Ch 6: Corporate Debt

corporate bonds

Corporations issue bonds to raise capital Advantage of issuing bonds over stock is that they're not giving up ownership or a portion of profits Disadvantage is that they pay semiannual interest plus principal Corporate bonds are divided into two major categories—secured and unsecured. Although all debt that's issued by a corporation is backed by the full faith and credit of the issuer, secured bonds are additionally backed by specific corporate assets.

investor profile and money-market securities

Essentially, money-market instruments may be viewed as a safe haven for investors. normally have very stable prices. Remember, the sooner an investor needs access to funds, the less risk she can take with her principal. With exam questions, an important point to consider is the objectives of the investor. An investor who is interested in capital preservation may seek a money-market equivalent that's backed by the U.S. government, such as a T-bill. A high income investor may seek a money-market equivalent that's tax-free. Investors may also obtain access to these types of securities by making an investment in a money-market mutual fund.

Conversion is NOT Taxable (convertible bonds)

If the owners of convertible bonds (or convertible preferred stock) convert those securities into the common stock of the corporation, the conversion is NOT a taxable event. When these securities are converted, the cost basis for the common stock that's received will be based on the cost basis of the original security.

structured products

Structured products are *derivative securities* that may be linked to a variety of underlying (reference) assets including a stock index, foreign currency, commodity, basket of securities, change in spread between asset classes, single security, or an interest-rate and inflation-linked product. A structured product is typically built around a *fixed-income instrument (a note)* and a *derivative product*. While the *note pays a specified rate of interest* to the investor at defined intervals, the *derivative* component establishes the *amount of payment at maturity.* These products are considered a form of *corporate debt* and are typically created by major financial services institutions. Structured products are usually *registered as securities with the SEC*; however, clients must receive disclosure that these products are NOT bank deposits and are NOT insured by the Federal Deposit Insurance Corporation (FDIC).

Converting bonds to stock (convertible bonds)

The bond's *conversion price* is set at the time it's issued. To determine the *conversion ratio* (i.e., the number of shares the investor will receive at conversion), the *par value of the bond ($1,000) is divided by the conversion price.* Stock splits and stock dividends affect the conversion price and conversion ratio (which are otherwise established at issuance and do not change) *Test tip*: Prior to trying to solve a computational question regarding convertibles, the first step should be to double- check the conversion price and conversion ratio. An important fact is that if the conversion price is multiplied by the conversion ratio, it should always equal $1,000. Whether it's worthwhile for investors to convert their bonds into stock depends largely on the *price of the underlying stock*. The aggregate market value of the stock that the investor receives at conversion is called the *conversion value.* If Widget's stock is convertible at $40 and is selling for $30 a share, then the conversion value is $750 ($30 x 25 shares). Since this is well below the $1,000 par value of the bond, the bondholder is unlikely to convert.

General relationship between risk and yield:

high risk = high yield (to compensate for riskiness and attract investors)

Non-US Market Debt

*Eurodollar bonds* dollar-denominated deposit made outside of the United States. Eurodollar bonds pay their principal and interest in U.S. dollars, but are issued *outside* of the U.S. (primarily in Europe). The issuers of Eurodollar bonds include foreign corporations, foreign governments, and international agencies, such as the World Bank. These bonds are *not registered with the SEC* and, consequently, may not be sold in the U.S. until *40 days have elapsed from the date of issuance*. For this reason, they're bought primarily by foreign investors. As with domestic U.S. bonds, movements in U.S. interest rates can greatly affect the prices of Eurodollar bonds. *Yankee bonds* Denominated in U.S. dollars. Issued by foreign entities *in* the US. Allow foreign entities to borrow money in the U.S. marketplace. These bonds *are* registered with the SEC and sold primarily in the United States. Can immediately trade in secondary market in the US. *Eurobonds* sold in one country, but denominated in the currency of another country. In fact, the issuer, currency, and primary market may all be different. This type of bond, referred to as a *foreign pay bond*, can be greatly affected by interest-rate movements in the country in which it's denominated. A Eurodollar bond is a type of Eurobond *Sovereign bonds* Represent debt that's issued by foreign national governments. Although government debt is generally considered quite safe, the credit rating of these bonds is based on the current standing of the issuing government. Issuer's ability to repay the principal and interest is reflected in the bond's yield.

Advantages and disadvantages of convertible bonds

*advantages*: Convertible bonds allow corporations to borrow money at a *lower rate* (lower coupon) since the convertible feature is attractive to investors. Investors are willing to accept the lower interest rate in exchange for the opportunity to convert the bonds into common stock. Convertible bonds provide investors with a *greater degree of safety* than preferred or common stock (general creditor), but *also offer them the potential for capital appreciation if the underlying stock rises in value.* In addition, the investor has some downside protection because, even if the price of the stock falls, the convertible bond still has inherent value as a bond. *disadvantages*: if all of the bonds are converted into stock, then the number of outstanding shares may increase dramatically. This will cause the stockholders' equity to be *diluted* and the *earnings per share (EPS) to decrease*. At this point, the company will need to divide the earnings over a larger group of shareholders, thereby giving each of them a smaller percentage. In order to reflect this possibility, a company's EPS may need to be restated as *fully diluted EPS*—a figure that assumes all conversions have been made. From the issuer's point of view, conversion adjusts the mandatory debt obligation into equity and deleverages the corporation's balance sheet. This *deleveraging is useful because it removes both the near-term and long-term debt service obligations*. Remember, dividend payments to common shareholders are voluntary, while interest payments to bondholders are mandatory. Therefore, *after conversion*, the former bondholders are *no longer owed money at maturity*. The bonds are eliminated and will be replaced with an ownership interest.

Types of unsecured bonds

*high-yield (junk) bonds*: Corporate bonds that are rated below investment grade (below BBB by S&P or below Baa(3) by Moody's) carry a higher-than-normal credit risk. High-yield bonds must pay *higher coupons* in order to compensate investors for the added degree of risk that's associated with these investments. Essentially, these bonds are suitable only for *speculative* investors. If bonds start out with an investment-grade rating, but are later lowered to below investment grade, they're referred to as *fallen angels.* *income bonds*: normally issued by companies in reorganization (*bankruptcy*). The issuer promises to repay the principal amount at maturity, but does *NOT* promise to pay interest unless it has sufficient earnings. Since interest payments are not promised, income bonds *trade flat* (without accrued interest), sell at a *deep discount* (well below par), and are considered *speculative* investments. Despite their name, income bonds (also referred to as *adjustment bonds*) are not suitable for the typical income-seeking bond investor. *guaranteed bonds*: secured by a guarantee of another corporation. The other corporation promises that it will pay interest and principal if necessary. A typical example is a parent company guaranteeing a bond that's issued by a subsidiary company. *stepped coupon bonds*: Also called dual coupon or step-up coupons. Issued with a low coupon that increases at regular intervals. The issuer generally reserves the right to call the bond on the dates that the coupon is reset. *zero coupon bonds*: don't pay periodic interest. Instead, an investor purchases a zero-coupon at a *deep discount* from its par value, but is able to redeem the bond for its full face value at maturity. The difference between the purchase price and the amount that the investor receives at maturity is considered the bond's interest. Trade flat. Eliminate reinvestment risk. Typically, the longer the zero coupon bond's maturity, the deeper its discount from par value. Investors who purchase zero-coupon bonds often do so knowing that they're going to need a lump sum of money at some future date (like daughter's college in 20 years)

To be exempt from SEC registration and prospectus requirements the maturity length cap is typically:

270 days. that's why commercial paper is 270 days

zero-coupon bonds and accretion

Although a zero-coupon bond doesn't provide the purchaser with semiannual interest payments, the basis (value) of the bond must be *upwardly* adjusted each year over its life. The adjusted dollar value of the bond is referred to as its *accreted value* (or *accumulated value to date*). The closer you are to maturity, the closer the price will get to par value Not subject to reinvestment risk The increase in the bond's value is considered *phantom income* and, for tax purposes, considered taxable interest income. A bond's accreted value may be higher or lower than the market value of the bond. Zero-coupon investments are *often placed into tax-protected accounts*, such as IRAs or other retirement accounts to avoid the taxation of the phantom interest. However, if the bond is placed in a taxable account, the increase in value (accretion) would become taxable income each year even though the customer has not received any actual interest. This tax implication should be discussed with a client prior to the purchase of any specific zero-coupon bond. (Please note that not all zero-coupon instruments are subject to this taxation. For example, a zero-coupon municipal bond is not subject to this liability due to the tax exemption afforded to municipal bond interest.) For exam purposes, if any reference is made to a *capital appreciation bond (CAB)*, it's a bond that's similar to a zero-coupon bond. CABs don't pay periodic interest and are unsuitable for investors who are seeking income. Their cost basis equates to the compound accreted value (*CAV*), which is calculated by adding the initial principal amount to the accreted value to date.

secured bonds

Backed by assets If the issuer falls into bankruptcy, an appointed trustee will take possession of the assets and liquidate them on the bondholders' behalf. Therefore, secured bondholders have a higher degree of protection if the company defaults. The following are the major types of secured bonds that companies issue: *Mortgage bonds*: secured by a first or second mortgage on real property; bondholders are given a *lien* on the property. Normally, mortgage bonds are issued serially over a number of years so as one group of bonds are paid off, the company will issue a new group to be secured by a mortgage on the same piece of property. *Equipment trust certificates*: secured by a specific piece of equipment that's owned by the company and used in its business. The trustee holds legal title to the equipment until the bonds are paid off. These bonds are usually issued by transportation companies and the collateral that's used by these companies is often referred to as *rolling stock* (i.e., assets that move) and includes railroad cars, airplanes, and trucks. *Collateral trust bonds*: secured by *third-party securities* that are owned by the issuer. The securities (stocks and/or bonds of other issuers) are placed in escrow as collateral for the bonds.

Negotiable Certificates of Deposit (CDs)

Banks and savings and loans issue the original certificates of deposit which are *time deposits* that carry *fixed rates of interest* and mature after a *specified period*. Negotiable CDs have the following characteristics: --They're *short-term* instruments that have maturities that range from two weeks to one year. --They have a minimum denomination of $100,000, but often trade in denominations of $1,000,000 or more (also referred to as jumbo CDs). --The Federal Deposit Insurance Corporation (FDIC) provides insurance of up to $250,000 per depositor. The typical purchasers of negotiable CDs are wealthy individuals and institutions, such as corporations, insurance companies, pension funds and mutual funds. These instruments attract investors who are seeking a return on their cash in a low-risk and liquid investment. If investors hold negotiable CDs to maturity, they *receive the face amount* from the issuer and the CDs expire. However, if the investors choose not to hold them to maturity, they can sell them in the secondary market *without penalty.* *Long-term CDs* also exist

The effect of stock splits and stock dividends (for convertible bond stuff)

Both the *conversion price and conversion ratio are established at the time the bonds are issued and will not change unless there's a change in the underlying stock*. Two types of corporate actions that create the need to adjust the conversion price and conversion ratio include *stock splits and the declaration of a stock dividend.* The adjustment may be required due to an existing non-dilutive feature or covenant in the bond's indenture.

higher coupon, higher risk for reverse convertible securities

From an investor's perspective, he's betting that the value of the underlying asset will *remain stable or rise*, while the issuer is betting that the value will *fall*. In the typical best case scenario, if the value of the underlying asset stays at or slightly above the knock-in level, he will receive a high coupon for the life of the investment as well as the return of the full principal in cash. However, in the worst case, if the value of the underlying asset drops below the knock-in level (which may be 70 to 80% of the original value), the issuer is able to *pay back the principal in the form of the depreciated asset*. The result is a potential *loss* of some, or all, of the original *principal.*

Parity (convertible bonds stuff)

If a convertible bond's conversion value (the market value of the stock received at conversion) is equal to its market price, then the bond is considered to be trading at *parity*. Most bonds trade at a premium to parity, which means that the market price of the bond is higher than the aggregate market value of the stock the investor will receive if he converted. Parity price of bond = conversion value which = (number of shares x price per share)

Market trading (of convertible bonds)

If interest rates are *stable*, most bond prices will have little movement. However, a convertible debenture could show significant price appreciation or depreciation if the *underlying common stock changes in value*. The conversion feature essentially links the bond's value to the underlying stock's value.

Forced conversion (of convertible bonds)

Most convertible issues are *callable* which provides the issuer with the ability to (at its option) redeem the bonds prior to maturity. However, if the call (redemption) price of the bonds is *less* than the conversion value, the bondholder could be *forced* to either convert the bond immediately or accept less than its conversion value. This possibility, referred to as forced conversion, may be a disadvantage for investors.

suitability issues (reverse convertible securities)

Obviously, these derivative securities are only suitable for investors who understand the inherent risks of the products. While the higher-than-average coupon may be appealing, reverse convertible investors must understand the potential *loss of principal on their investment*. Remember, if the underlying asset falls in value (under the knock in level), the investor may be forced to take the underlying asset in exchange for the par value at maturity. Also, for the higher coupon, investors sacrifice any *upside appreciation* in the value of the underlying asset.

money market securities

Short-term debt instruments with one year or less to maturity Money-market transactions provide an avenue for both acquiring money (borrowing) and investing (lending) excess funds for short periods. Typically, the investment period ranges from overnight to a few months, but may be as long as one year. Referred to as cash equivalents. (such high quality and safety that they're considered to be nearly the same as cash.) Important distinguishing feature: Returns are relatively uncorrelated to bonds. Types: --Commercial paper --Bankers' acceptances --Negotiable certificates of deposit Federal funds --Money-market funds --Repurchase agreements (Repos)

Reverse Convertible Securities

Short-term notes issued by banks and broker dealers that pay a coupon rate above market rates. The underlying security can be equity (unrelated to issuer), an index, or a basket of securities. If the price of the security falls below the "knock-in level," the investor will be obligated to buy the security at a set price. The investor wants the security to stay above the knock in level so they can continue to receive the high coupon rate until principal is returned. Far more complex than regular corporate bonds (involve elements of options trading)

Exchange traded Notes (ETNs)

Structured product created by broker-dealers and issued as unsecured debt of the issuing company. Trade on exchanges, have low fees, give investors access to irregular areas of the market Can be purchased on margin and sold short (because they are traded on exchanges) Performance of ETN linked to underlying asset (index, commodities, basket of securities, or other benchmark). ETN backed by full faith and credit of *issuer* Two main risks: 1. return is linked to performance of underlying benchmark, 2. Issuer might default (credit risk) don't usually pay an annual coupon (they're zero- coupon-like) or specified dividend; instead, all gains are paid at maturity

federal funds

The funds that are borrowed overnight on a bank-to-bank basis. Usually done to allow a bank to meet the reserve requirement that's set by the Federal Reserve. A bank with excess reserves may lend to a bank that's in need of reserves. This allows the bank with excess reserves to earn interest on funds that would otherwise remain idle. The rate charged on these overnight loans is referred to as the *fed funds rate.* The rate fluctuates on a daily basis and is a *leading indicator of interest-rate trends* since it reflects the availability of funds in the system. Although the Federal Reserve doesn't set the fed funds rate, it will attempt to influence the rate through its purchases and sales of government securities in the secondary market. Other short-term interest rates tend to follow changes in fed funds. A bank charges the *prime rate* when providing loans to a corporation that's among the bank's best credit-rated customers. Other corporations may be charged a higher rate, but the rate will be based on the prime rate. The *London Interbank Offered Rate (LIBOR)* is the average rate that banks charge each other on loans for London deposits of Eurodollars.

commercial paper

When corporations need long-term financing, they issue bonds; but when they need short-term financing, they issue commercial paper. Commercial paper is short-term, unsecured corporate debt which typically matures in 270 days or less. Exempt from SEC Registration and prospectus requirements usually issued at a discount; however, some issues are interest bearing. Typically, the minimum denomination is $100,000. There are two methods by which commercial paper may be sold: 1. *Directly placed commercial paper*: The issuer of commercial paper sells its issues directly to the public using its own sales forces 2. *Dealer-placed commercial paper:* The issuer sells to a large commercial paper dealer that then resells the issue to the public.

unsecured bonds

backed by only the corporation's full faith and credit referred to as *notes* and *debentures*. If the issuer defaults, the holders of these securities will have the same claim on the company's assets as any other *general creditor*—which means before the stockholders, but after secured bondholders. Occasionally, companies issue unsecured bonds that have a junior claim on their assets compared to its outstanding unsecured bonds. These bonds are referred to as *subordinated debentures*. In case of default, the claims of these bondholders are subordinate to those of the other bondholders, but still before the stockholders.

convertible bonds

can only be issued by corporations. a corporation with a weak credit rating may issue convertible bonds. Similar to convertible preferred stock, a convertible bond allows an investor to convert the par value of the bond into predetermined number of shares of the company's common stock. For the purchaser, the tradeoff for this opportunity is that convertible issues traditionally offer *lower coupons* than similar non-convertible issues. If the bonds are converted, the debt becomes equity and the issuers' capital structure will be significantly altered.

repurchase agreements (repos)

dealer sells securities (usually T-bills) to another dealer and agrees to repurchase them at both a specific time and price (short-term, usually overnight) In effect, the first dealer is borrowing money from the second dealer and securing the loan with securities (a collateralized loan). In return for making the loan, the second dealer (the lender) receives the difference between the purchase price and the resale price of the securities. If a dealer *purchases* securities and agrees to *sell* them back to the other dealer at a specific date and price, this is referred to as a *reverse repo or matched sale*. In this situation, the first dealer loans money (with securities as collateral) to the second dealer and earn the difference in sales prices. Many corporations, financial institutions, and dealers engage in repos and reverse repos.

Banker's Acceptance (BAs)

instruments that are used to facilitate foreign trade. Purchaser (importer) issues a time draft (i.e., a check that's good at a future date) which is secured by a letter of credit from a U.S. bank as payment. The exporter (seller) is able to hold the draft until its due date and receive the full amount or may cash it immediately at a bank for a discounted amount. At that point, the bank has the draft guaranteed by the issuing bank and it becomes a banker's acceptance. Now, the bank may choose to hold it until its due date or sell it in the market. BAs are actively traded and are considered quite safe since they're secured both by the issuing bank and by the goods that were originally purchased by the importer.

Long-term CDs

not money market securities Long-term or *brokered CDs* generally have maturities that range from *two to 20 years* and are *not considered money-market securities*. They also may carry additional risks that are not associated with traditional bank-issued CDs, including: limited liquidity, loss of principal if sold before maturity, potential call features that subject investor to reinvestment risk and no capital appreciation, FDIC insurance may not apply, things that may affect future interest payments such as variable rates, step-ups, and step-downs (these must all be disclosed to customer) Issued by banks and although sold by broker-dealers, they're insured up to certain limits by the FDIC in the event the issuing bank declares bankruptcy. The amount of FDIC insurance and tax considerations are different depending on whether the CD is purchased in a retirement account. Additionally, if the broker-dealer that sold the brokered CD to the client declares bankruptcy, SIPC coverage will apply since these products are considered securities. a *step-down, long-term* CD will offer an investor an interest rate that's initially higher than current market rates. Subsequent interest rates that are paid to investors will be *lower* and may be adjusted more than once. (An RR should disclose to the client that he will not receive the higher interest rate for the life of the CD.) a *step-up, long-term* CD which offers an investor an interest rate that's lower than current market rates for a similar maturity. However, the coupon will be subsequently adjusted upward (stepped-up). A broker-dealer is not required to maintain a secondary market or act as a market maker in a CD that was sold to the client. This will limit the liquidity of the security if the client needs the funds prior to maturity. If a brokered CD is callable, all risks that that poses should also be disclosed

Arbitrage (convertible bonds stuff)

technique that involves profiting from price differentials in the same or similar security. There are times when the market price of a convertible bond *doesn't* reflect the value of the common stock that will be received if the bond was converted into stock. If this situation occurs, the convertible bond will be selling at a *discount to parity* and arbitrageurs could profit from this differential.