Introduc corporate finance ch20

Chapter 20 Long-Term Debt 20.1 Long Term Debt: A Review 20.2 The Public Issue of Bonds 20.3 Bond Refunding 20.4 Bond Ratings 20.5 Some Different Types of Bonds 20.6 Direct Placement Compared to Public Issues 20.7 Long-Term Syndicated Bank Loans 20.8 Summary and Conclusions Long Term Debt: A Review   Corporate debt can be short-term (maturity less than one year) or long-term Different from common stock:      Creditor’s claim on corporation is specified Promised cash flows Most are callable Over half of outstanding bonds are owned by life insurance companies & pension funds Plain vanilla bonds to “kitchen sink” bonds Features of a Typical Bond  The indenture usually lists         Amount of Issue, Date of Issue, Maturity Denomination (Par value) Annual Coupon, Dates of Coupon Payments Security Sinking Funds Call Provisions Covenants Features that may change over time    Rating Yield-to-Maturity Market price Features of a Hypothetical Issue amount $20 million Bond issue total face value is $20 million Bond Issue date 12/15/98 Bonds offered to the public in December 1998 Maturity date Face value Coupon interest Coupon dates Offering price Yield to maturity Call provision Call price Trustee Security Rating 12/31/18 Remaining principal is due December 31, 2018 $1,000 Face value denomination is $1,000 per bond $100 per annum Annual coupons are $100 per bond 6/30, 12/31 Coupons are paid semiannually 100 Offer price is 100% of face value 10% Based on stated offer price Callable after 12/31/03 Bonds are call protected for years after issuance 110 before 12/31/08, Callable at 110 percent of par value through 100 thereafter 2008 Thereafter callable at par United Bank of Trustee is appointed to represent Florida bondholders None Bonds are unsecured debenture Moody's A1, S&P A+ Bond credit quality rated upper medium grade by Moody's and S&P's rating The Public Issue of Bonds    The general procedure is similar to the issuance of stock, as described in the previous chapter Indentures and covenants are not relevant to stock issuance The indenture is a written agreement between the borrower and a trust company The indenture usually lists        Amount of Issue, Date of Issue, Maturity Denomination (Par value) Annual Coupon, Dates of Coupon Payments Security Sinking Funds Call Provisions Covenants Principal Repayment   Term bonds versus serial bonds Sinking funds how they work?     Fractional repayment each year Good news security Bad news unfavorable calls How trustee redeems Protective Covenants    Agreements to protect bondholders 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 The Sinking Fund  There are many different kinds of sinking-fund arrangements:      Most start between and 10 years after initial issuance Some establish equal payments over the life of the bond Most high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue Sinking funs provide extra protection to bondholders Sinking funs provide the firm with an option Bond Refunding   Replacing all or part of a bond issue is called refunding Bond refunding raises two questions:   Should firms issue callable bonds? Given that callable bonds have been issued, when should the bonds be called? Callable Bonds versus Noncallable Bonds Most bonds are callable; 200 Noncallable bond Bond price (% of par) 175 some sensible reasons for call provisions include: taxes, managerial flexibility and the fact that callable bonds have less interest rate risk 150 125 100 75 Callable bond 50 25 12 Yield to maturity (%) 16 20 Bond Ratings  What is rated:    Who pays for ratings:     The likelihood that the firm will default The protection afforded by the loan contract in the event of default Firms pay to have their bonds rated The ratings are constructed from the financial statements supplied by the firm Ratings can change Raters can disagree Bond Ratings: Investment Grade Moody's Duff & S&P's Credit Rating Phelps Description Aaa AAA Aa1 Aa2 AA+ AA Aa3 A1 A2 AAA+ A A3 Baa1 Baa2 ABBB + BBB Baa3 10 BBB- Highest credit rating, maximum safety High credit quality, investment-grade bonds Upper-medium quality, investment grade bonds Lower-medium quality, investment grade bonds Bond Ratings: Below Investment Grade Moody's Duff & Phelps S&P's Credit Rating Description Speculative-Grade Bond Ratings Ba1 11 BB+ Ba2 Ba3 B1 12 13 14 BB BBB+ B2 B3 15 16 B B- Low credit quality, speculative-grade bonds Very low credit quality, speculative-grade bonds Extremely Speculative-Grade Bond Ratings Caa Ca C 17 CCC + CCC CCCCC C D Extremely low credit standing, high-risk bonds Extremely speculative Bonds in default Junk bonds    Anything less than an S&P “BB” or a Moody’s “Ba” is a junk bond A polite euphemism for junk is high-yield bond There are two types of junk bonds:    Current status of junk bond market   Original issue junk—possibly not rated Fallen angels—rated Private placement Yield premiums versus default risk Different Types of Bonds       Callable Bonds Puttable Bonds Convertible Bonds Deep Discount Bonds Income Bonds Floating-Rate Bonds Puttable bonds  Put provisions       Put price Put date Put deferment Extendible bonds Value of the put feature Cost of the put feature Convertible Bonds    Why are they issued? Why are they purchased? Conversion ratio:   Conversion price:   Bond par value / Conversion ratio Conversion value:   Number of shares of stock acquired by conversion Price per share of stock x Conversion ratio In-the-money versus out-the-money Convertible Bond Prices 150 140 Convertible bond price Bond price (% of par) 130 120 110 Stock price 100 90 80 Nonconvertible bond price 70 60 50 50 70 90 110 Conversion value (% of par) 130 150 More on Convertibles  Exchangeable bonds   Minimum (floor) value of convertible is the greater of:    Convertible into a set number of shares of a third company’s common stock Straight or “intrinsic” bond value Conversion value Conversion option value  Bondholders pay for the conversion option by accepting a lower coupon rate on convertible bonds versus otherwiseidentical nonconvertible bonds Direct Placement Public Issues    Compared A direct long-term loan avoids the cost of registration with the SEC Direct placement is likely to have more restrictive covenants In the event of default, it is easier to “work out” a private placement to Summary and Conclusions     The details of the long-term debt contract are contained in the indenture The main provisions are: security, repayment, protective covenants and call provisions Protective covenants are designed to protect bondholders from management decisions that favor stockholders at bondholders’ expense Most public industrial bonds are unsecured—they are general claims on the company’s value Most utility bonds are secured If the firm defaults on secured bonds, the trustee can repossess the asset Summary and Conclusions  Long-term bonds usually provide for repayment of (cont.)   principal before maturity This is usually accomplished with a sinking fund whereby a firm retires a certain number of bonds each year Most publicly issued bonds are callable There is no single reason for call provisions Some sensible reasons include taxes, greater flexibility, and the fact that callable bonds are less sensitive to interest-rate changes There are many different types of bonds, including floating-rate bonds, deep-discount bonds, and income bonds  ...Long Term Debt: A Review   Corporate debt can be short-term (maturity less than one year) or long-term Different from common