LT (7) Many different types of debt Flashcards
What is a debenture?
Debentures: long-term corportate bond (> 10 years)
Debenture: long-term secured debt (in UK), long-term unsecured issues (in US)
What is a Commerical Paper and Notes?
Commerical Paper and Notes: short-term corporate bond (< 10 years).
What is the face value?
Face value: principal at maturity, often 1,000
What is the coupon?
Coupon: interest payment
What is the yield?
Yield: the discount rate for future payments
What is accured interest?
Accrued interest: the amount of accumulated interest since the last coupon payment.
What is the dirty price?
‘Dirty’ price: the actual price you pay to purchase a bond (i.e. PV of future cash flows)
dirty price = quoted (‘clean’) price + accrued interest
What is a foreign bond?
Foreign bond – local-currency denominated bond that is issued/sold by a foreign company to investors in the local market.
Bulldog bond - a £-denominated bond sold by a foreign company in the U.K.
Similarly, Samurai and Yankee bonds are sold by a foreign firm in Japan and the US respectively
What is a euro bond?
Eurobond – bond that is underwritten by international bond syndicates and sold in several national markets in a major non-local currency (e.g. US dollar)
What is a Global Bond?
Global Bond - very large bond issue that is marketed both internationally (that is, in the eurobond market) and in individual domestic markets
What are credit ratings?
Corporate Bonds carry the possibility of default.
Agencies (e.g. Fitch Investors Service, Moodys, Standard & Poors) provide ratings to indicate the likelihood of default
What is the difference secured vs insecured debt?
Unsecured: no collateral, backed by the company’s creditworthiness
Secured: lender can seize collateral upon default.
Debenture: long-term secured debt (in UK), long-term unsecured issues (in US) Mortgage bonds: long-term debt secured by a firms property Asset-backed securities: securities backed by a portfolio of assets.
These include collateralized mortgage and debt obligations (CMOs, CDOs)
What is seniority?
Who gets paid first in bankruptcy?
Senior > Subordinated (Junior)
Secured > Unsecured
Debtholders > Equityholders (‘Absolute priority’)
Why would anyone accept junior debt?
It’s riskier, so the yield (return) is higher.
What is the recovery rate?
Recovery rate: the percentage an investor gets back in bankruptcy.
What is a sinking fund?
Its a form of repayment provision.
Sinking fund
A lumpy repayment of the entire principal can be disruptive.
A sinking fund is a established to retire debt gradually before maturity
The firm is obligated to make regular payments into the sinking fund.
What is a payment in kind (PIK)?
Its a form of repayment provision.
Pay in kind (PIK)
Payments don’t have to be in cash
Interest or sinking funds can be paid by bonds too (sometimes purchased from the market).
When in trouble, PIK is a cheaper way to pay than cash.
What are debt covenants?
Debt covenants contained in a bond contract are restrictions imposed by bondholders on the activities of the borrower.
Positive covenants specify actions that the firm must take. e.g. the interest coverage ratio (EBIT/Interest Expense) must be greater than 3, working capital must remain above a minimum level, etc.
Negative covenants limit or forbid actions that the firm may take.
Debt ratios:
Senior debt limits senior borrowing
Junior debt limits senior & junior borrowing
Dividend restrictions
Poison put: event-risk protections Certain events (e.g. a merger) may oblige the borrower to repay the loan.
What types of bonds are there with embeded options?
Valuation → equivalent to a ‘straight’/‘plain vanilla’ bond and an option.
Issuers have an option: Callable bonds
Bondholders have an option:
1) Puttable bonds
2) Convertible bonds
Both sides have options:
Callable convertible bonds
What is the price of a callable bond at time = T.
Ptcallable = Ptstraight − ct
where ct is the call option value
(STRAIGHT VANILLA BOND)
Call provisions give the issuer the option to ‘redeem’ or ‘retire’ (i.e. pay back) the debt early.
Callable bond – a bond that can be repurchased (called) by the firm before maturity at a specified price (call price)
e.g. at any time after date T, firm can buy back the bonds at 105%.
Why do firms call and pay back debt early?
Adjust capital structure: lower leverage.
Take advantage of lower interest rates.
Optimal strategy: call the bond when the (straight) market price reaches the call price
What is a puttable bond and how do you valuate it?
Puttable bond – a bond that gives investors the right to demand early repayment.
e.g. at or after date T, bond holders can sell the bond to the firm at par.
Bondholders have a straight bond + (long) put option
Puttable bonds can be poisonous for the issuer!!
Bond investors exercise the put option when bond price is low.
This is also when the firm is in trouble.
Firms usually dont have the money to redeem. Forced into default.
What is a convertible bond and how do you valuate it?
Convertible bonds give bondholders the right to exchange the bond into a pre-specified number of shares.
Conversion ratio – the number of shares into which each bond can be converted
Conversion price – value of the bond divided by the number of shares into which it may be exchanged
Note: the conversion price can be quoted in terms of face value or market value. When quoted in terms of the market value of the bond, we will refer to this as the market conversion price.
Conversion value – value if converted
Valuation:
Ptconvertible = Ptstraight + ct
where ct is the value of the call option to acquire common stock.
What must be the value of the convertible bond be?
Convertible Bonds
Lower bounds: The value of a convertible bond must be ≥ the larger of:
Straight bond value
Conversion value
Convertible bond payoff at maturity: maximum of these two cases:
Only convert if conversion value is greater than the straight bond value:
Dilution effect: converting a bond creates new shares → number of shares outstanding increases and existing shareholders are diluted
Why Issue Convertible Bonds? two reasons
1) Management and market disagree about the risk of the firm:
The market overestimates the variance
Recall the similarity in pecking order theory: market underestimates the value of the company
2) Reduce debtholder-shaereholder agency conflicts, specifically the asset substitution (risk shifting) problem:
If the gamble is successful, bondholders win as well It lowers the gambling payoff to equity.
What is a bond-warrant package?
Warrants: call options written by the company on new stock
A convertible bond is similar to a package of a straight bond and a warrant
Differences from normal stock options:
Warrants increase the number of shares outstanding if exercised.
Differences from convertible bonds:
Warrants can be issued on their own and can be detached
Convertibles have a random exercise price.
Different tax rules.
How do you value a convertible bond?
Convertible Bond = Straight Bond + Equity call option
Valuing the straight bond is relatively easy
Standard bond pricing: use coupon and maturity of the
convertible bond, use market interest rate the firm would pay on a straight bond
Valuing the option is trickier
American call with random exercise price
Conversion options are long term: changing volatility Dilution effect on equity
If you know the market price of the convertible bond, then:
Option value = Convertible price − Straight bond price
remember, the price of a convertible bond must always be at least the straight bond value or conversion value (whichever is larger)
What is the formula for conversion Price?
Conversion Price = Face Value/ Conversion Ratio
What is the formula for conversion value?
Conversion Value = Conversion Ratio × Stock Price
