HOFIS 12 - Corporate Bonds Flashcards
Participating bonds
Share profits of the issuer if they are above a certain level
Types of Corporate bonds
- Participating and Income bonds
- Zero-coupon
- Deferred-interest bond (DIB)
- Pay-in-kind debentures (PIK)
Income bonds
Only receive interest payments if the issuer has income above a certain level (can be cumulative or noncumulative)
What are Deferred-interest bonds (DIB)
- 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.
Pay-in-kind (PIK) debentures
Instead of just accruing interest in early years, pay coupons with additional pieces of the same security
Type of High-Yield (Junk) Bonds Issuers
- Original issuers (usally young, growing companies with promise)
- Fallen angels (investment grade bonds that have slipped)
- Restructurings and leveraged buyouts (companies that have increased their debt burden to maximize shareholder value)
Features of High-Yield (Junk) Bonds
- Deferred interest bonds
- Step-up bonds (low coupon rate in initial period)
- Payment-in-kind bonds (pays additional securities rather than cash)
- Extendible reset bonds
- Clawbacks
Clawbacks
issuer has right to call bond during non-callable period only with IPO money
Types of Security (Collateral) for Corporate Bonds
- Mortgage bond (secured by property)
- Collateral trust bond (secured by stock usually of a subsidiary)
- Equipment trust certificates (used mainly by railroads to get low interest rates)
- Debenture bonds (unsecured = no collateral)
- Subordinated and convertible debentures (last in line among creditors)
- Guarantee bonds (guaranteed by another company but still have credit risk)
Mechanisms to Retire Corporate Bond Debt Early
- Call and refunding provisions
- Sinking fund provisions
- Maintenance and replacement funds
- Redemption through sale of assets
- Tender offers
Benefits of call and refunding provisions for issuer
Issuer uses this right to:
- refinance at a lower rate
- alter capital structure
- improve flexibility
Types of call and refunding provions
- Fixed-price call provision: call price set in advance, usually at a premium above par.
- 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
Sinking fund provisions
Issuer can retire bonds periodically by:
- Making a cash payment to a trustee who calls the bond pro rata or randomly by lot
- Purchasing the bonds in the open market (will do when the bonds are selling at a discount)
- For utility companies, adding certified property
Sinking fund provisions advantages to bondholder
- Default risk reduced to bondholder
- 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)
Maintenance and replacement funds
- 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
Tender offers
The issuing firm can simply make and offer to the bond investors to buy back the bonds
Credit Spread formula (in words) of corporate bonds
= Bond Yield – Comparable U.S. Treasury Yield
Spread Duration of corporate bonds
Change in Bond Price for a 1% Change in Credit Spread
Default rate measures of corporate bonds
Examples of Corporate bonds event risk
Company-specific:
- Mergers and acquisitions
- leveraged buyouts
- restructuring
Corporate bonds headline risk
Media coverage might alter investor perceptions
Ways to metigate corporate bonds event risk
- Poison puts
- Maintenance of net worth clauses
Corporate bonds poison puts
- Designed to protect bondholders from unfriendly takeovers
- Forces issuer to repurchase bonds at unfavorable prices if certain events transpire
Corporate bonds maintenance of net worth clauses
require companies to begin retiring debt if a minimum level of net worth is not maintained.
Medium-Term Notes
“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.)
Describe four advantageous features of issuing a Medium Term Note
- MTNs are offered continuously to institutional investors by an agent of the issuer.
- MTNs are registered with the SEC, which gives a corporation sufficient flexibility for issuing securities on a continuous basis.
- MTNs can be issued with wide varieties of maturities of 9 months to 30 years or longer.
- MTNs are highly flexible debt instruments that can easily be designed to respond to market opportunities and investor preferences.
- 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.
Compare and contrast Fixed-Price and Make-Whole Call Provisions
- 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
Credit spread risk and its compenents
- 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.
- 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..
