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CHAPTER 21: Long Term Debt

Topics

• 21.1 - 21.2 Background

• 21.3 Bond Refunds

• 21.4 Bond Ratings

• 21.6 Direct placement vs. Public Issues

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21.1 - 21.2 Quick Review of Basics of Bond Issuance

• Public issue of bonds– Includes an indenture (agreement between firm and trust company)– Protective covenants (positive and negative)– Seniority, sinking fund provisions, call provisions, etc

• a trust company (trustee) is appointed by the issuer to represent the bondholders– ensure that the terms of the indenture are obeyed– manage sinking fund– act on behalf of bondholders in case of default

• a sinking fund is an account managed by the trust company trust company can either purchase bonds in the market or select via lottery and pay face value– provides early warning signal to bondholders if firm has trouble making

sinking fund payments– gives firm option to pay lower of market price or face value

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Review: Price quotation example

On Oct. 29, 2004, a TD Bank bond with a coupon of 6.00 and a maturity date of 26 July 2006 was quoted as selling for 104.39 (Ask) and had a yield of 3.36.

Price quotes are percent of par: $1,043.90Semi-annual coupon payment: 1,000 * 6%/2 = 30Next coupon date: Jan. 26, 2006Previous coupon date: July 26, 2006Days since previous coupon:

Accrued interest:

Price = quoted price + accrued interest =

Quoted yield: 3.36%, one-period (6 month) yield = 3.36%/2 = 1.68%Theoretical price:

Error:

07/26 10/29 01/21

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21.3 Callable Bonds

• call feature allows issuer to repurchase entire bond issue at a pre-specified price over a specified period

• call premium – difference between call price and face value

• call provisions have value Value of callable bond = value of straight bond – value of call

option

• Many long-term corporate bonds outstanding in Canada have call provisions.

• Replacing all (or part) of a bond issue is called bond refunding

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Example: Value of Call Provision: Perspective of BondholderAssume that a bond pays annual coupons of $100, has a maturity of 20 years and that yield of the bond is 0.10. Suppose that the interest rate (yield) will change to either 12% or 8% (with equal probability) after 5 years and remain at that level. Assume no personal taxes and annual coupon payment. The outstanding bond has a face value of $1,000.

(1)What is the value of this bond today?a. PV of first 5 years’ coupons:

b. PV of remaining coupon & principal: If r = 0.12

If r = 0.08

c. Bond value today

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Example cont’d(2) Now assume that the bond is callable after 5 years with a call premium

of $50 (and this is the only date on which it may be called).

(a) What is the value of the bond today?

PV (call price):

Value today if called in 5 years:

Value today if not called in 5 years:

Bond value today:

(b) What annual coupon would be required for this callable bond to be equally valuable as an otherwise identical but non-callable bond?

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Example cont’d: Should the bond be called and refunded?—Perspective of firm

(3) Suppose 5 years later, the interest rate drops to 8%. The firm is approached by an investment bank attempting to persuade the issuer to recall the bond (“old” bond) and issue the following bond (“new” bond) instead:

Issue size: $1,000; Coupon rate: 6%; floatation cost: 1% of face value; interest rate 8%; maturity: 15 years. Annual coupon payment.

To eliminate timing problems with the two issues, the new bonds will be sold a month before the old bonds are called. The firm is likely to pay the coupons on both issues during this month but can defray some of the cost by investing the issue at 3%, the short-term interest rate. Would this bond be called? Assume that the corporate tax rate is 40%.

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Example cont’d: Solution• Cost of refunding

1. Call premium (non tax-deductible expense): $502. Flotation costs: one-time expense but amortized over the life the

issue or five years, whichever is less. – Floatation costs 10– PV of tax savings (discounted at after-tax interest rate)

– Total after-tax cost

3. Additional interest – Extra interest paid on old issue

– Extra interest earned

– Total additional interest

– Total investment: 1+2+3

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Example solution cont’d

• Interest savings on new issue– Interest on old bond

– Interest on new bond– Annual savings

– After-tax savings

– PV of annual savings over 15 years (discounted at after-tax interest rate)

• NPV for the Refunding Operation

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Why issue callable bonds

• Superior interest rate predictions: company managers may know more about changes in yields on its bonds than bondholders do, e.g. they may have information about changes in the firm’s credit rating;

• Taxes: if the bondholder is taxed at a lower rate than the firm, the tax advantage of higher interest deductibility for a callable bond for the firm will be greater than what the bondholder in a lower tax bracket would lose; the firm and the bondholder can split this gain

• Financial flexibility: covenants may restrict a firm’s ability to take advantage of opportunities such as a spin off, calling the bonds allows managers to circumvent the covenants

• Reduced interest rate risk: if rates increase, the value of a callable bond drops (but not as much as a non-callable bond due to higher coupon); if rates fall, the value of a callable bond rises (but not as much due to the call feature)

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When to call a bond

• if there are no transactions costs, and managers are acting in the interests of the shareholders, then the firm should call its bonds whenever the value of the callable bond exceeds the call price

• in practice, there are some reasons why the firm might allow the bond to trade at prices above the call price– costs of issuing new bonds

– required notice periods

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21.4 Bond Ratings

• Bond rating firms (Standard and Poor’s, Moody’s, CBRS, DBRS) assess the likelihood of default on corporate debt issues and provide ratings (AAA, B, C ) that indicate the default risk to investors (Table 21.2)

• Investment grade bonds and Junk bonds.

• Junk bonds are low grade or high yield (high risk) bonds. S&P rating of BB and below.

• Bond ratings are based on publicly information

• Default spread increases with bond rating. For AAA ratings bond, default spread is only about 30 bp (0.20%). The spread increases to more than a thousand bp (10%) for D ratings bond.

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Moody's S&P's DBRS Credit Rating Description Investment Grade

Aaa AAA AAA Highest credit rating, maximum safety

Aa1 AA+

Aa2 AA AA High credit quality, investment-grade bonds

Aa3 AA-

A1 A+

A2 A A Upper-medium quality, investment grade bonds

A3 A-

Baa1 BBB+

Baa2 BBB BBB Lower-medium quality, investment grade bonds

Baa3 BBB-

Speculative-Grade Bond Ratings

Ba1 BB+ BB Low credit quality, speculative-grade bonds

Ba2 BB

Ba3 BB-

B1 B+ B Very low credit quality, speculative-grade bonds

B2 B

B3 B-

Extremely Speculative-Grade Bond Ratings

Caa1 CCC+ CCC Extremely low credit standing, high-risk bonds

Caa2 CCC

Caa3 CCC-

Ca CC CC Extremely speculative

C1 C C

D D Bonds in default

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Features of a Hypothetical Bond

Issue amount $20 million Bond issue total face value is $20 million Issue date 12/15/03 Bonds offered to the public in December 2003 Maturity date 12/31/23 Remaining principal is due December 31, 2023 Face value $1,000 Face value denomination is $1,000 per bond Coupon interest $100 per annum Annual coupons are $100 per bond Coupon dates 6/30, 12/31 Coupons are paid semiannually Offering price 100 Offer price is 100% of face value Yield to maturity 10% Based on stated offer price Call provision Callable after 12/31/08 Bonds are call protected for 5 years after

issuance Call price 110 before 12/31/13,

100 thereafter Callable at 110 percent of par value through 2008. Thereafter callable at par.

Trustee United Bank of Florida Trustee is appointed to represent bondholders Security None Bonds are unsecured debenture Rating Moody's A1, S&P A+ Bond credit quality rated upper medium grade

by Moody's and S&P's rating

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Direct Placements and Syndicated Loans

• Unlike what we have described so far (i.e. public debt), a large percentage of debt is directly placed

• A term loan is a direct business loan with a maturity of 1-5 years– lenders include banks, insurance companies, and trust

companies• A private placement is similar but has a longer maturity and

usually involves an investment dealer who facilitates the transaction– investment dealer does not underwrite– no need for a prospectus (just an offering memorandum)– sold to large “exempt purchasers”– the private placement market is dominated by insurance

companies and pension funds

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Direct Placements and Syndicated Loans cont’d

• Comparing public and direct placements:– registration and distribution costs are lower for direct financing

– direct placements tend to have more restrictive covenants

– it is easier to renegotiate a term loan or a private placement in case of a default

• Most bank loans are made with a commitment to the firm hat sets up a line of credit and allows the firm to borrow up to some pre-set limit– very large banks frequently have a larger demand for loans than they can

supply, and smaller banks often have more funds available than demand

– large banks then arrange loan and then sell portions of them to a group or syndicate of other banks

– each bank in the syndicate has a separate loan agreement with the borrower

– in some cases, syndicated loans are publicly traded

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Assigned problems: # 21.1, 3, 4, 7, 10, 12, 15, 19