BUAD 306 Valuing Bonds Part 2 Julia Plotts Associate Professor of Clinical Finance and Business Economics plotts marshall usc edu Agenda Today we will focus on Basic features of corporate bonds Bond ratings Basic features of government bonds Where market interest rates come from The YTM for a bond In ation and interest rates The yield curve 2 The bond indenture Contract between the company and bondholders Terms of the bonds Principal value coupon frequency maturity The total amount of bonds issued A description of property used as collateral if any Deferred call provisions Allow the company to repurchase the bond at par Call premium call price par Covenants Restrictive clauses in a bond contract that limit the issuers from undercutting their ability to repay the bonds this was discussed during our last class 3 Bond classi cations Depending on terms and collateral bonds are classi ed as In registered form if the company has a registrar tracking the bondholders In bearer form if the certi cate itself is proof of ownership and the company pays to the bearer Collateral assets as security Mortgage security real estate as security Debenture unsecured bond Notes debentures with original maturity 10 years Senior junior subordinated in case of default the latter is paid only after senior and junior bondholders 4 Bond characteristics and required returns The coupon rate depends on all the features previously mentioned as they a ect the risk characteristics of the bond when issued Hence they a ect the cost of borrowing for the issuer Which bonds will have the higher coupon all else equal Secured debt versus a debenture Subordinated debenture versus senior debt A callable bond versus a non callable bond 5 Bond ratings investment quality Bond ratings measure the creditworthiness of an issuer Its capacity to pay especially during adverse conditions Bond ratings are determined by how likely the rm government is to default how much can be recovered if there is default Rating agencies rms assessing the risk of default Moody s Standard Poor Du Phelps Fitch Ratings 6 Description of bond ratings High Grade gilt edge Medium Grade Lowest Investment Grade Duff Fitch Moody s S P Definition Phelp s AAA AAA Aaa AAA Highest quality strong capacity to pay principal and interest AA AA Aa A A A BBB BBB Baa AA High quality Lower rating because of weaker margins of protection ratios A Susceptible to impairment given adverse economic changes BBB Adequate capacity to pay principal and interest Weakened payment capacity could exist if adverse economic conditions 7 Description of bond ratings High Grade capacity to pay is extremely or very strong Medium Grade more susceptible to changes in circumstances or adverse conditions will have more impact on the ability to pay Low Grade Considered speculative with respect to capacity to pay Very Low Grade Bonds with no interest being paid D and below in default US Industrials Key Financial Ratios Long Term Debt 8 Factors a ecting bond ratings Bond Ratings Factors Financial Performan ce Debt ratio s Curre nt ratios Provisions in Bond Contract TIE FCC ratios Secured vs Unsecured Guarante e provisions Debt matur ity Senior vs Subordinate d Sinking fund provisions Other Facto rs Earnin gs stability Potential Product Liability Regulatory environme nt Accountin g policies 9 Hertz s December 2005 Junk Bonds 10 TXU Energy Future Holdings 40 billion leveraged buyout by KKR TPG Capital and Goldman Sachs Capital Partners in 2007 the 2nd largest Leveraged Buyout LBO in history In ation adjusted value TXU 47 23 billion compared to 1989 RJR Nabisco 55 38 Billion The buyout which left Dallas based Energy Future with more than 40 billion in debt was a gamble that natural gas prices would rise and give its coal red plants a competitive advantage Instead natural gas prices fell sharply Consequently Energy Future Holdings was mired in nancial problems leading up to its April 2014 ling for Chapter 11 bankruptcy protection In October 2016 the company emerged from bankruptcy The new company TCEH Corp is part of what s left of the fatally debt ridden energy giant Energy Future Holdings TCEH owns Luminant which has power plants and TXU Energy a major retail power seller 11 TXU Energy Future Holdings Capital Structure from Hell 12 Energy Future Holdings Junk 13 Treasuries and Munis Treasury Securities Federal Government debt T bills pure discount bonds with original maturity of up to one year T notes coupon debt with original maturity between one and ten years T bonds coupon debt with original maturity greater than ten years All income from Treasury securities is taxable at the federal level but not taxable at the state and local level 14 Treasuries and Munis STRIPS Separate Trading of Registered Interest and Principal Securities Zero coupon Treasury securities with maturities longer than one year that trade in the bond market The Treasury itself does not issue STRIPS Instead investment banks purchase Treasury notes and bonds and then resell each coupon and principal payment separately as a zero coupon bond 15 Treasuries and Munis Municipal Securities debt of State and Local Governments Varying degrees of default risk rated similar to corporate debt Interest received is tax exempt at the federal level and sometimes at the state and local level as well Sometimes referred to as tax exempt bonds 16 What determines the YTM of a bond The same variables determine the price and the YTM of a bond the crucial ones are Time value of money Term structure of interest rates Risk of default non payment Notice that if we know the price we can determine the YTM and vice versa But it is wrong to say that the price determines the YTM Both are jointly determined by the time value of money and the risk of default 17 In ation and Interest Rates Real rate of interest change in purchasing power Nominal rate of interest quoted rate of interest change in purchasing power and in ation The ex ante nominal rate of interest includes our desired real rate of return plus an adjustment for expected in ation In economics in ation is a rise in the general level of prices of goods and services in an economy over a period of time When the price level rises each unit of currency buys fewer goods and services consequently in ation is also the destruction of the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy 18 Term structure of interest rates Term structure is the