Week 8 - The many different types of debt Flashcards
Corporate bond yield
The CONSTANT discount rate for future PROMISED payments
*NOT expected payments
Dirty price of corporate bonds
The actual price you pay to purchase a bond, ie. PV of future cash flows
Quoted (‘clean’) price = dirty price - accrued interest
> Pay seller quoted price + accrued interest. Why? The SELLER of the bond is due that interest b/c they are the one who have held the bond for the past 2 months.
2 types of repayment provision
- Sinking fund
- repayment of principal periodically before maturity
- OBLIGATION to the firm. If firm doesn’t make regular payments into sinking fund, it goes into default - Pay in kind (PIK)
- interest/sinking funds can be paid by bonds too, not necessarily cash
- cheaper way to pay than cash when firm is suffering from SHORT-RUN LIQUIDITY PROBLEMS (although giving more bonds creates more debt)
Debt covenants
Restrictions imposed by bondholders on what the borrower (companies) can/cannot do when they have debt to PROTECT debt holders
- Positive covenants specify the actions the firm must take. Increase the co’s probability of being able to make its debt repayments.
- Negative covenants forbid actions the firm may take. Prevent equity holders from screwing over debt holders of the firm
Callable bond
1. valuation
2. why do firms call and pay back debt early?
3. optimal strategy
A bond that can be repurchased (called) by the firm
[issuer] before maturity at a specified price (call price),
ie. option to BUY BACK BOND EARLY
- Callable bond price = straight bond price - call option value
*minus in the equation b/c the issuer is the holder of the option. The party who is writing the option is the one receiving the option premium ct.
> Value of callable bond should be LOWER than straight bond. - Callable bond allows firms to REFINANCE their DEBT
- Take advantage of LOWER interest rates. Raise money today at new interest rates, then use that money to buy back old bonds
- Also to adjust capital structure: lower leverage - Optimal strategy: call the bond when market price reaches the call price
- Irrational to buy at a price > call price
Puttable bond
1. valuation
2. why poisonous for the issuer
A bond that gives investors the right to demand early repayment
- Bondholders have a straight bond + (long) put option
- Puttable bonds can be poisonous for the issuer b/c bond investors EXERCISE the put option when bond price is LOW
- most likely this is when the firm is in trouble (when bondholders want their money back)
- firms usually don’t have the money to redeem, hence FORCED into default
Convertible bonds
1. valuation
2. optimal strategy for bondholder to exercise early
3. decision rule for converting at MATURITY
+ conversion ratio, conversion price // market conversion price, conversion value
(CB is a type of hybrid security - behaves like debt and equity)
- A mix of debt and equity
- Give bondholders the RIGHT to exchange/give up the bond for a pre-specified no. of the company’s SHARES
- Convertible bond price = straight bond price + call option to ACQUIRE common stock
- Convert early as long as exercise price < market price of shares after converting
- Convert only if conversion value > straight bond value at MATURITY
Can the market price of a convertible bond be lower than its conversion value?
Dilution effect of converting a bond
No. There will be an arbitrage opportunity - buy CB, immediately convert into shares & then sell shares. This will secure them a RISK-FREE PROFIT = Conversion Value – Convertible Price.
Market price of CB should be ≥ the larger of straight bond value & conversion value.
Dilution effect: converting a bond creates NEW SHARES (share issuance) -> no. of shares outstanding increases, existing shareholders diluted
3 reasons why firms issue convertible bonds
- Claim: convertibles are “cheaper” (often lower yields)
- Misleading. Firm is essentially issuing 2 securities -> non-convertible bond + call option - Management and market DISAGREE about the RISK of the firm
- If market OVERESTIMATES VARIANCE of firm, the market overestimates the call option. Convertible will be over-valued. Then yes, issuing an overpriced/under-valued security is a cheap source of financing. - REDUCE debt holder-shareholder agency conflicts, esp. RISK SHIFTING problem
- If equity holders gamble and it’s successful (the upside happens), bondholders can choose to convert & become equity holder themselves, then upside needs to be SHARED with bondholders.
- This reduces the PAYOFF of GAMBLING to EHs to begin with, therefore less likely to engage in risky activities.
Bond-warrant package
1 difference of warrant from normal stock options
3 differences of warrants from convertible bonds
Warrants - call options written by the company on NEW stock.
A convertible bond is similar to a package of a straight bond + a warrant
3 differences from CBs
1. Warrants can be issued on their own and has the option to be sold (ie. an option to sell an option)
2. Warrants tend to have fixed exercise price (hence easier to be valued). Convertibles have a random exercise price
3. Diff. tax rules
Difference from normal stock options
1. Warrants increase the no. of shares outstanding if exercised
How to calculate the equity call option value of a convertible bond?
Option value = Convertible bond price - Straight bond price
Conversion premium = market value of a convertible bond - conversion value
Why is a convertible bond buyer is willing to pay a premium over conversion value?
- Since the convertible bond is more secure than common stock
- and generally pays higher interest than the stock dividend
Conversion price
Face value of debenture / Conversion ratio
Prior to maturity, when is conversion optimal? ie. when to exercise convertible bond option?
If net dividend > time premium
where
Net dividend = dividend - interest
Time premium = market value of convertible - max(conversion value, straight bond value)
Explain why bond indentures may place limitations on the following actions:
(a) Sale of the company’s assets
(b) Payment of dividends to shareholders
(c) Issue of additional senior debt
Why might a bond issuer voluntarily choose to put such restrictive covenants into a new bond issue?
(a) 2 primary reasons for limitations on the sale of company assets.
1. coupon and sinking fund payments provide a regular check on the company’s solvency. If the firm does not have the cash, the bondholders would like the shareholders to put up new money or default. But this check has little value if the firm can sell assets to pay the coupon or sinking fund contribution.
2. the sale of assets in order to reinvest in more risky ventures (i.e. asset substitution) harms the bondholders.
(b) The payment of dividends to shareholders reduces assets that can be used to pay off debt. In the extreme case, a dividend that is equal to the value of the assets leaves bondholders with nothing.
(c) If the existing debt is JUNIOR, then the original debtholders lose by having the new debt rank ahead of theirs.
If the existing debt is SENIOR, then the issuance of additional senior debt means that the same amount of equity supports a greater amount of debt; i.e., the firm’s leverage has increased, and the firm faces a greater probability of default. This harms the original debtholders.
Bond issuers may benefit from placing restricting covenants because by doing so they can obtain a LOWER INTEREST RATE.
