Chapter 6 &14

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Chapter 6 &14

Corporate Debt & Credit Risk

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) –9781442502000 / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1st edition

14.1 Corporate Debt

When companies raise capital by issuing debt, they can use different sources to seek funds:

Public debt, which trades in a public market.

Private debt, which is negotiated directly with a bank or a small group of investors.

The securities that companies issue when raising debt are called corporate bonds.

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Private debt Debt that is not publicly traded (e.g. a bank loan). Private debt has the advantage that it avoids the

cost and delay of registration with ASIC. The disadvantage is, that because it is not

publicly traded, it is illiquid, meaning that it is hard for a holder of the firm’s private debt to sell it in a timely manner.

Segments of private debt: Bank loans Private placements

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14.1 Corporate Debt


Public debt A public bond issue is similar to a stock issue. The prospectus: the prospectus describes the

details of the offering and must include an indenture, a formal contract that specifies the firm’s obligations to the bondholders.

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14.1 Corporate Debt


14.1 Corporate Debt

Corporate bonds Bonds which are issued by corporations. Corporations with higher default risk will need

to pay higher coupons to attract buyers to their bonds.


14.2 Bond Covenants

Covenants Restrictive clauses in a bond contract that limit the

issuer from taking actions that may undercut its ability to repay the bonds.

Advantages: By including more covenants, firms can reduce

their costs of borrowing.

The reduction in the firm’s borrowing cost can more than outweigh the cost of the loss of flexibility associated with covenants.

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14.3 Repayment Provisions

A firm repays its bonds by making coupon and principal payments as specified in the bond contract.

Balloon payment: principal payment on a maturity date.

Sinking funds: a provision that allows the company to make regular payments into a fund administered by a trustee over the life of the bond instead of repaying the entire principal balance on the maturity date.

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Convertible provisions: corporate bonds with a provision that gives the bondholder an option to convert each bond owned into a fixed number of ordinary shares at a ratio called the conversion ratio.

Callable provisions: corporate bonds with a provision that permits the issuer to repurchase the bond prior to its maturity, at a predetermined price.

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14.3 Repayment Provisions


6.5 Corporate Bonds

Credit risk

Treasury bonds are widely regarded to be ‘risk-free’ because there is virtually no chance the government will fail to pay the interest and default on these bonds.


6.5 Corporate Bonds

With corporate bonds, the bond issuer may default—e.g. a company with financial difficulties may be unable to fully repay the loan.

This risk of default, which is known as the credit risk of the bond, means that the bond’s cash flows are not known with certainty.

To compensate for the risk that the firm may default, investors demand a higher interest rate than the rate on Treasury securities.

The difference between yields on corporate bonds and yields on Treasury bonds is referred to as credit spread.

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6.5 Corporate Bonds

Corporate bond yields The cash flows promised by the bond are the

most that bondholders can hope to receive. Due to credit risk, the cash flows that a

purchaser of a corporate bond actually expects to receive may be less than that amount.

Investors may incorporate an increased probability that the bond payments will not be made as promised and prices of the bond would fall.

Yield to maturity of these bonds is calculated by comparing the price to the promised cash flows.

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6.5 Corporate Bonds Note

1. Investors pay less for bonds with credit risk than for an otherwise identical default-free bond.

2. As the yield to maturity for a bond is calculated using the promised cash flows, the yield of bonds with credit risk will be higher than that of otherwise identical default-free bonds.

Conclusion A higher yield to maturity does not

necessarily imply that a bond’s expected return is higher!

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6.5 Corporate Bonds

Bond ratings The probability of default is clearly important to

price a corporate bond.

The creditworthiness of bonds is rated and made available to investors, which encourages widespread investor participation and relatively liquid markets.

The two best-known bond-rating companies are Standard & Poor’s and Moody’s.

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Table 6.4 Bond Ratings

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Table 6.5 Credit Spreads: Australian Corporate Bonds

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Example 6.10 Credit Spreads and Bond Prices (p.178)

Problem: Your firm has a credit rating of A.

You notice that the credit spread for 10-year maturity debt is 90 basis points (0.90%).

Your firm’s 10-year debt has a coupon rate of 5%. You see that new 10-year Treasury bonds are being issued at par with a coupon rate of 4.5%.

What should the price of your outstanding 10-year bonds be?

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Solution:Plan: If the credit spread is 90 basis points, then YTM

should be the YTM on similar Treasury bonds plus 0.9%.

New 10-year Treasury bonds are being issued at par with coupons of 4.5% which means that these bonds are selling for $100 per $100 face value.

Thus, their YTM is 4.5% and your debt’s YTM should be 4.5% + 0.9% = 5.4%.

The cash flows on your bonds are $5 per year for every $100 face value, paid as $2.50 every 6 months. The six-month rate corresponding to a 5.4% yield is 5.4%/2 = 2.7%.

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Execute:

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Evaluate: Your bonds offer a higher coupon (5% vs 4.5%)

than Treasury bonds of the same maturity, but sell for a lower price

The reason is the credit spread.

Your firm’s higher probability of default leads investors to demand a higher YTM on your debt.

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Chapter 6 &14

Documents

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corporate debtwhen companies

firms private debt

bond contract

segments of private

small group of investors

principal payments

firms obligations