CHP 21 - AFTER MID-TERM 1

Long-term debt

definition: debt with maturity > 1 year; commonly issued as bonds by corporations/governments

Bond indenture

The legal contract between the issuer and a trust company representing bondholders

Trust company (trustee) roles

1) Enforce indenture terms 2) Manage sinking fund 3) Represent bondholders in default

Sinking fund

Account managed by trustee to accumulate cash to retire bonds

Security (collateral)

Specific assets pledged to back the bond issue

Seniority

Priority of repayment in bankruptcy or liquidation

Protective covenants

Contract clauses that restrict issuer actions to protect bondholders

Call provision

Allows issuer to repurchase (call) bonds at a set price within a specified period

Callable vs straight bond value

Callable bond value = Straight bond value – Call value

Investor effect of call provision

Higher required YTM because of call/reinvestment risk; lower price than straight bond

Why calls happen

When interest rates fall, issuer refinances at lower rates and calls old high-coupon bonds

Reinvestment risk

If bond is called in a low-rate environment, cash must be reinvested at lower yields

Yield to Maturity (YTM)

The IRR of a bond’s cash flows if held to maturity and coupons are reinvested at YTM

Relationship of price and YTM

Higher price → lower YTM; lower price → higher YTM (inverse relationship)

Bond refunding

Replacing outstanding bonds with a new issue (often after calling the old bonds)

Refunding sequence

Call old bonds at call price → issue new lower-coupon bonds → reduce interest expense

Bond ratings purpose

Assess default risk and strength of protections in the contract

Who pays for ratings

The issuer pays; agencies use issuer financial statements; ratings may change over time

Investment grade

BBB/Baa or higher (lower to moderate credit risk)

Junk (high-yield)

Below BBB/Baa; higher default risk → higher promised yields

Zero-coupon bond

Pays no coupons; sold at discount; price = PV(face) only

Floating-rate bond (floater)

Coupon adjusts with a benchmark (e.g., T-bill); often has floors/ceilings and put options

Convertible bond

Holder may convert bond into a fixed number of shares before maturity

Retractable bond

Holder can force issuer to repurchase at a stated price (investor put)

Income bond

Interest is paid only if issuer income exceeds a threshold

Effect of call on price cap

Call feature caps price appreciation when rates fall (issuer can call near the call price)

Straight vs callable YTM

Callable bonds generally have higher YTM than comparable straight bonds to compensate for call risk

Call premium

Extra amount over par paid by issuer when calling (e.g., 1-year’s coupon)

When issuer will call

When PV of keeping the bond (high coupon) exceeds call price; typically after rate declines

Non-callable perpetual price today calculation (3 steps)

1. Price next year (P1 = C/R1)

2. Total Value at t = 1

3. Discount back to today at R0

Coupon that makes a callable in 1 year sell at par (1,000$) calculation (3 steps)

1. Expected Value in 1 Year

2. Plug into Today’s Price Formula (P0 = C + E(V1) / 1 + R0)

3. Impose “sells at par”… P0 = 1000 and solve for C

Value of call provision to the issuer (3 Steps)

1. Callable price today

2. Straight price today

3. P0(Straight) - P0 (Callable)