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Chapter 10

Chapter 10. Default Risk. Bond Indenture. Every bond issue has a contract called the bond indenture among three parties – the bondholders, the issuer, and the trustee. The trustee is appointed to protect the interests of the bondholders and must be independent of the issuing firm.

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Chapter 10

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  1. Chapter 10 Default Risk

  2. Bond Indenture • Every bond issue has a contract called the bond indenture among three parties – the bondholders, the issuer, and the trustee. • The trustee is appointed to protect the interests of the bondholders and must be independent of the issuing firm.

  3. Protective Covenants • Corporate bond issues have protective covenants. These are restrictions on the issuer to prevent the issuer from taking advantage of the bondholders. • Typical protective covenants include restrictions on • Issuance of additional debt. • Dividends. • Mergers. • Disposition of assets.

  4. Default • Default is a violation of any part of the bond indenture agreement. • Some defaults involved nonpayment of interest or principal. • Other defaults involve violation of some protective covenant in the bond indenture.

  5. The trustee acts on behalf of the bondholders in the event of default. If there is a nonpayment of cash, 100 percent agreement of the bondholders is required for the trustee to take action. For other defaults, complete agreement of the bondholders is not necessary for the trustee to act.

  6. Liquidate Bankruptcy Default Reorganize Renegotiate

  7. Common Pool Problem Fishermen acting individually $100,000 now Fishermen acting in concert $25,000 annually

  8. Costs of Bankruptcy • Court costs. • Attorneys fees. • Lost profit opportunities. Who would lend money to or buy products from firms in bankruptcy?

  9. Financial Distress • Financial distress is defined as a condition in which operating income is less than fixed charges payable to creditors. • A firm in financial distress may request protection of the bankruptcy court.

  10. However, some firms in financial distress may consider other courses of action. • Sale of assets. • Raise equity. • Merge. • Borrow more. Reschedule old loans. • Use depreciation. • Government assistance.

  11. Rule of Absolute Priority • According to the rule of absolute priority, claimants are paid in the following order. Each category must be paid in full before the next can receive any payments. • Courts, tax obligations, employees, secured creditors, unsecured creditors, preferred stockholders, equity stockholders.

  12. The rule of absolute priority applies in liquidations, which represent about 10 percent of corporate bankruptcies. • In reorganizations, which represent probably 90 percent of corporate bankruptcies, the rule of absolute priority is not followed.

  13. Reorganization Procedures • In a reorganization, the bankruptcy courts have set up a complicated set of procedures for trying to arrive at a reorganization. Stockholders have the first chance to present a reorganization plan, followed by creditors. If the parties cannot agree, the bankruptcy court has the right to impose a reorganization plan.

  14. While a firm is in bankruptcy, the firm’s securities typically continue to trade, although there may be some interruptions of trading. Investing in either the bonds or the stocks of firms in bankruptcy is extremely risky. The returns can be very poor or very good.

  15. Important Terms • Debentures are bonds which have a general claim on the assets of a firm. There may be priorities of claims, such as junior and senior or subordinated and unsubordinated. • Mortgage bonds are secured bonds, which have the first claim on a specific asset. • Income bonds arise out of bankruptcies.

  16. Bond Ratings • Because there are so many corporate bonds outstanding and each issue has special characteristics, rating agencies have developed to provide information to investors about to the likelihood of default. • The three largest rating agencies are Moody’s, Standard & Poor’s, and Fitch.

  17. Bond Ratings

  18. Bond Ratings

  19. Yield on Comparable Maturity Treasury Security (Default-Free) = – . TreasurySpread BondYield TreasurySpread 4% 3% 2% 1% BondRating AAA AA A BBB BB B

  20. UnderwriterSpread 4% 3% 2% .75% BondRating AAA AA A BBB BB B

  21. Factors Determining Bond Ratings • While the rating agencies do not follow a simple formula in determining ratings, the following factors have been found to be statistically important determinants of ratings.

  22. A bond will tend to have a higher rating if the following are true: • The firm has lower debt ratios (debt/assets, debt/equity). • The firm has higher interest coverage ratios (earnings before interest and taxes divided by interest). • The firm has higher rates of return of assets (profit/assets, profit/equity). • The firm has lower relative variation in earnings over time. • The firm is of larger size. • The bond issue is unsubordinated.

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