### Corporate Bonds

After completing this reading, you should be able to:

• Describe a bond indenture and explain the role of the corporate trustee in a bond indenture.
• Explain a bond’s maturity date and how it impacts bond retirements.
• Describe the main types of interest payment classifications.
• Describe zero-coupon bonds and explain the relationship between original-issue discount and reinvestment risk.
• Distinguish among the following security types relevant for corporate bonds: mortgage bonds, collateral trust bonds, equipment trust certificates, subordinated and convertible debenture bonds, and guaranteed bonds.
• Describe the mechanisms by which corporate bonds can be retired before maturity.
• Differentiate between credit default risk and credit spread risk.
• Describe event risk and explain what may cause it in corporate bonds.
• Define high-yield bonds, and describe types of high-yield bond issuers and some of the payment features unique to high yield bonds.
• Define and differentiate between an issuer default rate and a dollar default rate.
• Define recovery rates and describe the relationship between recovery rates and seniority.

## Bond Indenture

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.

#### 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
• 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

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

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.

## Recovery Rates

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.

## Question

A bond paying the Fed funds rate plus 4 percent in semiannual payments would be best known as a (an):

1. Income bond
2. Straight-coupon bond
3. Floating-rate bond
4. Collateral trust bond