Slides_Fundamentals of Investments - Chapter 11 docx

All rights reserved.McGraw Hill / Irwin Corporate Bonds Our goal in this chapter is to introduce the specialized knowledge that money managers who trade in corporate bonds possess... All

© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Corporate Bonds

Our goal in this chapter is to introduce the specialized knowledge that money managers who trade in corporate bonds possess

Goal

Corporate bond

A security issued by a corporation that represents a promise to pay to its

bondholders a fixed sum of money (called

the bond’s principal, or par or face value) at

a future maturity date, along with periodic payments of interest (called

coupo ns).

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Corporate Bond Basics

Š Corporate bonds differ from common stock in three fundamental ways

Corporate Bonds Common Stock Represent a creditor’s Represents an ownership claim on the corporation claim on the corporation.

Promised cash flows Amount and timing of (coupons and principal) dividends may change are stated in advance at any time.

Mostly issued as Almost never callable.

callable bonds.

Š There are several trillion dollars of corporate

bonds outstanding in the United States

Š More than half of these are owned by life

insurance companies and pension funds

Î These institutions can eliminate much of their

financial risk via cash flow matching.

Î They can also diversify away most default risk by including a large number of different bond issues

in their portfolios.

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Corporate Bond Basics

Š Bonds issued with a standard, relatively simple

set of features are popularly called plain

vanilla bonds.

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Work the Web

 For more information on corporate

bonds, visit:

http://www.investinginbonds.com

http://www.bondresources.com

Š Debentures - Unsecured bonds issued by a

Š Equipment trust certificate - Shares in a trust

with income from a lease contract

Types of Corporate Bonds

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Š In practice, very few bond investors read the

original indenture Instead, they may refer to

an indenture summary provided in the

prospectus of the bond issue.

Bond indenture

A formal written agreement between the corporation and the bondholders that spells out in detail their rights and obligations with respect to the bond issue

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Š The Act is available at the SEC website:

Š Some of the important provisions frequently

specified in bond indentures include:

can usually be differentiated according to the seniority of their claims on the firm’s assets Bond

seniority may be protected by a negative pledge

clause.

to buy back all or part of its outstanding bonds at a specified call price sometime before the bonds

mature, hence facilitating bond refunding.

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Put provisions - A bond with a put provision can

be sold back to the issuer at a prespecified price (normally set at par value) on any of a sequence of prespecified dates Such bonds are often called

extendible bonds.

bonds are bonds that holders can exchange for common stock according to a prespecified

conversion ratio.

Bond Indentures

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 Find out more about convertible bonds

at:

http://www.convertbond.com

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Bond Indentures

-Term bonds are issued with a single maturity date,

while serial bonds are issued with a regular

sequence of maturity dates.

account used to provide for scheduled redemptions

of outstanding bonds.

coupon payment dates is specified in the bond indenture.

Š A bond indenture is likely to contain a number

of protective covenants, which are restrictions

designed to protect bondholders

-The firm cannot pay dividends to stockholders in excess of what is allowed by a formula based on the firm’s earnings.

-Proceeds from the sale of assets must be used either to acquire other assets of equal value or to redeem outstanding bonds.

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Event Risk

announced its intention to spin off part of the company The spinoff, called Host Marriott, would acquire most of the parent company’s debt and its poorly performing real estate holdings.

Event risk

The possibility that the issuing corporation will experience a significant change in its bond credit quality

Š Private placements are exempt from

registration requirements with the SEC, although they often have formal indentures

Š Debt issued without an indenture is basically a simple IOU of the corporation

Private placement

A new bond issue sold to one or more parties

in private transactions not available to the public

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Preferred Stock

Š Preferred stockholders have a claim to

dividend payments that is senior to the claim

of common stockholders However, their claim

is subordinate to the claims of bondholders and other creditors

both bonds and common stock.

Š Typically, preferred stock issues

Î do not grant voting rights to their holders,

Î promise a stream of fixed dividend payments,

Î have no specified maturity but are often callable,

Î may have their dividends suspended without setting off a bankruptcy process (as long as common stock dividends are also suspended),

Î cumulate unpaid preferred dividends, and may be convertible.

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Adjustable-Rate Bonds & Preferred Stock

Š Many bond, note, and preferred stock issues

allow the issuer to adjust the annual coupon according to a rule or formula based on current market interest rates These securities are

called adjustable-rate or floating-rate

securities

Š When a corporation sells a new bond issue to

investors, it usually subscribes to several bond rating agencies for a credit evaluation of the bond issue

Š Each contracted rating agency then provides a

credit rating - an assessment of the credit

quality of the bond issue based on the issuer’s financial condition

Corporate Bond Credit Ratings

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Why are bond ratings important?

Š Only a few institutional investors have the

resources and expertise necessary to properly evaluate a bond’s credit quality on their own

Š Many financial institutions have prudent

investment guidelines stipulating that only

securities with a certain level of investment safety may be included in their portfolios

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Work the Web

 Visit these rating agencies:

Duff and Phelps:

Š Junk bonds are attractive investments for many institutional investors with well-diversified

portfolios

High-yield bonds

Bonds with a speculative credit rating that is offset by a yield premium offered to

compensate for higher credit risk

Also called junk bonds.

Junk Bonds

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Š An active secondary market with a substantial volume of bond trading exists, thus satisfying most of the liquidity needs of investors.

Š Corporate bond trading is characteristically an OTC activity Nevertheless, bond trading on the New York Stock Exchange is watched by bond investors and traders throughout the

world

Bond Market Trading

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© 2002 by The McGraw-Hill Companies, Inc All rights reserved.

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Work the Web

 You can find current information on

corporate bond prices and yields using the Bond Finder tool at Bond

Resources:

http://www.bondresources.com

Š Corporate Bond Basics

Š Types of Corporate Bonds

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Î Bond-to-Stock Conversion Provisions

Î Graphical Analysis of Convertible Bond Prices

Î Bond Maturity and Principal Payment Provisions

Î Sinking Fund Provisions

Î Coupon Payment Provisions

Š Corporate Bond Credit Ratings

Î Why Bond Ratings Are Important

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Chapter Review

Š Junk Bonds

Š Bond Market Trading