HOFIS 12 - Corporate Bonds

Question 1

Participating bonds

Answer 1

Share profits of the issuer if they are above a certain level

Question 2

Types of Corporate bonds

Answer 2

1. Participating and Income bonds
2. Zero-coupon
3. Deferred-interest bond (DIB)
4. Pay-in-kind debentures (PIK)

Question 3

Income bonds

Answer 3

Only receive interest payments if the issuer has income above a certain level (can be cumulative or noncumulative)

Question 4

What are Deferred-interest bonds (DIB)

Answer 4

• Blend of a straight coupon and zero coupon bonds.
• Most are junk (low credit quality).
• Most do not pay cash interest for the first 5 years.

Question 5

Pay-in-kind (PIK) debentures

Answer 5

Instead of just accruing interest in early years, pay coupons with additional pieces of the same security

Question 6

Type of High-Yield (Junk) Bonds Issuers

Answer 6

1. Original issuers (usally young, growing companies with promise)
2. Fallen angels (investment grade bonds that have slipped)
3. Restructurings and leveraged buyouts (companies that have increased their debt burden to maximize shareholder value)

Question 7

Features of High-Yield (Junk) Bonds

Answer 7

1. Deferred interest bonds
2. Step-up bonds (low coupon rate in initial period)
3. Payment-in-kind bonds (pays additional securities rather than cash)
4. Extendible reset bonds
5. Clawbacks

Question 8

Clawbacks

Answer 8

issuer has right to call bond during non-callable period only with IPO money

Question 9

Types of Security (Collateral) for Corporate Bonds

Answer 9

1. Mortgage bond (secured by property)
2. Collateral trust bond (secured by stock usually of a subsidiary)
3. Equipment trust certificates (used mainly by railroads to get low interest rates)
4. Debenture bonds (unsecured = no collateral)
5. Subordinated and convertible debentures (last in line among creditors)
6. Guarantee bonds (guaranteed by another company but still have credit risk)

Question 10

Mechanisms to Retire Corporate Bond Debt Early

Answer 10

1. Call and refunding provisions
2. Sinking fund provisions
3. Maintenance and replacement funds
4. Redemption through sale of assets
5. Tender offers

Question 11

Benefits of call and refunding provisions for issuer

Answer 11

Issuer uses this right to:

• refinance at a lower rate
• alter capital structure
• improve flexibility

Question 12

Types of call and refunding provions

Answer 12

1. Fixed-price call provision: call price set in advance, usually at a premium above par.
2. Make-whole call provision: call price is the greater of the par value and the present value of remaining cash flows at a current interest rate at a current interest rate. (eliminates refinancing benefits to issuer and call risk to investor)
   
   • The discount rate used to determine the present value is the yield on a comparable-maturity Treasury security plus a contractually specified make-whole call premium

Question 13

Sinking fund provisions

Answer 13

Issuer can retire bonds periodically by:

1. Making a cash payment to a trustee who calls the bond pro rata or randomly by lot
2. Purchasing the bonds in the open market (will do when the bonds are selling at a discount)
3. For utility companies, adding certified property

Question 14

Sinking fund provisions advantages to bondholder

Answer 14

1. Default risk reduced to bondholder
2. If rates rates rise, either the trustee or issuer will continue to purchase the bonds above the market value (however, if rates fall this is bad because it limits appreciation)

Question 15

Maintenance and replacement funds

Answer 15

• Intended to offset the depriciation of equipment collateral over time
• Issuer can make cash payments to retire principal or add property
• Not as common now

Question 16

Tender offers

Answer 16

The issuing firm can simply make and offer to the bond investors to buy back the bonds

Question 17

Credit Spread formula (in words) of corporate bonds

Answer 17

= Bond Yield – Comparable U.S. Treasury Yield

Question 18

Spread Duration of corporate bonds

Answer 18

Change in Bond Price for a 1% Change in Credit Spread

Question 19

Default rate measures of corporate bonds

Answer 19

Question 20

Examples of Corporate bonds event risk

Answer 20

Company-specific:

• Mergers and acquisitions
• leveraged buyouts
• restructuring

Question 21

Corporate bonds headline risk

Answer 21

Media coverage might alter investor perceptions

Question 22

Ways to metigate corporate bonds event risk

Answer 22

• Poison puts
• Maintenance of net worth clauses

Question 23

Corporate bonds poison puts

Answer 23

• Designed to protect bondholders from unfriendly takeovers
• Forces issuer to repurchase bonds at unfavorable prices if certain events transpire

Question 24

Corporate bonds maintenance of net worth clauses

Answer 24

require companies to begin retiring debt if a minimum level of net worth is not maintained.

Question 25

Medium-Term Notes

Answer 25

“Medium” is a misnomer.

Issued with maturities of 9 months to 30+ years.

Key distinction from other types of bonds is that MTNs are offered continuously to investors (like commercial paper).

Structured medium-term notes are coupled with a derivative (option, swap, etc.)

Question 26

Describe four advantageous features of issuing a Medium Term Note

Answer 26

1. MTNs are offered continuously to institutional investors by an agent of the issuer.
2. MTNs are registered with the SEC, which gives a corporation sufficient flexibility for issuing securities on a continuous basis.
3. MTNs can be issued with wide varieties of maturities of 9 months to 30 years or longer.
4. MTNs are highly flexible debt instruments that can easily be designed to respond to market opportunities and investor preferences.
5. Structured MTNs with hedging swap allows the issuer to create structured notes with interesting risk/return features desired by a swath of fixed income investors.

Question 27

Compare and contrast Fixed-Price and Make-Whole Call Provisions

Answer 27

• Fixed-price and Make-whole call provisions give the issuer the right (option) to buy the bonds in whole or in part back before their scheduled maturity. Therefore, such bonds are issued at a lower price (higher yield) to compensate bondholders
• Fixed-price call provision uses a fixed price to buy back the issue (based on a schedule included in the indenture)
• While the make-whole call price is calculated as the present value of the bond’s remaining cashflows subject to a floor price equal to the par value.
• Since the make-whole call price floats inversely with the level of Treasury yields, this provision eliminates the motivation of pure refunding purpose and results in lower cost than fixed-price provision.
• Disadvantage of make-whole call provision is the relatively higher cost for the additional protection of bond being called back earlier than scheduled

Question 28

Credit spread risk and its compenents

Answer 28

1. Credit spread risk is the risk of financial loss of a portfolio resulting from the changes in the level of credit spread used in the marking-to-market of a fixed income security.
2. The credit spread of a corporate bond is due to corporate bonds’ exposure to not only credit (default) risk, but also other risks, including liquidity, embedded options, etc..