11 11 C h a p t e r Corporate BondsCorporate Bonds second edition Fundamentals of Investments Valuation & Management Charles J. Corrado Bradford D.Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 2 Corporate Bonds Our goal in this chapter is to introduce the specialized knowledge that money managers who trade in corporate bonds possess. Goal © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 3 Corporate Bond Basics Corporate bond A security issued by a corporation that represents a promise to pay to its bondholders a fixed sum of money (called the bond’s principal, or par or face value) at a future maturity date, along with periodic payments of interest (called coupo ns). © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 4 Corporate Bond Basics Corporate bonds differ from common stock in three fundamental ways. Corporate Bonds Common Stock Represent a creditor’s Represents an ownership claim on the corporation. claim on the corporation. Promised cash flows Amount and timing of (coupons and principal) dividends may change are stated in advance. at any time. Mostly issued as Almost never callable. callable bonds. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 5 Corporate Bond Basics There are several trillion dollars of corporate bonds outstanding in the United States. More than half of these are owned by life insurance companies and pension funds. Î These institutions can eliminate much of their financial risk via cash flow matching. Î They can also diversify away most default risk by including a large number of different bond issues in their portfolios. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 6 Corporate Bond Basics © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 7 Corporate Bond Basics Bonds issued with a standard, relatively simple set of features are popularly called plain vanilla bonds. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 8 Work the Web For more information on corporate bonds, visit: http://www.investinginbonds.com http://www.bondresources.com © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 9 Types of Corporate Bonds Debentures - Unsecured bonds issued by a corporation. Mortgage bond - Debt secured with a property lien. Collateral trust bond - Debt secured with financial collateral. Equipment trust certificate - Shares in a trust with income from a lease contract. Types of Corporate Bonds 11 - 10 McGraw Hill / Irwin [...]... par value) on any of a sequence of prespecified dates Such bonds are often called extendible bonds Bond-to-stock conversion provisions - Convertible bonds are bonds that holders can exchange for common stock according to a prespecified conversion ratio McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 16 Bond Indentures McGraw Hill / Irwin 11 - 17 Bond Indentures... rating that is offset by a yield premium offered to compensate for higher credit risk Also called junk bonds Junk bonds are attractive investments for many institutional investors with well-diversified portfolios McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 32 Junk Bonds McGraw Hill / Irwin @2002 by the McGraw- Hill Companies Inc.All rights reserved 11 - 33 Bond... sequence of maturity dates Sinking fund provisions - A sinking fund is an account used to provide for scheduled redemptions of outstanding bonds Coupon payment provisions - An exact schedule of coupon payment dates is specified in the bond indenture McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 21 Protective Covenants A bond indenture is likely to contain a number of. .. McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 14 Bond Indentures No matter how low market interest rates may fall, the maximum price of an unprotected callable bond is generally bounded above by its call price McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 15 Bond Indentures Put provisions - A bond with a put provision can be... 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 25 Preferred Stock Preferred stock has some of the features of both bonds and common stock Typically, preferred stock issues do not grant voting rights to their holders, promise a stream of fixed dividend payments, have no specified maturity but are often callable, may have their dividends suspended without setting off a bankruptcy process... Irwin 11 - 17 Bond Indentures McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 18 Bond Indentures McGraw Hill / Irwin 11 - 19 Work the Web Find out more about convertible bonds at: http://www.convertbond.com McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 20 Bond Indentures Bond maturity and principal payment provisions Term... substantial volume of bond trading exists, thus satisfying most of the liquidity needs of investors Corporate bond trading is characteristically an OTC activity Nevertheless, bond trading on the New York Stock Exchange is watched by bond investors and traders throughout the world McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 34 Bond Market Trading 11 - 35 Bond Market... rights reserved 11 - 12 Bond Indentures The Trust Indenture Act of 1939 requires that any bond issue subject to regulation by the Securities and Exchange Commission (SEC) must have a trustee appointed to represent the interests of the bondholders The Act is available at the SEC website: http://www.sec.gov McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 13 Bond Indentures... © 2002 by The McGraw-Hill Companies, Inc All rights reserved 11 - 26 Adjustable-Rate Bonds & Preferred Stock Many bond, note, and preferred stock issues allow the issuer to adjust the annual coupon according to a rule or formula based on current market interest rates These securities are called adjustable-rate or floating-rate securities McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc... reserved 11 - 27 Corporate Bond Credit Ratings When a corporation sells a new bond issue to investors, it usually subscribes to several bond rating agencies for a credit evaluation of the bond issue Each contracted rating agency then provides a credit rating - an assessment of the credit quality of the bond issue based on the issuer’s financial condition McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, . ratio. Bond Indentures 11 - 16 McGraw Hill / Irwin © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 17 Bond Indentures Bond Indentures 11 - 18 McGraw Hill. McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 6 Corporate Bond Basics © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 7 Corporate. by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 11 - 9 Types of Corporate Bonds Debentures - Unsecured bonds issued by a corporation. Mortgage bond - Debt secured