10 years after initial
  issuance.
• Some establish equal payments over the life of
  the bond.
• Most high-quality bond issues establish payments
  to the sinking fund that are not sufficient to
  redeem the entire issue.
• Sinking funds provide extra protection to
  bondholders.
• Sinking funds provide the firm with an option.

10
The Call Provision

• A call provision lets the company repurchase or
  call the entire bond issue at a predetermined
  price overa specified period.
• The difference between the call price and the
  face value is the call premium.
• Many long-term corporate bonds outstanding in
  Canada have call provisions.
• New corporate debt features a different call
  provision referred to as a Canada plus call.
• The Canada plus call is designed to replace the
  traditional call feature by making it
  unattractive for the issuer ever to call the
  bonds.

11
20.3 Bond Refunding

• Replacing all or part of a bond issue is called
  refunding.
• Bond refunding raises two questions
• Should firms issue callable bonds?
• Given that callable bonds have been issued, when
  should the bonds be called?

12
Should firms issue callable bonds?

• Common sense tells us that call provisions have
  value.
• A call works to the advantage of the issuer.
• If interest rates fall and bond prices go up, the
  option to buy back the bonds at the call price is
  valuable.
• In bond refunding, firms will typically replace
  the called bonds with a new bond issue.
• The new bonds will have a lower coupon rate than
  the called bonds.

13
Why are callable bonds issued in the real world?

• Four specific reasons why a company might use a
  call provision
• Superior interest rate predictions
• Taxes
• Financial flexibility for future investment
  opportunities
• Less interest-rate risk

14
Callable Bonds versus Noncallable Bonds
Most bonds are callable some sensible reasons
for call provisions include taxes, managerial
flexibility, and the fact that callable bonds
have less interest rate risk.
15
Calling Bonds When does it make sense?

• In a world with no transaction costs, it can be
  shown that the company should call its bonds
  whenever the callable bond value exceeds the call
  price.
• This policy minimizes the value of the callable
  bonds.
• The costs from issuing new bonds change the
  refunding rule to allow bonds to trade at prices
  above the call price.
• The objective of the company is to minimize the
  sum of the value of the callable bonds plus new
  issue costs.

16
20.4 Bond Ratings

• What is rated
• The likelihood that the firm will default.
• The protection afforded by the loan contract in
  the event of default.
• Who pays for ratings
• Firms pay to have their bonds rated.
• The ratings are constructed from the financial
  statements supplied by the firm.
• Ratings can change.
• Raters can disagree.

17
Bond Ratings Investment Grade
18
Bond Ratings Below Investment Grade
19
Junk bonds

• Anything less than an SP BB or a Moodys Ba
  is a junk bond.
• A polite euphemism for junk is high-yield bond.
• There are two types of junk bonds
• Original issue junkpossibly not rated
• Fallen angelsrated
• Current status of junk bond market
• Private placement
• Yield premiums versus default risk

20
20.5 Different Types of Bonds

• Callable Bonds
• Puttable Bonds
• Convertible Bonds
• Zero Coupon Bonds
• Floating-Rate Bonds
• Other Types of Bonds

21
Puttable bonds

• Put provisions
• Put price
• Put date
• Put deferment
• Extendible bonds
• Value of the put feature
• Cost of the put feature

22
Convertible Bonds

• Why are they issued?
• Why are they purchased?
• Conversion ratio
• Number of shares of stock acquired by conversion
• Conversion price
• Bond par value / Conversion ratio
• Conversion value
• Price per share of stock x Conversion ratio
• In-the-money versus out-the-money

23
Convertible Bond Prices
24
Example of a Convertible Bond
25
More on Convertibles

• Exchangeable bonds
• Convertible into a set number of shares of a
  third companys common stock.
• Minimum (floor) value of convertible is the
  greater of
• Straight or intrinsic bond value
• Conversion value
• Conversion option value
• Bondholders pay for the conversion option by
  accepting a lower coupon rate on convertible
  bonds versus otherwise- identical nonconvertible
  bonds.

26
Example of an Exchangeable Bond
27
Zero-Coupon Bonds

• A bond that pays no coupons at all must be
  offered at a price that is much lower than its
  stated value.
• For tax purposes, the issuer of a zero-coupon
  bond deducts interest every year even though no
  interest is actually paid.
• Zero-coupon bonds, often in the form of stripped
  coupons, are attractive to individual investors
  for tax-sheltered Registered Retirement Savings
  Plans (RRSPs).

28
Floating Rate Bonds

• With floating rate bonds, the coupon payments are
  adjustable.The adjustments are tied to the
  Treasury bill rate or another short-term interest
  rate.
• Majority of floaters have the following features
• The holder has the right to redeem her note at
  par on the coupon payment date after some
  specified amount of time.
• The coupon rate has a floor and a ceiling. i.e.,
  a minimum and a maximum.

29
Financial Engineering and Bonds

• Income bonds coupon payments are dependent on
  company income.
• Retractable bonds allow the holder to force the
  issuer to buy the bond at the stated price.
  Examples are Canada Savings Bonds (CSBs).
• A stripped real-return bond is a zero coupon bond
  with inflation protection.

30
20.6 Direct Placement Compared to Public Issues

• There are two basic forms of direct private
  long-term financing
• Term loans
• Private placements
• Differences between direct private long-term
  financing and public issues of debt are
• Registration costs are lower for direct
  financing.
• Direct financing is likely to have more
  restrictive covenants.
• It is easier to renegotiate a term loan or a
  private placement in the event of default.

31
20.7 Long-Term Syndicated Bank Loans

• A syndicated loan is a corporate loan made by a
  group (or syndicate) of banks and other
  institutional investors.
• A syndicated loan may be publicly traded.
• It may be a line of credit and be undrawn or it
  may be drawn and be used by a firm.
• Syndicated loans are always rated investment
  grade.

32
20.8 Summary and Conclusions

• The details of the long-term debt contract are
  contained in the indenture. The main provisions
  are security, repayment, protective covenants,
  and call provisions.
• Protective covenants are designed to protect
  bondholders from management decisions that favour
  stockholders at bondholders expense.
• Most public industrial bonds are unsecuredthey
  are general claims on the companys value.
• Most utility bonds are secured. If the firm
  defaults on secured bonds, the trustee can
  repossess the asset.

33
20.8 Summary and Conclusions (cont.)

• Long-term bonds usually provide for repayment of
  principal before maturity. This is usually
  accomplished with a sinking fund whereby a firm
  retires a certain number of bonds each year.
• Most publicly issued bonds are callable. There is
  no single reason for call provisions. Some
  sensible reasons include taxes, greater
  flexibility, and the fact that callable bonds are
  less sensitive to interest-rate changes.
• There are many different types of bonds,
  including floating-rate bonds, deep-discount
  bonds, and income bonds.