Chapter 20 Long-Term DebtLong Term Debt: A ReviewFeatures of a Typical BondFeatures of a Hypothetical BondThe Public Issue of BondsPrincipal RepaymentProtective CovenantsThe Sinking FundBond RefundingCallable Bonds versus Noncallable BondsBond RatingsBond Ratings: Investment GradeBond Ratings: Below Investment GradeJunk bondsDifferent Types of BondsPuttable bondsConvertible BondsConvertible Bond PricesMore on ConvertiblesDirect Placement Compared to Public IssuesSummary and ConclusionsSummary and Conclusions (cont.)Chapter 20 Long-Term Debt20.1 Long Term Debt: A Review20.2 The Public Issue of Bonds20.3 Bond Refunding20.4 Bond Ratings20.5 Some Different Types of Bonds20.6 Direct Placement Compared to Public Issues20.7 Long-Term Syndicated Bank Loans20.8 Summary and ConclusionsLong 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” bondsFeatures of a Typical BondThe indenture usually listsAmount of Issue, Date of Issue, MaturityDenomination (Par value)Annual Coupon, Dates of Coupon PaymentsSecuritySinking FundsCall ProvisionsCovenantsFeatures that may change over timeRatingYield-to-MaturityMarket priceFeatures of a Hypothetical BondIssue amount $20 million Bond issue total face value is $20 million Issue date 12/15/98 Bonds offered to the public in December 1998 Maturity date 12/31/18 Remaining principal is due December 31, 2018 Face value $1,000 Face value denomination is $1,000 per bond Coupon interest $100 per annum Annual coupons are $100 per bond Coupon dates 6/30, 12/31 Coupons are paid semiannually Offering price 100 Offer price is 100% of face value Yield to maturity 10% Based on stated offer price Call provision Callable after 12/31/03 Bonds are call protected for 5 years after issuance Call price 110 before 12/31/08, 100 thereafter Callable at 110 percent of par value through 2008. Thereafter callable at par. Trustee United Bank of Florida Trustee is appointed to represent bondholders Security None Bonds are unsecured debenture Rating Moody's A1, S&P A+ Bond credit quality rated upper medium grade by Moody's and S&P's ratingThe 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SecuritySinking FundsCall ProvisionsCovenantsPrincipal RepaymentTerm bonds versus serial bondsSinking funds--how do they work?Fractional repayment each yearGood news -- securityBad news -- unfavorable callsHow trustee redeemsProtective CovenantsAgreements to protect bondholdersNegative covenant: Thou shalt not:pay dividends beyond specified amountsell more senior debt & amount of new debt is limitedrefund existing bond issue with new bonds paying lower interest rate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 informationThe Sinking FundThere are many different kinds of sinking-fund arrangements: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 issue.Sinking funs provide extra protection to bondholders.Sinking funs provide the firm with an option.Bond RefundingReplacing all or part of a bond issue is called refunding.Bond refunding raises two questions:Should firms issue callable bonds?Given that callable bonds have been issued, when should the bonds be called?Callable Bonds versus Noncallable Bonds2550751001251501752000 4 8 12 16 20Yield to maturity (%)Bond price (% of par)Noncallable bondCallable bondMost bonds are callable; some sensible reasons for call provisions include: taxes, managerial flexibility and the fact that callable bonds have less interest rate risk.Bond RatingsWhat is rated:The likelihood that the firm will default.The protection afforded by the loan contract in the event of default.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.Bond Ratings: Investment GradeMoody's Duff & Phelps S&P's Credit Rating Description Aaa 1 AAA Highest credit rating, maximum safety Aa1 2 AA+ Aa2 3 AA High credit quality, investment-grade bonds Aa3 4 AA- A1 5 A+ A2 6 A Upper-medium quality, investment grade bonds A3 7 A- Baa1 8 BBB+ Baa2 9 BBB Lower-medium quality, investment grade bonds Baa3 10 BBB-Moody's Duff & Phelps S&P's Credit Rating Description Speculative-Grade Bond Ratings Ba1 11 BB+ Low credit quality, speculative-grade bonds Ba2 12 BB Ba3 13 BB- B1 14 B+ Very low credit quality, speculative-grade bonds B2 15 B B3 16 B- Extremely Speculative-Grade Bond Ratings Caa 17 CCC+ Extremely low credit standing, high-risk bonds CCC CCC- Ca CC Extremely speculative C C D Bonds in default Bond Ratings: Below Investment GradeJunk 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 riskDifferent Types of BondsCallable BondsPuttable BondsConvertible BondsDeep Discount BondsIncome BondsFloating-Rate BondsPuttable bondsPut provisionsPut pricePut datePut defermentExtendible bondsValue of the put featureCost of the put featureConvertible BondsWhy are they issued?Why are they purchased?Conversion ratio:Number of shares of