Finance 301 1st Edition Lecture 11 Outline of Last Lecture I Background on bonds II Bond Yields III Treasury and Federal Agency Bonds IV Municipal bonds Current Lecture V Corporate Bonds VI Secondary Market for Corporate Bonds VII Junk Bonds VIII How Corporate Bonds Finance Restructuring IX Globalization of Bond Markets X Other Types of Long Term Debt Outline of Current Lecture I Corporate Bonds a How are these similar different than municipal or agency or treasury bonds i Investor doesn t get a tax break corp gets a tax break b Agency bonds mortgage backed bonds freddie mae and freddie mack issued secured home is the collateral i Don t have any collateral they can be secured or unsecured issued by corporation debt of corporations good investment but not tax exempt c What is the minimum denomination i 1 000 dollars d What is the typical maturity i 10 30 years could be longer than that such as 75 years if it is a good company ii Interest paid by the corporation to investors is tax deductible to the corporation but interest income to the investor is subject to income taxation e Characteristics of Corporate Bonds i Sinking fund provision they have to pay back a certain percentage of the bond in a certain amount of time example 10 percent a year differs depending on the company They need this because investors wouldn t want to invest if they don t know if they are going to get paid back or not ii Protective covenants for safety reason protecting bond holder Example wont give large bonuses to management if we make income we wont just give it to the rich guys Example wont add extra shares of stock This is important to the bond holders because if more stock is issued price of the stock goes down iii Call provisions Normally requires a price above par value when bonds are called The difference between the bond s call price and par value is the call premium Why would we use the call iv Corporation When interest rates go down change significantly to save money v Bond collateral Bonds can be classified according to whether they are secured by collateral and by the nature of that collateral vi 0 coupon bonds bought at a discount and paid on coupons II Secondary Market for Corporate Bonds a The value of all corporate bonds in the secondary market exceeds 5 trillion b Big money millions of dollars c Who are the typical investors i Mutual funds pension funds corporations insurance companies ii Insurance company would want to invest in something like this because they want to pay future obligations d Why are they considered liquid i They are sold on secondary market there are a lot of investors that are willing to buy corporate bonds A lot of corporations make a lot of money and people think that this investment is very safe big time company is not going broke e Corporate Bond Listing i Listed on an over the counter market or on an exchange such as the American Stock Exchange Remember the primary market is generally over the counter OTC ii In 2007 the NYSE developed an electronic bond trading platform f Bonds and stocks i Types of Orders 1 Market order you pay the market price Bond selling for 1500 dollars you pay that much when you call in 2 Limit order you specify a price say if it falls to 1450 ill buy it ii Trading Online 1 More orders to buy and sell corporate bonds are being placed online III Junk Bonds a What are Junk Bonds i High risk bond arent junk companies that are in default entrepreneurs venture capitalists companies that are start ups pay high yields ii Big time companies when they need money fast really good return you have to pick the right one this is the risk b Risk Premium of Junk Bonds i Junk bonds offer high yields that contain a risk premium spread to compensate investors for the high risk ii What is the typical risk premium 1 4 7 over a treasury high return iii When is the risk premium higher During a strong or weak economy iv Expected to get paid more in a weak economy high return because investors don t want to invest folks that need money there is either a problem or people don t know or they need it fast they are taking a big risk v AAA AA A BBB BB B CCC CC C DD D not investment grade until you are in the As D means in default banking on a turn around vi AAA low interest rate D range 8 9 10 percent out to get money not necessarily accurate because of conflicts of interest they were getting paid by companies to rate them AAA companies were getting rating that werent supposed to be that high IV How Corporate Bonds Finance Restructuring a Corporations Use Bonds to Finance a Leveraged Buyout i What is a LBO 1 Debt to buy the company you are buying out their equity using debt to buyout the shareholders to buy the majority of the shares in the company so you own the company or more of it A company would use debt to buy another company because you can buy bigger companies may not have that kind of cash People would invest in a company that s using debt to buy other companies 2 KKR Krbis and Roberts buyout weak companies so they can fix them and then resell them later b Corporations Use Bonds to Revise the Capital Structure i What is capital structure ii How a company is financed do they use equity or do they use debt iii Is debt or equity cheaper 1 Bonds are cheaper equity is more expensive because when you do pay it back you have to pay that market price iv What is a debt for equity swap 1 You will take on more debt V Globalization of Bond Markets a Global Government Debt Markets i In general bonds issued by foreign governments referred to as sovereign bonds are attractive to investors because of the government s ability to meet debt obligations These are rated just like other investments b What is the Greek Debt Crisis i Greece couldn t t pay back their bonds they decided to get second biggest military in the world they started to hire more public workers Greek failed and they got dropped to junk bond status they have been bailed out twice already countries have ratings too Greece had to pay upwards to 8 percent on their bonds VI Other Types of Long Term Debt a Structured Notes i The amount of interest and principal to be paid is based on specified market conditions i e S P 500 index goes up or down ii Bonds tied in with derivatives b Risk of Structured Notes i In the early 1990s Orange County California suffered losses and filed for bankruptcy due to investments in structured notes ii Because of the difficulty in assessing the risk of structured notes some investors