2.4Corporate Bonds
Bondsare tradable fixed-income securities. Exhibit 2.5 describes the most important
features that bond issuers can set: covenants, option features, cash flow pattern (via
coupon and principal schedule), maturity, price, and rating. Much of the nomenclature
used in referring to bonds derives from these features.
Bond Covenants
As later chapters of this text point out, equity holders who control the firm can expro-
priate wealth from bondholders by making assets more risky, reducing assets through
the payment of dividends, and adding liabilities. Virtually all debt contracts contain
covenants to restrict these kinds of activities. In the absence of such covenants, the
incentives of equity holders to expropriate bondholder wealth would be reflected in the
bond’s coupon or price, resulting in higher borrowing rates.
Exhibit 2.6 classifies covenants by type. Exhibit 2.7 contains a portion of the bond
covenants from Philip Morris’s sinking fund bond, due in the year 2017.9
The covenants
shown are largely financing covenants. In plain language, the paragraph states that in
the event of default the sinking fund bonds have equal claims to the firm’s existing
assets as other unsecured and unsubordinated debt (defined subsequently), and that new
financing shall not take precedence over this debt issue in making claims on any mate-
rially important manufacturing facility in the event of default.
8
In a few cases, lower-quality issuers offer collateral as a guarantee of payment.
9Sinking funds are defined shortly.
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36Part IFinancial Markets and Financial Instruments
EXHIBIT2.5Bond Features
-
Bond covenants(also
called
The rules that specify the rights of the lender and the
bond indentures)
restrictions on the borrower. Smith and Warner (1979)
identified four major kinds of bond covenants: asset
covenants, dividend covenants, financing covenants, and
bonding covenants. Not all of these types are included
in every bond.
-
Options
Bond features that allow both buyers and sellers to
terminate the bond agreement, often requiring the party
exercising the option to make certain payments or take
on different risks. The most important embedded
options are callability, convertibility, and putability (see
Exhibit 2.10).
-
Cash flow pattern
Specified by the annual interest payments, or coupon,
per $100 of principal, schedule for payment of
principal, known as amortization, and face value, a
number which denominates the size of the bond.a
-
•
Fixed-rate bonds typically pay half the stated
coupon every six months. The coupon rate, whichis the coupon stated as a percentage of the bond’sface value, determines the coupon. Hence, an 8
percent coupon typically means two $4 paymentsper $100 of face value per year.
-
•
Floating-rate bonds are more complicated becauseof the many ways in which they can float. The
interest rates on such bonds are typically some
benchmark rate plus a fixed or a variable spread.b
-
Maturity
The maximum length of time the borrower has to pay
off the bond principal in full. Maturities on corporate
bonds are generally less than 30 years, but it is possible
to sell bonds with longer maturities.c
-
Price
The amount at which a bond sells, particularly in
relation to principal owed.
-
Bond rating
Asequence of letters and numbers that specifies the
creditworthiness of a bond.
aFace value is usually either the principal at the maturity date of the bond or the amount borrowed at the issue date of
the bond. For mortgages and other annuity bonds (defined later in this chapter), face values are the amount borrowed
at the issue date of the bond.
bMore exotic floaters exist. Inverse floaters, bought by Orange County and partly responsible for its bankruptcy in
December 1994, have coupons that rise as the benchmark rate falls. (See Chapter 23 for a discussion of inverse
floaters.)
cConrail and TVAissued 50-year bonds in the early 1990s. IBM issued 100-year bonds in 1996. News Corp.,
Wisconsin Electric Power, Bell South Telecommunications, and Columbia/HCAHealthcare sold 100-year bonds in
1995. Walt Disney, ABN-AMRO (a Dutch bank), and Coca-Cola sold 100-year bonds in 1993. In spite of these
unusual cases, the average maturity of bonds has been falling in the last 25 years and is now less than 10 years. The
decline in average maturity is probably due to the increased volatility of interest rates.
Asset Covenants.Among other things, asset covenants specify what rights the bond-
holder has to the firm’s assets in case of default. Some bonds are seniorbonds, which
give its investors the rights to liquidate or manage the assets to satisfy their claims
before any of the holders of juniorbonds(which have subordinated claimson a com-
pany’s assets) receive payment. Other bonds are secured bonds, which means the firm
has pledged specific assets to the bondholders in case of default. Some asset covenants
may prevent acquisitions of other companies.
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Chapter 2
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37
EXHIBIT2.6Types of Bond Covenants
-
Asset covenant
Governs the firm’s acquisition, use, and disposition of assets.
Dividend covenant
An asset covenant that restricts the payment of dividends.
-
Financing covenant
Description of the amount of additional debt the firm can issue
and the claims to assets that this additional debt might have in
the event of default.
-
Bonding
covenant
Description of the mechanism for enforcement of the
covenants. It includes an independent audit of the company’s
financial statements, the appointment of a trustee to represent the
bondholders and monitor the firm’s compliance with bond
covenants, periodic signatures by company officers that certify
compliance with bond covenants, and “lock-box mechanisms.”a
aAlock-boxis a bank account whose beneficial owner is the debt holder. Hence, the cash in the account is a form of
collateral for the bondholder. For example, when debt is collateralized by accounts receivable, the checks of the firm’s
“accounts receivable” clients are written to the bank and directed to the account held in the name of the debt holders.
Bonds are often named for their asset covenants. In addition to “senior” and
“junior,” the names used to refer to a bond depend on whether a bond is backed by
collateral and, if so, what that collateral is. Exhibit 2.8 illustrates this point.
Dividend Covenants.Dividend covenants are beneficial in preventing a manager
from leaving bondholders penniless by simply liquidating the firm and paying out
the liquidation proceeds as a dividend to shareholders. Bondholders view even a par-
tial payment of dividends as a liquidation of a portion of the firm’s assets; thus, div-
idends per se are detrimental to bondholders. Simply prohibiting dividends, how-
ever, is not likely to be a good policy because it might cause the firm to waste cash
by investing in worthless projects instead of using the cash to pay dividends. Kalay
(1982) described the typical form of a dividend covenant: a formula that defines an
inventory of funds available for dividend payments. The inventory will depend on
the size of earnings, new funds derived from equity sales, and the amount of divi-
dends paid out so far.
Financing Covenants.Financing covenants prevent the firm from promiscuously
issuing new debt, which would dilute the claims of existing bondholders to the firm’s
assets. Such covenants generally specify that any new debt has to have a subordinated
claim to the assets. If the firm is allowed to issue new bonds having the same priority
to the firm’s assets in the event of bankruptcy as existing debt, the issuing amount is
generally limited and often contingent on the financial health of the firm.
The debt contracts of companies with exceptional credit ratings generally do
not contain subordination clauses. For these companies, “straight” subordinated
debt issues almost never exist. In contrast, convertible debt (discussed in the next
section; see Exhibit 2.10) generally is subordinated to straight debt, even for high-
quality issuers.
Financial Ratio Covenants.Both asset covenants and financing covenants are embed-
ded in covenants that require the firm to maintain certain financial ratios. For instance, a
covenant may specify a minimum value for net working capital—that is, current assets
less current liabilities—or for net worth, as noted earlier. Similarly, such covenants
may prescribe a minimum interest coverage ratio—that is, the ratio of earnings to
-
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EXHIBIT2.7Bond Covenants
Source:Reprinted by permission of Moody’s Investment Service of 1996. All Rights Reserved Worldwide.
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Chapter 2
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39
EXHIBIT2.8Bond Type Based on Asset Claims in Default
-
Secured bond
Abond for which the firm has pledged title to specific
assets.
-
Mortgage bond
Atype of secured bond giving lenders a first-mortgage
lien on certain assets, such as land, a building, or
machinery. If the firm defaults, the lien allows the
lender to foreclose and sell the assets.
-
Collateral trust bond
Atype of secured bond involving assets placed in a
trust. The trustee gives the assets to the bondholder in
the event of default.
-
Equipment trust certificate
Atype of secured bond with indentures that give
lenders the right to specific pieces of equipment in the
event of default.
-
Debenture
Atype of unsecured bond. In the event of default,
debenture holders are unsecured creditors, meaning
that they have a claim on all of the firm’s assets not
already pledged.
interest—or a minimum ratio of tangible assets to total debt. When the firm cannot
meet the financial ratio conditions, it is technically in default even when it has made
the promised payments to bondholders.
Sinking Fund Covenants.Acommon covenant related to financing is a sinking fund
provision, which requires that a certain portion of the bonds be retired before matu-
rity. Atypical sinking fund on a 30-year bond might ensure that 25 percent of the bonds
are retired between years 10 and 20. The firm makes payments to the trustee, who then
repurchases randomly chosen bonds. The trustee may do this in the open market or,
more typically, may retire the bonds by exercising the call provision in the bond. (See
the subsection on bond options for details.)
Exhibit 2.9a describes the sinking fund in the Philip Morris bond due in 2017. It
specifies that 95 percent of the bond issue will be retired early, with at least $10 mil-
lion in principal redeemed annually.
Bonding Mechanism.Covenants generally specify some sort ofbonding mecha-
nism, or provision to ensure that the borrower is upholding the bond indentures. Large
bond issues require the appointment of a trustee to ensure that no violation of the bond
indentures takes place.
Bond Options
Exhibit 2.9b contains a description of an option embedded in the 2017 bond from
Moody’s Industrial Manual. This option gives Philip Morris the right to call (that is,
redeem) the bond at a price per $100 of face value that is given in the exhibit. The
price varies according to the date the bond is called. Virtually all bonds with sinking
fund provisions have this call feature, so that the firm has the ability to implement the
sinking fund in the event that it is unable to find a sufficient number of bonds to repur-
chase on the open market.
Exhibit 2.10 describes the various types of options embedded in bonds.
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EXHIBIT2.9aSinking Fund Example
Source: Reprinted with permission from Moody’s Investment Service of 1996. All Rights Reserved Worldwide.
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Chapter 2
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41
EXHIBIT2.9bCall Feature Example
Source: Reprinted by permission of Moody’s Investment Service of 1996. All Rights Reserved Worldwide.
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EXHIBIT2.10Types of Bond Options
-
Callability
Allows the issuing firm to retire the bonds before maturity by paying
a prespecified price. Typically, the bond indenture contains a schedule
of dates and the prices on those dates at which the firm can call the
bonds. These call provisions:
-
•
Give firms protection from bondholders who refuse to
renegotiate bond covenants that the firm believes, after the fact,are too restrictive.
-
•
Allow firms to retire high-coupon bonds when interest rateshave fallen or when the firm’s creditworthiness has improved.
-
•
Enable firms to implement sinking fund provisions.
-
•
Result in bonds that sell for lower prices than noncallable
bonds.
If covenants do not prevent the call from being financed by issuing
new lower interest rate debt, the bonds are called refundable bonds.
-
Convertibility
Gives the bondholderthe option to convert the bond into another
security, typically the common stock of the firm issuing the
convertible bond. The terms of the conversion option are specified in
the bond covenants by indicating the conversion price or the number
of shares that the bondholder can exchange for the bond.
-
Exchangeability
Gives the issuing firmthe right to exchange the bond for a bond of a
different type. For example, the firm might be able to exchange a
bond with floating-rate payments for one with fixed-rate payments.
-
Putability
Gives the bondholderthe right, under certain circumstances, to sell the
bond back to the firm. If the value of the outstanding bonds falls
(perhaps owing to a proposal to leverage the firm much more
highly), bondholders could force the firm to buy back the
outstanding bonds at an exorbitant price. Putable bonds sell for
higher prices than nonputable bonds.
How Abundant Are These Options?At one time, nearly all long-term corporate
bonds were callable. Since the mid-1980s, however, call provisions are rarely found
except in the bonds issued by the least creditworthy firms.10Of course, exceptions exist
to every observed pattern. For example, in November 1993, Canon, a Japanese firm
with a superb credit rating, issued ¥100 billion of yen-denominated bonds in the United
States with maturities at time of issue ranging from 10 to 15 years. The 15-year bonds
are callable at any time after January 2002 at a price of ¥106 per ¥100 face value, with
the call price declining by ¥1 annually to ¥100 on January 2008.
Convertible bonds, which possess desirable properties for resolving certain bond-
holder-stockholder conflicts,11
are frequently issued by small firms, although some large
firms do use them. For example, the Canon issue described above is convertible into
Canon’s common stock.
10We
believe that the decline in the issuance of callable bonds is due to the substitution by many
firms of a derivative security known as an interest rate swap optionfor the call features in bonds. See
Chapter 7 for a discussion of both swaps and options.
11See Chapter 16.
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Chapter 2
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43
The Conversion Price of a Convertible Bond.The conversion priceof a convert-
ible bond is its face value divided by the number of shares into which each bond can
be converted. It is the face value given up per share received upon conversion. The
conversion premiumis the percentage difference between the conversion price and the
stock price.
Example 2.1 illustrates the calculations.
Example 2.1:Computing a Conversion Price
Lowe’s Companies, a hardware store chain, issued $250 million of convertible subordinated
notes in July 1993 which mature in 2003.The notes had a 3 percent coupon rate, but sold
at an offer price (per $100 face value) of $88.027 with the firm getting $86.927 and the rest
going for fees.The notes were convertible into 19.136 shares of common stock for each
$1,000 of principal.Lowe’s common stock was selling for $38.875 per share.What was the
conversion price and the conversion premium?
Answer:The conversion price was $52.258 ($1000/19.136).With Lowe’s selling at
$38.875, the conversion premium was about 34 percent ($52.258 $38.875)/$38.875.
Poison Puts.Putable bonds became popular after the merger and acquisition boom
in the mid-1980s. Apopular type of putable bond, known as a poison put bond, is
designed to protect bondholders in the event of a corporate takeover.12The leveraged
buyout—that is, a purchase of a firm with large amounts of debt—of RJR-Nabisco by
Kohlberg, Kravis, and Roberts (KKR) in 1988 provided the major impetus for poison
put provisions. When KKR finally won the $25 billion bidding battle, RJR-Nabisco
bonds had dropped by 16 points or $160 for each $1,000 bond. With long-term debt
of roughly $5 billion, bondholders had losses of $800 million, which meant plenty of
work for lawyers suing RJR-Nabisco. New issuers responded to bondholder concerns
by including put options in their bonds.
In July 1993, for example, after recently going through a leveraged recapitaliza-
tion—a procedure in which debt is issued to buy back equity—the Kroger Company
issued $200 million of senior secured debentures with a 10-year maturity and a poison
put provision. The put option allowed bondholders to sell bonds back to the firm at a
price of $101 should any person or group obtain more than 50 percent ownership of
the voting stock of Kroger or a majority on the board of directors.
Cash Flow Pattern
Bond types are often categorized by their cash flow pattern, as Exhibit 2.11 describes.
Exhibit 2.12 contrasts the cash flows patterns for the five types of bonds described in
Exhibit 2.11. Note the pattern of cash flows for a straight-coupon bond. This pattern
consists of a set of small, equal cash flows every period until the maturity date of the
bond, at which time there is a much larger cash flow. The stream of small, level periodic
cash flows are typically semiannual coupons until the bond’s maturity date. At maturity,
the large balloon payment13of straight-coupon bonds reflects the payment of all ofthe
principal due in addition to the semiannual coupon. The coupon is usually set so that
the bond initially trades close to parvalue($100 selling price per $100 of face value).
12Lehn
and Poulsen (1991) reported that 32 percent of the corporate bonds issued in 1989 contained
poison put provisions. This percentage has declined substantially since that time.
13A
balloon payment refers to a bond payment that is much larger than its other payments.
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EXHIBIT2.11Bond Types Based on Coupon orCash Flow Pattern
-
Straight-coupon bond
Fixed-rate instrument in which the coupon is typically
a
(also called a bullet bond)
paid in two equal semiannual installments with only
the last installment including the principal repayment.
-
Zero-coupon bond
Bonds that pay no periodic interest but have a single
(also called pure
payment at maturity. These bonds are sold at a
discount bond)
discount from their face value. The size of the
discount depends on prevailing interest rates and
the creditworthiness of the borrower.
-
Deferred-coupon bond
Bonds that permit the issuer to avoid interest payment
obligations for a certain period (for example, five
years). This allows cash-constrained firms some
breathing space in the hope that their cash flows
will grow.
-
•
In one variation, the coupon deferral causes the
bondholder to be paid in kind with additional
bonds; hence the name PIK (payment-in-kind)bonds.
-
•
In another variation, the coupon is at a fixed
rate, hence the name Zerfix bond.
-
Bonds that last forever and only pay interest.b
Perpetuity bond
(also called a consol)
-
Annuity bond
Bonds that pay a mix of interest and principal for a
finite amount of time. In contrast to a straight
coupon bond, there is no balloon payment of
principal at the bond’s maturity date.
aIn some circles, zero-coupon bonds, which do not pay interest periodically, are also considered bullets. We will
consider as bullets only those bonds that pay interest.
bPerpetuities, while useful for understanding bond pricing because of their mathematical properties, are extremely rare
in practice. They are found mostly in the United Kingdom where they are generally referred to as consols.
Amortization of Annual Pay Annuity Bonds.The promised cash flows of some
bonds resemble an annuity rather than a straight-coupon bond. For instance, residential
mortgages and many commercial mortgages pay a level monthly payment, a portion of
which is interest and another portion principal.
The right-hand side of Exhibit 2.13 illustrates the pattern of principal paydown for
a 30-year annual pay mortgage over time (that is, its amortization). It shows that early
in the life of this annuity bond the largest portion of the payment is interest. With each
subsequent payment, a greater portion of the payment applies to principal and a smaller
portion applies to interest. For example, $10,000 of the $10,607.925 first year payment
is interest, but this interest drops to $9,939.208 in the second year, even though the
first and second year payments are identical.
The Amortization of an Annual-Pay Straight Coupon Bond.The left-hand side of
Exhibit 2.13 illustrates the amortization of a straight-coupon bond. In contrast with the
annuity on the right-hand side, the $10,000 first-year payment on the straight-coupon
bond, the sum of columns (a) and (b) on the left-hand side is sufficient only to cover
the bond’s 10 percent interest on the $100,000 principal. Hence, there is no reduction
in the principal balance due on the loan, and the borrower still owes $100,000 princi-
pal on the bond in year 2. In subsequent years, only interest is covered by each $10,000
annual payment. Thus, not until the final year of the bond is any principal paid. In this
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Chapter 2Debt Financing |
45 |
EXHIBIT2.12 |
Cash Flows of Various Bond Types |
|
-
interest
principal
Straight-Coupon
Deferred-Coupon
-
Cash Flow
Cash Flow
-
. . .
. . .
Year
T
Year
T
-
Zero-Coupon
Annuity
-
Cash Flow
Cash Flow
-
. . .
. . .
Year
T
Year
T
Perpetuity
Cash Flow
-
. . .
Year
T T+1 T+2 T+3 T+4 T+5 T+6 T+7 T+8 . . .
case, both the $10,000 in interest due and the entire $100,000 principal make up the
final payment.
Amortization of Perpetuities and Zero-Coupon Bonds.The amortization of a per-
petuity is identical to that of a straight-coupon bond except that, lacking a maturity
date, there is never any payment of principal in one final balloon payment. In contrast,
a zero-coupon bond has negative amortization. No payment is made, so the principal
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EXHIBIT2.13Amortization of Straight-Coupon Bonds and Mortgages
-
Annual Pay
Straight-Coupon Bond
Annual Pay Mortgage
-
Interest
Principal
Interest
Principal Paid
Total
Year
(a)
(b)
(c)
(d)
(c) & (d)
-
1
$10,000
$ 0
$10,000.000
$ 607.925
$10,607.925
2
10,000
0
9,939.208
668.717
10,607.925
3
10,000
0
9,872.336
735.589
10,607.925
4
10,000
0
9,798.777
809.148
10,607.925
5
10,000
0
9,717.862
890.063
10,607.925
6
10,000
0
9,628.856
979.069
10,607.925
7
10,000
0
9,530.948
1,076.976
10,607.925
8
10,000
0
9,423.251
1,184.674
10,607.925
9
10,000
0
9,304.784
1,303,141
10,607.925
10
10,000
0
9,174.470
1,433.455
10,607.925
11
10,000
0
9,031.124
1,576.800
10,607.925
12
10,000
0
8,873.444
1,734.480
10,607.925
13
10,000
0
8,699.996
1,907.929
10,607.925
14
10,000
0
8,509.203
2,098.721
10,607.925
15
10,000
0
8,299.331
2,308.594
10,607.925
16
10,000
0
8,608.472
2,539.453
10,607.925
17
10,000
0
4,814.527
2,793.398
10,607.925
18
10,000
0
7,535.187
3,072.739
10,607.925
19
10,000
0
7,227.913
3,380.012
10,607.925
20
10,000
0
6,889.912
3,718.013
10,607.925
21
10,000
0
6,518.111
4,089.814
10,607.925
22
10,000
0
6,109.129
4,498.796
10,607.925
23
10,000
0
5,659.250
4,948.675
10,607.925
24
10,000
0
5,164.382
5,443.543
10,607.925
25
10,000
0
4,620.028
5,987.897
10,607.925
26
10,000
0
4,021.238
6,586.687
10,607.925
27
10,000
0
3,362.569
7,245.355
10,607.925
28
10,000
0
2,638.034
7,969.891
10,607.925
3029
10,00010,000
100,0000
1,841.045
8,766.880
10,607.925
964.357
9,643.568
10,607.925
on which interest is owed grows over time. The principal of a zero-coupon bond at
year t,denoted P,satisfies the equation:
t
PP(1 r)
tt1
where ris the stated rate (sometimes called the yield) of the zero-coupon bond. Since
the initial principal of a zero-coupon bond, P, is the price paid for the T-year zero-
0
coupon bond, the tax authorities in most countries will impute an interest rate and
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Chapter 2
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47
EXHIBIT2.14Bond Type Based on Market Price
-
Premium bond
Bond with a quoted price that exceeds the face value of the bond.
Parbond
Bond with a quoted price that equals the face value of the bond.
Discount bond
Bond with a face value that exceeds the quoted price of the bond.
charge tax on interest earned but not paid. The interest imputed by the tax authorities
is at a rate rthat satisfies the equation:
1
PT
r T1
P
0
Tax is then paid each year on the imputed interest. For year t, t T,the imputed inter-
est is
Pr
t1
Bond Prices: Par, Discount, and Premium Bonds
Bonds are also categorized by their market price in relation to the amount of principal
due, as Exhibit 2.14 illustrates.
As time elapses, a straight-coupon bond that traded at par when it was issued can
become a discount bond or a premium bond. This occurs if either riskless bonds of the
same maturity experience price changes, which implies a change in the level of inter-
est rates, or if the credit risk of the bond changes.
Bonds that are issued at a discount are known as original issue discount (OID)
bonds. This occurs when the coupon rate is set lower than the coupon rate of par bonds
of the same maturity and credit risk. There may be no coupon as in the case of zero-
coupon bonds. Alternatively, the bond may pay a dual coupon; a dual-coupon bond
has a low coupon initially and a higher coupon in later years. Dual coupons are typi-
cally found in a number of high-yield bonds or bonds that have large amounts of default
risk (to be discussed later in this chapter).
Maturity
It is also possible to classify debt instruments based on their maturity. Generally, a bill
or paper issue consists of a zero-coupon debt security with one year or less to matu-
rity at the issue date. Anotegenerally refers to a medium-term debt security with matu-
rity at issue of 1 to 10 years. Abond generally refers to a debt security with more than
10 years to maturity. However, these distinctions are not always so sharp. For exam-
ple, the terms medium-term note, structured bond, and structured note can refer to a
particular type of debt security of almost any maturity. The term bondalso can be a
generic term referring to any debt security, as we have used it here.
Bond Ratings
Abond ratingis a quality ranking of a specific debt issue. There are three major
bond-rating agencies: Moody’s, Standard & Poor’s (S&P), and Fitch.
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120 Titman: FinancialI. Financial Markets and
2. Debt Financing
© The McGraw
120 HillMarkets and Corporate
Financial Instruments
Companies, 2002
Strategy, Second Edition
48Part IFinancial Markets and Financial Instruments
EXHIBIT2.15Summary of Rating Symbols and Definitions
-
Moody’s
S&P
Fitch
Brief Definition
-
Investment
Grade–High
Creditworthiness
Aaa
AAA
AAA
Gilt edge, prime, maximum safety
Aa1
AA
AA aeeebeeec aeeebeeec
Aa2
AA
AA
Very high grade, high quality
Aa3
AA
AA
A1
A
A
A2
A
A
Upper medium grade
A3
A
A
Baa1
BBB
BBB aeeebeeec
Baa2
BBB
BBB
Lower medium grade
Baa3
BBB
BBB
-
Distinctly
Speculative–Low Creditworthiness
Ba1
BB BB aeeebeeec aeeebeeec
Ba2
BBBB
Low grade, speculative
Ba3
BBBB
B1
B B
B2
BB
Highly speculative
B3
B B
Predominantly Speculative–Substantial Risk orin Default
CCC aeeebeeec
CaaCCCCCCSubstantial risk, in poor standing
CCC
CaCCCCMay be in default, extremely speculative
CCCEven more speculative than those above
CIIncome bonds—no interest being paid
DDDaeeebeeec
DDDefault
DD
Source: Reprinted with permission of The McGraw-Hill Companies, Inc., from The New Corporate Bond Market, by
Richard Wilson and Frank Fabozzi, ©1990 Probus Publishing Company.
The Process of Obtaining a Rating.For a fee ranging from thousands of dollars to
tens of thousands of dollars, each agency will rate the credit quality of a debt issue and
follow that issue over its lifetime with annual or more frequent reviews. Debt may be
upgraded or downgraded depending on the financial condition of the firm.
Arating agency is hired to rate a bond before the firm offers it to the public. To
produce a rating, the agency must first scrutinize the financial statements of the firm
and talk to senior management. After the agency notifies the firm of its initial rating,
the firm’s management generally provides additional information if it believes the rat-
ing is too low. Once the final rating is determined, the rating agency will continue to
monitor the firm for any changes in its financial status.
The Ratings Designations and TheirMeaning.Exhibit 2.15 shows the rating des-
ignations used by the four leading rating agencies and their meaning.
The Relation between a Bond’s Rating and Its Yield.Bond ratings can have an
important influence on the promised rates of return of corporate bonds, known as bond
Grinblatt |
I. Financial Markets and |
2. Debt Financing |
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The McGraw |
Markets and Corporate |
Financial Instruments |
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Companies, 2002 |
Strategy, Second Edition |
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Chapter 2
Debt Financing
49
yields. For instance, during 1983 the spread between AAA-rated bonds and BBB-rated
bonds varied between 180 and 246 basis points, which was unusually large. In con-
trast, that spread varied between 75 and 90 basis points during 1993. This widened
again in the latter part of 1998, following the default by Russia on its sovereign debt
and the financial difficulties of a large hedge fund (Long-Term Capital Management).
When Ederington, Yawitz, and Roberts (1987) investigated the relation between
bond yields and both ratings and accounting measures of creditworthiness, they found
that both types of information influenced bond yields. Thus, according to their study,
the bond of a firm with a high rating would sell at a higher price than the bond of a
firm with a lower rating if the two firms have similar financial ratios and their bonds
have the same features (for example, similar seniority, coupon, collateralization, and
options).
The High-Yield Debt Market
An investment-grade ratingon a bond is a rating of Baa and above by Moody’s and
BBB and above for the other three agencies. Because many large investors are pro-
hibited from owning below-investment-grade bonds, also known as high-yield bonds
or junk bonds,most firms strive to maintain an investment-grade rating.14Despite
these negative consequences, the growth of the high-yield bond market has been
spectacular.
Issuance in the High-Yield Debt Market.Exhibit 2.16 shows the dollar volume of
junk bonds issued for each year from 1980 to 1999. Two features of the line graphs
are worth noting:
-
•
The number of issues plunged in 1990 and 1991.
•
Astriking rebound occurred in the market beginning in 1992 and 1993.
-
•
The market remained strong with the volume of new issues increasing in thesecond half of the 1990s.
Causes of the Increase in High-Yield Debt Issuance.Much of the 1980–1987
increase in high-yield debt issuance was linked to the increase in corporate takeovers
that was taking place simultaneously. There were two reasons for the subsequent
1990–1991 “bust.” First, Drexel, Burnham, Lambert, underwriter of more than 50 per-
cent of high-yield issues and the center of the over-the-counter market in junk bonds
at the time (and the employer of junk-bond WunderkindMichael Milken), went bank-
rupt in February 1990. Drexel experienced a great deal of financial distress prior to the
bankruptcy and many other Wall Street firms shunned dealings with the firm to avoid
exposure to Drexel’s credit risk. Second, Congress passed the Financial Institutions
Reform, Recovery, and Enforcement Act (FIRREA) in 1989, forcing insurance com-
panies and thrifts to divest their holdings of non-investment-grade debt.
The rebound of the early 1990s demonstrated, however, that high-yield debt was
an innovative product with staying power. Prior to this innovation, bank loans were the
only available sources of debt capital for small firms and for leveraged buyouts. With
the advent of the junk bond market, firms in need of debt financing found a public
14Government
workers’pension funds and teachers’pension funds in most states are prohibited by
law from investing in junk bonds. The charters of numerous corporate pension funds have similar
prohibitions.
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Grinblatt
124 Titman: FinancialI. Financial Markets and
2. Debt Financing
© The McGraw
124 HillMarkets and Corporate
Financial Instruments
Companies, 2002
Strategy, Second Edition
50 |
Part IFinancial Markets and Financial Instruments |
EXHIBIT2.16 |
Volume of High-Yield Debt Issues |
160,000
140,000
Millions of dollars
120,000
100,000
80,000
60,000
40,000
20,000
0
19801982198419861988199019921994199619982000
Year
Sources: Information Please Business Almanac and Sourcebook, 1995 for 1980–1993. Reprinted with permission of Inso Corporationand Chase Securities 1999 High-Yield Annual Review for 1994–1999.
market willing to provide financing at lower cost than the banks and often with more
flexible covenants.
To its supporters, the evolution of the junk bond market illustrates how the finan-
cial markets respond to a demand and create enormous value in doing so. There had
always been high-yield debt. Before 1980, however, nearly all of it was made up of
so-called “fallen angels,”that is, investment-grade debt that had been downgraded
because the issuing firm had experienced financial distress. Milken and Drexel had the
genius to realize that there could be a primary market for non-investment-grade debt.
Drexel was fortunate to be in the right place at the right time. The late 1970s and
the early 1980s were characterized by high interest rates, high interest rate volatility,
and an economic environment in which short-term interest rates were as much as 400
basis points (4 percent) above long-term rates.15This situation made banks wary of
lending long-term, thereby drying up the most important source of funds for unrated
firms. Drexel, aware of the funding gap, created the market for high-yield securities.
When the banks began to make long-term loans again in the mid-1980s, it was too late.
The securitized financing issued with the help of Drexel was popular with investors
and cheaper than the financing the banks were providing. The rest is history.
The Default Experience and the Returns of High-Yield Debt.The junk bond mar-
ket continues to be controversial. Early studies by Altman and Nammacher (1985), Alt-
man (1987), and Weinstein (1986–1987) claimed that the probability of default on a
typical junk bond was quite low while its return relative to a typical investment-grade
bond was high, implying that junk bonds were a great buy. However, such studies
underestimated default probabilities because they measured the default rate as the per-
centage of bonds defaulting in a year divided by the total amount of bonds outstanding.
15Risk-free,
short-term interest rates hit a peak of about 16 percent in 1981.
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I. Financial Markets and |
2. Debt Financing |
©
The McGraw |
Markets and Corporate |
Financial Instruments |
|
Companies, 2002 |
Strategy, Second Edition |
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Chapter 2
Debt Financing
51
Subsequent studies by Altman (1989) and Asquith, Mullins, and Wolff (1989)
pointed out that the huge growth in the high-yield market meant that old issues with
relatively high default rates were masked by the large volume of new issues, which had
much lower default rates. In the first year after issue, bonds did have low default rates,
in the range of 2–3 percent, but once they had aged by 6–10 years, the proportion that
ultimately defaulted rose to 20–30 percent. As expected, this compares unfavorably to
investment-grade debt whose cumulative default rate is roughly 1–2 percent after
10years.16
Evidence on the value of investing in junk bonds is less clear-cut. Although the
present consensus is that about 20–30 percent of the junk bonds issued in any given
year are likely to eventually default, the returns from holding junk bonds continue
to be disputed. Altman (1989) showed that default-adjusted spreads over Treasuries
on high-yield bonds were large and positive, indicating that investors did well.
Because Altman adjusted only for default risk, however, his results must be viewed
with skepticism.
Cornell and Green (1991) and Blume, Keim, and Patel (1991) reached different
conclusions. Cornell and Green analyzed returns from mutual funds that invested in
junk bonds, thus circumventing the data problems associated with individual bonds.
Blume, Keim, and Patel used bond price data from Drexel and Salomon, which are
more reliable than a random sample of bonds. Both studies found that, on average, the
returns from holding junk bonds lie between the returns from holding high-grade bonds
and from holding common stock. Both studies concluded that the average returns expe-
rienced by investors in junk bonds compensated them fairly for the risk they bore.