CORPORATE DEBT



Corporate Debt 557
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Debt represents borrowed funds in which the borrower promises to make interest payments and to repay the principal in accordance with an agreed upon schedule. Along with equity (common stock plus retained earnings), debt represents one of the two major sources of capital for business enterprises.

The primary raisers of funds in the debt market are the U.S. Department of the Treasury, federally sponsored credit agencies, state and local governments, and corporations. Historically, the amount of new, long-term debt financing issued in the United States greatly exceeds the volume of equity financing. Corporate bonds constitute a smaller amount of long-term borrowing than either federal government and agency issues or the issues of state and local governments. Corporations also engage in extensive short-term borrowing, such as through commercial loans.

TYPES OF CORPORATE DEBT

The money market is the market for debt instruments with a maturity of one year or less at the time of issuance. The primary example of a corporate money market instrument is commercial paper. Commercial paper represents short-term pure discount obligations issued by the largest and most creditworthy industrial and financial firms. Commercial paper can be issued directly by the corporation or through a broker/dealer. Ford Credit recently became the first direct issuer to sell commercial paper via the Internet.

A pure discount bond promises to make only a single payment at a specified time in the future. Therefore, its market value will always be less than its face, or par, amount. The promised future payment is the par value or face value of the bond, with the difference between the par value and the market value being the bond discount.

Coupon bonds make regularly scheduled interest payments, between the issuance and the maturity date. These bonds also have a par value that is paid to the owner of the bond at a specified time in the future. Most bonds pay interest every six months.

Bond prices are related to prevailing interest rates on the bond markets. Typically, bond issues are originally sold at a price very near their face value. If the market price equals the face value, the bond is a par bond and the prevailing market interest rate will equal the coupon rate of the bond. Subsequently, they may trade at prices above or below par value, depending what happens to interest rates. When the market price exceeds the face value, the bond sells at a premium and the bond's coupon rate will be greater than the prevailing market rate. When the price is less than the face value, the bond sells at a discount and the bond's coupon rate will be less than the prevailing market rate. For most bonds, the bond price does not reflect the actual price that an investor must pay. Instead, the investor must pay the stated price plus the accrued interest, which reflects the portion of the following coupon payment that has been earned by the bondholder since the last interest payment date.

For some bonds, the individual interest coupons from the bond are separated, and each payment is treated as a separate security through a process known as coupon stripping. The resulting securities are zero coupon bonds, and each instrument represents a single payment due on a particular date. Since these securities pay no periodic interest, the purchaser pays less than the par value for them, and redeems them for face value at maturity. Since no periodic interest payments are made, the investor has no reinvestment rate risk —a major advantage of investing in zero coupon bonds.

The high-yield corporate bond market gained increased prominence in the 1980s. High-yield bonds are those bonds that are rated below investment grade, and are commonly referred to as junk bonds. The majority of issuers do not qualify for investment grade ratings, and many junk bonds were issued to finance mergers and acquisitions. Since junk bonds have higher default rates than investment grade issues, they also earn a sufficiently higher return to compensate for the greater default risk.

A term loan is defined as any debt obligation having an initial maturity between one and 30 years. Term loans have a number of advantages over public debt issuances including speed, flexibility, and lower issuance costs. The key provisions of term loans are negotiated between the lender and borrower, and therefore can be worked out more quickly or modified more easily than the terms of public debt issues. Term loans are available from banks, insurance companies, pension funds, small business investment companies, government agencies, and equipment suppliers. These instruments are often used for financing small additions to plant and equipment where the cash flows from the investment cover the requirements of the debt. They can also be used to finance increases in "permanent" working capital. Term loans usually require that the principal be amortized over the life of the loan.

GENERAL CHARACTERISTICS OF
CORPORATE BONDS

When a corporation issues a bond, it promises to make a series of interest payments based on a fixed interest rate on prespecified dates. Hence, bonds are referred to as fixed income instruments. In recent years, a growing number of corporate bonds are being issued with variable, or floating interest rates.

To assist bond investors in making their assessment about the likelihood of future payments on a particular bond, bond issues are rated by rating agencies, the two most prominent of which are Moody's Investors Service and Standard & Poor's. These ratings attempt to measure default risk—the chance that one or more payments on the bond will be deferred or missed altogether. The ratings range from AAA to D, and determine the required yield to sell the security in the market. Although there are no firm rules to determine a rating, strong attention is paid to such factors as cash flow and earnings in relation to interest and other obligations (coverage ratios) as well as to the amount of debt in relation to stockholders' equity and total assets in the issuing firm's capital structure. In addition to financial-ratio analysis, other factors of importance including the nature of the industry, the relative position of the firm within the industry, and the overall quality of management.

The bond indenture, or bond contract, is a legal document stating the obligations of the issuer of a bond and the rights of the bondholders. For all bonds issued by firms involved in interstate commerce with an issue size exceeding $5 million, the Trust Indentures Act requires that an independent trustee be named to protect the interests of the bondholders and ensure that the terms of the indenture are fulfilled. The bond indenture may also contain numerous protective covenants. Some covenants define the security that the issuer is offering for the bond and others protect the bondholders by restricting the behavior of the issuer.

Bonds may be issued in either bearer or registered forms. A bearer bond is payable to the bearer of the instrument. Therefore, its ownership is not recorded with the issuer. For an owner to receive a periodic interest or principal payment, a coupon attached to the bond for that interest payment date must be clipped off and sent to the issuer. The ownership of registered bonds is recorded with the issuer, so interest and principal payments can be disbursed automatically. Most bonds issued in recent years are registered and their ownership is tracked electronically.

Mortgage bonds have specific real estate assets pledged as collateral. First mortgage bonds have the first claim on the assets, while second mortgage bonds have the next claim. Collateral trust bonds are secured by financial assets and equipment trust certificates are secured by equipment, such as railroad cars or airplanes. Debentures, on the other hand, have no specific security pledged. Subordinated debentures are unsecured bonds that have an inferior claim to other outstanding debentures.

Investors evaluate corporate debt on a variety of factors, including yield, maturity, and security provisions. The greater the protection and privileges granted the bondholder, the lower the yield. Thus, U.S. Treasury securities generally provide a lower yield than corporate bond issues because of the lower likelihood of default. For the 1926 to 1993 period, high-quality, long-term corporate bonds offered an annual rate of about 5.5 percent, which translated into a real return of slightly more than 2 percent.

The bond market is reasonably efficient in terms of incorporating new information into the price of existing issues. Some researchers have suggested that the bond market may be slightly less efficient than the stock market in pricing outstanding issues because of the lack of a highly active secondary market for certain issues. Institutional investors, such as pension funds, and bank trust departments are not normally active traders in their bond portfolios.

RETIREMENT OF BONDS

If a bond is callable, the issuer has the right to redeem the bonds prior to maturity and at a specified price. The call price is stipulated in the bond contract, but bonds are not usually called unless they can be refunded by issuing new bonds at a lower interest rate. The call price usually includes a premium over the par value equivalent to one year's interest. Frequently, the call price decreases over time.

Many bonds also have a sinking fund that provides for the orderly retirement of the bond issue over its life. One method of satisfying the sinking fund requirement is to purchase the required amount of bonds in the open market each year. Alternatively, the firm may randomly call the bonds. The price paid for bonds called for sinking fund purposes is usually the bond's face value.

Sometimes bonds are scheduled for retirement with a certain portion of the principal amount becoming due at predetermined dates. These bonds are called serial bonds. The interest rate paid for each portion of a serial bond issue will vary with the yield curve in existence at the time the bonds are issued.

Another method of retiring bonds is through conversion. Convertible bonds are bonds that give the bondholder the option of converting the bond into a specified number of shares of common stock of the same company. The conversion ratio determines the number of shares received for each bond. The conversion price is the face value of the bond divided by the conversion ratio. The conversion premium is the difference between the bond's market value and the higher of its investment value or conversion value.

INTERNATIONAL DEBT INSTRUMENTS

One of the primary forms of credit in the international debt market is a form of bank lending called a syndicated loan, which is a loan made by a consortium of banks to a single borrower. Syndicated loans are priced as a spread above the London interbank offered rate (LIBOR). LIBOR is the rate that banks participating in the international debt market charge each other for short-term loans. Euro-commercial paper is commercial paper traded in the international market, usually denominated in dollars. Note issuance facilities are a form of medium-term lending through an assortment of instruments, usually floating rate notes.

International bonds can be either Eurobonds or foreign bonds. A Eurodollar bond or Eurobond is a bond issued by a borrower in one country, denominated in the borrower's currency, and sold outside the country of the borrower. If a U.S. firm issues a bond denominated in a foreign currency for sale solely in the country of the foreign currency, the bond is a foreign bond.

International bonds can also be classified as straight bonds, floating rate notes, and equity-related bonds. A straight bond is a bond with a fixed payment schedule with no special characteristics, such as convertibility into stock or a variable interest rate. A floating rate note is a bond that pays a different coupon rate over time as interest rates change. Thus, the coupon rate is tied to an index rate, typically LIBOR. Equity-related bonds include both convertible bonds and bonds with equity warrants. An equity warrant is a security that gives the holder the right to acquire newly issued shares of common stock from a company for the payment of a stipulated price. The majority of new international bond issues are straight bonds, with floating rate notes being relatively scarce.

PRINCIPLES OF BOND VALUATION

The price of a bond is computed by summing the present value of its future interest payments plus present value of the principal at maturity. There is an inverse relationship between bond prices and market interest rates. As interest rates go up, bond prices go down, and vice versa. Long-term bond prices are more sensitive than shorter maturities for a given change in interest rates. Furthermore, the lower the coupon interest rate of a bond, the more price-sensitive its market value will be to a change in interest rates. Therefore, an investor who wishes to capture maximum gains from an anticipated interest-rate decline can maximize the return on a portfolio by investing in low-coupon, (especially zero coupon) and long-term bonds.

Duration is the number of years, on a present-value basis, that it takes to recover an initial investment in a bond. In calculating duration, each year is weighted by the present value of the cash flow as a proportion to the present value of the bond, and is then summed. The greater the duration, the more sensitive the bond price is to a change in interest rates. Duration captures the three variables—maturity, coupon rate, and market rate of interest in one measurement—to indicate the price sensitivities of different bonds. Bond duration increases as both coupon rates and market interest rates decrease. On the other hand, duration increases as the maturity of the debt instrument goes up.

The true return on a bond investment may be measured by yield to maturity or the yield to call. The yield to maturity is the rate of return that will be realized if all promised payments are made and the investor holds the bond to maturity. The yield to maturity is the interest rate that equates the present value of the remaining interest and principal payments with the investor's original cost of the bond. For bonds likely to be called, the yield to maturity is inappropriate. In this case, the yield to call is a better calculation. This measure is the promised return on a bond from the present to the date that the bond is likely to be called.

Another important valuation concept has to do with the reinvestment of the periodic interest payments at rates other than the investor's original yield to maturity. This comes about because of the volatility of interest rates. The calculation of the yield to maturity assumes all periodic interest payments will be reinvested at that yield. If the reinvestment rate is different from the original yield to maturity, the realized annual return will be substantially different from that anticipated.

The term structure of interest rates depicts the relationship between term to maturity and yield to maturity over a long time horizon for bonds similar in all respects except maturity. This relationship is captured graphically on a yield curve. The slope of the curve gives some indication as to future movements, with an upward sloping pattern generally followed by higher interest rates and a descending pattern associated with a possible decline in the future. The Wall Street Journal daily has a graph of the yield curve for U.S. Treasury instruments.

Management of a bond portfolio will also include a consideration of the yield spread or risk premium between low- and high-quality issues. The risk structure of interest rates analyzes the differences in risk among different classes of bonds. The yield spread between long-term U.S. government bonds and corporate Baa's increases during a recession and decreases during periods of strong economic growth. When interest rates are high, risk premiums tend to be large. In addition, the evidence tends to suggest that longer maturities lead to higher yield spreads. Finally, there is evidence that the marketability of the bond issue has an effect on the risk premium with lower marketability leading to higher yield spreads.

BOND PORTFOLIO STRATEGIES

A laddered portfolio strategy spreads bonds out across the entire maturity spectrum. The laddered strategy technique makes it relatively easy to maintain the chosen maturity distribution of bonds but difficult to change the maturity of the portfolio significantly without making many trades. The dumbbell strategy places bonds only in very short and very long maturities, making it easy to shift the average maturity of the portfolio.

A number of studies have examined interest rate forecasting models. The tests indicate that sophisticated forecasting models have generally not been able to outperform naive forecasts of no change. Given the lack of success of models or experts in predicting interest rates, some managers have taken a passive approach to bond portfolio management. Passive management strategies do not seek active trading possibilities in an attempt to outperform the market.

Immunization strategies attempt to create portfolios whose investment returns are not affected by increases or decreases in interest rates. Thus, immunized portfolios are managed passively once the immunization is in effect. By careful management of its liabilities and assets, a bank can achieve immunization by having asset and liability portfolios with the same duration. With identical durations, the value of both portfolios will rise and fall by the same amount for a given change in interest rates. Under planning period immunization, the duration of a bond portfolio is set equal to the number of years in the intended holding period. When duration equals the holding period, a change in interest rates will have a reinvestment rate effect that almost exactly offsets the change in the market value of the bond that is also caused by the change in interest rates.

Under contingent immunization, the manager is permitted to manage the portfolio as long as its value is large enough to cover the minimum guaranteed return. The manager agrees to implement immunization, however, once the portfolio's value falls below the trigger point, the value necessary to guarantee the minimum return. The investor risks earning a return less than that which could be achieved on a portfolio immunized throughout its life in exchange for the possibility that the initial pursuit of an active strategy will generate higher returns. This is a dynamic process since the duration of a bond portfolio changes constantly.

[ Robert T. Kleiman ,

updated by Ronald M. Horwitz ]

FURTHER READING:

Bemstein, Peter L., and Aswath Damodaran. Investment Management. New York: John Wiley & Sons, 1998.

Fabozzi, Frank J. Bond Markets, Analysis and Strategies. 4th ed. Upper Saddle River, NJ: Prentice Hall, 2000.

Fabozzi, Frank J., and Richard S. Wilson. Corporate Bonds: Structure and Analysis. Homewood, IL: Richard Irwin, 1996.



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