Ross Westerfield Jaffe
University of Manitoba
American University of
2. Chapter 20 Long-Term Debt20.1 Long Term Debt: A Review
20.2 The Public Issue of Bonds
20.3 Bond Refunding
20.4 Bond Ratings
20.5 Some Different Types of Bonds
20.6 Direct Placement Compared to Public Issues
20.7 Long-Term Syndicated Bank Loans
20.8 Summary and Conclusions
3. 20.1 Long Term Debt: A Review• Corporate debt can be short-term (maturity less
than one year) or long-term.
• Different from common stock:
– Creditor’s claim on corporation is specified
– Promised cash flows
– Most are callable
• Over half of outstanding bonds are owned by life
insurance companies & pension funds
• Plain vanilla bonds to “kitchen sink” bonds
4. Features of a Typical Bond• The indenture usually lists
– Amount of Issue, Date of Issue, Maturity
– Denomination (Par value)
– Annual Coupon, Dates of Coupon Payments
– Sinking Funds
– Call Provisions
• Features that may change over time
– Market price
5. Features of a Hypothetical BondIssue amount
Yield to maturity
Bond issue total face value is $20 million
Bonds offered to the public in December 1998
Remaining principal is due December 31,
Face value denomination is $1,000 per bond
$100 per annum
Annual coupons are $100 per bond
Coupons are paid semiannually
Offer price is 100% of face value
Based on stated offer price
Callable after 12/31/03 Bonds are call protected for 5 years after
110 before 12/31/08,
Callable at 110 percent of par value through
2008. Thereafter callable at par.
United Bank of
Trustee is appointed to represent
Bonds are unsecured debenture
Moody's A1, S&P A+ Bond credit quality rated upper medium
grade by Moody's and S&P's rating
6. 20.2 The Public Issue of Bonds• The general procedure is similar to the issuance of stock, as
described in the previous chapter.
• Indentures and covenants are not relevant to stock issuance.
• The indenture is a written agreement between the borrower
and a trust company. The indenture usually lists
Amount of Issue, Date of Issue, Maturity
Denomination (Par value)
Annual Coupon, Dates of Coupon Payments
7. Principal Repayment• Term bonds versus serial bonds
• Sinking funds: How do they work?
– Fractional repayment each year
– Good news---security
– Bad news---unfavourable calls
– How trustee redeems
8. Protective Covenants• Agreements to protect bondholders
• Negative covenant: Thou shalt not:
– pay dividends beyond specified amount
– sell more senior debt and amount of new debt is limited
– refund existing bond issue with new bonds paying lower
– buy another company’s bonds
• Positive covenant: Thou shalt:
– use proceeds from sale of assets for other assets
– allow redemption in event of merger or spinoff
– maintain good condition of assets
– provide audited financial information
9. The Sinking Fund• There are many different kinds of sinking-fund
– Most start between 5 and 10 years after initial issuance.
– Some establish equal payments over the life of the bond.
– Most high-quality bond issues establish payments to the
sinking fund that are not sufficient to redeem the entire
• Sinking funds provide extra protection to
• Sinking funds provide the firm with an option.
10. The Call Provision• A call provision lets the company repurchase or call the entire
bond issue at a predetermined price overa specified period.
• The difference between the call price and the face value is the
• Many long-term corporate bonds outstanding in Canada have
• New corporate debt features a different call provision referred
to as a Canada plus call.
• The Canada plus call is designed to replace the traditional call
feature by making it unattractive for the issuer ever to call the
11. 20.3 Bond Refunding• Replacing all or part of a bond issue is called
• Bond refunding raises two questions:
– Should firms issue callable bonds?
– Given that callable bonds have been issued, when
should the bonds be called?
12. Should firms issue callable bonds?• Common sense tells us that call provisions have
• A call works to the advantage of the issuer.
• If interest rates fall and bond prices go up, the option
to buy back the bonds at the call price is valuable.
• In bond refunding, firms will typically replace the
called bonds with a new bond issue.
• The new bonds will have a lower coupon rate than
the called bonds.
13. Why are callable bonds issued in the real world?• Four specific reasons why a company might
use a call provision:
1. Superior interest rate predictions
3. Financial flexibility for future investment
4. Less interest-rate risk
14. Callable Bonds versus Noncallable Bonds200
Bond price (% of par)
Most bonds are callable;
some sensible reasons for
call provisions include:
flexibility, and the fact
that callable bonds have
less interest rate risk.
Yield to maturity (%)
15. Calling Bonds: When does it make sense?• In a world with no transaction costs, it can be shown
that the company should call its bonds whenever the
callable bond value exceeds the call price.
• This policy minimizes the value of the callable bonds.
• The costs from issuing new bonds change the
refunding rule to allow bonds to trade at prices above
the call price.
• The objective of the company is to minimize the sum
of the value of the callable bonds plus new issue costs.
16. 20.4 Bond Ratings• What is rated:
– The likelihood that the firm will default.
– The protection afforded by the loan contract in the event
• Who pays for ratings:
– Firms pay to have their bonds rated.
– The ratings are constructed from the financial statements
supplied by the firm.
• Ratings can change.
• Raters can disagree.
17. Bond Ratings: Investment GradeMoody's Duff &
Highest credit rating,
High credit quality,
investment grade bonds
investment grade bonds
18. Bond Ratings: Below Investment GradeMoody's Duff &
Speculative-Grade Bond Ratings
Low credit quality,
Very low credit quality,
Extremely Speculative-Grade Bond Ratings
Extremely low credit
standing, high-risk bonds
Bonds in default
19. Junk bonds• Anything less than an S&P “BB” or a Moody’s “Ba”
is a junk bond.
• A polite euphemism for junk is high-yield bond.
• There are two types of junk bonds:
– Original issue junk—possibly not rated
– Fallen angels—rated
• Current status of junk bond market
– Private placement
• Yield premiums versus default risk
20. 20.5 Different Types of Bonds
Zero Coupon Bonds
Other Types of Bonds
21. Puttable bonds• Put provisions
– Put price
– Put date
– Put deferment
• Extendible bonds
• Value of the put feature
• Cost of the put feature
22. Convertible Bonds• Why are they issued?
• Why are they purchased?
• Conversion ratio:
– Number of shares of stock acquired by conversion
• Conversion price:
– Bond par value / Conversion ratio
• Conversion value:
– Price per share of stock x Conversion ratio
• In-the-money versus out-the-money
23. Convertible Bond Prices150
Convertible bond price
Bond price (% of par)
Nonconvertible bond price
Conversion value (% of par)
24. Example of a Convertible Bond
25. More on Convertibles• Exchangeable bonds
– Convertible into a set number of shares of a third company’s
• Minimum (floor) value of convertible is the greater of:
– Straight or “intrinsic” bond value
– Conversion value
• Conversion option value
– Bondholders pay for the conversion option by accepting a
lower coupon rate on convertible bonds versus otherwiseidentical nonconvertible bonds.
26. Example of an Exchangeable Bond
27. Zero-Coupon Bonds• A bond that pays no coupons at all must be offered
at a price that is much lower than its stated value.
• For tax purposes, the issuer of a zero-coupon bond
deducts interest every year even though no interest
is actually paid.
• Zero-coupon bonds, often in the form of stripped
coupons, are attractive to individual investors for
tax-sheltered Registered Retirement Savings Plans
28. Floating Rate Bonds
With floating rate bonds, the coupon payments are
adjustable.The adjustments are tied to the Treasury bill rate
or another short-term interest rate.
Majority of floaters have the following features:
1. The holder has the right to redeem her note at par on the
coupon payment date after some specified amount of time.
2. The coupon rate has a floor and a ceiling. i.e., a minimum
and a maximum.
29. Financial Engineering and Bonds• Income bonds: coupon payments are
dependent on company income.
• Retractable bonds: allow the holder to force
the issuer to buy the bond at the stated price.
Examples are Canada Savings Bonds (CSBs).
• A stripped real-return bond is a zero coupon
bond with inflation protection.
30. 20.6 Direct Placement Compared to Public Issues1.
There are two basic forms of direct private long-term
Differences between direct private long-term financing and
public issues of debt are:
Registration costs are lower for direct financing.
Direct financing is likely to have more restrictive covenants.
It is easier to renegotiate a term loan or a private placement
in the event of default.
31. 20.7 Long-Term Syndicated Bank Loans• A syndicated loan is a corporate loan made by
a group (or syndicate) of banks and other
• A syndicated loan may be publicly traded.
• It may be a line of credit and be “undrawn” or
it may be drawn and be used by a firm.
• Syndicated loans are always rated investment
32. 20.8 Summary and Conclusions• The details of the long-term debt contract are
contained in the indenture. The main provisions
are: security, repayment, protective covenants,
and call provisions.
• Protective covenants are designed to protect
bondholders from management decisions that
favour stockholders at bondholders’ expense.
• Most public industrial bonds are unsecured—they
are general claims on the company’s value.
• Most utility bonds are secured. If the firm
defaults on secured bonds, the trustee can
repossess the asset.
33. 20.8 Summary and Conclusions (cont.)• Long-term bonds usually provide for repayment
of principal before maturity. This is usually
accomplished with a sinking fund whereby a firm
retires a certain number of bonds each year.
• Most publicly issued bonds are callable. There is
no single reason for call provisions. Some
sensible reasons include taxes, greater flexibility,
and the fact that callable bonds are less sensitive
to interest-rate changes.
• There are many different types of bonds,
including floating-rate bonds, deep-discount
bonds, and income bonds.