Chapter 20 Fixed-Income Financing and Pension Liability

1. Chapter 20Fixed-Income Financing and Pension Liability

2. Features of Debt • Coupon rate is fixed return of long-term debt • Trustee represents the interests of bondholders • Indenture contains the terms of the bond issue and the restrictions placed on the company (protective covenants) • Bond ratings reflect a rating agency’s opinion as to the creditworthiness of publicly traded debt • High-yield debt is rated Ba/BB or below • Sinking funds retire a portion of the bonds prior to maturity • Issuer’s option • Nasty accumulators

3. Floating-Rate Notes (FRNs) • The interest rate can float with some short-term rate, such as the (LIBOR), Treasury bill, or commercial paper rate • Used in a volatile interest rate environment to reduce risk • Special features Options Declining spread Fixed-rate provision

4. European Corporate Bond Issuance • Lacked depth and breadth necessary to be attractive before Euro • Bond issue denominated in the Euro has become the vehicle of choice in cross-border financing • Viable European corporate bond market has developed

5. Types of Debt Financing • Debentures • Subordinated debentures • Mortgage bonds • Income bonds • Equipment trust certificates • Equity-linked debt • Debt + warrants • Convertible bond • Project financing • Nonrecourse basis • Sharing rules

6. Call Feature and Refunding • Embedded options • Sinking fund • Call feature • Gives the issuer the option to buy back a debt instrument at a specific price (call price) before maturity • Forms of the provision • Immediately callable • Deferred for a period of time • Gives the company flexibility • Call the bonds and refinance if interest rates decline significantly • Unduly restrictive protective covenants

7. Refunding Versus Redemption • Refunding means refinancing the bond issue with a new bond issue at a lower interest cost • Many bond issues can be redeemed provided the source of the redemption is not a refunding • Investor has no call protection • Redemption price often is the face value • The line of demarcation between a call and a redemption is blurred

8. Value of Call Privilege • Determined by supply and demand forces in the market for callable securities • Investors are unwilling to invest in callable bonds unless such bonds yield more than noncallable bonds • Borrower has to be able to refund at a profit

9. Valuation in an Option Pricing Context • More volatility increases the value of the call option • Equilibrium pricing • Callable bond = Noncallable bond - Call option • Level and volatility of interest rates are key factors in giving value to the call feature • Identifies arbitrage opportunities

10. Refunding a Bond Issue in a Capital Budget Framework • A riskless investment project after new bonds are sold • Calculate the net investment • Net cash outflow at time 0 • Calculate the interest savings • Cash inflows • Calculate the net present value of refunding • Timing of refunding • Based on expectations of future interest rates

11. Problems With Analyzing Bond Refunding • Longer maturity of new issue • Sinking-fund bonds or serial bonds • Decrease in the leverage of the firm

12. Private Placement Features • Speed of the commitment • Terms tailored to the needs of the borrower • Renegotiation is possible • Actual borrowing does not have to take place all at once • No registration with SEC • Company avoids making certain detailed information available to the public • Slightly higher interest rate • Lower floatation costs

13. Developments in the Market for Private Placements • Considerable popularity over the last two decades • Allowance for secondary trading • Distinction between private placement and public market has blurred

14. Preferred Stock • A form of fixed-income security, but the dividend is at the discretion of the company’s board • Adds to the equity base of the company and enhances the ability of the company to borrow in the future • Cumulative feature provides for unpaid dividends to be carried forward • Voting power • Normally not given unless management defaults

15. Retirement of Preferred Stock • Call feature affords the company flexibility to retire the issue • Sinking fund partially assures an orderly retirement of the stock • Convertibility • Convertible into common stock at the option of the holder • Force conversion by calling the preferred stock

16. Tax Treatment of Preferred Dividend • Taxed as ordinary income for individual investors • If the investor is a corporation, 70% is not subject to taxation (intercorporate dividend exclusion) • Preferred stock dividend paid is not tax deductible

17. Tax-Deductible Preferred Stock • Instrument devised to be tax-deductible • A special-purpose vehicle (SPV) is created • Most widely used instruments • MIPS • QUIPS • TOPrS

18. Auction-Rate Preferred Stock • An instrument whose interest rate floats with money market rates • 70% intercorporate dividend exclusion does apply • Money market preferred stock (MMP) • Rate is set by auction every 49 days, the effective maturity date • Tax arbitrage involved in the instrument benefits both investor and issuer at the expense of the federal government

19. Pension Fund Liability • Binding claim under (ERISA) • Types of pension plans • Defined benefit plans are a liability of the employer to provide retirement benefits • Flat benefit formula • Unit benefit formula • Defined contribution plans are not a liability of the employer

20. Funded and Unfunded Liabilities of a Defined Benefit Plan • Liability to currently retired employees depends on their average life expectancy and the discount rate used • Liability to employees not yet retired • Past employment • Future service • Total pension liability of a company must be valued • The present value of liabilities is calculated by discounting to present value likely future benefits to be paid based on past service and expected future service

21. Unfunded Liability • PV of pension liabilities - PV of pension assets • Reported on the balance sheet as a liability • FASB No. 87 • Matter of concern to creditors • Pension Benefit Guarantee Corporation (PBGC) makes good on most of the total obligations for a bankrupt company

22. Accounting for Pensions • FASB No. 87 brought a consistent treatment of pension expense accounting together with bringing pension liability firmly onto the balance sheet • Expenses • Interest cost • Service cost for additional benefits that employees earn during the year • Amortization of any accumulated deficit • Expected investment return (offset expenses)