EMBAF

1
Corporate Debt Instruments

• Zvi Wiener
• Based on Chapter 7 in Fabozzi
• Bond Markets, Analysis and Strategies

2
Corporate Debt

• Financial obligations of a corporation that have
  priority over its common stock and preferred
  stock in the case of bankruptcy.
• Corporate bonds
• Medium-term notes
• Commercial papers
• Asset-backed securities

3
Major groups of issuers

• Utilities
• Transportation
• Industrials
• Banks and finance companies
• communication

4
Features of Corporate Bonds (indentures)

• Corporate trustee represents bondholders
• Term bonds maturity
• Under 10 years notes
• Some bonds have specific collateral
• Others are debentures
• Guaranteed bonds (third partys guarantees)

5
Call provision

• Company can retire the debt before maturity.
• This is an option and makes the debt more
  expensive.
• Sinking fund provision predetermined.

6
Bond Provisions

• Sinking fund provision sometimes the issuer is
  required to retire a portion of an issue each
  year.
• either by cash payment to bondholders (lottery)
• or by buyback bonds

7
Bond Rating

• Standard and Poors
• Moodys Investor Service
• Fitch
• Duff and Phelps
• ?????

8
Investment Grade

• Moodys SPFDP
• Aaa AAA
• Aa1 AA
• Aa2 AA
• Aa3 AA-
• A1 A
• A2 A
• A3 A-
• Baa1 BBB
• Baa2 BBB
• Baa3 BBB-

9
Speculative Grade

• Moodys SPFDP
• Ba1 BB
• Ba2 BB
• Ba3 BB-
• B1 B
• B2 B
• B3 B-
• CCC
• Caa CCC
• CCC-
• Ca CC
• C C

10
High Yield Bonds

• LBO, downgrading, refinancing
• fallen angels
• deferred interest bonds
• Step-up bonds pay initially low interest which
  increases with time
• Spreads as a measure of risk and premium.

11
Transition Matrix

• One year transition matrix (very old)
• Start\end Aaa Aa A Baa Ba B CD
• Aaa 91.9 7.38 0.72 0.00 0.00 0.00 0.00
• Aa 1.13 91.26 7.09 0.31 0.21 0.00 0.00
• A 0.10 2.56 91.20 5.33 0.61 0.20 0.00
• Baa 0.00 0.21 5.36 87.94 5.46 0.82 0.21

12
Default Rates

• ??????

13
Loss Given Default

• ??????

14
SEC rule 144A

• Allows to trade private placements among
  qualified institutions.

15
Medium Term Notes (MTN)

• Notes are registered with the SEC under Rule 415
  (the shelf registration) and are offered
  continuously to investors by an agent of the
  issuer.
• Maturities vary from 9 months to 30 years.
• Can be either fixed or floating.
• Very flexible way to raise debt!

16
Primary Market (MTN)

• Issuer posts spreads over Treasuries for a
  variety of maturities.
• Then an agent tries to find an investor. Minimal
  size is between 1M and 25M.
• The schedule can be changed at any time!
• Often structured MTNs are used (caps, floors,
  etc.) structured notes.

17
Structured Notes

• Many institutional investors can use swaps and
  structured notes to participate in markets that
  were prohibited.
• Another use of structured notes is in risk
  management.
• Financial Engineering is used to create
  securities satisfying the needs of investors.

18
Commercial Papers

• Short term debt issued with less documentation
  typically by large and stable corporations for up
  to 270 days.
• Much cheaper borrowing than banks.
• Bridge financing.
• Rollover Risk
• An alternative to CD.

19
Commercial Papers

• Short term unsecured promissory note
• An alternative to short term bank borrowing
• A typical round-lot transaction is 100,000
• In the USA maturity is up to 270 days
• Requires less paperwork
• Those with maturity up to 90 days can be used as
  collateral for FED discount window.

20
Commercial Papers

• Typically rolled over
• Rollover risk is backed by an unused bank credit
  line
• In order to issue CP one need either a high
  rating or good collateral
• Sometimes credit enhancement is used (LOC)
• CP issued in the USA by foreigners are called
  Yankee CP

21
Commercial Papers

• Between 71 an 89 there was one default on CP.
• 3 defaults occurred in 89 and 4 in 90
• Direct paper is sold without an agent
• Secondary market is thin
• There is a special rating for CP, P-1,3, A-1,3
• discount instruments, used by money market

22
Bankruptcy and Creditor rights

• Liquidation (Chapter 7)
• Reorganization (Chapter 11)

23
Bankruptcy and Credit Rights

• liquidation - all assets will be distributed
• reorganization - a new corporate entity will
  result
• a company that files for protection becomes a
  debtor in possession and continues to operate
  under the supervision of the court

24
Bankruptcy and Credit Rights

• Absolute priority rule - senior creditors are
  paid in full before junior creditors are paid
  anything.
• Works in liquidation but often does not work in
  reorganization.

25
Mertons model

firm
equity
debt
D V
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Home AssignmentChapter 7

• Questions 10, 21, 25