After completing this reading, you should be able to:
- Describe features of bond trading and explain the behavior of bond yield.
- Describe a bond indenture and explain the role of the corporate trustee in a bond indenture.
- Define high-yield bonds and describe types of high-yield bond issuers and some of the payment features unique to high yield bonds.
- Differentiate between credit default risk and credit spread risk.
- Describe event risk and explain what may cause it in corporate bonds.
- Describe the different classifications of bonds characterized by issuer, maturity, interest rate,
- Describe the mechanisms by which corporate bonds can be retired before maturity.
- Define recovery rate and default rate, differentiate between an issue default rate and a dollar default rate
and describe the relationship between recovery rates and seniority.
- Evaluate the expected return from a bond investment and identify the components of the bond’s expected return.
The bond indenture, also known as the trust deed, refers to the official document that outlines the terms of the contract, including the obligations of the issuer and the rights of bondholders. Being representative of a binding contract, the indenture is a well-detailed document crafted by legal experts. For this reason, it’s usually in the best interests of the bondholder to seek the services of a corporate trustee to interpret the language therein.
A Corporate Trustee’s role is to act in the best interests of investors by being an independent supervisor of the security. All bond issues over $5 million and sold in interstate commerce must have a corporate trustee. All trustees are required to be professionally competent with no competing interests with their client.
A Bond’s Maturity and How It Impacts Bond Retirements
A bond’s maturity is the date on which the principal amount of a bond – the “par value” – is to be paid in full, including any accrued interest. A bond’s maturity is set when it’s issued. Generally, bonds that mature in 1-3 years are said to be short-term, those maturing in 4-10 years are said to be medium-term. Long-term bonds mature in more than 10 years.
A bond’s indenture may allow for early retirement of a bond. This means the issuer pays out cash and removes the bond from its balance sheet before the scheduled maturity date. The longer the maturity of the bond, the more time the issuer has to retire the bond issue.
Types of Interest Payment Classifications
Straight-coupon bonds pay a fixed interest rate for the entire life of the issue. In the U.S., bonds typically pay interest twice a year. In Europe, most straight-coupon bonds pay interest annually. At maturity, the amount paid consists of the interest earned in the final period plus principal.
Just like straight-coupon bonds, floating-rate bonds pay interest but based on a non-constant rate. For example, the interest payment at each payment date may be tied to the LIBOR rate on that date.
Participating bonds have a minimum interest rate but may pay more if the issuer’s profits increase.
Income bonds pay at most the specified interest rate but may pay less if the issuer’s profits decline.
Zero coupon bonds do not pay any interest. At maturity, the issuer pays the par value of the bond. Bondholders earn a capital gain by purchasing the bond at a discount to the face value.
$$ Original-issue\quad discount(OID)=face\quad value–offering\quad price $$
Zero coupon bonds have zero reinvestment risk. The bondholder doesn’t have to contend with the issue of reinvesting cash interest payments because there aren’t any. The downside, however, is that the bondholder may still be required to pay tax on the accrued interest even though no cash is actually received. In other instances, the par value received at maturity is subject to capital gain tax.
Mortgage bonds have a security, such as real property, underlying the issue. The bondholders have the first-mortgage lien on the properties of the issuer. As secured bonds, the rate of interest payable may be less than that payable on unsecured bonds.
Collateral trust bonds are secured by a range of financial assets including stocks, notes, bonds, or similarly ranked securities owned by the issuer. The issuer is usually a holding company, and the collateral consists of claims on their subsidiaries.
Equipment trust certificates (ETCs) are debt instruments that allow the borrower to take possession of an asset and put it to use while paying for it over time. The trustee purchases the asset/equipment and leases it to the borrower who pays rent on the equipment. The rent is then passed on to the holder of the ETC.
Debentures are unsecured bonds only issued by highly rated institutions. As a result, the interest rate payable is usually higher than that in secured bonds. However, if the issuer has no outstanding secured bonds, debentures have a claim on all of the issuer’s assets along with those of guarantors. If the issuer has secured debt, the debenture holder has a claim on all assets not backing the secured debt.
Subordinated debenture bonds are bonds that rank the lowest on the list of creditors in the event of a winding up. They rank below debentures and unsecured debt. As a result, the issuer has to pay a higher interest rate.
Convertible debentures are unsecured bonds that give the holder the right to convert the bond into common stock. This right to convert is a benefit to the holder and therefore reduces the interest rate paid. However, the issuer has to contend with a dilution of their stock in the event the bondholder exercises their right to convert.
Guarantee bonds are bonds issued by one company but guaranteed by another company.
Mechanisms by Which Corporate Bonds Can Be Retired before Maturity
Some of the reasons why an issuer might decide to retire a bond early include:
- To take advantage of lower interest rates. If the current borrowing cost is significantly lower than the rate agreed in the contract, the issuer might retire the bond and replace it with a cheaper bond.
- To get rid of restrictive terms/conditions
- To increase shareholder value
- To alter the firm’s capital structure
Corporate bonds can be retired in two main ways, namely:
- Mechanisms included in the bond’s indenture
- Mechanisms not included in the bond’s indenture
Mechanisms included in the bond’s indenture
Call Provisions: Call provisions are basically call options on the bond. The provisions give the issuer the right to purchase the outstanding debt at a fixed price either in whole or in part prior to maturity. There are two types of call provisions:
- Fixed-price call: In a fixed-price call, the issuer can call back the bond at various points in time, but the price paid bat each point is specified in the indenture. Normally, the price gradually declines as the bond’s maturity nears. There may also be provisions that make it impossible to call a bond in its early years.
- Make-whole call: Make-whole call provisions use the prevailing market price as the call price subject to a floor price equivalent to the bond’s par value. All futures cash flows are discounted based on the current yield of comparable-maturity Treasury securities plus a premium.
Sinking fund provision
A sinking fund provision retires a bond periodically/systematically, rather than retiring the entire issue at once. The terms of the provision are clearly outlined in the indenture. For example, if a bond has a principal of $60 million and 20 years to maturity, a sinking fund provision may seek to retire the bond in chunks of $15 million at 5-year intervals.
Maintenance and replacement fund
This mechanism is used by electric utility companies that retire their bonds for the maintenance and repair of the pledged collateral.
Redemption through the Sale of Assets
Release-of-property and substitution-of-property clauses are found in most secured bond indentures because bondholders want the integrity of the collateral to be maintained.
Mechanisms excluded from the indenture
Tender offers: In this method, the issuer sends a tender offer declaring its intention to buy back its debt issue. A circular is sent out to all bondholders outlining the finer details of the offer, including the price at which the issuer is willing to execute the offer.
Credit Default risk vs. Credit Spread Risk
Credit default risk is the risk that the bond issuer will not make timely payments of interest and principal as obligated within the bond’s indenture framework.
Credit default risk is usually evaluated using credit ratings issued by rating agencies like Moody’s and Standard & Poor’s. The agencies assign a symbol to the rating, e.g., AAA for bonds with the lowest credit risk and C for bonds whose default is imminent.
Credit spread risk is the risk of loss in the value of a bond arising from changes in the level of credit spreads used in the marking to market. (Credit spread refers to the difference between a bond’s yield and the yield of a Treasury security with a comparable maturity.)
Credit spread risk is determined by macroeconomic as well as issuer-specific factors.
Some of the macroeconomic factors include:
- Level and slope of the Treasury yield curve
- Business cycle
- Consumer confidence
Issuer-specific factors include:
- The issuer’s future prospects and production outlook
- The issuer’s current financial position.
A measure commonly used to assess credit spread risk is spread duration – the change in the value of a bond for a 1% (100 basis points) change in credit spread, assuming the yield of the underlying treasury security is constant.
Event risk refers to the risk that an unexpected event will negatively impact a company’s financial position. Such an unexpected event could take the form of a natural disaster, hostile takeover, restructuring, recapitalization, or even a large-scale share repurchase program.
Any of these events have the potential to drastically change a firm’s capital structure and reduce the creditworthiness of outstanding bonds as well as their value. In a bid to protect bondholders from such eventualities, a firm may include a poison put in the indenture. A poison put gives bondholders the right to redeem a bond before maturity, at or above par value, in the event that the firm suffers a hostile takeover. The poison put may also cover the other unexpected events listed above.
High-yield bonds are bonds rated below investment-grade by rating agencies – a rating below “BBB” from S&P, and below “Baa” from Moody’s.
Since they carry more default risk, they must pay a higher yield than investment-grade bonds. They are usually issued by startups or forms with high debt ratios. However, just because high-yield bonds are not investment-grade doesn’t necessarily mean they are a no-go zone. Failure is not a certainty. As such, “junk” bonds – as they are often called – can offer excellent returns to investors. In most cases, junk bonds do not fail.
There are several types of high-yield bonds:
- Story bonds – issued to fund a specified venture project
- Fallen angels – bonds that were once investment-grade but which have since been downgraded following negative impact events.
Issuer Default Rate vs. Dollar Default Rate
There are two ways in which default can be measured: by the raw number of issuers that defaulted or the dollar amount of issues that defaulted. This leads us to two types of default rates.
Issuer default rate is the number of issuers that defaulted over a year divided by the total number of issuers at the beginning of the year. It only looks at the number of defaults that have occurred as a proportion of the total number of issues made in a year. It doesn’t dig deeper to establish the dollar amount of loss arising from any of the default events.
Dollar default rate is the par value of all bonds that defaulted in a given calendar year divided by the total par value of all bonds outstanding during the year.
The recovery rate refers to the percentage amount recovered by a bondholder following a default event. The loss given default, LGD, is the amount that a bondholder stands to lose in the event of default. It’s given by:
$$ LGD = 1 – Recovery \quad rate $$
For example, if the recovery rate on an issue is \(60\%\), the loss given default is \(40\%\). On a \($100\) million debt instrument, the estimated loss following a default event would be \($40 \quad million\).
Bonds with higher seniority have higher recovery rates because they take precedence in the event of a winding up.
Note that recovery rate and loss given default are important concepts that we will see in more details in FRM part II Book 4 and FRM part II.
A bond paying the Fed funds rate plus 4 percent in semiannual payments would be best known as a (an):
- Income bond
- Straight-coupon bond
- Floating-rate bond
- Collateral trust bond
The correct answer is C.
A floating-rate note (FRN) is a debt instrument with a variable interest rate. The interest rate for an FRN is tied to a benchmark rate—in this case, the Feds fund rate.