HOFIS Ch10 Flashcards
Describe the legal relationship between a corporate bond issuer and the bondholders
Indenture – complicated contract between the bond issuer and bondholders
Corporate trustee – bank or trust company that acts as a fiduciary for the investors
Paid by the issuer
Enforces bondholders’ interests in indenture
Can declare default if issuer breaches indenture
Describe the fundamentals of a corporate bond
Issuers: utilities, transportation cos., industrial, banks, etc.
Maturity is typically less than 30 years
Most are registered or book entry: pay automatic coupons
Straight coupon bonds: pay fixed coupons semiannually
Participating bonds share profits over a certain level
Income bonds (rare) only pay interest if issuer’s income is high enough
Coupons may also be zero, deferred, or paid-in-kind (PIK)
Describe the following coupon types:
Zero
Deferred
Paid-in-Kind Interest
Zero-coupon bonds
A type of OID bond
Less popular today (tax benefits have declined)
No reinvestment risk if held to maturity
Deferred-interest bond (DIB) – blend of a straight coupon and zero coupon bond
Most are junk bonds
Most do not pay cash interest for the first 5 years
Pay-in-kind (PIK) debentures
Pays additional pieces of security instead of coupons
Additional securities can be sold separately
Note: All of these have higher credit risk than straight coupon bonds
Describe 5 different types of securities for bonds
Debentures – no specific security pledged (most common)
Bondholders = general creditors (security = financial strength of issuer)
Common issuer restrictions: min net worth, selling major assets, stock dividends
Other B/H protections: negative pledge clause
Subordinated issues may offer conversion rights
Mortgage Bonds – gives B/H a 1st-mortgage lien on property backing bond
Blanket mortgage – allows issue of additional series of bonds on the same mortgage
Possible B/H protection: after-acquired clause
Collateral Trust Bonds – backed by stock of issuer’s subsidiaries
B/H protection: if issuer defaults, it forfeits voting rates on subsidiary stock
Equipment Trust Certificates – issued by railroads
Trustee owns RR equipment, leases to RR, then RR buys equipment at end of lease
Very secure since RR heavily depends on equipment and always buys back
Guaranteed Bonds – guaranteed by one or more other companies
List 5 methods to retire debt before maturity
- Call and refunding provisions
- Sinking fund provisions
- Maintenance and replacement funds (doesn’t retire bonds)
- Redemption through sale of assets (usually restricted)
- Tender offers – issuer buys back bonds based on PV at CMT + fixed spread
The first 4 must be included in the indenture if applicable
Describe corporate bond call provisions
Call Provisions
Riskiest for bondholders: fixed price call provision
Call price usually starts at a premium, then declines
May have initial lockout period or initial non-refundable period
Less risky and more common: make-whole call provision
Make-whole call price = max(par, PV remaining CFs at CMT + spread) + accrued
interest
Make-whole call price moves inversely with interest rates
Issuer advantage: can issue at a lower yield
Describe sinking fund provisions
Sinking Fund Provisions (popularity has declined)
Indenture requires issuer to retire a portion of bonds each year (usually at par)
Lowers default risk
Bondholders benefit if interest rates rise (they get par even if MV < par)
Issuer may be able to accelerate sinking fund if interest rates fall
Define issuer default rate
Issuer default rate – based on number of defaulting issuers
No. Issuers that Default in the Year /
Total Issuers at BOY
Define dollar default rate
Dollar default rate – based on amount of defaulted par
Can be expressed over a certain number of years:
Cumulative $ Value of All Defaulted Bonds
Cumulative $ Value of All Issues Weighted Avg. No. Years Outstanding
or reported as an annual default rate:
Cumulative $ Value of All Defaulted Bonds
Cumulative $ Value of All Issues
Define default loss rate and recovery rates
Default Loss Rate = Default Rate * (1 - Recovery Rate)
Recovery rate = % of defaulted bond that bondholders recover after default
Difficult to measure historically: consists of cash and securities
Define event risk and headline risk
Event risk – risk that a stockholder-driven event results in lower bond prices
Rating downgrades, increased leverage, etc. can result from M&A, etc.
Headline risk – risk of bad media coverage that results in lower bond prices
Describe unique features of high-yield bonds
A.k.a. “junk bonds,” but many are only just below investment grade ( BBB or Baa)
Deferred Coupon Structures (3 kinds)
1. Deferred-interest bonds (most common) – no coupons for 3–7 years
2. Step-up bonds – low coupon rate in initial period, then later increases
3. Payment-in-kind (PIK) bonds
Extendible Reset Bonds
Coupon rate resets periodically to keep the bond at a specified price
New rate reflects the new interest rate level and credit spread
Different from a floating rate bond, which is based on a fixed spread
In practice, issuer may not be able to afford the coupon
Clawback – redemption of bonds during a non-callable period with IPO proceeds
Can hurt bondholders since their investment would be rising
