Chapter 7: Corporate Debt Instruments
The absolute priority rule is the principle that senior creditors are paid in full before junior creditors are paid anything.
Notes: Bankruptcy and Creditors Rights (slide) -In liquidations, the absolute priority rule generally holds
Debt obligations that are assigned a rating in the top four categories are said to be investment-grade.
Notes: Bankruptcy and Creditors Rights (slide) -Issues that carry a rating below the top four categories are said to be noninvestment-grade, or more popularly referred to as high-yield debt or junk debt.
The bankruptcy act is composed of 15 chapters, each chapter covering a particular type of bankruptcy.
Notes: Bankruptcy and Creditors Rights (slide) -Of particular interest to us are two of the chapters, Chapter 7 and Chapter 11.
Corporate debt instruments have a much bigger varieties than compared to government issued bonds
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Covenants = restrictions
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The issuer will only call the bond if they think that they can issue a new bond with a lower cost
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A company that files for protection under the bankruptcy act generally becomes a debtor in possession (DIP), and continues to operate its business under the supervision of the court.
Notes: Bankruptcy and Creditors Rights (slide)
A new corporate entity results in a reorganization.
Notes: Bankruptcy and Creditors Rights (slide)
Chapter 11 deals with the reorganization of a company.
Notes: Bankruptcy and Creditors Rights (slide)
Entities that assign credit ratings and have been approved to do so by the Securities and Exchange Commission (SEC) are more formally referred to as nationally recognized statistical rating organizations (NRSROs).
Notes: Bankruptcy and Creditors Rights (slide)
In contrast, there is a good body of literature that argues that strict absolute priority has not been upheld by the courts or the Securities and Exchange Commission (SEC).
Notes: Bankruptcy and Creditors Rights (slide)
Other institutional investors do not perform their own analysis but, despite well-known problems with credit ratings, improperly and excessively rely on credit rating companies that perform credit analysis and issue their conclusions in the form of ratings.
Notes: Bankruptcy and Creditors Rights (slide)
Professional money managers use various techniques to analyze information on companies and bond issues in order to estimate the ability of the issuer to live up to its future contractual obligations. This activity is known as credit analysis.
Notes: Bankruptcy and Creditors Rights (slide)
Rating agencies monitor the bonds and issuers that they have rated.
Notes: Bankruptcy and Creditors Rights (slide)
Some large institutional investors and many banks have their own credit analysis departments.
Notes: Bankruptcy and Creditors Rights (slide)
Studies of actual reorganizations under Chapter 11 have found that the violation of absolute priority is the rule rather the exception.
Notes: Bankruptcy and Creditors Rights (slide)
The liquidation of a corporation means that all the assets will be distributed to the holders of claims of the corporation and no corporate entity will survive.
Notes: Bankruptcy and Creditors Rights (slide)
Thus, the corporate debt market can be divided into two sectors based on credit ratings: -the investment-grade -noninvestment-grade markets.
Notes: Bankruptcy and Creditors Rights (slide)
When a company is liquidated, creditors receive distributions based on the absolute priority rule to the extent that assets are available.
Notes: Bankruptcy and Creditors Rights (slide)
Chapter 7 deals with the liquidation of a company.
Notes: Bankruptcy and Creditors Rights (slide) -Historically, liquidations have been less common than Chapter 11 filings.
Securities privately placed are exempt from registration with the SEC because they are issued in transactions that do not involve a public offering.
Notes: Corporate Bonds (slide)
Although there are 10 NRSROs, the three major ones are -Moody's Investors Service -Standard & Poor's Rating Services -Fitch, Inc.
Notes: Bankruptcy and Creditors Rights (slide) -In all three systems, the term high grade means low credit risk, or conversely, high probability of future payments.
The promises of corporate bond issuers and the rights of investors who buy them are set forth in great detail in contracts called bond indentures.
Notes: Corporate Bonds (slide)
Bond issues in the high-yield corporate bonds (junk bonds) sector of the bond market may have been rated (1) noninvestment grade at the time of issuance (2) investment grade at the time of issuance and downgraded subsequently to noninvestment grade.
Notes: Corporate Bonds (slide)
When they are offered, MTNs are usually sold in relatively small amounts on a continuous or an intermittent basis, whereas corporate bonds are sold in large, discrete offerings.
Notes: Medium-Term Notes (slide)
Bond indentures mainly specify the responsibilities that the issuer has against the buyer
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Capital structure is how the financing sources of a corporation is divided between debt and equity
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The U.S. bankruptcy law gives debtors who are unable to meet their debt obligations a mechanism for formulating a plan to resolve their debts through an allocation of their assets among their creditors.
Notes: Bankruptcy and Creditors Rights (slide) -One purpose of the bankruptcy law is to set forth the rules for a corporation to be either liquidated or reorganized.
A number of companies issue long-term debt with extended call protection, not refunding protection. A number are noncallable for the issue's life. For such issues the prospectus expressly prohibits redemption prior to maturity. These noncallable-for-life issues are referred to as bullet bonds.
Notes: Corporate Bonds (slide)
Accrued Interest
Notes: Corporate Bonds (slide)
Although there may be certain exceptions to absolute or complete call protection in some cases (such as sinking funds and the redemption of debt under certain mandatory provisions), a noncallable bond still provides greater assurance against premature and unwanted redemption than does refunding protection.
Notes: Corporate Bonds (slide)
Another structure found in the high-yield bond market is one that requires the issuer to reset the coupon rate so that the bond will trade at a predetermined price.
Notes: Corporate Bonds (slide)
As with all bonds, the principal secondary market for corporate bonds is the over-the-counter market. The major concern is market transparency.
Notes: Corporate Bonds (slide)
At the time of issuance, a callable bond issue may contain a restriction that prevents the issuer from exercising the call option for a specified number of years.
Notes: Corporate Bonds (slide)
Auction systems allow market participants to conduct electronic auctions of securities offerings for both new issues in the primary markets and secondary market offerings.
Notes: Corporate Bonds (slide)
Bond issues in the first category are referred to as original-issue high-yield bonds. Bonds issues in the second category are either issues that have been downgraded because the issuer voluntarily significantly increased its use of debt as a result of a leveraged buyout or a recapitalization, or issues that have been downgraded for other reasons. The latter issues are commonly referred to as fallen angels.
Notes: Corporate Bonds (slide)
Bonds can be called in whole (the entire issue) or in part (only a portion).When less than the entire issue is called, the specific bonds to be called are selected randomly or on a pro rata basis.
Notes: Corporate Bonds (slide)
Bonds that are noncallable for the issue's life are more common than bonds that are nonrefundable for life but otherwise callable.
Notes: Corporate Bonds (slide)
Callable bonds with this feature are said to have a deferred call and the date at which the issue may first be called is said to be the first call date.
Notes: Corporate Bonds (slide)
Corporate bonds are debt obligations issued by corporations.
Notes: Corporate Bonds (slide)
Corporate borrowings due in 20 to 30 years tend to be referred to as bonds.
Notes: Corporate Bonds (slide)
Cross-matching systems bring dealers and institutional investors together in electronic trading networks that provide real-time or periodic cross-matching sessions.
Notes: Corporate Bonds (slide)
Efforts to increase price transparency in the U.S. corporate debt market resulted in the introduction of a mandatory reporting of over-the-counter secondary market transactions for corporate bonds that met specific criteria.
Notes: Corporate Bonds (slide)
Finally, payment-in-kind (PIK) bonds give the issuer an option to pay cash at a coupon payment date or give the bondholder a similar bond.
Notes: Corporate Bonds (slide)
Generally, obligations due in under 10 years from the date of issue are called notes.
Notes: Corporate Bonds (slide)
Generally, the coupon rate at reset time will be the average of rates suggested by a third part, usually two banks .
Notes: Corporate Bonds (slide)
If, instead, a callable bond does not have any protection against early call, then it is said to be a currently callable issue.
Notes: Corporate Bonds (slide)
In a leverage buyout (LBO) or a recapitalization, the heavy interest payment burden that the corporation assumes places severe cash flow constraints on the firm.
Notes: Corporate Bonds (slide)
Interdealer systems allow dealers to execute transactions electronically with other dealers via the anonymous services of "brokers' brokers."
Notes: Corporate Bonds (slide)
Most corporate bonds are term bonds; that is, they run for a term of years, and then become due and payable.
Notes: Corporate Bonds (slide)
Multidealer systems allow customers with consolidated orders from two or more dealers that give the customers the ability to execute from among multiple quotes. Multidealer systems, also called client-to-dealer systems, typically display to customers the best bid or offer price of those posted by all dealers.
Notes: Corporate Bonds (slide)
Not all private placements are Rule 144A private placement.
Notes: Corporate Bonds (slide)
Private Placements Market for Corporate Bonds
Notes: Corporate Bonds (slide)
Provisions for Paying off Bonds Prior to Maturity
Notes: Corporate Bonds (slide)
Refunding a bond issue means redeeming bonds with funds obtained through the sale of a new bond issue.
Notes: Corporate Bonds (slide)
SEC Rule 144A allows the trading of privately placed securities among qualified institutional buyers.
Notes: Corporate Bonds (slide)
Secondary Market for Corporate Bonds
Notes: Corporate Bonds (slide)
Single-dealer systems permit investors to execute transactions directly with the specific dealer desired; this dealer acts as a principal in the transaction with access to the dealer by the investor, which increasingly has been through the Internet.
Notes: Corporate Bonds (slide)
Some corporate bond issues are arranged so that specified principal amounts become due on specified dates. Such issues are called serial bonds.
Notes: Corporate Bonds (slide)
Some corporate bond issues have call provision granting the issuer an option to buy back all or part of the issue prior to the stated maturity date. Some issues specify that the issuer must retire a predetermined amount of the issue periodically.
Notes: Corporate Bonds (slide)
Sometimes investors are confused by the terms noncallable and nonrefundable. Call protection is much more absolute than refunding protection.
Notes: Corporate Bonds (slide)
Special Structures for High-Yield Corporate Bonds
Notes: Corporate Bonds (slide)
Step-up bonds do pay coupon interest, but the coupon rate is low for an initial period and then increases ("steps up") to a higher coupon rate.
Notes: Corporate Bonds (slide)
The call price is referred to as the regular price or general redemption price because there may also be a special redemption price for debt redeemed through the sinking fund and through other provisions such as with the proceeds from the confiscation of property through the right of eminent domain.
Notes: Corporate Bonds (slide)
The call price that the price that the issuer must pay to retire the issue and may be a single call price or a call schedule that sets forth a call price based on when the issuer exercises the option to call the bond.
Notes: Corporate Bonds (slide)
The covenants or restrictions on management are important in the analysis of the credit risk of a corporate bond issue as well as for bank loans.
Notes: Corporate Bonds (slide)
The private-placement market can be divided into two sectors. -First is the traditional private-placement market, which includes non-144A securities. -Second is the market for 144A securities.
Notes: Corporate Bonds (slide)
The term refunding means to replace an old bond issue with a new one, often at a lower interest cost.
Notes: Corporate Bonds (slide)
There are the following five types of electronic corporate bond trading systems: -auction systems -cross-matching systems -interdealer systems -multidealer systems -single-dealer systems.
Notes: Corporate Bonds (slide)
There are three types of deferred coupon structures: 1)deferred-interest bonds 2)step-up bonds 3)payment-in-kind bonds.
Notes: Corporate Bonds (slide)
To reduce this burden, firms involved in LBOs and recapitalizations have issued bonds with deferred coupon structures that permit the issuer to avoid using cash to make interest payments for a period of three to seven years.
Notes: Corporate Bonds (slide)
With a traditional call provision, the call price is fixed and is either par or a premium over par based on the call date. With a make-whole call provision, the payment when the issuer calls a bond is determined by the present value of the remaining payments discounted at a small spread over a maturity-matched Treasury yield. The specified spread which is fixed over the bond's life is called the make-whole premium.
Notes: Corporate Bonds (slide)
In addition to the agreed-upon price, the buyer must pay the seller accrued interest.
Notes: Corporate Bonds (slide) -Each month in a corporate bond year is 30 days, whether it is February, April, or August. -The corporate calendar is referred to as "30/360."
Historically, corporate bond trading has been an OTC market conducted via telephone and based on broker-dealer trading desks, which take principal positions in corporate bonds in order to fulfill buy and sell orders of their customers.
Notes: Corporate Bonds (slide) -There has been a transition away from this traditional form of bond trading and toward electronic trading.
Deferred-interest bonds are the most common type of deferred coupon structure.
Notes: Corporate Bonds (slide) -These bonds sell at a deep discount and do not pay interest for an initial period, typically from three to seven years.
A corporate bond issue may require the issuer to retire a specified portion of an issue each year. This is referred to as a sinking fund requirement.
Notes: Corporate Bonds (slide) -This kind of provision for repayment of corporate debt may be designed to liquidate all of a bond issue by the maturity date, or it may be arranged to pay only a part of the total by the end of the term. -If only a part is paid, the remainder is called a balloon maturity. The purpose of the sinking fund provision is to reduce credit risk.
The new rate will then reflect (1) the level of interest rates at the reset date (2) the credit spread the market wants on the issue at the reset date.
Notes: Corporate Bonds (slide) -This structure is called an extendable reset.
Some bond issues include a provision that grants the issuer the option to retire more than the amount stipulated for sinking fund retirement. This is referred to as an accelerated sinking fund provision.
Notes: Corporate Bonds (slide) -Usually, the sinking fund call price is the par value if the bonds were originally sold at par. -When issued at a price in excess of par, the call price generally starts at the issuance price and scales down to par as the issue approaches maturity.
Borrowers have flexibility in designing MTNs to satisfy their own needs. They can issue fixed-or floating-rate debt. The coupon payments can be denominated in U.S. dollars or in a foreign currency.
Notes: Medium-Term Notes (slide)
MTNs differ from corporate bonds in the manner in which they are distributed to investors when they are initially sold.
Notes: Medium-Term Notes (slide)
When the treasurer of a corporation is contemplating an offering of either an MTN or corporate bonds, there are two factors that affect the decision: 1)The most obvious is the cost of the funds raised after consideration of registration and distribution costs. This cost is referred to as the all-in-cost of funds. 2)The second is the flexibility afforded to the issuer in structuring the offering.
Notes: Medium-Term Notes (slide)
A medium-term note (MTN) is a corporate debt instrument, with the unique characteristic that notes are offered continuously to investors by an agent of the issuer.
Notes: Medium-Term Notes (slide) -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.
Creditors holding subordinated debt rank after senior secured creditors, after senior unsecured creditors, and often after some general creditors in their claim on assets and earnings. The class of debt that has seniority within the ranks of subordinated debt is referred to as senior subordinated debt.
Notes: Seniority of debt in a corporations capital structure (slide)
Issuers of corporate debt obligations are categorized into the following three sectors: -Utilities -Financials -Industrials
Notes: Seniority of debt in a corporations capital structure (slide)
Senior unsecured debt is debt that is not secured by a specific pledge of property, but that does not mean that the creditors holding this type of debt have no claim on property of issuers or on their earnings. The bonds that are issued with priority against claims are commonly referred to as debenture bonds.
Notes: Seniority of debt in a corporations capital structure (slide)
The different creditor classes are classified as follows: 1)senior secured debt 2)senior unsecured debt 3)senior subordinated debt 4)subordinated debt.
Notes: Seniority of debt in a corporations capital structure (slide)
In capital structure decision-making, the issue is whether there is an optimal capital structure.
Notes: Seniority of debt in a corporations capital structure (slide) -Although optimal capital structure and the optimal debt structure is important in corporate finance and in credit risk modeling, our focus here is to merely describe the seniority structure.
Financials include bonds of the wide range of financial institutions
Notes: Seniority of debt in a corporations capital structure (slide) -Banks, investment banks, security dealers, etc. -More short term financial needs
Industrials include companies that are not utilities of financials
Notes: Seniority of debt in a corporations capital structure (slide) -Car manufacturers, retailers and so on. -Tech Companies -Riskier, more fluctuations because its a business for profit
Senior secured debt is backed by or secured by some form of collateral beyond the issuer's general credit standing.
Notes: Seniority of debt in a corporations capital structure (slide) -Either real property (using a mortgage) or personal property may be pledged to offer security. -Senior secured debt is the safest, obviously because its at the top rank -No matter what rank its not always 100% sure you will even get anything in the case of bankruptcy
The capital structure of the firm is the way in which the firm's management has elected to finance itself.
Notes: Seniority of debt in a corporations capital structure (slide) -In broad terms, the capital structure of a firm consists of common stock, preferred stock, and debt.
A mortgage bond grants the creditor a lien against the pledged assets; that is, the creditor has a legal right to sell the mortgaged property to satisfy unpaid obligations that are owed.
Notes: Seniority of debt in a corporations capital structure (slide) -In practice, foreclosure and sale of mortgaged property is unusual. -doesn't have to be mortgage bonds can be other financial assets too
Utilities include investor-owned companies that are involved in the generation, transmission, and distribution of electric, gas, and water.
Notes: Seniority of debt in a corporations capital structure (slide) -Typically corporations with a lot of fixed assets -Lots of safe assets, good infrastructure -Predictable streams of revenue -More regulated, safer
To satisfy the desires of bondholders for security, they will pledge stocks, notes, bonds or whatever other kind of obligations they own. Bonds secured by such assets are called collateral trust bonds.
Notes: Seniority of debt in a corporations capital structure (slide) -Used as collateral for issuing another bond (Like repo ones)
Because of the small size of a structured note offering and the flexibility to customize the offering in the swap market, investors can approach an issuer through its agent about designing a security for their needs. This process of customers inquiring of issuers or their agents to design a security is called a reverse inquiry.
Notes: Structured Notes (slide)
Structured notes include: -inverse floating-rate notes -equity-linked notes -commodity-linked notes -currency-linked notes -credit-linked notes.
Notes: Structured Notes (slide)
MTNs created when the issuer simultaneously transacts in the derivative markets (such as a swap or an option) in order to created the security are called structured notes.
Notes: Structured Notes (slide) -By using the derivative markets in combination with an offering, borrowers are able to create investment vehicles that are more customized for institutional investors to satisfy their investment objectives, even though they are forbidden from using swaps for hedging.