AFM 371 Winter 2008 Chapter 21 - Long Term Debt

Transcription

1 AFM 371 Winter 2008 Chapter 21 - Long Term Debt 1 / 15

2 Outline Review of Basic Concepts Call Provisions and Bond Refunding Bond Ratings Some Different Types of Bonds Direct Placements and Syndicated Loans 2 / 15

3 Review of Basic Concepts recall that the procedures for selling public debt and equity securities are basically the same (except for the indenture) the indenture specifies contractual features (maturity, coupon, callability, etc.) as well as covenants (positive and negative) the indenture is a written contract between the issuer and a trust company the trust company is appointed by the issuer to represent the bondholders ensure that the terms of the indenture are obeyed manage sinking fund act on behalf of bondholders in case of default a sinking fund is an account managed by the trust company trust company can either purchase bonds in the market or select via lottery and pay face value provides early warning signal to bondholders if firm has trouble making sinking fund payments gives firm option to pay lower of market price or face value 3 / 15

4 Review of Basic Concepts Cont d features of a hypothetical bond: Issue amount $20 million Total face value is $20 million Issue date 12/15/03 Offered to the public in Dec Maturity date 12/31/23 Remaining principal due Dec. 31, 2023 Face value $1,000 Face value 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 semi-annually Offering price 100 Offering price is 100% of face value Yield to maturity 10% Based on stated offer price Call provision Callable Bonds are call protected after 12/31/08 for 5 years Call price 110 until 12/31/13, Callable at 110% of par 100 thereafter through 2013, at par thereafter Trustee United Bank of Appointed to represent Florida bondholders Security None Bonds are an unsecured debenture Rating Moody s A1, Bond credit quality rated S&P A+ upper medium grade 4 / 15

5 Review of Basic Concepts Cont d example of a bond price quotation: on Jan. 15, 2008, a Great-West Life Assurance Company bond with a coupon of 6.75 and a maturity date of Aug. 10, 2010 was quoted as trading for (bid) and had a yield of / 15

6 Call Provisions and Bond Refunding a call provision lets the issuer repurchase or call the entire bond issue at a specified price over a specified period call provisions usually are not operative during the first few years after a bond is issued (the bond is said to be call protected during this period the difference between the call price and the face value is the call premium call options have value here, since the issuing firm holds the option, it makes the bond worth less to investors value of callable bond = value of straight bond value of call option replacing all (or part) of a bond issue is called bond refunding two questions: should firms issue callable bonds? if so, when should bonds be called? 6 / 15

7 Call Provisions and Bond Refunding Cont d the call provision works to the advantage of the issuer if interest rates fall and bond prices go up, the option to buy back the bonds at the call price is valuable with bond refunding, the issuer will typically replace the called bonds with a new bond issue (which will have a lower coupon rate) however, investors will take this into account when they buy a callable bond in particular, they will demand higher coupon rates on callable bonds as compensation for the call option consider the following example: a bond pays annual coupons of $100, has a maturity of 20 years, and a yield of Suppose that the interest rate will change to either.08 or.12 (with equal probability) after 5 years and remain at that level. Assume coupons are paid annually and that the bond has a face or par value of $1,000. (a) What is the value of the bond today? (b) Now assume the bond is callable after 5 years with a call premium of $50 (and that this is the only time at which it can be called). What is the value of the bond today? (c) What annual coupon would be required for this callable bond to be equally valuable as an otherwise identical but non-callable bond? 7 / 15

8 Call Provisions and Bond Refunding Cont d 8 / 15

9 Call Provisions and Bond Refunding Cont d this implies that there is neither an advantage nor a disadvantage to issuing callable bonds: firms can either issue non-callable bonds, or callable bonds with higher coupons (investors will demand the same return either way). so why are callable bonds issued in the real world? superior interest rate predictions: company managers may know more about changes in yields on its bonds, e.g. they may have information about changes in the firm s credit rating; if managers believe the chance of rates falling is higher than bondholders do, then the firm may want to have the call option taxes: if the bondholder is taxed at a lower rate than the firm, the tax advantage of higher interest deductibility for a callable bond for the firm will be greater than what the bondholder in a lower tax bracket would lose; the firm and the bondholder can split this gain financial flexibility: covenants may restrict a firm s ability to take advantage of opportunities such as a spin off, calling the bonds allows managers to circumvent the covenants reduced interest rate risk: if rates increase, the value of a callable bond drops (but not as much as a non-callable bond due to higher coupon); if rates fall, the value of a callable bond rises (but not as much due to the call feature) 9 / 15

10 Call Provisions and Bond Refunding Cont d when should bonds be called? if there are no transactions costs, and managers are acting in the interests of the shareholders, then the firm should call its bonds whenever the value of the callable bond exceeds the call price in practice, there are some reasons why the firm might allow the bond to trade at prices above the call price costs of issuing new bonds required notice periods the Canada plus call: much recent corporate debt in Canada has a different feature call premium not specified at time of issue if bond is called, call premium is set to compensate investors for the difference in interest between the original bond and the new bond that would be sold to replace it so why not just issue non-callable bonds? 10 / 15

11 Bond Ratings bond rating firms (Standard & Poor s, Moody s, DBRS) assess the likelihood that the firm will default and the protection offered by the debt contract in the event of default firms pay to have their bonds rated ratings can change, and raters can disagree investment grade bonds have a Standard & Poor s rating of BBB and up, junk bonds have a rating of BB and lower (more prevalent in U.S., often used to finance takeovers) ratings are based on publicly available information the spread increases for lower rated bonds: for AAA bonds, spreads are often about 30 b.p. for D rated bonds, spreads can be more than 1,000 b.p. the table on the next slide shows the ratings designations for different agencies, see Table 21.2 in the text for a detailed description of the ratings for DBRS 11 / 15

12 Bond Ratings Cont d Moody s S&P s DBRS Desription Investment Grade Aaa AAA AAA Highest credit rating, maximum safety Aa1 AA+ Aa2 AA AA High credit quality Aa3 AA- A1 A+ A2 A A Upper medium quality A3 A- Baa1 BBB+ Baa2 BBB BBB Lower medium quality Baa3 BBB- Speculative Grade Ba1 BB+ BB Low credit quality Ba2 BB Ba3 BB- B1 B+ B Very low credit quality B2 B B3 B- Extremely Speculative Grade Caa1 CCC+ CCC Extremely low credit quality Caa2 CCC Caa3 CCC- Ca CC CC Extremely speculative C1 C C D D Bonds in default 12 / 15

13 Some Different Types of Bonds zero coupon bonds pay no coupons, only the face value at maturity imputed interest for tax purposes (both issuer and owner) floating rate bonds have adjustable coupon payments (a function of short term interest rates) a good hedge against inflation risk cheaper than continually rolling over short term debt real return bonds are bonds where coupons are adjusted based on the consumer price index income bonds have pay coupons only if the firm has enough income coupons can be skipped without causing default, but interest is not tax deductible for the issuer convertible bonds can be exchanged for shares in the firm combinations of features: LYONs (callable, puttable, convertible, zero coupon) 13 / 15

14 Direct Placements and Syndicated Loans unlike what we have described so far (i.e. public debt), a large percentage of debt is directly placed a term loan is a direct business loan with a maturity of 1-5 years lenders include banks, insurance companies, and trust companies a private placement is similar but has a longer maturity and usually involves an investment dealer who facilitates the transaction investment dealer does not underwrite no need for a prospectus (just an offering memorandum) sold to large exempt purchasers the private placement market is dominated by insurance companies and pension funds 14 / 15

15 Direct Placements and Syndicated Loans Cont d comparing public and direct placements: registration and distribution costs are lower for direct financing direct placements tend to have more restrictive covenants it is easier to renegotiate a term loan or a private placement in case of a default most bank loans are made with a commitment to the firm that sets up a line of credit and allows the firm to borrow up to some pre-set limit very large banks frequently have a larger demand for loans than they can supply, and smaller banks often have more funds available than demand large banks then arrange loan and then sell portions of them to a group or syndicate of other banks each bank in the syndicate has a separate loan agreement with the borrower in some cases, syndicated loans are publicly traded 15 / 15