Chapter 6 &14

1. Chapter 6 &14 Corporate Debt & Credit Risk

2. 14.1 Corporate Debt • When companies raise capital by issuing debt, they can use different sources to seek funds: • Public debt, which trades in a public market. • Private debt, which is negotiated directly with a bank or a small group of investors. • The securities that companies issue when raising debt are called corporate bonds. 2

3. 14.1 Corporate Debt • Private debt • Debt that is not publicly traded (e.g. a bank loan). • Private debt has the advantage that it avoids the cost and delay of registration with ASIC. • The disadvantage is, that because it is not publicly traded, it is illiquid, meaning that it is hard for a holder of the firm’s private debt to sell it in a timely manner. • Segments of private debt: • Bank loans • Private placements 3

4. 14.1 Corporate Debt • Public debt • A public bond issue is similar to a stock issue. • The prospectus: the prospectus describes the details of the offering and must include an indenture, a formal contract that specifies the firm’s obligations to the bondholders. 4

5. 14.1 Corporate Debt • Corporate bonds • Bonds which are issued by corporations. • Corporations with higher default risk will need to pay higher coupons to attract buyers to their bonds.

6. 14.2 Bond Covenants • Covenants • Restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds. • Advantages: • By including more covenants, firms can reduce their costs of borrowing. • The reduction in the firm’s borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants. 6

7. 14.3 Repayment Provisions • A firm repays its bonds by making coupon and principal payments as specified in the bond contract. • Balloon payment: principal payment on a maturity date. • Sinking funds: a provision that allows the company to make regular payments into a fund administered by a trustee over the life of the bond instead of repaying the entire principal balance on the maturity date. 7

8. 14.3 Repayment Provisions • Convertible provisions: corporate bonds with a provision that gives the bondholder an option to convert each bond owned into a fixed number of ordinary shares at a ratio called the conversion ratio. • Callable provisions: corporate bonds with a provision that permits the issuer to repurchase the bond prior to its maturity, at a predetermined price. 8

9. 6.5 Corporate Bonds • Credit risk • Treasury bonds are widely regarded to be ‘risk-free’ because there is virtually no chance the government will fail to pay the interest and default on these bonds.

10. 6.5 Corporate Bonds • With corporate bonds, the bond issuer may default—e.g. a company with financial difficulties may be unable to fully repay the loan. • This risk of default, which is known as the credit risk of the bond, means that the bond’s cash flows are not known with certainty. • To compensate for the risk that the firm may default, investors demand a higher interest rate than the rate on Treasury securities. • The difference between yields on corporate bonds and yields on Treasury bonds is referred to as credit spread. 10

11. 6.5 Corporate Bonds • Corporate bond yields • The cash flows promised by the bond are the most that bondholders can hope to receive. • Due to credit risk, the cash flows that a purchaser of a corporate bond actually expects to receive may be less than that amount. • Investors may incorporate an increased probability that the bond payments will not be made as promised and prices of the bond would fall. • Yield to maturity of these bonds is calculated by comparing the price to the promised cash flows. 11

12. 6.5 Corporate Bonds • Note • Investors pay less for bonds with credit risk than for an otherwise identical default-free bond. • As the yield to maturity for a bond is calculated using the promised cash flows, the yield of bonds with credit risk will be higher than that of otherwise identical default-free bonds. • Conclusion • A higher yield to maturity does not necessarily imply that a bond’s expected return is higher! 12

13. 6.5 Corporate Bonds • Bond ratings • The probability of default is clearly important to price a corporate bond. • The creditworthiness of bonds is rated and made available to investors, which encourages widespread investor participation and relatively liquid markets. • The two best-known bond-rating companies are Standard & Poor’s and Moody’s. 13

14. Table 6.4 Bond Ratings 14

15. Table 6.5 Credit Spreads: Australian Corporate Bonds 15

16. Example 6.10 Credit Spreads and Bond Prices (p.178) Problem: • Your firm has a credit rating of A. • You notice that the credit spread for 10-year maturity debt is 90 basis points (0.90%). • Your firm’s 10-year debt has a coupon rate of 5%. You see that new 10-year Treasury bonds are being issued at par with a coupon rate of 4.5%. • What should the price of your outstanding 10-year bonds be? 16

17. Example 6.10 Credit Spreads and Bond Prices (p.178) Solution: Plan: • If the credit spread is 90basis points, then YTM should be the YTM on similar Treasury bonds plus 0.9%. • New 10-year Treasury bonds are being issued at par with coupons of 4.5% which means that these bonds are selling for $100 per $100 face value. • Thus, their YTM is 4.5% and your debt’s YTM should be 4.5% + 0.9% = 5.4%. • The cash flows on your bonds are $5 per year for every $100 face value, paid as $2.50 every 6 months. The six-month rate corresponding to a 5.4% yield is 5.4%/2 = 2.7%. 17

18. Example 6.10 Credit Spreads and Bond Prices (p.178) Execute: 18

19. Example 6.10 Credit Spreads and Bond Prices (p.178) Evaluate: • Your bonds offer a higher coupon (5% vs 4.5%) than Treasury bonds of the same maturity, but sell for a lower price • The reason is the credit spread. • Your firm’s higher probability of default leads investors to demand a higher YTM on your debt. 19