Chapter 7

Corporate Debt Instruments

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Learning Objectives
Understanding
the key provisions of a corporate bond issue, including provisions for repaying a bond issue prior to the stated maturity date corporate bond ratings and what investment-grade bonds and noninvestment-grade (also called high-yield or junk) bonds are event risk bond structures used in the high-yield bond market empirical evidence concerning historical risk and return patterns in the corporate bond market what recovery ratings are the secondary market for corporate bonds

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Learning Objectives (continued)

Understanding
the private-placement market for corporate bonds medium-term notes the difference between the primary offering of a medium-term note and a corporate bond what a structured medium-term note is and the flexibility it affords issuers what commercial paper is and why it is issued the credit ratings of commercial paper the difference between directly placed and dealer-placed commercial paper what a bank loan is and the difference between an investmentgrade bank loan and a leveraged bank loan the market for leveraged loans

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Corporate Bonds
Corporate bonds are issued by utilities, transportation, industrial, and bank/finance companies. Bond terms are stated in the prospectus, including date(s) when principal will be repaid and dates and amounts of interest payments. The prospectus includes any other terms, such as security for the bond, embedded options, alternatives for interest payments and so on. Failure to pay either the principal or interest when due constitutes legal default; investors can go to court to enforce the contract.

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Corporate Bond Maturities (Terms)

Most corporate bonds are term bonds, due and payable at a set maturity date (generally called notes if original maturity is less than 10 years). Serial bonds have specified principal amounts due on specified dates before the final maturity date.

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Corporate Bond Security

Mortgage bonds are secured by a specific asset or assets. Debenture bonds are general obligations, not secured by a specific pledge of property. Subordinated debenture bonds rank after secured debt and debenture bonds for receipt of principal repayment. Guaranteed bonds are guaranteed by another entity, usually an insurance company, which substitutes its own (higher) credit rating for that of the issuing company. Mortgage bonds typically have lower rates than debenture bonds, and debenture bonds typically have lower rates than subordinated debenture bonds.

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Corporate Bond Repayment

Call provisions allow the company to buy back all or part of the issue prior to the stated maturity date, often at a premium over face value (especially in the first few years after the bonds are issued). Refunding protection prevents calls funded by lower cost debt; call protection prevents calls for any reason or for a specified period of time.

Sinking fund bonds will be partially redeemed early, either through calls determined by lottery or through open market purchases of bonds which the company makes to satisfy its obligation to retire some of the issue earlier than the stated maturity.

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Exhibit 7-1 Redemption Schedule for Anheuser-Busch Cos., Inc., 10% Sinking Fund Debentures Due July 1, 2018 (callable bonds)
The Debentures will be redeemable at the option of the Company at any time in whole or in part, upon not fewer than 30 nor more than 60 days notice, at the following redemption prices (expressed in percentages of principal amount) in each case together with accrued interest to the date fixed for redemption: If redeemed during the 12 months beginning July 1,

Redemption
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 and thereafter 104.5% 104.0% 103.5% 103.0% 102.5% 102.0% 101.5% 101.0% 100.5% 100.0%

Provided, however, that prior to July 1, 1998, the Company may not redeem any of the Debentures pursuant to such option, directly or indirectly, from or in anticipation of the proceeds of the issuance of any indebtedness for money borrowed having an interest cost of less than 10% per annum.

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Corporate Bond Ratings

The SEC requires that all publically traded bonds be rated by an approved ratings agency, which analyzes the companys credit and the terms of each of its debt issues to estimate the companys ability to pay its future contractual obligations. The best known of those agencies are Moodys Investors Service, Standard & Poors Corporation, and Fitch Ratings though there are a few other firms on the approved list. Although all investors pay some attention to rating agency ratings, professional money managers also independently analyze credit information on companies and bond issues.

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Corporate Bond Ratings (continued)

Ratings range from AAA (best) through AA and A to BBB (with + and ratings) for companies judged very likely to fulfill all their contractual obligations when due. Debt from such companies is considered investment grade, suitable for all investors. Debt which is rated lower than BBB- (BB, B, CCC, CC, C, D) is considered speculative, best owned by sophisticated investors. Such debt is called non-investment grade, high yield or junk. Debt may be rated below-investment grade at issue or may be downgraded later (fallen angels). Exhibit 7-3 (see slide 7-11) gives a rating transition matrix, showing the likelihood that a rating will change (either up or down) within one calendar year. (Note: does not include the experience of 2007-8 when record numbers of issues were downgraded.)

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Exhibit 7-3
Hypothetical One-Year Rating Transition Matrix Rating at End of Year
Rating at Start of Year Aaa Aa A Aaa 91.00 Aa 8.30 A 0.70 6.60 Baa 0.00 0.50 5.10 Ba 0.00 0.20 0.40 B 0.00 0.00 0.20 C or D 0.00 0.00 0.00 Total 100.00 100.00 100.00

1.50 91.40 0.10

3.00 91.20

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Corporate Bond Defaults and Losses

The next two slides show data on the numbers of bond issues that defaulted between 1985 and 2006, broken out between investment grade and high yield companies (slide 7-13) and on the total dollar amount of defaulted high yield debt (slide 7-14)

Note that defaults increase during recessions and that more high yield issues default than investment grade issues but also that the volume of high yield issues has risen steadily over this time period (until 2006).

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Exhibit 7-4 Defaults by Original Ratings (Investment Grade Versus

Non-Investment Grade) by Year, 19852006
Year 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 Total # Defaulted % Originally Rated Issues Investment Grade 52 184 79 203 322 258 142 87 39 20 24 13 49 19 33 39 14 16 13 31 0 13 % Originally Rated Non-Investment Grade 87 51 81 67 61 86 84 87 69 100 88

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Exhibit 7-5 Historical High-Yield Dollar-Denominated Default Rate for Corporate Bonds in the U.S. and Canada 19852006
Year 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 Par Value Outstanding ($ millions) 993,600 1,073,000 933,100 825,000 757,000 649,000 597,200 567,400 465,500 335,400 271,000 Par Value Defaults ($ millions) 7,559 36,209 11,657 38,451 96,858 63,609 30,295 23,532 7,464 4,200 3,336 Default Rate (%) 0.761 3.375 1.249 4.661 12.795 9.801 5.073 4.147 1.603 1.252 1.231

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Corporate Bond Defaults and Losses

(continued)
A bond is in default when the issuer fails to make an interest or principal payment when due. However, the bond holder often recovers at least part of the investment despite the default. The recovery rate is the percentage of the face amount of the bond recovered by the holder. The default loss rate is a measure of the actual investment loss following a default:

Default loss rate = Default rate (100% Recovery rate)

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Corporate Bond Event Risk

Event risk is a serious, unexpected change in the ability of a company to make interest and principal payments. Event risk usually happens because of a natural or industrial accident, regulatory change or a takeover/corporate restructuring (often involving the addition of significant amounts of new debt). Event risk may lead to a ratings downgrade.

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Corporate Bond Event Risk (continued)

Leveraged buyouts (LBOs) or recapitalizations with a lot of new debt are a common event risk. Interest payments on the new debt can cause severe cash flow constraints. Companies may structure debt issues to ease these constraints.
Deferred-interest bonds do not pay interest for an initial period, typically from three to seven years, and sell at a deep discount. Step-up bonds do pay coupon interest, but the coupon rate is low for an initial period and then increases (steps up). Payment-in-kind (PIK or PIK toggle) bonds give the company an option at each coupon payment date to pay cash or give the bondholder a similar bond for the amount of interest due (called a toggle if on each coupon payment date the company can choose either form of payment depending on its cash flow at that time).

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Corporate Bond Event Risk (continued)

Extendable reset bonds reflect both the level of interest rates at the reset date, and the credit spread the market wants on the issue. Companies that issue extendable reset bonds have a longterm source of funds based on short-term rates. Investors who own these bonds have a coupon rate and a credit spread which reset periodically to the market rate .

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High Yield Corporate Bonds

High-yield corporate bonds (also called below investment grade or junk bonds) have outperformed both investment grade corporate bonds and Treasuries over the long term, although they have underperformed common stock.

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Corporate Bond Trading

Secondary Market: Over-the-counter (OTC)
Traditionally, corporate bond traded on an OTC market conducted via telephone and based on broker-dealer trading desks. Electronic bond trading now makes up the majority of corporate bond trading, still done via trading desks, not exchanges.

Private-Placement Market for Corporate Bonds

Companies may also issue bonds privately. Such bond issues are not registered with SEC, have a limit on the number of buyers and are restricted to sophisticated investors. These bonds typically carry higher interest rates; trading is very limited and may not be possible at all.
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Corporate Bonds (continued)

Bond purchasers must pay sellers accrued interest as well as the bond price in the secondary market. Corporate bonds use a 30/360 calendar. Example: A 12% coupon corporate bond pays $120 per year per $1,000 par value, accruing interest at $10 per month or $0.33333 per day.

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Medium-Term Notes (MTN)

MTN are corporate debt instruments offered continuously to investors by an agent of the company. Investors can select from several maturity ranges: 9 months to 1 year, more than 1 year to 18 months, more than 18 months to 2 years, and so on up to 30 years. Medium-term notes give companies maximum flexibility for issuing securities: fixed or floating rates, US dollar or other currency. Companies often add swaps (or options, futures/ forwards, caps, and floors) to create structured notes with more interesting risk-return features than are otherwise available in the corporate bond market.

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Commercial Paper
Commercial paper is short-term unsecured borrowing issued in the open market to provide short-term funds for seasonal and working capital needs. Corporations sometimes use commercial paper for other purposes such as bridge financing. For example, if a corporation needs long-term funds to build a plant or acquire equipment but thinks that capital market conditions are unattractive, it may use commercial paper to finance the project temporarily. If companies have raised funds in the commercial paper market for long term uses, they typically replace that paper with a later sale of longer-term securities.

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Commercial Paper (continued)

In the United States, most commercial paper is sold with maturities ranging from 1 day to 270 days (paper with original maturity within 270 days does not need to be registered with the SEC). Companies generally roll over commercial paper at maturity, i.e., use the proceeds from selling new commercial paper to pay the maturing debt. Companies may sell directly to buyers (direct placement) or through dealers (dealer placed). Paper from less well-known companies may carry a guarantee from a third party or may have collateral (asset-backed paper) Commercial paper is rated by rating agencies just as longer term debt is; almost all marketable commercial paper carries the highest credit rating (there are strict limits on the amount of paper with lower ratings institutional investors may hold).

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Exhibit 7-12
Commercial Paper Ratings
Category Investment grade Fitch F-1+ F-1 F-2 F-3 Noninvestment grade In default F-S D P-1 P-2 P-3 NP (not prime) Moodys S&P A-1+ A-1 A-2 A-3 B C D

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Commercial Paper Trading

There is a small secondary market for commercial paper although there is a large amount outstanding (most buyers hold to maturity). Commercial paper is a discount instrument, with higher rates than similar Treasuries because: Commercial paper has credit risk. Interest on commercial paper is taxable (states/cities do not tax interest on Treasuries). Commercial paper is (significantly) less liquid than Treasury bills.

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Bank Loans
Bank loans to corporate borrowers are divided into two categories: investment-grade loans (made to corporate borrowers that have investment-grade ratings) and leveraged loans (made to below-investment grade borrowers). They trade in securities markets in several forms. Syndicated bank loans are provided by a group (or syndicate) of banks, generally used when borrowers seek a large loan. Lenders assign loans (transfer all ownership rights) to other banks or participate in loans (no rights transfer). Bank loans are senior to bondholders for repayment of interest and principal; generally the principal is due at maturity (bullet loans.)

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Bank Loan Trading

Syndicated loans can be traded in the secondary market or securitized to create collateralized loan obligations; they require periodic marking to market.

Non investment grade borrowers may use either leveraged loans or high-yield bonds as sources of debt financing.

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Bankruptcy and Creditor Rights

When companies are liquidated in bankruptcy, all company assets are distributed to creditors following creditor priority rules clearly established by law. However, if a company files for reorganization under Chapter XI of the Bankruptcy Code, the focus is on restructuring its debt so the company can emerge as a going concern. Creditor priority breaks down and equity holders often receive some value for their claims. Explanations for this phenomenon include:

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Bankruptcy and Creditor Rights (continued)

Incentive hypothesis: longer negotiations incur greater costs and a smaller distribution to all parties; equity holders participate so negotiations can settle more quickly. Recontracting process hypothesis: senior creditors recognize the ability of management (which holds equity) to preserve value for all claimants. Stockholders influence on the reorganization plan hypothesis: creditors may be less informed about the firms true economic operating conditions than management, which presents data to reinforce its position. Strategic bargaining process hypothesis: more complex bankrupt firms have more claimants, therefore risk longer negotiations. These firms have higher incidences of violation of the absolute priority rule, which supports this hypothesis.

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