Corporate Bonds

1. Corporate Bonds Chris Lamoureux, PhD

2. Credit Risk Unlike the Federal Government, corporate borrowers may default on debt, meaning that the nominal cash flows on a corporate bond cannot be known in advance with certainty. In particular, the company’s management may choose not to pay a scheduled interest and/or principal amount—forcing default. Upon entering default, the ultimate collection (or recovery rate) is uncertain. Credit Risk

3. Bond Ratings When a corporation (or public entity, such as the University of Arizona) issues debt, it pays a ratings agency (or two) to analyze the default characteristics of the debt. The major ratings companies for corporate debt are Standard & Poor’s and Moodys. These analysts assign a qualitative rating that reflects the probability of default. The credit spread on a bond is heavily influenced by this rating. Credit Risk

4. Ratings Properties As the hyperlinked report shows, from 1920 to 1996, the probability of default within a year for the major categories are: Credit Risk

5. Ratings (Cont’d.) The categories of Baa and above are called “Investment Grade.” The lower ratings are called “speculative grade” or junk bonds. Many asset managers, such as pension funds, are restricted to only invest in investment grade debt. The ratings are based on quantitative analysis of the borrower’s finances. The stability, predictability, and visibility of cash flows plays a key role. So do leverage and interest coverage ratios. Credit Risk

6. Ratings (Cont’d.) The ratings company has a fiduciary relationship to bond buyers, and as such generally continues to monitor borrowers. In addition to the default probabilities the previous linked Moodys study reports the transition probabilities of the various ratings. Note that on a 1-year horizon, the overall tendency is for ratings downgrades. Almost 8% of Aaa are down-graded within the year, while 2.5% of A rated debt are upgraded, and 6% are downgraded. Credit Risk

7. Ratings (Cont’d.) Remember the ratings agencies are not omniscient. The credit fiascoes of 2001-02 (Enron and MCI-Worldcom) resulted from an attempt by borrowers to manipulate their ratings using financial engineering. Partially because the incentives are highly skewed, the ratings companies did not invest in the expertise needed to identify the true risks in these credits. Credit Risk

8. Ratings Changes For the most part, ratings changes lag the relevant information events (especially true in the MCI-Worldcom case). All of this suggests that portfolio managers cannot relax vigilance, and rely exclusively on ratings as predictors of default. Credit Risk

9. Default In the US, there are 2 major avenues of defaulting: • Chapter 7 Here the assets of the company are liquidated, and proceeds distributed to claimants according to seniority. • Chapter 11 Here a (bankruptcy) judge oversees the company on a continuing basis. It should be noted that in Chapter 11, the judge may not (and almost never) adheres to Absolute Priority Rules (specified in the original contracts). Credit Risk

10. Chapter 11 The societal problem that the bankruptcy code is designed to solve is to enable companies that are illiquid, but not insolvent, to work back to liquidity, with minimal disruptions to the economy. Incremental financing is available through “Debtor in Possession” (DIP) loans that override existing seniority. A bondholder is most interested in the recovery rate, conditional on default. Credit Risk

11. Recovery As described in the linked Moodys study, the average time a firm spends in bankruptcy is 1.7 years. This may be as long as 7 years. Prepackaged bankruptcies (prepacks) are usually much shorter in duration. The Moodys study shows that bondholders (i.e., public debt), tends to do worse than private debt. Also, consistent with APR, recovery rates are increasing in seniority. Credit Risk

12. Recovery Credit Risk

13. Vultures There are specialists in assessing the risks of bankrupt debt. One group is vultures who will often attempt to exploit a bargaining advantage for favorable terms. Also, a major hedge fund strategy is on “distressed securities.” Credit Risk

14. Call Provisions The following is from the 2001 NSC prospectus: “The notes due 2031 may be redeemed in whole at any time or in part from time to time, at our option, at a redemption price equal to the greater of (1) 100% of their principal amount or (2) the sum of the present values of the remaining scheduled payments of principal and interest on the notes to be redeemed, discounted to the date of redemption on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at the applicable Treasury Yield plus 25 basis points for the notes, plus accrued and unpaid interest on the principal amount being redeemed to the redemption date.” Credit Risk

15. Make Whole Provision This is an example of the Make Whole Provision that is now standard in the world of corporate bonds. It replaces the old fixed call price schedules. The first Make Whole Provision on a public bond appeared in a Quaker State offering in 1995. The 25 basis points is the make whole premium. Credit Risk

16. Commercial Paper Commercial Paper is short-term debt issued by corporations. The major holders of CP are money-market mutual funds. Rule 2a-7 restricts these funds’ holdings of Tier-2 rated CP to less than 5% of total holdings. Rule 2a-7 identifies Nationally Recognized Statistical Ratings Organizations as the official source of these ratings. There are now 3 NRSRO’s: Moody’s, Standard & Poor’s, and Fitch. Credit Risk

17. Commercial Paper --2 Currently the CP market is around $1.6 Trillion. Of this, some 90% is Tier-1 paper. Critics contend that the rating agencies are experts at long-term debt, and CP is a side activity that is too closely linked to the Long-Term Ratings. In general, an A (LT) rating is needed for Tier-1 status. Credit Risk