Investments & Securities Chapter 7 Corporate Debt Instruments Summary Corporate Debt Instruments Are Financial Obligations

CHAPTER 7

CORPORATE DEBT INSTRUMENTS

CHAPTER SUMMARY

Corporate debt instruments are financial obligations of a corporation that have priority over its

common stock and preferred stock in the case of bankruptcy. In this chapter we discuss the

SENIORITY OF DEBT IN A CORPORATION’S CAPITAL STRUCTURE

Issuers of corporate debt obligations are categorized into the following five sectors: public

utilities, transportation, banks /finance, industrials, and Yankee and Canadian. The latter

capital structure. Although optimal capital structure and the optimal debt structure is important in

corporate finance and in credit risk modeling, our focus here is to merely describe the seniority

structure.

The different creditor classes are classified as follows: senior secured debt, senior unsecured

debt, senior subordinated debt, and subordinated debt.

To satisfy the desires of bondholders for security, they will pledge stocks, notes, bonds or

whatever other kind of obligations they own. Bonds secured by such assets are called collateral

trust bonds.

Creditors holding subordinated debt rank after senior secured creditors, after senior unsecured

creditors, and often after some general creditors in their claim on assets and earnings. The class

of debt that has seniority within the ranks of subordinated debt is referred to as senior

subordinated debt.

BANKRUPTCY AND CREDITOR RIGHTS

The liquidation of a corporation means that all the assets will be distributed to the holders of

claims of the corporation and no corporate entity will survive. A new corporate entity results in

a reorganization. A company that files for protection under the bankruptcy act generally

becomes a debtor in possession (DIP), and continues to operate its business under the

supervision of the court.

When a company is liquidated, creditors receive distributions based on the absolute priority rule

to the extent that assets are available. The absolute priority rule is the principle that senior

creditors are paid in full before junior creditors are paid anything.

Corporate Debt Ratings

Professional money managers use various techniques to analyze information on companies and

bond issues in order to estimate the ability of the issuer to live up to its future contractual

obligations. This activity is known as credit analysis.

Debt obligations that are assigned a rating in the top four categories are said to be investment-grade.

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be divided into two sectors based on credit ratings: the investment-grade and noninvestment-grade

markets. Rating agencies monitor the bonds and issuers that they have rated.

CORPORATE BONDS

Corporate bonds are debt obligations issued by corporations. Most corporate bonds are term

bonds; that is, they run for a term of years, and then become due and payable. Generally,

Provisions for Paying Off Bonds Prior to Maturity

Some corporate bond issues have call provision granting the issuer an option to buy back all or

part of the issue prior to the stated maturity date. Some issues specify that the issuer must retire

a predetermined amount of the issue periodically. Various types of corporate call provisions are

discussed below.

Refunding a bond issue means redeeming bonds with funds obtained through the sale of a new

bond issue. Bonds that are noncallable for the issue’s life are more common than bonds that are

nonrefundable for life but otherwise callable. Sometimes investors are confused by the terms

With a traditional call provision, the call price is fixed and is either par or a premium over par

based on the call date. With a make-whole call provision, the payment when the issuer calls a

Covenants

The promises of corporate bond issuers and the rights of investors who buy them are set forth in

Special Structures for High-Yield Corporate Bonds

Bond issues in the high-yield corporate bonds (junk bonds) sector of the bond market may have

been rated (1) noninvestment grade at the time of issuance or (2) investment grade at the time of

issuance and downgraded subsequently to noninvestment grade. Bond issues in the first category

Deferred-interest bonds are the most common type of deferred coupon structure. These bonds

sell at a deep discount and do not pay interest for an initial period, typically from three to seven

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Another structure found in the high-yield bond market is one that requires the issuer to reset the

coupon rate so that the bond will trade at a predetermined price. Generally, the coupon rate at

reset time will be the average of rates suggested by a third part, usually two banks. The new rate

will then reflect (1) the level of interest rates at the reset date, and (2) the credit spread the

market wants on the issue at the reset date. This structure is called an extendable reset.

Accrued Interest

In addition to the agreed-upon price, the buyer must pay the seller accrued interest. Each month

Secondary Market for Corporate Bonds

As with all bonds, the principal secondary market for corporate bonds is the over-the-counter market.

The major concern is market transparency. Efforts to increase price transparency in the U.S.

corporate debt market resulted in the introduction of a mandatory reporting of over-the-counter

secondary market transactions for corporate bonds that met specific criteria.

Historically, corporate bond trading has been an OTC market conducted via telephone and based

execute transactions electronically with other dealers via the anonymous services of “brokers’

brokers.” Multidealer systems allow customers with consolidated orders from two or more

dealers that give the customers the ability to execute from among multiple quotes. Multidealer

systems, also called client-to-dealer systems, typically display to customers the best bid or offer

price of those posted by all dealers. Single-dealer systems permit investors to execute

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First is the traditional private-placement market, which includes non-144A securities. Second is

the market for 144A securities.

MEDIUM-TERM NOTES

A medium-term note (MTN) is a corporate debt instrument, with the unique characteristic that

notes are offered continuously to investors by an agent of the issuer. Investors can select from

several maturity ranges: nine months to one year, more than one year to 18 months, more than

Medium-term notes differ from corporate bonds in the manner in which they are distributed to

investors when they are initially sold. When they are offered, MTNs are usually sold in relatively

Structured Notes

MTNs created when the issuer simultaneously transacts in the derivative markets (such as a swap

or an option) in order to created the security are called structured notes. By using the derivative

markets in combination with an offering, borrowers are able to create investment vehicles that

are more customized for institutional investors to satisfy their investment objectives, even though

they are forbidden from using swaps for hedging.

Because of the small size of a structured note offering and the flexibility to customize the

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The payments of a commodity-linked note are tied to the price performance of a designated

commodity (such as crude oil, heating oil, natural gas, or precious metal) or a basket of

commodities. At the maturity date, the investor receives the initial principal amount plus a return

based the percentage change in the price of the designated commodity or basket of commodities.

A credit-linked note (CLN) is a security whose credit risk is linked to a second issuer (called

the reference issuer), and the return is linked to the credit performance of the reference issuer. A

A currency-linked note pays a return linked to a global foreign-exchange index. Typically, this

structured note is short-term, paying out a fixed minimum rate of interest determined by the

movement in foreign exchange rates over the life of the note. On the maturity date, the note pays

the initial principal amount plus return, if any.

COMMERCIAL PAPER

Commercial paper is a short-term unsecured promissory note that is issued in the open market

and that represents the obligation of the issuing corporation. The minimum round-lot transaction

To pay off holders of maturing paper, issuers generally use the proceeds obtained by selling new

commercial paper. This process is often described as “rolling over” short-term paper. The risk

There are three types of financial companies: captive finance companies, bank-related finance

companies, and independent finance companies. Captive finance companies are subsidiaries of

Directly Placed versus Dealer-Placed Paper

Tier-1 and Tier-2 Paper

The Investment Company Act of 1940 limits the credit risk exposure of money market mutual

funds by restricting their investments to “eligible” paper. Eligibility is defined in terms of the

BANK LOANS

Bank loans to corporate borrowers are divided into two categories: investment-grade loans and

leveraged loans. An investment-grade loan is a bank loan made to corporate borrowers that

Syndicated Bank Loans

A syndicated bank loan is one in which a group (or syndicate) of banks provides funds to the

borrower. Syndicated bank loans are used by borrowers who seek to raise large amounts of funds

A syndicated loan is typically structured so that it is amortized according to a predetermined

schedule, and repayment of principal begins after a specified number of years. Structures in

which no repayment of the principal is made until the maturity date can be arranged and are

While at one time, a bank or banks who originated loans retained them in their loan portfolio,

today those loans can be traded in the secondary market or securitized to create collateralized

loan obligations and therefore require periodic marking to market.

The Loan Syndications and Trading Association (LSTA) has helped foster the development of

a liquid and transparent secondary market for bank loans by establishing market practices and

loan obligation (CLO). A CLO is created using the securitization technology described in later

chapters.

A CLO is a special purpose vehicle (SPV) that issues debt and equity and from these funds

raised invests in a portfolio of leveraged loans. The entity responsible for managing the portfolio

of leverage loans (i.e., the collateral) is the collateral manager. In addition to the bond classes,

collateral principal must be understood. These rules for the distribution of collateral interest and

collateral principal, referred to as the cash flow waterfalls, specify the order in which bond

classes get paid and by doing so enforce the seniority of one CLO creditor over another.

Another key feature of a CLO is the coverage tests set forth in the indenture. They are important

because the outcomes of these tests can result in a diversion of cash that would have gone to the

subordinated bond classes and redirect it to senior bond classes.

CORPORATE DEFAULT RISK

For a corporate debt obligation, default risk is the risk that the corporation issuing the debt

instrument will fail to satisfy the terms of the obligation with respect to the timely payment of

interest and repayment of the amount borrowed.

Default loss rate = Default rate × (100%– Recovery rate)

As with default rates, there are different methodologies that can be employed for computing

recovery rates.

Fitch and Standard & Poor’s developed recovery rating systems for corporate bonds. The

recovery ratings were introduced by Standard & Poor’s in December 2003. The recovery ratings

were for secured debt.

CORPORATE DOWNGRADE RISK

Rating agencies monitor the debt obligations and issuers that they have rated. Corporate

downgrade risk is the risk that one or more of an issue’s debt obligations will be downgraded.

CORPORATE CREDIT SPREAD RISK

Corporate credit risk is the risk that a debt obligation’s price will decline due to an increase in the

credit spread sought by the market either for individual issue, the industry, or the sector. That is,

it is the risk of credit spread widening.

An illustration of event risk is a corporate takeover or corporate restructuring. A specific

example of event risk is the 1988 takeover of RJR Nabisco for $25 billion through a financing

technique known as a leveraged buyout (LBO). The new company took on a substantial amount

An example of headline risk is a natural or industrial accident that would be expected to have an

adverse economic impact on a corporation. To illustrate, an accident at a nuclear power plant is

KEY POINTS

• Corporate bonds are debts obligating a corporation to pay periodic interest with full

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• The issuer sectors of the corporate debt are public utilities, transportation, banks/finance,

industrials, and Yankee and Canadian.

• The different creditor classes in a corporation’s capital structure include senior secured

creditors senior unsecured creditors, senior subordinated creditors, and subordinated creditors.

The bankruptcy law governs the bankruptcy process in the United States. Chapter 7 of the

bankruptcy act deals with the liquidation of a company. Chapter 11 deals with the

reorganization of a company. Creditors receive distributions based on the absolute priority

rule to the extent assets are available. This means that senior creditors are paid in full before

junior creditors are paid anything. Generally, this rule holds in the case of liquidations. In

contrast, the absolute priority rule is typically violated in a reorganization.

• The credit risk of a corporate borrower can be gauged by the quality rating assigned by the

three nationally recognized rating companies. Issues rated in the top ratings of both raters are

referred to as investment-grade bonds; those below the top four ratings are called

registered with the SEC under the shelf registration rule and are offered through agents. The

rates posted are for various maturity ranges, with maturities as short as nine months to as long

as 30 years.

• Medium-term notes have been issued simultaneously with transactions in the derivatives market,

particularly the swap market, to create structured MTNs. These products allow issuers greater

paper. There is little liquidity in the commercial paper market.

• Bank loans represent an alternative to the issuance of bonds. Bank loans to corporations are

classified as investment-grade loans and leveraged bank loans. It is the latter that are sold to

institutional investors and traded in a secondary market.

• A collateralized loan obligation is created when leveraged bank loans are pooled and used as

ANSWERS TO QUESTIONS FOR CHAPTER 7

(Questions are in bold print followed by answers.)

1. What is the significance of a secured position if the absolute priority rule is typically not

followed in a reorganization?

A corporate debt obligation can be secured or unsecured. In the case of a liquidation, proceeds

from a bankruptcy are distributed to creditors based on the absolute priority rule where senior

claimants are paid first. For example, debt holders are paid before stockholders. However, in the

Even though the absolute priority rule is not typically followed, it is still significant because

senior claimants can use it to exercise clout in the reorganization process to insure they get the

2. Answer the below questions.

(a) What is the difference between a liquidation and a reorganization?

First, there is a difference in how the absolute priority rule holds. A corporate debt obligation can

be secured or unsecured. In the case of a liquidation, proceeds from a bankruptcy are distributed

to creditors based on the absolute priority rule. However, in the case of a reorganization, the

Second, there is a difference in outcome as to what happens to the company being liquidated

versus the company being reorganized. The liquidation of a corporation means that all the assets

(b) What is the difference between a Chapter 7 and Chapter 11 bankruptcy filing?

3. What is a debtor in possession?

4. Does the principle of absolute priority always hold?

When a company is liquidated, creditors receive distributions based on the absolute priority rule

to the extent that assets are available. The absolute priority rule is the principle that senior

The incentive hypothesis argues that the longer the negotiation process among the parties, the

greater the bankruptcy costs and the smaller the amount to be distributed to all parties.

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to violation of the absolute priority rule.

The strategic bargaining process hypothesis advocates that the increasing complexity of firms

that declare bankruptcy will accentuate the negotiating process and result in an even higher

incidence of violation of the absolute priority rule.

Consequently, although investors in the debt of a corporation may feel that they have priority

over the equity owners and priority over other classes of debtors, the actual outcome of a

bankruptcy may be far different from what the terms of the debt agreement state.

5. Comment of the following statement: “A senior secured creditor has little risk of

realizing a loss if the issuer goes into bankruptcy.”

When a company goes bankrupt there are varying degrees of risk for all creditors. Even though

the risk can be “little” or small relatively speaking compared to junior unsecured claimants, there