FIN 472 Fixed-Income Securities Corporate Debt Securities

Professor Robert B.H. Hauswald Kogod School of Business, AU

FIN 472

Fixed-Income Securities

Corporate Debt Securities

Corporate Debt Securities

• Financial obligations of a corporation that have priority over its common stock and preferred stock in the case of bankruptcy. • In decreasing order of importance

– Corporate bonds – Medium-term notes – Commercial papers – Asset-backed securities

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Corporate Funding

0.0 200.0 400.0 600.0 800.0 1,000.0 1,200.0 1,400.0 1,600.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 YTD Investment Grade High Yield Total Fixed Rate Call. Floating Rate Call. Fixed Rate Noncall. Floating Rate Noncall Convertible

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Corporate-Debt Market

• There are several trillion dollars of corporate bonds outstanding in the United States.

• More than half of these are owned by life insurance companies and pension funds.

– can eliminate much of their financial risk via

cash flow matching.

– can diversify away most default risk by holding a large number of different bonds.

Commercial Paper: CP

• Unsecured promissory notes, issued by corporations, maturing in less than 270 days

– discount securities: completely analogous to T-bills

• The use of CP increased significantly in the early 1980s due to the rising cost of bank loans.

– the spread between CP and prime rates remains roughly 200 basis points

– volume only began to fall recently: annual market is still quite large at over $1 trillion outstanding

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Commercial-Paper Characteristics

• Short term debt issued with less documentation typically by large and stable corporations

– Much cheaper borrowing than banks. – Bridge financing.

– An alternative to CDs and T-bills

• A typical round-lot transaction is $100,000 • Those with maturity up to 90 days can be used

as collateral for FED discount window

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Commercial Paper Volume

Commercial-Paper Risks

• Typically rolled over

– Rollover risk is backed by an unused credit line

• Between 1971 to 1989: one default on CP

– 3 defaults occurred in 1989 and 4 in 1990

• 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

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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!

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,

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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.

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Types of Corporate Bonds

• Bonds with standard, relatively simple set of

features: Plain Vanilla Bonds – “bullet” bonds: lump-sum repayment

• Debentures: unsecured bonds issued by corporations

• Mortgage bondsare secured with a property lien.

• Collateral trust bondsare debt secured with financial

collateral.

• Equipment trust certificatesare shares in a trust with

income from a lease contract

Bond Indentures

• A Bond indenture is a formal written agreement between the corporation and the bondholders.

– spells out, in detail, the obligations of the corporation, the rights of the corporation, and the rights of the bondholders – in practice, few bond investors read the original indenture. – instead, they might refer to an indenture summaryprovided

in the prospectusof the bond issue.

• The Trust Indenture Act of 1939

– any bond issue subject to regulation by the SEC must have a trustee appointed to represent bondholders’ interests

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Protective Covenants

• A bond indenture is likely to contain a number of

protective covenants.

• Protective Covenantsare restrictions designed to

protect bondholders.

– Negative covenant (“thou shalt not”): the firm cannot pay dividends to stockholders in excess of what is allowed by a formula based on the firm’s earnings. – Positive covenant (“thou shalt”): proceeds from the

sale of assets must be used either to acquire other assets of equal value or to redeem outstanding bonds.

Attributes of Corporate Bonds

• Registered Bonds • Restrictive Covenants

• Call and repayment provisions

– Higher yield – Sinking fund

– Interest of the stockholders – Alternative opportunities

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Security and Seniority

• Secured Bonds: collateral

– Mortgage bonds

– Equipment trust certificates

• Guaranteed bonds: third party’s guarantees • Unsecured Bonds

– Debentures

– Subordinated debentures – Variable-rate bonds

• Junk Bonds

Call and Put Provisions

• A call provisionallows the issuer to buy back all or part of

its outstanding bonds at a specified call price sometime before the bonds mature.

– when interest rates fall, bond prices increase: the firm can “call-in” the existing bonds, i.e., pay the call price.

– the corporation can then issue new bonds with a lower coupon: this process is called bond refunding.

• A bond with a put provisioncan be sold back to the issuer at a pre-specified price (normally set at par) on any of a sequence of pre-specified dates.

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Call vs. Put Option: Yields?

non-callable

callable

Callable bond = noncallable – call option price

Negative convexity area

yield price

Convertibles

• Convertible bondsare bonds that can be exchanged for common stock according to a pre-specified conversion ratio (i.e., the number of shares acquired).

– Suppose the conversion ratio for a $1,000 par value bond is 20 shares.

• Conversion Price = Bond Par Value / Conversion Ratio

– Then, the conversion price is $50 ($1,000 / 20).

• Conversion Value = Price Per Share X Conversion Ratio

– If the market price per share of stock is currently $40, the conversion value is $800 ($40 x 20).

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Maturity

• Term bondsare issued with a single maturity date, while serial bondsare issued with a regular

sequence of maturity dates.

• Term bonds normally have a sinking fund, which is an account used to repay some bondholders before maturity.

– Money paid into a sinking fund can only be used to pay bondholders.

– Some bondholders are repaid before the stated maturity of their bonds, whether they want to be repaid or not. – At maturity, only a portion of the original bond issue

will still be outstanding.

Bond Market Trading

• An active secondary market with a substantial volume of bond trading exists,

– satisfies most of the liquidity needs of investors. – Corporate bond trading is characteristically an

OTC activity: typical block?

• Nevertheless, the New York and Luxemburg Stock Exchanges trade bonds

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NYSE Bonds Quote

Trade Reporting and Compliance

Engine (TRACE)

• At the request of the SEC, corporate bond trades are now reported through TRACE.

– TRACE provides a means for bond investors to get accurate, up-to-date price information.

• TRACE has dramatically improved the information available about bond trades.

– Transaction prices are now reported on more than 4,000 corporate bonds

– about 75% of market volume for investment grade bonds. – more bonds to be added to TRACE over time.

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Standard & Poor’s Role in Credit Markets

Provide independent opinion

Evaluate creditworthiness

Determine the “risk of default”

Analyze business and financial risk

Ratings used by investors as a guide

How Does S&P

Determine Ratings

29 2/22/2016 0 5 10 15 20 25 30 35 40 AAA AA A BBB BB B CCC CC D SD FI Crop Ratings Distribution

Corporate & Financial Institution as at 18 Aug 2003

Utilities Fin'l Institutions Health/Chemicals Telecom Energy /Resources Forest/Builders Transport Leisure/Media Consumer/Serv ice Aerospace/Auto/Cap Goods/Metal Tech/Computers/Office Equip Insurance/Real estate Average 0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

Default Rates by Industry

S&P Default rates by industry: 1981-2001

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Market vs. Credit Returns

Typical market returns Typical credit returns

Portfolio Value

Source: CIBC

Comparison of the distributions of credit returns and market returns

Frequency

The Yield Spread

• A bond’s credit rating helps determine its yield spread.

– The yield spread is the extra return (increased yield to maturity) that investors demand for buying a bond with a lower credit rating (and higher risk).

• Yield spreads are often quoted in basis points over Treasury notes and bonds. That is,

– Suppose we see a 5-year Aaa/AAA yield spread equal to 59. – This means the YTM on this bond is 59 basis points (0.59%)

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Corporates vs. UST: Credit Spreads

Time to maturity

y_zero

0 3m 6m 1yr 3yr 5yr 10yr 30yr

UST yield curve Corporate ‘A’ yield curve

Non-callable Bond Pricing

• Traditional yield spread method

– Based on YTM

– Ignores differences in cash flow characteristics

• Static spread analysis: noncallables

– Based on term structure

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Source: Merrill Lynch European triple-A Corporate Index (ER10), European single-A Corporate Index (ER30) and European triple-B Corporate Index (ER40).

ER10 Index consists of 172 issues. Current modified duration of 3.737 years (modified duration at inception 2.996 years). ER30 Index consists of 567 issues. Current modified duration of 4.698 years (modified duration at inception 3.549 years). ER40 Index consists of 323 issues. Current modified duration of 3.934 years (modified duration at inception 2.63 years).

N.B. Spread indices when compared from month to month can give a misleading impression of market movements because the composition of the index may change. They

are most useful as an indicator of long-term trends.

Single-A Spread Over Triple-A

Launch of ECL

Nasdaq Collapse WTC Attack

Corporate Default Peak

Triple-B Spread Over Triple-A

0 25 50 75 100 125 150 175 200 225 250 275 300 325 A p r-9 8 M a y -9 8 J u l-9 8 S e p -9 8 N o v -9 8 J a n -9 9 M a r-9 9 A p r-9 9 J u n -9 9 A u g -9 9 O c t-9 9 D e c -9 9 F e b -0 0 M a r-0 0 M a y -0 0 J u l-0 0 S e p -0 0 N o v -0 0 J a n -0 1 F e b -0 1 A p r-0 1 J u n -0 1 A u g -0 1 O c t-0 1 D e c -0 1 J a n -0 2 M a r-0 2 M a y -0 2 J u l-0 2 S e p -0 2 N o v -0 2 J a n -0 3 F e b -0 3 A p r-0 3 J u n -0 3 A u g -0 3 O c t-0 3 D e c -0 3 J a n -0 4 M a r-0 4 M a y -0 4 J u l-0 4 S e p -0 4 N o v -0 4 D e c -0 4 F e b -0 5 A p r-0 5 J u n -0 5

EU Credit Spreads:

A and BBB over AAA

Source: Goldman Sachs.

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Benchmark: UST

• The benchmark is the Treasury term structure Term Structure 5.00% 5.50% 6.00% 6.50% 7.00% 7.50% 8.00% 8.50% 9.00% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Term to Maturity

Spot-Rate Pricing

• The term structure implies a set of zero prices that can be used to price any cash flow

B(0,t)

=

1

1

+

R(0,t)

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Static Spread Analysis

• The benchmark is the Treasury term

structure. Term Spot Yield Zero Price

t R(0,t) B(0,t) 1 5.36% $ 0.94916 2 5.68% $ 0.89541 3 5.97% $ 0.84030 4 6.24% $ 0.78508 5 6.48% $ 0.73068 6 6.70% $ 0.67784 7 6.89% $ 0.62706 8 7.08% $ 0.57870 9 7.24% $ 0.53298 10 7.39% $ 0.49001 11 7.53% $ 0.44983 12 7.66% $ 0.41241 13 7.78% $ 0.37769 14 7.89% $ 0.34557 15 7.98% $ 0.31592 Here’s an example

Default-Free Corporate Bond

• We use the term structure to price the cash flow of a bond we wish to price.

For example, suppose we want to price a 15-year 12% coupon corporate bond.

Term Spot Yield Zero Price Cash Present

t R(0,t) B(0,t) Flow Value 1 5.36% $ 0.94916 $ 12.00 $ 11.38989 2 5.68% $ 0.89541 $ 12.00 $ 10.74491 3 5.97% $ 0.84030 $ 12.00 $ 10.08364 4 6.24% $ 0.78508 $ 12.00 $ 9.42090 5 6.48% $ 0.73068 $ 12.00 $ 8.76818 6 6.70% $ 0.67784 $ 12.00 $ 8.13407 7 6.89% $ 0.62706 $ 12.00 $ 7.52475 8 7.08% $ 0.57870 $ 12.00 $ 6.94444 9 7.24% $ 0.53298 $ 12.00 $ 6.39578 10 7.39% $ 0.49001 $ 12.00 $ 5.88013 11 7.53% $ 0.44983 $ 12.00 $ 5.39795 12 7.66% $ 0.41241 $ 12.00 $ 4.94894 13 7.78% $ 0.37769 $ 12.00 $ 4.53228 14 7.89% $ 0.34557 $ 12.00 $ 4.14678 15 7.98% $ 0.31592 $ 112.00 $ 35.38272 Theoretical price $ 139.69536

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Static Spread Analysis

• The difference between the bond’s market price and its “theoretical” risk-free price reflects the yield premium investors demand for bearing risk. • For example, the 12% 15-year corporate was

priced at 86 15/16 recently.

• We calculated a theoretical price of 139.695 for this bond, which implies a price differential of $52.758 per $100 of face value.

Static Spread

• The “static spread” is the yield pickup (over and above the term structure) needed to equate the present value of a bond’s cash flow with its price.

• That is, instead of using the term structure to value a bond’s cash flow, we use

B∗(0,t)= 1

1+R(0, t)+s

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Junk-Bond Pricing

• For example: Bond Coupon 12.00%

Bond Price 86 15/16

Static Spread 6.82%

Term Spot Yield Zero Price Cash Present

t R(0,t) B(0,t) Flow Value 1 5.36% $ 0.89147 $ 12.00 $ 10.69768 2 5.68% $ 0.79017 $ 12.00 $ 9.48210 3 5.97% $ 0.69696 $ 12.00 $ 8.36349 4 6.24% $ 0.61216 $ 12.00 $ 7.34595 5 6.48% $ 0.53576 $ 12.00 $ 6.42909 6 6.70% $ 0.46745 $ 12.00 $ 5.60941 7 6.89% $ 0.40678 $ 12.00 $ 4.88139 8 7.08% $ 0.35319 $ 12.00 $ 4.23831 9 7.24% $ 0.30607 $ 12.00 $ 3.67286 10 7.39% $ 0.26480 $ 12.00 $ 3.17761 11 7.53% $ 0.22877 $ 12.00 $ 2.74525 12 7.66% $ 0.19740 $ 12.00 $ 2.36885 13 7.78% $ 0.17016 $ 12.00 $ 2.04194 14 7.89% $ 0.14655 $ 12.00 $ 1.75858 15 7.98% $ 0.12612 $ 112.00 $ 14.12499 Theoretical price $ 86.93751 Price spread $ 0.00001 In this case, the

bond is priced at a 682 bp static spread (over the

Treasury term structure)

Dynamic Spread

Reuters Corporate Spreads for Banks 3/1/2006

Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr Aaa/AAA 14 16 27 40 56 68 90 Aa1/AA+ 22 30 31 48 64 77 99 Aa2/AA 24 37 39 54 67 80 103 Aa3/AA- 25 39 40 58 71 81 109 A1/A+ 43 48 52 65 79 93 117 A2/A 46 51 54 67 81 95 121 A3/A- 50 54 57 72 84 98 124 Baa1/BBB+ 62 72 80 92 121 141 170 Baa2/BBB 65 80 88 97 128 151 177 Baa3/BBB- 72 85 90 102 134 159 183 Ba1/BB+ 185 195 205 215 235 255 275 Ba2/BB 195 205 215 225 245 265 285 Ba3/BB- 205 215 225 235 255 275 295 B1/B+ 265 275 285 315 355 395 445 B2/B 275 285 295 325 365 405 455 B3/B- 285 295 305 335 375 415 465 Caa/CCC+ 450 460 470 495 505 515 545 UST Yield 4.74 4.71 4.68 4.63 4.6 4.59 4.56

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Summary

• Introduction to corporate-debt markets

– commercial paper – medium-term notes – corporate bonds

• Terms and structure of issues • The rating game

• From credit risk to credit spread and pricing

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More on Credit Spreads

• A premium in returns on risky bonds that should compensate for:

– the expected losses on risky corporate bonds – the risk premium for accepting the expected

losses

• Measured as the difference between the yield to maturity on corporate bond and government security with similar maturity.

Characteristics of Credit Spreads

• Higher spreads for lower credit ratings

– Duffee (1998), Kao (2000), King & Khang (2002)

• US evidence

– Higher spreads for industrial bonds and lower for utility bonds

– Higher volatile credit spreads for lower ratings – No significant changes in credit spreads over time

• European evidence

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Credit Spreads and Default Risk

• Default event is linked to company’s business risk

– Information on assets’ value, debt value, debt maturity, interest rates, etc.

• Assumption: Firm’s value follow a stochastic process in perfect and complete markets

– Merton (1974), Geske (1977), Longstaff & Schwartz (1995), Leland & Toft (1996).

• Limitations

– Not applicable for private companies

– Assumption of independence between interest rates and credit spreads – Failure to capture default events for highly rated companies

Credit Spreads and Issue/Issuer

Characteristics

• Strong positive impact of leverage ratios on credit spreads

– Positive impact of the changes in leverage on the changes in credit spreads

• Strong positive relation between company’s stock volatility and credit spreads

– Positive impact of the changes in stock volatility on the changes in credit spreads

• Changes in credit spreads are significantly positively related to changes in the probability of bond prices’ jumps. • Negative impact of the issue size on credit spreads

• Credit spreads not significantly related to the variables of: • Free-cash flows

2/22/2016 Corporate Debt © Robert B.H. Hauswald 51 0% 2% 4% 6% 8% 10% 12% J a n -9 8 M a r-9 8 M a y -9 8 J u l-9 8 S e p -9 8 N o v -9 8 J a n -9 9 M a r-9 9 M a y -9 9 J u l-9 9 S e p -9 9 N o v -9 9 J a n -0 0 M a r-0 0 M a y -0 0 J u l-0 0 S e p -0 0 N o v -0 0 J a n -0 1 M a r-0 1 M a y -0 1 J u l-0 1 S e p -0 1 N o v -0 1 J a n -0 2 M a r-0 2 M a y -0 2 J u l-0 2 S e p -0 2 N o v -0 2 J a n -0 3 M a r-0 3 M a y -0 3 J u l-0 3 S e p -0 3 N o v -0 3 J a n -0 4 M a r-0 4 M a y -0 4 J u l-0 4 S e p -0 4 N o v -0 4 J a n -0 5 M a r-0 5 M a y -0 5 J u l-0 5 S e p -0 5 N o v -0 5 J a n -0 6 M a r-0 6 M a y -0 6 2003-2005 A ctual 2005 Forecast 1920-2005 A verage

Moody’s Speculative-Grade

Default Rate Forecast

• Speculative grade default rate at 1.9%, well below long-run historical average of 4.9%

• Moody’s model forecasting default rate of 2.5% in December 2005

• European speculative grade default rate at 1.7% in April 2005 versus 2.1% in April 2004Source: Moody’s “Monthly Default Report – April 2005”, 5

thMay 2005.

Statistical model based on three broad factors

• Changes in distribution of credit ratings

– Percent rated speculative-grade

– Percent of speculative-grade rated below Ba

• New issuance/seasoning effect

– New speculative-grade issuers are most likely to default in third year after issuance

• Macroeconomic trends

– Growth rate of industrial production (negatively related) – Nominal 10-year yield (positively related)

– Slope of Treasury yield curve (positively related)

Moody’s default rate forecasting

model

Corporate Debt © Robert B.H. Hauswald 53

Whither default rates?

• Default rates currently sending mixed signals about trends in credit risk:

– Issuer-based default rates show decade-low default rates: 1.7% as of March 2006, well below 5.1% historical average

– Dollar volume-based default rates have increased sharply to 4.2% as of March 2006, approaching its 5.2% historical average

• Defaults in the past 12 months primarily arising from troubled industry sectors in

the U.S.:

– Non-U.S. default rate 0% as of March 2006

– Independent power, cable, transportation and autos sectors comprised 86% of total volume of defaults in 2005

2006 spec-grade default rate

forecast

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% J a n -0 3 M a r -0 3 M a y -0 3 J u l-0 3 S e p -0 3 N o v -0 3 J a n -0 4 M a r -0 4 M a y -0 4 J u l-0 4 S e p -0 4 N o v -0 4 J a n -0 5 M a r -0 5 M a y -0 5 J u l-0 5 S e p -0 5 N o v -0 5 J a n -0 6 M a r -0 6 M a y -0 6 J u l-0 6 S e p -0 6 N o v -0 6 J a n -0 7 M a r -0 7 Model: 3.0% High: 4.5% Low: 1.6% Historical Average

Corporate Debt © Robert B.H. Hauswald 55

2006 default & recovery rate

outlook

y = 0.5688e-7.1116x R2 = 0.612 0% 10% 20% 30% 40% 50% 60% 70% 0% 2% 4% 6% 8% 10% 12%

Annual Default Rate

A v e r a g e R e c o v e r y R a te 2004 2005 Forecast Default Rate Recovery Rate Point 3.0% 45.9% Low 1.6% 50.4% High 4.5% 41.3%

Merton (1974) Model

D

V

$

equity

debt

firm

Ratings Counts

Ratings Transitions

• Transition Matrices measure how often rating changes occur, and

– display the percentage or number of

issuers/issues in each rating category that have

– either maintained their rating or migrated to a

Default Rates

• Default rates are given on a marginal and cumulative basis.

Cumulative Annual Default Rates

Average Cumulative15-Year Default

Rates (%)

0.67 1.30 2.30 4.27 24.51 27.83 60.70 0 10 20 30 40 50 60 70 AAA AA A BBB BB B CCC

2/22/2016 Corporate Debt © Robert B.H. Hauswald 61 0 5 10 15 20 25 30 35 40 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Investment Grade Specualtive Grade

Average Cumulative15-Year Default

Rates (%): Investment vs. Speculative