Chapter 11

Corporate Bonds
• Corporate Bond Basics
• Types of Corporate Bonds
• Bond Indentures
• Protective Covenants
• Bonds without Indentures
• Preferred Stock
• Adjustable-Rate Bonds & Preferred Stock
• Corporate Bond Credit Ratings
• Junk Bonds
• Bond Market Trading
• Summary & Conclusions
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 Bond Basics
• Corporate debt
• Principal & Coupons
• Different from common stock:
• Creditor’s claim on corporation
• Promised cash flows
• Most are callable
• Over 1/2 owned by life insurance companies & pension
funds
• Cash flow matching
• Bond indenture
• Plain vanilla bonds
• Unsecured debt
• Rating agency
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 Bond Issue Terms
Issue amount $20 million Bond issue total face value is $20 million
Issue date 12/15/98 Bonds offered to the public in December 1998
Maturity date 12/31/18 Remaining principal is due December 31, 2018
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 12/31/03 Bonds are call protected for 5 years after
issuance
Call price 110 before 12/31/08, 100 Callable at 110 percent of par value through
thereafter 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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 Corporate Bond Types

• Notes versus bonds

• Debentures
• Mortgage bonds
• Collateral trust bonds
• Equipment trust certificates
• Leasing arrangements

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 The Indenture
• Indenture summary
• Prospectus
• Senior debentures / subordinated debentures
• Negative pledge clause
• Call feature--bond refunding
• Deferred call provision / call protection
• Call premium
• (anti) refunding provision
• Cost of the call feature / convexity

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 Figure 11.2. Callable and noncallable bonds

200

175

Noncallable bond
Bond price (% of par)

150

125

100

75
Callable bond
50

25
0 4 8 12 16 20

Yield to maturity (%)

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 Put bonds

• Put provisions
• Put price
• Put date
• Put deferment
• Extendible bonds
• Value of the put feature
• Cost of the put feature

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 Convertible bonds
• Why are they issued?
• Why are they purchased?
• Conversion ratio:
• CR = No. of stock shares acquired by conversion
• Conversion price:
• CP = Bond par value / Conversion ratio
• Conversion value:
• CV = Price per share of stock x Conversion ratio
• In-the-money versus out-the-money

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 Conversion strategy

• Optimal conversion?
• Forced conversion
• When do calls typically occur?
• What should an investor do?

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 More on Convertibles

• Exchangeable bonds
• Minimum (floor) value of convertible:
• Straight or “intrinsic” bond value
• Conversion value
• Conversion option value

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 Figure 11.4. Convertible bond prices

150

140

130 Convertible bond price

Bond price (% of par)

120

110

100

90

80

70 Nonconvertible bond price

60

50
50 70 90 110 130 150

Conversion value (% of par)

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 Principal repayment

• Term bonds versus serial bonds

• Sinking funds--how do they work?
• Fractional repayment each year
• Good news -- security
• Bad news -- unfavorable calls
• How trustee redeems

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 Protective Covenants
• Agreements to protect bondholders / Event risk
• Negative covenant: Thou shalt not:
• pay dividends beyond specified amount
• sell more senior debt & amount of new debt is limited
• refund existing bond issue with new bonds paying
lower interest rate
• buy another company’s bonds
• Positive covenant: Thou shalt:
• use proceeds from sale of assets for other assets
• allow redemption in event of merger or spinoff
• maintain good condition of assets
• provide audited financial information

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 Private Placements

• Trust Indenture Act of 1939

• Indenture not required
• Exempt from SEC
• Notes / Bonds

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 Preferred Stock

• Preferred stockholders are not creditors

• Generally don’t vote
• Fixed dividend expressed as percent of face;
paid quarterly
• No maturity, but often callable
• Sometimes convertible
• Cumulative versus noncumulative
• Corporate tax treatment

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 Adjustable-Rate

• Adjustable-Rate Bonds
• Floaters
• Putable
• Adjustable-Rate Preferred Stock

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 Credit ratings

• What is rated and who does it?

• Who pays for ratings and why?
• Credit cost
• Potential buyers
• Do ratings change?
• Do raters disagree?
• Prudent investment guidelines

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 Corporate Bond Credit Ratings
Moody's Duff & Phelps S&P's Credit Rating Description
Investment-Grade Bond Ratings
Aaa 1 AAA Highest credit rating, maximum
safety
Aa1 2 AA+
Aa2 3 AA High credit quality, investment-
grade bonds
Aa3 4 AA-
A1 5 A+
A2 6 A Upper-medium quality,
investment grade bonds
A3 7 A-
Baa1 8 BBB+
Baa2 9 BBB Lower-medium quality,
investment grade bonds
Baa3 10 BBB-
Speculative-Grade Bond Ratings
Ba1 11 BB+ Low credit quality, speculative-
grade bonds
Ba2 12 BB
Ba3 13 BB-
B1 14 B+ Very low credit quality,
speculative-grade bonds
B2 15 B
B3 16 B-
Extremely Speculative-Grade Bond Ratings
Caa 17 CCC+ Extremely low credit standing,
high-risk bonds
CCC
CCC-
Ca CC Extremely speculative
C C
D Bonds in default
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 Junk bonds

• High-yield bonds
• Original issue junk -- possibly not rated
• Fallen angels -- rated
• Current status of junk bond market
• private placement
• Yield premiums versus default risk

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 Bond Market Trading

• Active secondary market

• NYSE
• OTC
• New York Exchange Bonds
• Current yield
• cv
• f
• zr

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