Corporate Debt

Funded Debt

Sometimes, long-term corporate debt is referred to as "funded" debt since the issuer has use of the funds for a long time period before repayment is due. (Obviously, this term would not be applicable to commercial paper.)

Trading "Flat"

The buyer is expected to pay the accrued interest only if the bond is currently making interest payments. If the bond is not making interest payments, then the buyer would be paying interest to the seller that would not be received on the interest payment date. Bonds that trade without accrued interest are said to trade "flat

When a convertible security trades below par,

convertible bonds act in the trading market like normal bonds, where price changes are primarily caused by interest rate movements.

How is corporate debt traded?

in the over the counter (OTC) market New York Stock Exchange trades very small amounts of bonds of those companies listed on the exchange (less than $10,000,000 per day).

When a convertible security trades above par

its price is usually being pulled up by the rising market price of the common stock. Thus, interest rate movements are not causing the bond's price changes; rather, the common stock price movements are the cause.

Corporate Bonds can be ___________ or ___________

secured or unsecured

Why do corporations issue debt?

to raise capital

Corporate Bond Financial Listing Information in the news media is presented below:

The first column gives the corporate name, the stated interest rate and the maturity. The ANR Corporation has issued 8 5/8% bonds maturing in 2030. Advest has issued 9% bonds maturing in 2030 ("9s" means "Nines" or nine % bonds). Alger International has issued 10 3/4% bonds maturing in 2031 that are trading flat (f) because they have defaulted (symbol vi). Allied Chemical has issued zero coupon (zr) bonds maturing in 2029. Remember, zero coupon bonds also trade flat. The second column gives the bond's current yield. The symbol cv means convertible bond - no yield is shown for these. There is no yield shown for defaulted or zero coupon bonds since no interest payments are being made. The third column gives the trading volume for that day. 5 ANR bonds traded that day ($5,000 face amount). Remember, corporate bond trading is very limited when compared to trades of common stock. The fourth column gives the day's closing price. Airbus closed at 86 3/4, i.e., at 86 3/4% of par = $867.50 per bond. Alger closed at 59 5/8, i.e., 59 5/8% of par = $596.25. The fifth column gives the change in closing price from the preceding day. Allied Chemical closed at 49 1/4, down 1 from the preceding day. This indicates that on the preceding day the bond closed at 50 1/4.

Serial Issues

- issued in serial form (unlike most other corporate debts which are term issues). which obligates the issuer to repay a portion of principal each year until the bonds are retired. - In effect, the equipment is bought under a "pay as you use it" plan. --The life of the issue coincides with, or is less than, the equipment's life. -rated highly, because if the issuer defaults, the equipment can easily be sold to repay the bondholders. -Furthermore, because the principal amount of the loan is "paid down" each year due to the loan's serial structure, if the collateral has depreciated, it is unlikely that the depreciated value of the asset will be less than the outstanding loan balance. These issues are generally non-callable, making them attractive to investors who want to avoid call risk.

FINRA

-(A general note: In mid-2007, the NYSE and NASD merged their regulatory units into a new single regulator called "FINRA" - Financial Industry Regulatory Authority. -The marketplaces, NYSE and NASDAQ, are completely separate from this regulator. -FINRA intends to eliminate unneeded duplication between NYSE and NASD rules, and is developing a single harmonized set of rules for dealing with the public. -Until this is finished (it is still a work-in-progress), FINRA is enforcing the separate sets of NYSE and NASD rules. In the text, we refer to these rules as either "FINRA/NYSE," "FINRA/NASD," or FINRA for the completed harmonized rule.)

Collateral Trust Certificate

-A portfolio of marketable securities is placed in trust as collateral. -The typical use of this type of financing is when a parent company (Proctor and Gamble) pledges the securities of a subsidiary (Gillette, which is owned by P & G) as collateral. -highly rated because the trust indenture requires that additional collateral be given if the securities drop in value, protecting investors.

Seller's Option

-A seller who does not feel that he or she can have the securities for delivery in 2 business days can specify that the trade be done "seller's option." -The seller specifies how many days are needed for delivery at the time of the trade (e.g., 5M Ford 4 ½s of '29 offered at 90, seller's 15). The seller is specifying that 15 days are needed for delivery. The seller must deliver the bonds by the 15th business day but is allowed to deliver earlier at 24 hours' notice. Of course, to obtain a buyer for this unusual delivery, the price must be dropped.

Interest Income Taxed At Rates Up To 37% - TAX STATUS OF CORPORATE DEBT INTEREST

-Also note that interest income received from bonds held by individuals is taxed by the federal government at ordinary income tax rates (up to a maximum of 37%). -In contrast, cash dividend income received by holders of common and preferred stock is taxed at 15%, raised to 20% for individuals in the highest tax bracket.

When Issued

-An unusual situation arises when a corporation announces it will issue new securities. -The exchanges allow trading in the securities before they exist. -These trades are settled on a "when, as and if issued" basis. -There is no established settlement date. -If the issue is canceled, the trades are canceled. -The actual settlement date is set by the exchange once the securities are physically issued.

Tender Offer - CORPORATE DEBT RETIREMENT PROVISIONS

-Another way for a corporation to retire debt is to make a tender offer for the outstanding bonds. -the corporation makes an offer to buy the bonds from any of the bondholders, typically at a better than market price. -Such offers may be for part of the bonds outstanding; so not all of the bondholders who tender may actually sell their bonds back to the corporation. -The issuer will fill tenders of bonds on a first come, first served basis, until the issuer has retired the desired amount of debt. -Any bonds tendered in excess of the amount repurchased by the company are returned to the holders

Discount Instrument - Commercial Paper

-Because of the short term nature, obviously semi-annual interest payments cannot be made as with longer term debt. -Instead, sold at discount and matures at face value. The difference is the earned interest income, which is effectively received at maturity. -Unlike longer term debt sold in $1,000 units, commercial paper is sold in large units - $100,000 is the minimum denomination and it is often sold in multiples of $1,000,000.

Dealer Paper

-Commercial paper also is sold over-the-counter through dealers and, more and more can be bought directly from the issuing corporation. -Paper bought from the issuer is termed "direct" paper. -Paper bought from a dealer who has purchased the security from the issuer is called "dealer" paper. -If the dealer is simply acting as an agent in selling paper for the issuer, the paper is "bought as sold." -There is little trading of commercial paper - it is usually held to maturity. Commercial paper is sold at a discount and matures at par. It is quoted on a discount yield basis.

Trades Of Corporate Bonds Settle In Clearing House Funds At NSCC

-Corporate bond trades are settled through clearing houses owned by the exchanges and their member firms. -The clearing house for corporate bond trades (and also for municipal bond trades and all equity trades) is NSCC - the National Securities Clearing Corporation. -NSCC is responsible for clearing virtually all domestic corporate (and municipal) securities trades. The deposits at NSCC are known as "clearing house funds."

Retiring Debt/ Sinking Fund - CORPORATE DEBT RETIREMENT PROVISIONS

-Corporate bonds may be redeemed at maturity, or, if a call provision is included in the Trust Indenture, may be called under the terms of the provision. In this manner, debt is retired. -The indenture can also call for the establishment of a "sinking fund." Money is deposited into the fund periodically (usually annually) and the funds are used to retire the bonds at maturity or to retire a portion of the issue each year after a specified date. -This is an extra protection measure for bondholders. The terms of a sinking fund provision allow the issuer to retire portions of the issue by either calling the bonds or buying them in the open market if the price is lower than the call price.

Types Of Bonds That Trade Flat

-Defaulted bonds trade flat; -income bonds trade flat since they are not currently paying interest; -zero coupon bonds trade flat because no periodic interest payments are made; -commercial paper trades flat because no interest payments are made - the paper is bought at a discount and redeemed at par. The increase in value is the "interest." Finally, if a bond trade settles on the interest payment date, no accrued interest is due since this is the exact cut-off date for the seller to receive his 6-month payment and the buyer to pick up the next 6-month period.

Corporate Bond Quotes / Bloomberg

-Electronic dealer quotes (bids and offers) for corporate bonds are posted by services such as Bloomberg and Reuters. -The larger bond dealers, such as Goldman Sachs, Morgan Stanley, and Barclays, have their own internal trading systems that can access these quotes and trade against them. -For trades that are too large for these proprietary systems, bond traders will simply pick up the phone and trade manually. Corporate bonds are quoted in this market as a percentage of par value in 1/8ths.

Equipment Trust Certificates

-Equipment owned by the corporation is pledged as collateral. -This is the typical form of financing for common carriers such as airlines, trucking companies and railroads. -For example, if United Airlines wants to buy new planes, it will finance the purchase by issuing equipment trust certificates. The planes are the collateral backing the issue.

Portion Of The Discount Is Accreted And Taxed Each Year

-For obligations maturing over 1 year, the IRS requires that the pro-rata portion of the discount earned that year be taken as interest income on the tax return. -This is called the "accretion" of the discount. -Each year, the portion of the discount that is earned is added to the cost basis of the bond. At maturity, the bond will have a tax cost basis of par; since it is redeemed at par, there is no capital gain.

Information Source - Standard And Poor's Bond Guide / Migrated To The Internet - Now Part Of S&P Net Advantage

-For summarized bond (and preferred stock) financial information, Standard and Poor's publishes a "Bond Guide," giving capsule summaries for every corporate fixed income issue, including recent price, yield, and rating. -The Bond Guide used to be printed monthly, but has been migrated to the Internet by S&P through a service called S&P Net Advantage (Moody's publishes a similar guide).

Cash

-If a seller does not want to wait for a number of business days to be paid, a trade can be done "for cash." -Cash settlement occurs the same day as trade date before 2:30 PM. -The downside for the seller is, to induce someone to pay today, the bonds would have to be sold at a lower price than in a regular way trade.

Trades Of Treasury Bonds Settle In Federal Funds At FICC

-In contrast, trades of U.S. Government, Government Agency securities, and mortgage-backed securities (all covered in the next section) clear through FICC - the Fixed Income Clearing Corporation. -The majority of government bond trading is done by commercial banks that are members of the Federal Reserve Banking system. The deposits maintained at FICC by member banks are known as "Federal funds."

Refunding Debt - CORPORATE DEBT RETIREMENT PROVISIONS

-Instead of retiring debt, a corporation may simply roll it over in part or in full. -It does this by issuing a refunding bond issue and using the proceeds to call or retire debt. -A corporation issues refunding bonds when interest rates have dropped (to retire expensive debt and replace it with lower interest rate debt) or when it simply doesn't have the funds or the desire to retire bonds.

Income Bonds Trade Flat

-Interest accrues on the bonds but is only paid if the corporation returns to profitability. -In theory, if the corporation is profitable, all missed interest payments will be made up. -Because these bonds are not currently paying interest, they trade "flat" in the market - without any accrued interest.

Interest Accrues Until Settlement / 30 / 360 Basis

-Interest accrues up to, but not including, settlement date. -This makes sense because as of settlement, the buyer has paid for the bond and should get interest from that day forward. -For corporate bonds, interest accrues on an arbitrary 30 day month / 360 day year basis.

Debenture

-Intermediate and long-term corporate debt which is backed solely by the full faith and credit of the issuer. -There is no collateral backing the issue. -Debentures are issued by "blue chip" corporations with high credit ratings who do not have to back the issue with assets, and also by lower credit rated companies in the form of high yield or "junk" bonds. Compared to a secured bond, credit risk is higher for a debenture holder.

How are convertible bonds issued?

-Issuance Of Convertible Bonds require Shareholder Approval -Existing shareholders tend to have a problem with a new convertible issue proposed by a corporation. The reason is if the securities are converted, new common shares are issued. The earnings of the company are then spread over more shares, causing a dilution of earnings per share. This can depress the stock's market price.

Over-The-Counter Trading

-Most corporate debt is traded in the over-the-counter market. -The NASDAQ Stock Market quotes convertible corporate bonds, since they are an "equivalent" security to common stock, but does not quote non-convertible bonds. -This is a dealer-to-dealer market, with trading conducted over the phone and through electronic trading systems. A round lot trade of bonds is five $1,000 par value bonds ($5,000 face amount).

Discount On Original Issue Discount Bonds Is "Interest Income" - TAX STATUS OF CORPORATE DEBT INTEREST

-Original issue discount obligations, such as commercial paper and zero-coupon obligations, are unusual in that interest "payments" are not made. -The securities are purchased at a discount and mature at par. -The Internal Revenue Service considers the discount to be interest income earned over the life of the security. -Since commercial paper matures in 270 days or less, the entire discount is included as interest income for that tax year.

Discount On Original Issue Discount Bonds Is "Interest Income"

-Original issue discount obligations, such as commercial paper and zero-coupon obligations, are unusual in that interest "payments" are not made. -The securities are purchased at a discount and mature at par. The Internal Revenue Service considers the discount to be interest income earned over the life of the security. -Since commercial paper matures in 270 days or less, the entire discount is included as interest income for that tax year.

Mortgage Bond

-Real estate such as a factory is pledged as collateral for the bond issue. -The bondholder has a lien on the real estate. Under a "lien," the bondholder has the legal right to sell the mortgaged property if the bondholders' claims are not satisfied. -The real estate that is pledged is worth more than the bonds that are issued, so the bondholders have a collateral "cushion."

Subordinated Debenture

-Subordinated debenture holders agree to a lower status in a corporate liquidation. If a company liquidates, subordinated debtholders are paid after all other creditors. -In order to induce customers to buy subordinated debentures, another feature would have to be given to bondholders to compensate for the extra risk. -This usually takes the form of a "conversion" feature - which allows the bondholder to convert the bond into a fixed number of common shares. This is covered in the following section.

Convertible Bonds - What happens to Tax-Deductible Interest Payments?

-Tax deductible interest payments are replaced By Non-Deductible Dividends -Conversion also causes debt to be replaced with equity. -the corporation no longer makes tax-deductible interest payments to bondholders. Instead, it makes dividend payments which are paid "after tax."

NYSE Trading

-The New York Stock Exchange has a separate bond trading area where a computerized system matches trades. -Bonds of companies that are listed on the exchange trade here, but volume is comparatively light - averaging less than 10,000 bonds per day. A round lot trade is 5 - $1,000 par value bonds, quoted as a percentage of par in 1/8ths.

Convertible Bonds - Capital Gains

-The advantages to the convertible bondholder are the possibility of capital gains if the stock price goes up, and the fact that bondholders have priority over stockholders if the company is liquidated. -The disadvantages to the convertible bondholder are the lower interest rates on these issues, and the possible dilutive effect of a large conversion.

Trust Indenture

-The bonds are issued under a bond contract called an indenture. -The indenture spells out the interest rate, maturity, collateral, call or put provisions, and all other relevant features of the bonds. -The indenture may also call for the corporation to maintain specific protections for the bondholders such as insurance coverage, audit by an independent accountant, and certain ratios of assets to liabilities. -To ensure that the corporation adheres to the indenture, an independent trustee is appointed to monitor compliance with the provisions of the indenture. -The trustee reports annually to the bondholders, and is expected to inform the bondholders if he finds non-compliance. The trustee is usually a commercial bank.

Convertible Bonds - Dilution of Earnings

-The disadvantage to the issuer of convertible bonds is that when conversion occurs, existing stockholder's equity is diluted (since more shares have been issued). -Because earnings are spread over a greater number of shares, reported earnings per share can fall

Interest Income Subject To Both Federal And State Tax - TAX STATUS OF CORPORATE DEBT INTEREST

-The interest income derived from corporate obligations is fully taxable by both the federal government and by state and local government. -The interest income is taxable in the year the payment is made. -Since most bonds pay interest semi-annually, two interest payments are included on each year's tax return.

Registered to principal only

-The next version of the bond -The $1,000 face amount of the bond is now registered in the owner's name, but the bond still has bearer coupons attached. -

Fully registered bond

-The next version of the bond gets rid of bearer coupons. This is a bond that is "registered to principal and interest," also called a fully registered bond. -Fully registered bonds have the bondholder registered with the transfer agent as the owner of record and a physical certificate is issued to the bondholder. The paying agent sends the semi-annual interest payments directly to the registered owner and, at maturity, sends the final $1,000 principal repayment to the registered owner.

Zero-Coupon Bonds Held In Tax Deferred Accounts To Avoid Current Taxation

-The problem for the holder of a zero-coupon bond is that every year tax must be paid on the "earned" portion of the discount even though no payment is made by the issuer. -Because of this, zero-coupon bonds are generally not purchased unless they will be placed in a tax-deferred retirement account (IRA or Keogh).

Book Entry Bond

-The problem with all of these bonds is that they are very expensive to print. -The final solution comes in the form of the "book entry" bond. With book entry securities, no physical certificates are issued; but the holder's name, address, and purchase amount are registered with the transfer agent. -All new issues of bonds coming out in the United States are now book entry only.

Bearer bonds

-The very first bonds issued -not registered in an owner's name. -payable to the "bearer" and have rows of coupons attached to the bond. Each semi-annual coupon has a payment date and amount on it. The bearer of the bond clips the coupon at the due date and sends it to the paying agent for cash payment. -In essence, a bearer bond is really no different than holding paper currency. Because there is no record of the owner, if the bond is lost or destroyed, it cannot be replaced

TRACE Reports Of Corporate Bond Trades

-Trades of corporate, government, and agency bonds are reported by a FINRA system called TRACE (Trade Reporting and Compliance Engine). -Any dealer that executes a trade in these securities must report the trade to TRACE "as soon as practicable, but no later than 15 minutes after execution." -Once TRACE receives the report, it publishes the trade on the TRACE tape immediately.

Commercial Paper

-Very short-term corporate financing needs are met by issuing commercial paper. -Maturities typically range from 14 days to 90 days, with 30 days being the most common maturity. -The maturity will never exceed 270 days, because the issue would then have to be registered with the SEC, an expensive and time consuming process.

Convertible bond - Forced conversion

-What the issuer has done by calling in the bonds is termed a forced conversion. -A forced conversion allows the issuer to replace the bonds with equity securities and relieves the issuer of the interest payment burden. -Instead, the issuer will now pay dividends on the stock. -Remember, interest payments are a legal obligation; dividend payments are discretionary.

Accrued Interest

-When a bond trade settles, the buyer must pay to the seller the purchase price of the bond plus any commissions due to the broker. -In addition, the seller has earned any interest on the bond for the period that it has been held between interest payment dates. -When the bond changes hands, the ownership record is changed with the transfer agent. -The new holder of the bond will receive the entire 6-month interest payment coming due. -However, the new holder has not earned this entire payment and is obligated to pay the portion of interest earned to the seller on settlement date. For example, assume a customer purchases a 10% bond at 90 which pays interest on Jan 1st and Jul 1st. The trade settles on Feb 1st. The new owner will receive the 6-month interest payment on Jul 1st, but has only earned 5 months of the interest payment (Feb through Jun). The buyer must pay to the seller the accrued interest due for the month of January on settlement date.

Income Bonds / Termed "Adjustment Bonds"

-When a corporation goes bankrupt, the issuer defaults on the outstanding debt. The company then tries to reorganize and emerge from bankruptcy. -Part of the reorganization is getting the existing bondholders to give up any claims under the old bonds and accept a new type of bond. This new bond is an "income" bond, that only obligates the issuer to pay if it has sufficient "earnings." -The bondholders are likely to accept this new instrument since they are receiving nothing anyway. -To induce the bondholders to accept the new issue, they are often given a greater principal amount than they had before. Therefore, the principal amount is "adjusted" on these bonds.

Odd First Interest Payment - New Issue

-When a new issue of bonds comes out, the issue date may not be a psychologically "convenient" date for investors. Isn't it comforting and easy to remember that your bond pays interest on Jan 1st and Jul 1st? If the issue date is Feb 4th, six-month interest payments would be due on Aug 4th and next Feb 4th. To make life easier, the first interest payment will be designated as "odd" and cover either the period from Feb 4th to Jul 1st or Feb 4th - Jan 1st. Thereafter, interest payments are made on Jan 1st and July 1st.

How is commercial paper sold? who are the purchasers?

-in book entry form -The purchasers are not small investors because of the large denominations. They are large institutions with excess cash to invest and money market mutual funds. -There is very limited trading of these instruments - most investors simply hold them to maturity

Convertible bond - lower interest rate

-investors will accept a lower interest rate since there is potential price appreciation based on converting the bond if the stock price rises. -If the bond is callable, the issuer has a second advantage. We know that bonds are called if interest rates fall. Assume that falling interest rates over the five years following issuance have forced the price of our sample bond to $1,200. The stock price has also increased to $60. Since the conversion ratio is 20, there is no advantage to converting currently - the security is at parity (20 shares per bond x $60 market price = $1,200 bond parity price. The market price is also $1,200). Assume that the issuer can call the bonds at 105. If the bonds are called, the bondholder tendering the bonds will receive $1,050 per bond. This is a loss of $150 from the current market value of $1,200. Once a call notice is announced, the bondholder has 3 choices; tender the bonds for 105, convert the bonds or do nothing. Doing nothing is not a solution because once the bonds are called, interest payments will cease. If the bonds are redeemed, the bondholder receives $1,050. If the bond is converted, the bondholder receives 20 shares valued at $60 = $1,200. Clearly, the best choice is to convert.

Transfer Agent/Paying Agent

-keeps the record of the owners of the debt outstanding, and when the debt is traded, "transfers" the ownership record to the new owner. -The same financial institution usually acts as paying agent for the issuer as well. The paying agent makes the actual interest payments to the owners of record and handles debt redemptions

Forms of corporate debt:

-long term bonds -intermediate term notes -short term notes (commercial paper)

Secured corp debt

-specific collateral is pledged to back the bond issue. -If the corporation defaults, the bondholders have claim to the collateral. -Because of the extra protection afforded by the collateral, secured bonds can be sold at lower interest rates than unsecured bonds. -Secured bonds are typically long-term maturities.

A customer buys a 10% $1,000 par corporate bond at 90 in a regular way trade. The trade date is Tuesday, March 7th. The bond pays interest on Jan 1st and Jul 1st. How many days of accrued interest are due to the seller? How much accrued interest will be paid?

The trade date is Tuesday, March 7th. Regular way settlement is 2 business days, and so settlement takes place on Thursday, March 9th. Interest accrues up to, but not including settlement, therefore, interest accrues through March 8th. The number of days of accrued interest is: January 30 days February 30 days March 8 days _______________________________ Total 68 days 68 days Amount Paid = ------------ = x $100 annual interest = $18.88 360 days

Trust Indenture Act Of 1939

All corporate issues of $50,000,000 or more must have a Trust Indenture as specified by the Trust Indenture Act of 1939.

Senior/Junior Lien

Therefore, there can be senior lien mortgage bonds and junior lien mortgage bonds. Another way of showing the status of a mortgage bond is by calling the senior issue a first mortgage bond; junior issues are second and third mortgage bonds.

Conversion ratio formula

C.R. = Par value of bond / conversion price.

Let's use the example of the $1,000 par bond convertible at $50. The current market price of the stock is $40. The bond is currently selling for $900. What is the conversion ratio?

C.R. = Par value of bond / conversion price. C.R. = $1,000/$50 = 20:1 This bond is convertible into 20 shares of stock. The second formula is for the parity price. In theory, the bond and the stock should always be trading at equivalent values (since the bond is convertible into the stock).

Commercial Paper Quotations

Commercial paper is not listed in the newspapers like bonds since there is almost no trading. Instead, representative discount yields are given each day in The Wall Street Journal for prime paper. A sample listing is: COMMERCIAL PAPER; High grade unsecured notes sold through dealers by major corporations: 1.85% 30 days; 2.95% 60 days; 3% 90 days Dealers are offering 30-day paper priced to yield 1.85%; 60-day paper to yield 2.95%; and 90-day paper to yield 3.00%.

Convertible Corporate Debt

Convertible bonds are corporate debentures which can be converted, at the option of the owner, into the common stock of the issuer. At the time of issuance, a conversion price is set per share. The bond can then be converted, based on its par value, into a fixed number of common shares. At the time of issuance, the conversion price is set at a premium to the stock's current market price. In order for the conversion feature to benefit the bondholder, the stock's price must rise in the market above the conversion price. For example, a $1,000 par bond is issued, convertible into stock at $50 per share. As of the date of issuance, the market price of the stock is $40. This bond is convertible into 20 shares of stock ($1,000 par/$50 conversion price = 20 shares per bond). In order for the shareholder to benefit, the market price must rise above $50.

Regular Way Settlement

Corporate bond trades settle "regular way" unless special delivery terms are required. A regular way trade settles 2 business days after trade date.

Who issues mortgage bonds?

UTILITIES Mortgage bonds are the most common form of corporate debt, and are the principal financing source for public utilities. These issues generally get high credit ratings due mainly to the quality of the collateral backing the issue, and can be sold at lower interest rates than unsecured debt.

Unsecured corp debt

Unsecured corporate debt is simply backed by the issuer's promise to pay. There is no collateral backing the issue. Unsecured debt is issued in short term, intermediate term and long-term maturities.

Guaranteed Bond

Debentures can be guaranteed. -In this case, bonds are typically issued by a subsidiary company; with the corporate parent company guaranteeing payment of interest and principal as due. Such bonds take on the credit rating of the guarantor.

Trading above parity

When a convertible security trades above parity, the conversion feature does not have any value. There is no reason to convert into stock which is valued at less ($40 market) than the effective conversion price ($45). Therefore, the bond trades like any other debt security and its price movements respond inversely to interest rate swings.

Trading below parity

However, when a convertible security trades below parity, the conversion feature is valuable. Assume this $1,000 par bond is trading at $1,100. The market price of the stock is $60 while the conversion price is $50. The bond can be converted into 20 shares of stock worth $60 each or $1,200. Since the market price is $1,100, a large profit ($1,200 conversion - $1,100 purchase = $100 profit) can be made by purchasing the bond and converting it into stock. Any astute investor will take advantage of this opportunity. When a convertible security is trading below parity, the profit can be quickly realized through arbitrage.

CLAIM PRIORITY IN A LIQUIDATION

If a corporation liquidates in bankruptcy, the following is the priority of making payments to creditors: 1st: Secured creditors such as mortgage bondholders and equipment trust certificate holders receive the proceeds from the sales of the property pledged; 2nd: Unpaid wages, taxes, and trade creditors are paid (in the order just presented); 3rd: Debenture bondholders are paid; 4th: Subordinated debenture bondholders are paid; 5th: Preferred stockholders are paid; and finally 6th: Common stockholders are paid anything that remains. -Note that a point of confusion that exists about the priority of claim in a liquidation is the status of secured creditors. Secured creditors are "carved out" in a liquidation and get the proceeds from the sale of any assets pledged as collateral before any other creditors are paid. That is why they are "secured" and accept a lower interest rate than other creditors. The balance of the assets left in the bankruptcy estate are then distributed to the unsecured creditors, with workers' claims being the first unsecured claim to be paid.

Conversion Price Is Adjusted For Stock Dividends And Stock Splits - Convertible Bonds

If the conversion price is not adjusted, the stock will now be valued below parity. -To keep the bondholder whole, the conversion price will also be adjusted (divided by the factor of 1.25) to get a conversion price of $40. In this way, the bondholder is protected from dilution affecting the value of the bond. Therefore, the conversion price will be adjusted for stock dividends, stock splits, and for the issuance of new shares.

closed end trust indenture

If the trust indenture is closed-end, new bonds can be issued against the real estate only if they are junior (have lower status in a liquidation) to the existing bonds.

Open end trust indenture

If the trust indenture is open-end, the corporation can sell additional bonds having equal status against the real estate. However, open-end trust indentures will typically include an "additional bonds test" requirement that must be met before new bonds may be sold. This test usually requires that earnings before interest expense for the preceding period or number of periods must exceed both the current interest expense plus the projected interest expense on the additional bonds to be sold by a stated multiple. For example, it might be required that earnings before interest expense be at least 2 times the current interest cost, plus projected interest cost on the new bond issue, before that issue can be sold.

Arbitrage

In an arbitrage, a trader buys the lower price security and simultaneously sells the equivalent higher priced security to lock in the profit before someone else does. In this case, the trader will buy the lower priced security (the bond at $1,100) and sell the equivalent number of shares of the higher priced security (the stock - 20 shares at $60 = $1,200) The arbitrage trade is: Buy 1 Convertible Bond = $1,100 Sell 20 shares of Stock at $60 = $1,200 The trader then converts the bond into 20 shares of stock through the transfer agent and delivers them to satisfy the sale. A quick profit of $100 was made. Arbitrage only works when the convertible security trades below parity. If the security is trading at or above parity, there is no profit potential.

Anti-Dilutive Covenant of Convertible Bonds

Once convertible securities are issued, the bondholder is protected by an "anti-dilutive" covenant in the Trust Indenture. Assume that the market price of the stock is now $50 and the conversion price is $50. Both are at parity. If the company issues 25% more shares, the market price of the stock will fall since the earnings are spread over a greater number of shares. In theory, the new market price will be $50/1.25 = $40.

Parity Price of a bond formula

P.P. of bond = Conversion Ratio x Stock's Mkt Price = 20 x $40 =$800 In order for the bond to be of equal value to the stock, it must trade for $800. The current market price is $900. Therefore, the bond is trading above its parity price.

Parity Price of stock formula

P.P. of stock = Bond Mkt Value / Conversion Ratio = $900 / 20 = $45 The market price of the stock must be $45 (it is currently $40) for the stock to be at parity. Therefore, the stock is selling below its parity value.