Chapter 18 Objectives

• Explain different types of corporate bonds

• Discuss bond indenture provisions
• Understand callable and convertible bonds
• Discuss protective covenants
• Understand government bond basics

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 Corporate Bond Basics
• A Corporate bond is issued by a corporation, represents
a promise to pay bondholders the principle at a future
maturity date, along with periodic payments of interest.
• Bond trading: An active secondary market exists with a
substantial volume of bond trading, satisfying most of
the liquidity needs of investors.
• Corporate bonds trade on OTC and also on NYSE. There
are several trillion dollars of corporate bonds
outstanding in the U.S. More than half of these are
owned by life insurance companies and pension funds.
The investors diversify away most default risk by
including a large number of different bond issues in
their portfolios. 2
 Types of Corporate Bonds
• Plain Vanilla Bonds (or “bullet” bonds): these bonds are
issued with a standard, relatively simple set of features
on maturity, coupon and indenture provisions
• Debentures are unsecured bonds issued by a large firm.
• Mortgage bonds are debt secured with a property lien.
• Collateral trust bonds, commonly issued by holding
companies, are debt secured with financial collateral
such as stocks and bonds.
• Equipment trust certificates are debt issued by a trust
with income from a lease contract for heavy industrial
equipment (commonly used by rail roads, airlines and
other transportation firms). Investors buy the certificates
and the funds are used to purchase the equipment. The
trustee, representing the certificate holders, owns the
equipment, collects the lease payments and distributes
the net income to certificate holders. 3
 Bond Indentures
• A Bond indenture is a formal written agreement
between the corporation and the bondholders.
• This agreement spells out, in detail, the rights and
obligations of the corporation and the rights of the
bondholders (with respect to the bond issue) such as
coupon rate, maturity, collateral, etc. Term bonds are
issued with a single maturity date, while serial bonds
are issued with a regular sequence of maturity dates.
• In practice, few bond investors read the original
indenture. Instead, they might refer to an indenture
summary provided in the prospectus of the bond issue.
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 Seniority Provisions
• Different bond issues can be differentiated according
to the seniority of their claims on the firm’s assets in
case of default.
– Senior Debentures are the bonds paid first in case
of default.
– Subordinated Debentures are paid after senior
debentures.
• Bond seniority may be protected by a negative
pledge clause, prohibiting a new debt issue that
would have seniority over existing bonds.

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 Call Provisions
• Most corporate bonds are callable bonds. A call
provision gives the issuer the option to buy back the
bond at a specified call price, which is often equal to par
value (callable at par) although it may be higher.
• Common restrictions to call privilege:
(1) a deferred call provision provides a call protection
period, usually 5 years after its issue date
(2) a call premium, included in the call price, usually
equals to one year coupon payment
• Bond refunding: When interest rates fall, bond prices
increase. The corporation can “call-in” the existing
bonds, then issue new bonds with a lower coupon.
• Which bond will sell at a higher price: callable or non-
callable bond, other things equal?
• Non-callable bonds 6
 Value of a Callable Bond
• The maximum price of a callable bond after protection
period is likely its call price. The existence of a price
ceiling alters a bond’s convex price-yield relationship.
Callable bonds show the convex price-yield relation only
in high yield region, but not when yields are low.

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 Put Provisions
• A bond with a put provision can be sold back to the issuer at a
pre-specified price (normally set at par value) on any of a
sequence of pre-specified ‘put’ dates. Putable bonds can be
retractable or extendible.
• Retractable bond: a retractable bond gives bondholder the
option to redeem the bond early, when the bond’s coupon rate
is below current market yields. Extendible bond: an extendible
bond gives bondholder the option to retain the bond for
additional period beyond maturity, when coupon exceeds
current rates.
• Which bond sells at a higher price: putable or non-putable
bond, other things equal?
• Putable bonds sell at higher price

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 Bond-to-Stock Conversion Provisions
• Convertible bonds can be exchanged for common
stocks according to a pre-specified conversion ratio
(i.e., the number of shares acquired). The value of a
convertible bond is linked to the firm’s stock price.
Conversion Price = Bond Par Value / Conversion Ratio
Conversion Value = Stock Price X Conversion Ratio
• Example: Suppose the conversion ratio for a $1,000
par value bond is 20 shares, and the firm’s stock is
worth $40.
conversion price = $1,000 / 20 = $50
conversion value = $40 x 20 = $800
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 Value of Convertible Bonds
• A convertible bond consists of two assets: a bond and a
warrant (which is a call option issued by the firm). Valuing a
convertible requires assumptions of (1) the underlying stock
volatility, and (2) the credit spread for the fixed income portion
that takes into account the firm's credit profile and the ranking
of the convertible within the capital structure.
• Which bond sells at a higher price: convertible or non-
convertible bond, other things equal?
• Convertible bonds

• A convertible bond is out-of-money if conversion value <

straight bond value (when the convertible is issued), or in-the
money if conversion value > straight bond value.
• The floor value of a convertible bond is either its intrinsic value
(straight bond value) or conversion value, whichever is higher.10
 Value of a Convertible Bond
Convertible
bond value

Conversion
Convertible bond
value
values

Option value

Straight bond value

Floor value

Conversion
ratio
Stock
Out-of-money: In-the-money: price
conversion value < conversion value >
straight bond value straight bond value
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 Investors: Why Convertible Bonds?
• Convertible bonds are usually issued with a higher
yield than obtainable on the stocks.
• Convertible bonds are safer than preferred or
common shares for the investor. They provide asset
protection, because the value of the convertible bond
will only fall to the value of the bond floor. At the same
time, convertible bonds can provide the possibility of
high returns like equities.
• Convertible bonds behave like a call option and are
usually less volatile than regular shares.
• The simultaneous purchase of convertible bonds and
the short sale of the same issuer's common stock is a
hedge fund strategy known as convertible arbitrage.
The motivation is that the equity option embedded in a
convertible bond is a source of cheap volatility, which
can be exploited by convertible arbitrageurs. 12
 Firms: Why Convertible Bonds?
• Convertible bonds allow debt financing with lower
borrowing costs. A convertible bond at issue often yields
1% to 3% less than straight bonds.
• Convertible bonds allow the firm to issue equity in the
future at a price higher than current stock price. The
conversion price can be higher than the level that the
share price ever reached recently.
• Voting dilution deferred. With a convertible bond,
dilution of the voting rights of existing shareholders only
happens on eventual conversion of the bond.
• Trading of convertibles: There is a highly liquid market
in the U.S. for convertible bonds. In Canada, convertibles
are exchange traded. Most of the Canadian convertible
bond market consists of unsecured sub-investment
grade bonds with high yields that are reflective of the
issuer's risk of default. 13
 Sinking Fund Provisions
• A Sinking fund provision requires the firm to make
periodic payments into a trustee-managed account, to
ensure the repayment of principle.
• Sinking fund provides security to bondholders for the
repayment of principle.
• A sinking fund provision may require the firm to
purchase a fraction of outstanding debt in the open
market or with a call price. Therefore, some
bondholders may be repaid before the stated maturity
of their bonds, whether they want to be repaid or not.

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 Protective Covenants
• Protective Covenants are restrictions designed to
protect bondholders.
• Negative covenants:
- The firm cannot pay dividends in excess of what is
allowed by some formula based on the firm’s earnings.
- The firm cannot pledge any assets to other lenders
- The firm cannot merge with other firms
- The firm cannot issue additional long term debt
• Positive covenants:
- The firm must maintain collateral in good condition
- Working capital must be above some specified level
- The firm must provide financial statements to lenders
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 Government Bond Basics
• The Bank of Canada finances government debt by
issuing marketable securities (T-bills and Canada
Bonds) and non-marketable securities, which must be
redeemed by the issuer, such as Canada Savings Bonds.
• T-bills are short-term obligations with maturities of 13,
26, or 52 weeks (when issued). T-bills pay their face
value (or redemption value) at maturity. Treasury notes
are medium-term securities with maturities of 10 years
or less, but more than a year.
• Canada bonds are long-term obligations with
maturities of more than 10 years (when issued), and
may be up to 40 years.
• Canada bonds pay semiannual coupons (at a fixed
coupon rate) in addition to their face value at maturity.
Coupons are set according to prevailing interest rates at
the time of issue. These bonds have face value 16
denominations as small as $1,000.
 Last Day of Class: Thursday, Nov.28
• Course Experience Survey: 15 minutes. Bring a
mobile device to login: ces.uvic.ca

• Portfolio Presentation: 5 minutes per group.

See CourseSpace “Portfolio Simulation” for details.

• Load your presentation slides on a USB device if

you want to use Hao’s computer for the
presentation.

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 1. ______ bonds are secured by financial assets of
the issuing company.

→ A. Collateral trust
B. Plain vanilla
C. Debentures
D. Trust
E. Indentures

Chapter 18
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 2. Which of the following are negative protective covenants
that can be found in a bond indenture?
I) Bond proceeds must be used to finance fixed assets
II) Bonds with senior status cannot be issued while this
bond issue is outstanding
III) The issuer is prohibited from guaranteeing debt of
another firm
IV) The issuer must furnish audited financial statements
on an annual basis

A. I and IV
→ B. II and III
C. I, III and IV
D. II, III and IV
E. I, II, III and IV
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 3. Which of the following is not a common feature
associated with a bond’s call provision?

A. The bond is usually call deferred.

→ B. The call can be refused at the discretion of the
bondholder.
C. If the bond is called, a premium above par is
usually paid.
D. The company may be prohibited from calling
the bond to issue new debt with a lower coupon.
E. None of the above.

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 4. The floor value of a convertible bond is the
_____ value.

A. intrinsic value
B. conversion value
C. in-the-money value
→ D. greater of the intrinsic value or conversion
value
E. lesser of the intrinsic value or conversion value

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 Useful Websites
• www.investinginbonds.com (for more
information on corporate bonds)
• www.sec.gov (U.S. Securities and Exchange
Commission)
• www.convertbond.com (for more information
about convertible bonds)
• www.bondsonline.com (follow the "corporate
bond spreads" link)

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