Corporate Debt Instruments

Corporate Debt Instruments Chapter 7—Fabozzi Chapter Pages 155 – 183 (top 2 lines only)

Introduction • What are corporate debt instruments? • Financial obligations of a firm with priority over common and preferred shareholders in the event of bankruptcy. • Types: • Corporate bonds (long-term borrowing) • Medium-term notes (short-, medium- and long-term) • Commercial paper (short-term) • Asset-backed securities (discussed in a later chapter)

Corporate Bonds • 4 Major Corporate bond issuer types: • Public Utilities: electric power, gas distribution, water companies, and communication companies. • Transportations: airlines, railroads, and trucking. • Banks/Finance: money center banks, regional banks, savings and loans, brokerage firms, insurance companies, and finance companies. • Industrials: Catchall including manufacturers, mining, merchandising, retailers, energy, and service industries.

Corporate Bond Features • A corporate bond contractually obligates the corporation, among other things, to pay periodic coupons and repay the principal at maturity. • The contract is called an indenture: • It is a detailed legal document that specifies the obligations of the corporation. • An important part is called the covenant – a set of rules placed on the issuer designed to stabilize performance and reduce the likelihood of default. • The indenture is overseen by a trustee who monitors and enforces the indenture for bondholders.

Security for Bonds • A firm’s ability to pay coupons and principal as promised is supported by the firm’s cash flows and assets. • Bonds are classified according to assets backing the bonds: • Mortgage Bonds: bonds that are backed by specific real assets of the firm. • Collateral Trust Bonds: bonds that are backed by securities (firm may have no significant real assets). • Debentures: bonds backed by no specific assets. Have claim on all assets not specifically pledged to secure other debt. • Subordinated Debentures: debentures that get paid third in line after secured debt and debentures. (junior securities) • Guaranteed Bonds: Obligations are guaranteed by another entity. The guarantor’s creditworthiness becomes important.

Provisions for Paying Off Bonds • The way in which the bond issue is ultimately paid off is outlined in the indenture. • There are several ways to payoff a bond: • Call Provision: Bond is called prior to maturity. • Refunding: Issuer sells bonds in order to use the proceeds to redeem an earlier issue. • Sinking Fund: A portion of the bond issue is retired each year. • Bullet Payoff: Bond paid off at maturity.

Call Provision • Bonds are callable at a premium, usually initially at par + coupon rate. • E.g., a 10% coupon rate bond issued at 100 would initially be callable at 110% (of par value). • The call premium declines over time as the bond approaches maturity. • There is also a Make-Whole Premium Provision: • The call price that when reinvested on the redemption date in a Treasury Security having the same remaining life would provide a yield equal to bond’s original yield. • Also called the yield-maintenance premium provision.

Sinking Fund Provision • Rather than one big balloon payment at maturity, a portion of the principal is paid off each year. • Purpose: reduce credit risk. • Under a sinking fund the bonds are usually retired at par value.

Corporate Bond Ratings • Money managers use various techniques to estimate the ability of an issuer to make its promised payments. • Although some institutions have internal credit analysis departments many do not. • Those that don’t rely on nationally recognized rating agencies to perform credit analysis and summarize their findings in the form of ratings. • The “big three” rating agencies are: • Moody’s Investors Service • Standard & Poor’s • Fitch Ratings

High Yield Bond Performance • From 1978-2004, promised yields on junk bonds ranged from 281 bps to 1050 bps above Treasuries and averaged 490 bps above Treasuries. (Exhibit 7-6 page 169) • Are these yields justified given the greater default risk of the bonds? • Evidence: • Over the long run, junk bonds outperformed investment-grade bonds and Treasuries, but have been outperformed by common stock.

Secondary Markets for Publicly-Traded Corporate Bonds • The main secondary market is the over-the-counter market, which can lack transparency. • To increase price transparency, NASD required all NASD member broker/dealers to report all corporate bond transactions that met certain criteria. • System is called “TRACE” (Trade Reporting and Compliance Engine). • When introduced in 2002, 500 investment grade bond issues were reported in TRACE. • By 2005, almost the entire corporate bond universe (29,000) issues were included in TRACE.

Private Placement of Corporate Bonds • Not all corporate bonds are traded publicly. • Instead, some issues are placed privately: • These issues are exempt from SEC registration because they do not involve the public and are not actively traded. • However, securities privately placed under SEC Rule 144A (1990) can be traded among institutional buyers and sellers. • 144A securities tend to be more liquid than non-144A issues, but are not nearly as liquid as publicly traded bonds. • Issuers of privately place bonds tend to be less well known than publicly traded issuers.

Medium-Term Notes • Corporate debt instrument with a unique characteristic: • It can be issued as-needed without additional SEC registration, under SEC Rule 415 (shelf-registration). • Maturities range from 9 months to 30 years (so calling these “notes” is misleading). • MTNs are very flexible instruments for firms: • Can be fixed-rate or floating. • Can be denominated in US$ or other currency. • Can be issued on a continuous basis. • Can be issued as structured notes—a simultaneous trade of MTNs and derivatives (as a package) to create an instrument that is more closely tailored to the needs of the issuer.

Medium-Term Notes • When firms decide to raise funds, they must decide between corporate bonds on MTNs. • The decision rests on two factors: • The all-in-cost of funds: Cost of registration and distribution of bonds. • Flexibility (refers to ability to customize structure). • The tremendous growth in MTNs suggests there is a relative advantage to issuing MTNs. • However, given the fact that traditional corporate bonds and MTNs are both issued by some firms suggest there is not an absolute advantage.

Commercial Paper • A short-term unsecured borrowing by a corporation. • Typical uses of commercial paper are: • Finance seasonal or working capital needs. • Bridge financing—using short-term funds to temporarily finance a long-term project until more favorable market conditions prevail for issuing long-term debt. • Very little secondary market trading in CP. • Most buyers hold CP to maturity so there is no need to trade.

Characteristics of Commercial Paper • Maturities range from 1 day to 270 days. • CP is exempt from SEC registration if not exceeding 270 days in maturity. • This saves costs associated with registration. • Many CP issues do not exceed 90 days: • When banks borrow from the Fed discount window, they must post collateral to the Fed. • CP eligible for collateral cannot exceed 90 days. • CP is paid off by the firm issuing new CP issue. This is called roll-over. • Creates roll-over risk: Risk that issuer will be unable to issue new paper at maturity. • This would cause the original CP issue to be in default

Issuers of Commercial Paper • Commercial paper issuers can be divided into financial and nonfinancial: • The number of financial issuers has grown dramatically. • Financial—Three types: • Captive finance companies—subsidiaries of manufacturers, purpose is to secure sales for manufacturer (Ford Credit, Nissan Financial, etc). • Bank-related finance companies—subsidiaries of banks, purpose is to secure financing for purchase of products by individuals and businesses. • Independent finance companies—not subsidiaries, but in the business to finance the purchase of products.

CP Default Risk • Most issuers of CP typically have high credit ratings. • However, firms with lesser credit ratings have been able to issue paper with credit enhancements from banks: • E.g., bank may issue a letter of credit, essentially guaranteeing repayment of the CP (called LOC Paper). • Default risk for high grade CP is very low.

CP Credit Ratings • CP is rated by the same agencies that rate bonds: • CP is categorized as investment grade and noninvestment grade.

Placement of Commercial Paper • Commercial paper is placed in one of two ways: • Directly placed • Dealer placed • Directly Placed: • CP is sold by the issuing firm directly to investors without the help of an intermediary. • Majority of directly placed deals are by financial companies. • Dealer Placed: • CP is sold with the services of an agent.

Secondary Markets and Yields in CP • The CP market is one of the largest for in money market instruments: • However, secondary trading is much smaller. • Typically, investors in CP hold the paper until maturity, so there is no need to trade it. • Like T-bills, CP is sold as discount instruments: • CP rates track other money market instruments but trade at a spread above similar maturity T-bills. • Why? (1) Credit risk, (2) CP is taxable at state and local level, and (3) CP is less liquid than T-bills.

Bankruptcy and Creditor Rights • Law governing bankruptcy in the U.S. is the Bankruptcy Reform Act of 1978. • One purpose of act is to set rules for a firm to be liquidated or reorganized in the event of bankruptcy. • Liquidation (Chapter 7)—all assets are distributed to holders of securities and the firm ceases to exist. • Reorganization (Chapter 11)—a new corporate entity emerges: • Some security holders receive cash for their claims. • Others may receive new securities in the new firm. • Other may receive some of both.

Bankruptcy and Creditor Rights • Another purpose of Bankruptcy Reform Act is to give a corporation time to decide whether to reorganize or liquidate: • Firm receives bankruptcy protection from creditors who seek to collect on their claims. • A firm under bankruptcy protection becomes a debtor in possession and continues to operate its business under the supervision of the court.

Absolute Priority: Theory and Practice • When a company is liquidated in bankruptcy, creditors receive distributions based on the absolute priority rule to the extent that assets are available: • APR—senior creditors are paid in full before junior creditors are paid anything. • In liquidations the APR holds generally, but strict adherence to the APR has not been upheld by the courts or SEC. • In reorganizations, violations to APR are the rule rather than the exception. (top of page 183 - end)

Corporate Debt Instruments