20-0 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Corporate Finance Ross Westerfield Jaffe Sixth Edition 20 Chapter Twenty Long-Term Debt Prepared.

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McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Corporate Finance Ross Westerfield Jaffe Sixth Edition

20Chapter Twenty

Long-Term Debt

Prepared by

Gady JacobyUniversity of Manitoba

and

Sebouh AintablianAmerican University of Beirut

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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

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20.1 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

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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

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Features of a Hypothetical Bond

Issue amount $20 million Bond issue total face value is $20 million Issue date 12/15/98 Bonds offered to the public in December 1998 Maturity date 12/31/18 Remaining principal is due December 31,

2018 Face value $1,000 Face value denomination 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 semiannually Offering price 100 Offer price is 100% of face value Yield to maturity 10% Based on stated offer price Call provision Callable after 12/31/03 Bonds are call protected for 5 years after

issuance Call price 110 before 12/31/08,

100 thereafter Callable at 110 percent of par value through 2008. Thereafter callable at par.

Trustee United Bank of Florida

Trustee is appointed to represent bondholders

Security None Bonds are unsecured debenture Rating Moody's A1, S&P A+ Bond credit quality rated upper medium

grade by Moody's and S&P's rating

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20.2 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

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Principal Repayment

• Term bonds versus serial bonds• Sinking funds: How do they work?

– Fractional repayment each year

– Good news---security

– Bad news---unfavourable calls

– How trustee redeems

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Protective Covenants

• Agreements to protect bondholders• Negative covenant: Thou shalt not:

– pay dividends beyond specified amount– sell more senior debt and 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

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The Sinking Fund

• There are many different kinds of sinking-fund arrangements:– Most start between 5 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 funds provide extra protection to bondholders.

• Sinking funds provide the firm with an option.

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The Call Provision

• A call provision lets the company repurchase or call the entire bond issue at a predetermined price overa specified period.

• The difference between the call price and the face value is the call premium.

• Many long-term corporate bonds outstanding in Canada have call provisions.

• New corporate debt features a different call provision referred to as a Canada plus call.

• The Canada plus call is designed to replace the traditional call feature by making it unattractive for the issuer ever to call the bonds.

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20.3 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?

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Should firms issue callable bonds?

• Common sense tells us that call provisions have value.

• A call 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.

• In bond refunding, firms will typically replace the called bonds with a new bond issue.

• The new bonds will have a lower coupon rate than the called bonds.

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Why are callable bonds issued in the real world?

• Four specific reasons why a company might use a call provision:

1. Superior interest rate predictions

2. Taxes

3. Financial flexibility for future investment opportunities

4. Less interest-rate risk

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Callable Bonds versus Noncallable Bonds

25

50

75

100

125

150

175

200

0 4 8 12 16 20

Yield to maturity (%)

Bo

nd

pri

ce (

% o

f p

ar)

Noncallable bond

Callable bond

Most bonds are callable; some sensible reasons for

call provisions include: taxes, managerial

flexibility, and the fact that callable bonds have

less interest rate risk.

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Calling Bonds: When does it make sense?

• In a world with no transaction costs, it can be shown that the company should call its bonds whenever the callable bond value exceeds the call price.

• This policy minimizes the value of the callable bonds.

• The costs from issuing new bonds change the refunding rule to allow bonds to trade at prices above the call price.

• The objective of the company is to minimize the sum of the value of the callable bonds plus new issue costs.

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20.4 Bond Ratings

• What is rated:– The likelihood that the firm will default.

– The protection afforded by the loan contract in the event of default.

• Who pays for ratings:– 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.

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Bond Ratings: Investment Grade

Moody's Duff & Phelps

DBRS Credit Rating Description

Aaa 1 AAA Highest credit rating,

maximum safety Aa1 2 Aa2 3 AA High credit quality,

investment-grade bonds Aa3 4 A1 5 A2 6 A Upper-medium quality,

investment grade bonds A3 7 Baa1 8 Baa2 9 BBB Lower-medium quality,

investment grade bonds Baa3 10

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Moody's Duff & Phelps

S&P's Credit Rating Description

Speculative-Grade Bond Ratings

Ba1 11 BB+ Low credit quality, speculative-grade bonds

Ba2 12 BB Ba3 13 BB- B1 14 B+ Very low credit quality,

speculative-grade bonds B2 15 B B3 16 B-

Extremely Speculative-Grade Bond Ratings Caa 17 CCC

+ Extremely low credit standing, high-risk bonds

CCC CCC- Ca CC Extremely speculative C C D Bonds in default

Bond Ratings: Below Investment Grade

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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:

– Original issue junk—possibly not rated

– Fallen angels—rated

• Current status of junk bond market– Private placement

• Yield premiums versus default risk

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20.5 Different Types of Bonds

• Callable Bonds• Puttable Bonds• Convertible Bonds• Zero Coupon Bonds• Floating-Rate Bonds• Other Types of Bonds

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Puttable bonds

• Put provisions– Put price

– Put date

– Put deferment

• Extendible bonds• Value of the put feature• Cost of the put feature

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Convertible Bonds

• Why are they issued?

• Why are they purchased?

• Conversion ratio:– Number of shares of stock acquired by conversion

• Conversion price:– Bond par value / Conversion ratio

• Conversion value:– Price per share of stock x Conversion ratio

• In-the-money versus out-the-money

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Convertible Bond Prices

50

60

70

80

90

100

110

120

130

140

150

50 70 90 110 130 150

Conversion value (% of par)

Bo

nd

pri

ce (

% o

f p

ar)

Convertible bond price

Nonconvertible bond price

Stock price

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Example of a Convertible Bond

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More on Convertibles

• Exchangeable bonds– Convertible into a set number of shares of a third

company’s common stock.

• Minimum (floor) value of convertible is the greater of:– 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 otherwise- identical nonconvertible bonds.

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Example of an Exchangeable Bond

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Zero-Coupon Bonds

• A bond that pays no coupons at all must be offered at a price that is much lower than its stated value.

• For tax purposes, the issuer of a zero-coupon bond deducts interest every year even though no interest is actually paid.

• Zero-coupon bonds, often in the form of stripped coupons, are attractive to individual investors for tax-sheltered Registered Retirement Savings Plans (RRSPs).

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Floating Rate Bonds

• With floating rate bonds, the coupon payments are adjustable.The adjustments are tied to the Treasury bill rate or another short-term interest rate.

Majority of floaters have the following features:

1. The holder has the right to redeem her note at par on the coupon payment date after some specified amount of time.

2. The coupon rate has a floor and a ceiling. i.e., a minimum and a maximum.

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Financial Engineering and Bonds

• Income bonds: coupon payments are dependent on company income.

• Retractable bonds: allow the holder to force the issuer to buy the bond at the stated price. Examples are Canada Savings Bonds (CSBs).

• A stripped real-return bond is a zero coupon bond with inflation protection.

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20.6 Direct Placement Compared to Public Issues

There are two basic forms of direct private long-term financing:

1. Term loans

2. Private placements

Differences between direct private long-term financing and public issues of debt are:

1. Registration costs are lower for direct financing.

2. Direct financing is likely to have more restrictive covenants.

3. It is easier to renegotiate a term loan or a private placement in the event of default.

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20.7 Long-Term Syndicated Bank Loans

• A syndicated loan is a corporate loan made by a group (or syndicate) of banks and other institutional investors.

• A syndicated loan may be publicly traded.• It may be a line of credit and be “undrawn” or it

may be drawn and be used by a firm.• Syndicated loans are always rated investment grade.

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20.8 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 favour 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.

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20.8 Summary and Conclusions (cont.)

• Long-term bonds usually provide for repayment of 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.