Download Chapter 21: Bond financing

CHAPTER 21: Long Term Debt
Topics
• 21.1 - 21.2
• 21.3
• 21.4
• 21.6
Background
Bond Refunds
Bond Ratings
Direct placement vs. Public Issues
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21.1 - 21.2 Quick Review of Basics of Bond Issuance
• Public issue of bonds
– Includes an indenture (agreement between firm and trust company)
– Protective covenants (positive and negative)
– Seniority, sinking fund provisions, call provisions, etc
• a trust company (trustee) 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
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Review: Price quotation example
On Oct. 29, 2004, a TD Bank bond with a coupon of 6.00 and a maturity date of
26 July 2006 was quoted as selling for 104.39 (Ask) and had a yield of 3.36.
Price quotes are percent of par: $1,043.90
Semi-annual coupon payment: 1,000 * 6%/2 = 30
Next coupon date: Jan. 26, 2006
Previous coupon date: July 26, 2006
Days since previous coupon:
07/26
10/29
01/21
Accrued interest:
Price = quoted price + accrued interest =
Quoted yield: 3.36%, one-period (6 month) yield = 3.36%/2 = 1.68%
Theoretical price:
Error:
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21.3 Callable Bonds
• call feature allows issuer to repurchase entire bond issue at a
pre-specified price over a specified period
• call premium – difference between call price and face value
• call provisions have value
Value of callable bond = value of straight bond – value of call
option
• Many long-term corporate bonds outstanding in Canada
have call provisions.
• Replacing all (or part) of a bond issue is called bond
refunding
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Example: Value of Call Provision: Perspective of Bondholder
Assume that a bond pays annual coupons of $100, has a maturity of 20
years and that yield of the bond is 0.10. Suppose that the interest rate
(yield) will change to either 12% or 8% (with equal probability) after 5
years and remain at that level. Assume no personal taxes and annual
coupon payment. The outstanding bond has a face value of $1,000.
(1)What is the value of this bond today?
a. PV of first 5 years’ coupons:
b. PV of remaining coupon & principal:
If r = 0.12
If r = 0.08
c. Bond value today
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Example cont’d
(2) Now assume that the bond is callable after 5 years with a call premium
of $50 (and this is the only date on which it may be called).
(a) What is the value of the bond today?
PV (call price):
Value today if called in 5 years:
Value today if not called in 5 years:
Bond value today:
(b) What annual coupon would be required for this callable bond to be
equally valuable as an otherwise identical but non-callable bond?
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Example cont’d: Should the bond be called and refunded?—
Perspective of firm
(3) Suppose 5 years later, the interest rate drops to 8%. The firm is
approached by an investment bank attempting to persuade the
issuer to recall the bond (“old” bond) and issue the following
bond (“new” bond) instead:
Issue size: $1,000; Coupon rate: 6%; floatation cost: 1% of face
value; interest rate 8%; maturity: 15 years. Annual coupon
payment.
To eliminate timing problems with the two issues, the new bonds
will be sold a month before the old bonds are called. The firm is
likely to pay the coupons on both issues during this month but can
defray some of the cost by investing the issue at 3%, the shortterm interest rate. Would this bond be called? Assume that the
corporate tax rate is 40%.
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Example cont’d: Solution
•
Cost of refunding
1. Call premium (non tax-deductible expense): $50
2. Flotation costs: one-time expense but amortized over the life the
issue or five years, whichever is less.
– Floatation costs
– PV of tax savings
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(discounted at after-tax interest rate)
– Total after-tax cost
3. Additional interest
– Extra interest paid on old issue
– Extra interest earned
– Total additional interest
–
Total investment: 1+2+3
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Example solution cont’d
• Interest savings on new issue
– Interest on old bond
– Interest on new bond
– Annual savings
– After-tax savings
– PV of annual savings over 15 years (discounted at after-tax interest
rate)
• NPV for the Refunding Operation
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Why issue callable bonds
• Superior interest rate predictions: company managers may know more
about changes in yields on its bonds than bondholders do, e.g. they may
have information about changes in the firm’s credit rating;
• 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)
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When to call a bond
• 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
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21.4 Bond Ratings
• Bond rating firms (Standard and Poor’s, Moody’s, CBRS,
DBRS) assess the likelihood of default on corporate debt
issues and provide ratings (AAA, B, C ) that indicate the
default risk to investors (Table 21.2)
• Investment grade bonds and Junk bonds.
• Junk bonds are low grade or high yield (high risk) bonds.
S&P rating of BB and below.
• Bond ratings are based on publicly information
• Default spread increases with bond rating. For AAA ratings
bond, default spread is only about 30 bp (0.20%). The spread
increases to more than a thousand bp (10%) for D ratings
bond.
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Moody's
S&P's
DBRS
Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBB-
AAA
Highest credit rating, maximum safety
AA
High credit quality, investment-grade bonds
A
Upper-medium quality, investment grade bonds
BBB
Lower-medium quality, investment grade bonds
Ba1
Ba2
Ba3
B1
B2
B3
Caa1
Caa2
Caa3
Ca
C1
BB+
BB
BBB+
B
BCCC+
CCC
CCCCC
C
D
Credit Rating Description
Investment Grade
Speculative-Grade Bond Ratings
Low credit quality, speculative-grade bonds
BB
B
Very low credit quality, speculative-grade bonds
Extremely Speculative-Grade Bond Ratings
Extremely low credit standing, high-risk bonds
CCC
CC
C
D
Extremely speculative
Bonds in default
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Features of a Hypothetical Bond
Issue amount
Issue date
Maturity date
Face value
Coupon interest
Coupon dates
Offering price
Yield to maturity
Call provision
$20 million
12/15/03
12/31/23
$1,000
$100 per annum
6/30, 12/31
100
10%
Callable after 12/31/08
Call price
110 before 12/31/13,
100 thereafter
United Bank of Florida
None
Moody's A1, S&P A+
Trustee
Security
Rating
Bond issue total face value is $20 million
Bonds offered to the public in December 2003
Remaining principal is due December 31, 2023
Face value denomination is $1,000 per bond
Annual coupons are $100 per bond
Coupons are paid semiannually
Offer price is 100% of face value
Based on stated offer price
Bonds are call protected for 5 years after
issuance
Callable at 110 percent of par value through
2008. Thereafter callable at par.
Trustee is appointed to represent bondholders
Bonds are unsecured debenture
Bond credit quality rated upper medium grade
by Moody's and S&P's rating
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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
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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 hat 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
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Assigned problems: # 21.1, 3, 4, 7, 10, 12, 15, 19
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