Slide 15.7 Bond Classifications
Slide 15.8 Required Yields
Security – debt classified by collateral and mortgage
Collateral – strictly speaking, pledged securities
Mortgage securities – secured by mortgage on real property
Debenture – an unsecured debt with 10 or more years to maturity
Note – a debenture with 10 years or less to maturity
Seniority – order of precedence of claims
Subordinated debenture – of lower priority than senior debt
Repayment – early repayment in some form is typical
Sinking fund – an account managed by the bond trustee for early
redemption
Call provision – allows company to “call” or repurchase part or all of an issue
Call premium – amount by which the call price exceeds the par value
Deferred call – firm cannot call bonds for a designated period
Call protected – the description of a bond during the period it can’t be
called
Protective covenants – indenture conditions that limit the actions of firms
Negative covenant – “thou shalt not” sell major assets, etc.
Positive covenant – “thou shalt” keep working capital at or above $X, etc.
Lecture Tip: Domestically issued bearer bonds will become obsolete in the
near future. Since bearer bonds are not registered with the
corporation, it was easy for bondholders to receive interest
payments without reporting them on their income tax returns. In an
attempt to eliminate this potential for tax evasion, all bonds issued
in the US after July 1983 must be in registered form. It is still legal
to offer bearer bonds in some other nations, however. Some foreign
bonds are popular among international investors particularly due
to their bearer status.
Lecture Tip: Ask the class to consider the difference in yield for a secured
bond versus a debenture. Since a secured bond offers additional
protection in bankruptcy, it should have a lower required return
(lower yield). It is a good idea to ask students this question for
each bond characteristic. It encourages them to think about the
risk-return tradeoff.
15.1. Some Different Types of Bonds
Slide 15.9 Zero Coupon Bonds
Slide 15.10 Pure Discount Bonds
Slide 15.11 Pure Discount Bonds Example
Zero coupon bonds are bonds that are offered at deep discounts because there
are no periodic coupon payments. Although no cash interest is
paid, firms deduct the implicit interest, while holders report it as
income. Interest expense equals the periodic change in the
amortized value of the bond. (Although not covered specifically in
the text, we include discussion and slides on discount bonds to
further understanding and help students with end of chapter
problems on the topic.)
Lecture Tip: Most students are familiar with Series EE savings bonds. Point
out that these are actually zero coupon bonds. The investor pays
one-half of the face value and must hold the bond for a given
number of years before the face value is realized. As with any
other zero-coupon bond, reinvestment risk is eliminated, but an
additional benefit of EE bonds is that, unlike corporate zeroes, the
investor need not pay taxes on the accrued interest until the bond
is redeemed. Further, it should be noted that interest on these
bonds is exempt from state income taxes. And, savings bonds yields
are indexed to Treasury rates.
Lecture Tip: A popular financial innovation is Treasury “strips.” You might
want to take a few minutes to describe these instruments and use
them as a springboard for a discussion of value additivity and/or
an example of cash flow valuation in practice.
Treasury strips are created when a coupon-bearing Treasury issue is
purchased, placed in escrow, and the coupon payments are
“stripped away” from the principal portion. Each component is
then sold separately to investors with different objectives: the
coupon portion is purchased by those desirous of safe current
income, while the principal portion is purchased by those with
cash needs in the future. (The latter portion is, in essence, a
synthetically created zero-coupon bond.) Merrill Lynch was the first to offer
these instruments, calling them “TIGRs” (Treasury Investment
Growth Receipts), soon to be followed by Salomon Brothers’ CATs
(Certificates of Accrual of Treasury securities).\
Lecture Tip: While unusual, there have been some circumstances
where T-bills (and similar securities from other governments) sold
above par even though they are zero coupon. For example, during
the financial crisis in 2008-2009, T-bills sold above face, as
investors undertook a “flight to quality.” In this case, the investors
are essentially paying the government to protect their money for a
period of time.
.A Floating-Rate Bonds
Slide 15.12 Floating Rate Bonds
Floating-rate bonds – coupon payments adjust periodically according to an
index.
Put provision – holder can sell back to issuer at par
Collar – coupon rate has a floor and a ceiling
Lecture Tip: Imagine this scenario: General Motors receives cash from a
lender in return for the promise to make periodic interest payments
which “float” with the general level of market rates. Sounds like a
floating-rate bond, doesn’t it? Well, it is, except that if you replace
“General Motors” with “Joe Smith,” you have just described an
adjustable-rate mortgage. The rates on ARMs are often tied to
rates on marketable securities, and the mortgage interest cost will
be adjusted, typically on an annual basis, to reflect changes in the
interest rate environment. From the bank’s perspective the
homeowner has signed (issued) a “floating-rate bond” that the
bank holds as its investment. Additionally, many variable rate
mortgages involve collars. A detailed summary of the factors that
affect interest rate changes is provided on a daily basis in the
“Credit Markets” section of The Wall Street Journal.
One other point of similarity is that in recent years corporate borrowers
have sought to lock-in low market rates by lengthening the
maturities of their issues (see the discussion of 100-year bonds in
the text); at the same time, homeowners similarly have tended to
opt for 30-year fixed rate mortgages rather than ARMs.
Lecture Tip: “Marketable Treasury Inflation-Indexed Securities, or TIPS,
have floating coupon payments, but the interest rate is set at
auction and fixed over the life of the bond. The principal amount is
periodically adjusted for inflation, and the coupon payment is
based on the current inflation-adjusted principal amount. The
CPI-U is used to adjust the principal for inflation. The bonds will
pay either the original par value or the inflation-adjusted
principal, whichever is greater, at maturity. For more information,
see the Bureau of the Public Debt online.
I-bonds are an inflation-indexed savings bond designed for the individual
investor. They pay an interest rate equal to a fixed rate plus the
inflation rate. The fixed rate is fixed for the 30-year possible life of
the bond and the inflation rate is adjusted every six months.
Interest is added to the bond value each month but compounded
semiannually. Like Series EE bonds, interest is exempt from state
and local taxes, and can be deferred for federal tax purposes for
30 years or until the bond is redeemed, whichever is sooner. Some
investors may qualify for preferred tax treatment if the bonds are
redeemed to pay for qualifying educational expenses.
Lecture Tip: Another novel financial innovation is inverse
floaters, which are bonds whose rates float in the opposite
direction as changes in market rates. Ask students why these
securities would exist. Essentially, if market rates rise, the rate on
the inverse floater would fall, resulting in a capital gain. Thus,
they can be used by traders to “speculate” on the movement of
interest rates. Although, as with any speculative security, there are
also hedging applications as well.
.B Other Types of Bonds
Slide 15.13 Other Bond Types
Income bonds – coupon is paid if income is sufficient
Convertible bonds – can be traded for a fixed number of shares of stock
Put bonds – shareholders can redeem for par at their discretion
Lecture Tip: Near the end of the 1990s, firms began issuing bonds which have
come to be known as “death puts” because they are designed to
appeal to investors approaching their own demise.
“To attract more retail investors, some enterprising underwriters are
selling corporate bonds that give you a little reward for dying:
Your estate has the right to put the bond back to the issuer and
collect par value. Depending on what you paid for the “death put”
bond and how interest rates have changed, your estate could make
a nice profit by exercising the put option. The sooner you die, the
greater the potential profit. And, the proceeds can be used however
you wish; they are not restricted to paying death duties.” (Forbes,
March 8, 1999)
These are essentially updated versions of the old “flower bonds” formerly
issued by the U.S. Treasury, which paid off at par upon the death
of the holder, as long as they were applied to the deceased’s tax
bill.
One more innovation you might want to discuss with students are “Bowie
Bonds,” so named because rock star David Bowie first securitized
his catalog of music by issuing bonds based on future royalties
from his compositions. Since then, Michael Jackson, Iron Maiden
and the Supremes have all expressed interest in similar deals. And,
from a purely financial point of view, it makes sense, doesn’t it.
Still, a cynic would say that it’s a sure sign that the rockers have
reached (or passed) middle age …
Lecture Tip: This would be an opportune time to discuss the
underlying foundation of the credit crisis that hit the global
financial markets beginning in 2007. A good summary of the entire
process of securitization and its impact can be found in an article
entitled “Tumbling Tower of Babel: Subprime Securitization and
the Credit Criss” by Bruce Jacobs in the March/April 2009 issue
of the Financial Analysts Journal.
15.2. Bank Loans
Slide 15.14 Bank Loans
.A Lines of Credit
Banks often provide business customers a line of credit, which sets
a maximum amount the bank is willing to lend. If the bank is
legally obligated, it is referred to as a revolving line of credit.
.B Syndicated Loans
Large money-center banks frequently have more demand for loans
than they have supply. Small regional banks are often in the
opposite situation. As a result, a lager money center bank may
arrange a loan with a firm or country and then sell portions of the
loan to a syndicate of other banks.
15.3. International Bonds
Slide 15.15 International Bonds
Eurobond – bonds issued in many countries but denominated in a single
currency
Lecture Tip: A dollar-denominated Eurobond is free of exchange rate risk for
a U.S. investor, regardless of where it is issued. A foreign bond
would be subject to this risk if it is not issued in the U.S. The
reason is that the Eurobond pays interest in U.S. dollars, but the
foreign bond pays interest in the currency of the country in which
it was issued.
Foreign bonds – bonds issued by a foreign company in a single country and in
that country’s currency
15.4. Patterns of Financing
Slide 15.16 Patterns of Financing
Slide 15.17 The Long-Term Financial Deficit
The pattern of financing by U.S. non-financial companies is
illustrated in Figure 15.1. Asking students to identify prominent
features usually results with the following:
internal financing is by far the most important source (and has
increased in importance through time);
net stock buybacks accelerated in 2002-2007, decreasing in
2008 (likely as a result of the economic crisis)
15.5. Recent Trends in Capital Structure
Slide 15.18 Recent Trends in Capital Structure
.A Which Are Best: Book or Market Values?
Most financial economists prefer market values since they better
reflect current opportunity costs of investment. Managers,
however, may prefer book values since they are more stable.
Slide 15.20 Quick Quiz