Capital markets  © Pranay J Darda

 

CHAPTER 5:

Corporate Bonds

 

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1. Features of a Corporate Bond Issue

Corporate bonds are classified by the type of the issuer. There are four types of corporate bonds base on the type of issuer: 1. Utilities, 2. Financials, 3. Transport and 4. Industrials. Among the fours types of issues industrial corporate bonds are the most heterogeneous in terms of investment characteristics. The transportation sector corporate bonds tend to be popular because of the resale value of the assets of transportation companies.

The basic features of a corporate bond consist of a coupon payment and a principal repayment. The corporate bond holders have seniority of claim to the assets of a company over the equity holders. The rights of the bond holders are detailed in a bond indenture. The bond indenture has covenants and restrictions on management and these can be important in the determining the credit quality of the bonds. Since the indenture is a legal document, comprehending an indenture requires expertise. The problem of making sure that the regulations outlined in the indenture are indeed implemented, a bond trustee is appointed. The bond trustee acts in a fiduciary role for the investors, who own the bond issue. Most corporate bond issues are term issues. They run for a term of years before maturing. The bonds may be notes with maturity of 10 years or less, bonds with maturity of 20 to 30 years or commercial paper with maturity ranging from 1 to 270 days.

Security for Bonds

The issuer of a corporate bond may pledge real property or personal property to offer security and increase the credit standing of the bond. A mortgage bond grants the bondholder a legal right to sell the pledged assets if the terms of the bond are not met. Some companies may pledge market securities such as stocks, notes, bonds to provide security to the bondholders. Such bonds are said to be collateralized bonds. When the bondholders have a general claim on the assets and earnings of the firm the bondholders hold debenture bonds. Sometimes the interest payments and the principal repayment of the bond are guaranteed by a third party. Such bonds are termed as guaranteed bonds.

Provisions for Paying Bonds

There are two mechanisms for paying off the bonds: 1. Call and refund provisions and 2. Sinking fund provision. A bond that is not callable for the life of the issue is termed as a bullet bond. Unlike bullet bonds, callable bonds can be called back by the issuer. This happens typically in a reducing interest rate environment, when the issuer can issue new bonds at a lower cost of capital. Since the call feature imposes an investment and interest rate risk to the investor, callable bonds have higher yields. The issuer can also make the bonds callable by promising to pay a price above par, when the bonds are called. In general if the bonds are called close to issue date a higher price has to be paid. If callable bonds are called closed to maturity a lower price premium above par may be required. A refunded bond is a bond that has been redeemed by issuing a similar bond in terms of maturity and principal. Certain bond indenture may mandate a sinking fund which requires retiring certain portion of principal each year.

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2. Corporate Bond Ratings

Money managers, institutional investors and private investors use various techniques to evaluate the ability of the bond issuers to meet their obligations in terms of interest payments and principal repayment. This is called credit analysis. Large institutional investors and investment banking firms have their own departments that carry out the credit analysis and determine the credit worthiness of the issuers. However most investors rely on the following three credit rating companies to provide information about the credit standing of the issuer. These companies are 1. Moody’s Investor Service, 2. Standard and Poor’s corporation and, 3. Fitch Ratings.

The credit rating systems used by these companies assigns a credit rating to each issuer. The highest grade bonds are assigned by Moody’s the letters Aaa, while S&P and Fitch assign AAA letters to the highest grade bonds. The second highest rating is Aa or AA, the third is A. The next three grades are Baa or BBB, Ba or BB and B respectively. There are also C grades. S&P and Fitch use + and – to further refine the credit ratings while Moody’s uses 1, 2 and 3 numbers to distinguish between bonds within each grade. Bonds of Aaa/ AAA ratings are of prime quality, Aa/ AA are of high quality, A are upper medium grade and Baa/ BBB are of medium grade. These bonds are called investment grade bonds. Issues carrying ratings below Baa/ BBB are non – investment grade, high yield or junk bonds.

Rating agencies monitor the bonds and issuers they rate. A rating agency many announce that it is reviewing a bond/ issuer and that the outcome of the review may lead to an upgrade or a downgrade of the bond/ issuer’s rating. When this happens the issuer is said to be on Credit Watch. A change of ratings over the years and over various grades is used to construct a transition matrix. The transition matrix shows the probability that a particular bond/ issuer may be upgraded/ downgraded to a different rating over a given time frame.

The downgrade in the rating of a bond/ issuer indicates an increased probability of default. An upgrade in the rating of the bond/ issuer indicates a decrease in the probability of default. Bonds that will transition to higher quality may lead to lower yields and bonds that are downgraded may provide higher yields. Thus the change in credit rating can have a significant impact on the issuers cost of raising capital.

Holders of bond issue not only face the interest rate risk but also an event risk. Event risk is defined as the risk that the issuer will unexpectedly change its payment schedule of coupon or principal payments. This may happen due to the issuer’s inability to make the payments due to unforeseen events such as a takeover or due to lack of political will of the issuer to make the payments when they are due. In both cases the event risk can vary from a missed or rescheduled payment to an outright default on the bonds.

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3. High Yield Corporate Bonds

High yield bonds or junk bonds are bonds which have credit rating below BBB. Such bonds may be original issue high yield bonds or may have been downgraded from investment grade to high yield bonds during the term of the bond. Bonds that have been downgraded may be due to increase in the level of debt of the issuer as a result of leveraged buyout or capital restructuring or due to other reasons.

Initially the high yield bonds had a relatively simple structure in that they paid a fixed rate coupon and were term bonds. However with the advent of Leveraged Buyouts, wherein the issuer will issue debt to finance a takeover, the high yield bonds have been structured so as to benefit the issuer. Some of the novel structured bonds include deferred coupon bonds, step up bonds and payment in kind (PIK) bonds.

Deferred interest bonds are the most common bonds in the special structured high yield bonds. These bonds sell at a deep discount. These bonds do not pay interest for the initial five to seven year period. Sometimes these bonds are also termed as zero coupon bonds since they do not pay interest for initial years. Step up bonds on the other hand do pay coupon but their coupon rates are low for an initial period. The coupon rate of the step up bonds increases to a higher rate after a certain initial number of years. Payment in kind bonds give the issuer option of either paying cash at the payment date or give the bondholder a similar bond – with similar coupon rate and par equal to the coupon on the original bond. Other types of high yield bonds include floating rate issues and extendable reset issues. In case of the floating rate issues the coupon rate is reset to the prevailing benchmark rate plus a specified spread in the bond indenture. In case of extendable reset the coupon rate is reset so as to make the market value of the bond equal to par.

The performance of the high yield bond over the past ten years has been marginally better than the treasury bonds. Stocks have however outperformed the high yield bonds. Thus there seems to be correlation between the seniority of claims on the assets of the firm and the returns on the securities. One way to assess the expected yields on the high yield bonds is to look at the default risk of the bond. A high default risk by the issuer will lead to a high yield demanded by the investors. Factors such as the stock price of the firm, the level of debt, quality of earnings the standard deviation of the earnings level will impact the default risk and hence the yields of the bonds. When a firms stock price falls below its market value of assets the firm would be normally considered bankrupt and would not be in a position to make coupon payments. Such bonds will be considered in default. However since the bondholders have a seniority of claim over firms assets, the bondholders may be able to recover certain percentage of their par. This is termed as recovery rate. Recovery rate plays a key role in the pricing of modern day financial innovations such as Credit Default Swaps and is also important in deciding the yield on the bonds. Historically recover rates have been in the range of 70 – 90 %. The rating agencies such as Fitch Ratings, publishes detailed recovery ratings on various firms. These ratings are in a band and have recovery rates in a range associated with them: R1: 91 – 100 %, R2: 71 – 90 %, R3: 51 – 70 %, R4: 31 – 50 %, R5: 11 – 30 % and R6: 0 – 10%.

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4. Secondary Market for Corporate Bonds

The secondary market for corporate bond is an over the counter (OTC) market. The issue with the OTC market is that of transparency. The National Association for Securities Dealers (NASD) requires that all OTC transactions of the corporate bond market be reported in a system called Trade Reporting and Compliance Engine (TRACE). At the end of each day market aggregate statistics are published about the corporate bond trading which indicate 1. Number of securities and total par amount traded, 2. Advances, declines and 52 weeks highs and lows and 3. The 10 most active investment grade, high yield and convertible bonds of the day.

Traditionally corporate bond trading has been OTC market, which means that orders are made and accepted over the telephone across the trading desks of broker dealers. Broker dealers fulfill buy/ sell orders. However 30 % of the corporate bond trading occurs electronically over website. The advantage of electronic trading is 1. Provide liquidity to market, 2. Price discovery, 3. Use of new technology and 4. Trading efficiency.

There are various electronic systems used:

Auction System: These allow market participants to conduct electronic auctions of securities.

Cross Matching System: These bring dealers and Institutional investors together and buy/ sell orders are executed when matched.

Interdealer System: Dealers can stay anonymous via the service of brokers broker.

Multidealer System: These systems also called client to dealer systems display bid/ ask quotes from various dealers for clients.

Private Placement Market for Corporate Bonds

Securities that are privately placed are exempt from the registration requirements of SEC. Privately placement may be done for qualified institutional buyers. Since 1990 a regulation governing the private placement of securities call 144A was adopted. The private placement can either be a 144A placement or the traditional private placement. In a 144A private placement investment bankers underwrite the security and the regulations on the borrowers are less stringent. 144A private placements can be comparable in size with public issues. Yields are higher for private placement, and generally mid size corporations go for private placements. Large corporations tend to prefer public issues, while small corporations borrow from banks.

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5. Medium Term Notes (MTNs)

Medium term Notes – MTNs are corporate fixed income instruments that were originally designed to meet the funding gap between long term bonds and commercial paper. Originally MTNs had maturities unto 15 years but now there maturity of a MTN can extend to 30 years. MTNs are offered to investors by the agents on a continuous basis with maturities ranging from 9 months to 1 year, more than 1 year to 18 months, more than 18 months to 2 years and unto 30 years.

The difference between a corporate bond and a MTN is that corporate bonds are underwritten by investment banks, whereas MTNs are sold on a best effort basis by broker/ dealers acting as agents or by investment bankers. Also MTNs are continuously offered in small amounts whereas corporate bonds are sold on an intermittent basis in large offerings. In case of MTNs borrowers have flexibility in designing MTNs to satisfy their own needs. MTNs can be issued fixed or floating or some other structure can also be devised for MTNs.

When a corporation is considering issuing debt and is contemplating between issuing bonds or MTNs the following factors are taken into account: 1. Cost of funds, which includes registration and distribution costs and 2. Flexibility afforded to the issuer in terms of structuring and offering. MTNs offer an advantage over bonds in that they are much more flexible and can be structured in any suitable way for the borrower or the investor.

The agent responsible for marketing the MTNs makes the investors aware of the yields on MTNs of various maturities. The yields and spread of the yield over a benchmark rate are originally made available to the agent by the issuer. If the investor chooses to invest in an offering, the agent will contact the issuer to confirm the terms of transaction. Since the schedule specifies a range of maturity the investor can choose a maturity subject to approval by the issuer. The minimum size of MTN an investor can purchase typically ranges from $ 1 million to $ 25 million.

Flexibility in MTN structuring is an attractive future since it allows issuers or investors to meet their cash flow requirements. MTNs can be sold in conjunction with the derivative instruments to get desired exposure. For example an MTN may be structured so that the coupon rate is periodically reset based on the performance of S&P 500. When an investor buys such a structured MTN, the investors gets exposure to S&P 500 through the MTN, without actually trading in S&P 500 futures. Similarly the coupon rate of an MTN can be tied to the swap instruments or foreign exchange instruments. MTNs may also be structured through a reverse enquiry. Investors may contact agents about a specific MTN and if such an MTN has to be created, agents may co-ordinate with the issuer to set up the specific MTN structure. The investor may have to bear the fees of setting up the structure but investor’s cash flow requirements will be met.

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6. Commercial Paper

Commercial paper is an unsecured promissory note that is issued by corporations to fund their short term seasonal and working capital needs. Commercial paper is issued directly in the market to the investors and the paper is the obligation of issuing corporation. Commercial paper is also used commonly for bridge financing. Corporations may delay the issuance of long term bonds until capital markets are favorable. Instead, funds are raised by issuing commercial paper for a short term. Interest rate swap market encourages issuance of commercial paper, since issuers can swap fixed for floating rates. The minimum round lot transaction for commercial paper is $ 100,000 however sometimes this can be $ 25,000. Commercial paper is issued directly to investors, who will hold the paper until maturity. Hence there is very little secondary market for commercial paper.

Typically commercial paper has maturity ranging from 1 to 270 days. The reason for the maximum maturity of 270 days is that commercial paper; whose maturity does not exceed 270 days is exempt from the registration requirements of the securities act of 1933. Also commercial paper with maturity less than 90 days is eligible to serve as collateral for borrowings at the federal reserves discount window. As a result of this commercial paper of maturity less than 90 days can be issued at a cost which is lower than issuing commercial paper with maturity exceeding 90 days. To payoff the holders of maturing paper corporations may issue more paper. This is called rollover. The issuing corporation may not be able to issue more paper and this is called rollover risk.

Issuers of commercial paper can be classified as finance companies and non – finance companies. Finance companies include captive finance companies, bank related finance companies and independent finance companies. Captive finance companies are subsidiaries of equipment companies. An example of a captive finance company is GMAC, which is a subsidiary of General Motors. Captive companies issue commercial paper to fund the customers of the holding company. The issuers of commercial paper usually have high credit ratings since normally the commercial paper is unsecured. However little known companies, which do not have established credit ratings can issue commercial paper by collateralizing the issue with assets or by credit support from a high credit firm. One such example is the issue of LOC paper – letter of credit paper. A bank issues a letter of credit stating that it would pay the amount due on maturity of the issuing firm fails to do so. The issuing firm pays fees and thus the cost of raising capital is increased but the firm is able to raise capital by issuing commercial paper. As with corporate bonds and MTNs commercial paper is also rated by Moody’s, Fitch and S&P.

Commercial paper can be either directly placed or dealer placed. Directly placed commercial paper is sold directly to the investors by the issuer. An example of directly placed commercial issuer is captive finance companies. These companies have their own sales force to market the commercial paper. Dealer placed commercial paper is sold through an agent, who distributes the paper on best efforts underwriting basis.

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7. Bankruptcy and Creditor Rights

The holders of the corporate debt instruments have priority of claim to the firm’s assets over equity holders. There may be a pecking order in the creditors. Secured creditors have seniority of claims compared to unsecured creditors. A corporation may either be liquidated or reorganized as a result of bankruptcy. In the liquidation process of the corporation all assets will be distributed to the holders of claims and the corporation will cease to exist. In reorganization a new corporate entity is formed. The holder of claim to corporation’s assets will either receive cash or securities or a combination of cash and securities in the new corporation. A firm in distress may file for bankruptcy protection. By filing for bankruptcy protection the firms continues its operation under the supervision of the court. This gives the firm time to decide whether to reorganize or liquidate and formulate a suitable plan.

The absolute priority rule dictates the distribution of the assets of the firm to the creditors in case of liquidation. The rule stipulates that senior creditors are paid before the junior creditors. The rule also establishes the priority of claims of creditors before equity holders. However in practice this rule may not be strictly followed. This is especially true in case of reorganization. In reorganization a committee representing various claimholders including equity holders is formulated to plan the organization. The plan has to be accepted by two thirds of the claimholders to be passed. Creditors may offer some part of claims to equity holders even if the firm’s remaining assets are less than the total claims of all creditors. This is done to provide incentive to equity holders to accept the plan. In a typical reorganization event senior creditors stand to loose the most while equity holders gain the most.

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