principles_of_corporate_finance_unit_j_lectures.pdf

Corporate Bonds Corporate Bond Terminology • Debentures: long-term (maturities more than 10 years) • Commercial Paper and notes: short-term (less than 10 years) • Face value: principal at maturity, often 1,000 • Coupon: interest payment • Yield: the discount rate for future promised payments • Acc...

Corporate Bonds Corporate Bond Terminology • Debentures: long-term (maturities more than 10 years) • Commercial Paper and notes: short-term (less than 10 years) • Face value: principal at maturity, often 1,000 • Coupon: interest payment • Yield: the discount rate for future promised payments • Accrued interest: the amount of accumulated interest since the last coupon payment • “Dirty” price: the actual price you pay to purchase a bond (ie, PV of future cash flows) Quoted (“clean”) price = Dirty price − Accrued interest J. C. Penney’s 8.25% Sinking Fund Debenture 2022 1 1 Source: Brealey, Myers, and Allen Quick Question Refer to the contract on the previous slide. • When is the first interest payment and what is the amount? 0.0825 × 250m = $10.3 million on 15 February, 1993 2 • What is the accrued interest if today is 15 April? • Previous interest payment: 15 February (two months ago)   2 × 6 0.0825 × 1, 000 2 | {z = $13.75 } semi-ann. coupon per bond • What price do you pay if the quoted price today is 99.1%? 0.991 × 1, 000 + 13.75 = $1, 004.75 The End Common Features Issuing a Bond • Foreign bond: local-currency denominated bond that is issued/sold by a foreign company to investors in the local market • Bulldog bond: a £-denominated bond sold by a foreign company in the UK • Similarly, Samurai and Yankee bonds are sold by a foreign firm in Japan and the US, respectively • Eurobond: bond that is underwritten by international bond syndicates and sold in several national markets in a major non-local currency (eg, US dollar) • Global bond: very large bond issue that is marketed both internationally (ie, in the eurobond market) and in individual domestic markets. Credit Ratings • Corporate bonds carry credit risk, ie, the possibility of default. • Agencies (eg, Fitch Investors Service, Moody’s, Standard & Poor’s) provide ratings to indicate the likelihood of default. S&P AAA MOODYS Aaa GUIDE Prime quality, gilt-edged- both coupon and face value are well protected. AA+,AA,AAAa1,Aa2,Aa3 High grade bonds, only slightly weaker than AAA. A+,A,AA1,A2,A3 Upper medium grade, strong current protection but could be affected by adverse future economic conditions. BBB+,BBB,BBB- Baa1,Baa2,Baa3 Lower medium grade, - current protection is adequate but there may be future problems. BB+,BB,BBBa1,Ba2,Ba3 Low grade – speculative, future payments are not well protected. B+,B,BB1,B2,B3 Little protection, speculative. CCC+,CCC,CCC- Caa, Poor protection, highly speculative. CC,C Ca,C Very risky, may be in default. D In Default UK Credit Spreads Secured vs Unsecured Debt • Unsecured: no collateral, backed by the company’s creditworthiness • Secured: lender can seize collateral upon default • Debenture: long-term secured debt (in UK), long-term unsecured issues (in US) • Mortgage bonds: long-term debt secured by a firm’s property • Asset-backed bonds: securities backed by a portfolio of assets • These include collateralised mortgage and debt obligations (CMOs, CDOs). Seniority • Who gets paid first in bankruptcy? • Senior > subordinated (“junior”) • Secured > unsecured • Debtholders > equity holders (“absolute priority”) • Why would anyone accept junior debt? • It is riskier, so the yield is higher • Recovery rate: the percentage an investor gets back in bankruptcy Recovery Rates Ultimate Percentage Recovery Rates on Defaulting Debt (1983–2017) 1 1 Source: Brealey, Myers, and Allen Repayment Provisions • Sinking fund • A lumpy repayment of the entire principal can be disruptive. • A sinking fund is established to retire debt gradually before maturity. • The firm is obligated to make regular payments into the sinking fund. • Pay in kind (PIK) • Payments do not have to be in cash. • Interest or sinking funds can be paid by bonds too (sometimes purchased from the market). • When in trouble, PIK is a cheaper way to pay than cash. Debt Covenants Debt covenants contained in a bond contract are restrictions imposed by bondholders on the activities of the borrower. • Positive covenants specify actions that the firm must take. • For example, the interest coverage ratio (EBIT/Interest expense) must be greater than 3, working capital must remain above a minimum level, etc • Negative covenants limit or forbid actions that the firm may take. • Debt ratios • Senior debt limits senior borrowing • Junior debt limits senior and junior borrowing • Dividend restrictions • Poison put: event-risk protections • Certain events (eg, a merger) may oblige the borrower to repay the loan Example: Marriott In October 1993, Marriott spun off its hotel management business, which was worth 80% of its value, as Marriott International. • Before the spin-off, Marriott’s long-term book debt ratio was 79%. • Almost all the debt remained with the parent (renamed Host Marriott), that had its debt ratio rise to 93%. • Marriott’s stock price rose 13.8% and its bond prices declined by up to 30%. • Marriott’s debt contained the usual provisions, but lacked event-risk covenants that would have blocked the restructuring. • Bondholders sued, forcing Marriott to modify the spin-off plan. Bonds With Embedded Options • Sometimes, the bond contract allows the issuer and/or holder of the bond to take certain actions • Valuation: equivalent to a “straight”/“plain vanilla” bond and an option • Issuers have an option • Callable bonds • Bondholders have an option • Puttable bonds • Convertible bonds • Both sides have options • Callable convertible bonds The End Callable and Puttable Bonds Callable Bond • Call provisions give the issuer the option to “redeem” or “retire” (ie, pay back) the debt early • Callable bond: a bond that can be repurchased (“called”) by the firm before maturity at a specified price (“call price”) • For example, at any time after date T, the firm can buy back the bonds at 105% • Valuation: straight Pcallable = Pt t − ct where ct is the call option value (Why minus?) • Why do firms call and pay back debt early? • Adjust capital structure: lower leverage • Take advantage of lower interest rates • Optimal strategy: call the bond when the market price reaches the call price Value of a bond Callable Bond (cont.) Straight bond 100 bond callable at 100 75 50 25 25 50 75 100 125 Value of straight bond 150 Puttable Bond • Puttable bond: a bond that gives investors the right to demand early repayment • For example, at or after date T, bondholders can sell the bond to the firm at par • Bondholders have a straight bond and a (long) put option • Puttable bonds can be poisonous for the issuer! • • • • Bond investors exercise the put option when bond price is low This is also when the firm is in trouble Firms usually do not have the money to redeem Forced into default The End Convertible Bonds Convertible Bond • Convertible bonds give bondholders the right to exchange the bond for a pre-specified number of shares. • Conversion ratio: the number of shares into which each bond can be converted • Conversion price: value of the bond divided by the number of shares into which it may be exchanged • Note: The conversion price can be quoted in terms of face value or market value. When quoted in terms of the market value of the bond, we will refer to this as the market conversion price. • Conversion value: value of shares received upon conversion • Valuation: straight = Pt Pconvertible t + ct where ct is the value of the call option to acquire common stock Quick Example: Amazon’s Convertible 2009 • Convertible into 6.41 shares per bond ($1,000 face value) • Conversion ratio = 6.41 • Conversion price = (1, 000/6.41) = $156.01 • Should we convert if market price of shares is higher than this? • Suppose the market price of a share is $120 • Conversion value = 6.41 × 120 = $769.20 • Can the market price of a convertible bond be lower than its conversion value? • Suppose the convertible bond is selling at $750 • Buy at 750, convert into 6.41 shares, then sell the shares • Arbitrage profit: 19.20 = 769.20 (conversion value) − 750 Convertible Bonds • Lower bounds: the value of a convertible bond must be greater than or equal to the larger of • Straight bond value • Conversion value • Dilution effect: converting a bond creates new shares – the number of shares outstanding increases and existing shareholders are diluted Why Issue Convertible Bonds? 1. Claim: convertibles are “cheaper” (often lower yields)? • Not necessarily. You are selling an option too! 2. Management and the market disagree about the risk of the firm. • The market overestimates the variance. • Similar rationale to pecking order theory. 3. Reduce debtholder-shareholder agency conflicts, specifically the asset substitution (risk-shifting) problem. • If the gamble is successful, bondholders win as well. • This lowers the gambling pay-off to equity. Bond-Warrant Package • Warrants: call options written by the company on new stock • A convertible bond is similar to a package of a straight bond and a warrant • Differences from normal stock options • Warrants increase the number of shares outstanding if exercised • Differences from convertible bonds • Warrants can be issued on their own and can be detached • Convertibles have a random exercise price • Different tax rules The End Convertible Bond Valuation Pay-offs Conversion value at maturity varies with firm value Conversion value ($‘000s) Bond value ($‘000s) Straight bond pay-off at maturity varies with firm value 2 1 0 0 1 2 Value of firm ($m) 3 2 1 0 0 1 2 Value of firm ($m) 3 Convertible Bond Pay-off at Maturity Decision rule: convert only if conversion value is greater than straight bond value Convertible value ($‘000s) 3 2 1 0 0 1 2 Value of firm ($m) 3 4 Valuing a Convertible Bond Convertible bond = Straight bond + Equity call option • Valuing the straight bond is relatively easy. • Standard bond pricing: use the coupon and maturity of the convertible bond, use the market interest rate the firm would pay on a straight bond • Valuing the option is trickier. • American call with random exercise price • Conversion options are long-term: changing volatility • Dilution effect on equity • If you know the market price of the convertible bond, then: Option value = Convertible price − Straight bond price Qualitative Features • Effect on the value of the straight bond and option components Conversion ratio Stock price Stock volatility Dividend Straight bond value Option value – Mixed ↓ ↓ ↑ ↑ ↑ ↓ • Also remember, the price of a convertible bond must always be at least the straight bond value or conversion value (whichever is larger) Example: Convertible Valuation • A firm issues 50,000 par convertible bonds that have a face value of $1,000. • The bond pays an annual coupon of 12%. • Maturity is at 20 years. • An equivalent straight coupon bond has a 14% yield. • The conversion ratio is 20. • There are 5m shares outstanding. Convertible Valuation Example: Bond Component 1. Compute conversion price Conversion price = 1, 000 = $50 20 2. Value of the bond component • Annual coupon of 0.12 × 1, 000 = $120 • Discount rate: 14% Pbond = 20 X t=1 120 1, 000 + = $867.54 t (1 + 0.14) (1 + 0.14)20 • Debt component of convertible bond issue: 50, 000 × 867.54 = $43.4m Convertible Valuation Example: Option Component 3. Value of the option component • Convertible bond is issued at par: Pconvertible = $1, 000 • Straight bond value: Pbond = $867.54 Option value = 1, 000 − 867.54 = $132.46 • Option/equity component of convertible bond issue: 50, 000 × 132.46 = 6.6m 4. At maturity, should bondholders convert? • Bond value (50K contracts) at maturity: 50, 000 × 1, 120 = $56m (principal and final coupon) • Default occurs if Vfirm < $56m • Conversion decision at maturity: convert if conversion value is greater than bond value Convertible Debt Example: Conversion Decision Conversion decision at maturity • At maturity, each bondholder will convert only if the price of the stock after conversion (PAC ) is: PAC × 20 ≥ 1, 120 PAC ≥ $56 • If bondholders convert, 50, 000 × 20 = 1m new shares created • When PAC = $56, Vfirm = $56 × (5m + 1m) = $336m Convert when Vfirm ≥ $336m The End Modelling 1: Pay-off Diagrams Convertible Debt Example: Pay-off to Bondholders 1. Pay-off to convertible bondholders at maturity Payoff ($m) • If Vfirm < $56m, firm defaults, bondholders get the entire firm, so pay-off = Vfirm . • If $56m < Vfirm < $336m, then receive principal and interest. • If Vfirm ≥ $336m, bondholders convert and receive 1/6 of firm. Slope = 1/6 56 56 336 Value of firm ($m) Convertible Debt Example: Pay-off to Old Equity Holders 2. Pay-off to old equity holders at maturity Payoff ($m) • If Vfirm < $56m, default. Equity gets nothing. • If $56m < Vfirm < $336m, receive residual value of firm = Vfirm − 56m. • If Vfirm ≥ $336m, original equity holders retain 5/6 of the firm. 280 Slope = 5/6 56 336 Value of firm ($m) Convertible Debt Example: Stock Dilution • Suppose Vfirm = $336m at maturity. Then, post-conversion share price is 336m/(5m + 1m) = $56. • What if the bondholders choose not to convert? Vfirm − (Principal + Interest) × Contracts Shares 336m − (1, 000 + 120) × 50, 000 = 5m = $56 P= • So, there is no dilution at cut-off firm value of $336m. • At the cut-off, conversion is a fair trade (ie, NPV = 0). • Dilution occurs if firm value is strictly higher. The End Dilution and Optimal Conversion Dilution: Example • All-equity firm with a stock price of $50 • Nshares = 1m • Firm issues 7,500 zero-coupon convertible (face value $1,000) • Conversion ratio = 13.33 1. Conversion price? 1, 000 = $75 13.33 Dilution Example: Convert? 2. When is it optimal to convert as a function of firm value? • If bondholders convert, they get 7, 500 × 13.33 = 0.1m shares. • 0.1m shares represents 0.1/(1 + 0.1) = 9.09% of the post-conversion equity. • Convert if 9.09% of the firm is worth more than the debt component/payment: 9.09% × Vfirm > 7, 500 × 1, 000 Vfirm > 82.5m • You should verify that the share price at this cut-off is $75 with or without conversion (use the method in the previous exercise). Dilution Example: Dilution! 3. Suppose firm value is $90m. What is the share price with and without conversion? Why? • Without conversion (WoC): PWoC = Vfirm − D 90m − 7.5m = = $82.50 NWoC 1m • With conversion: PAC = Vfirm 90m = = $81.82 NWoC + NC 1.1m • The difference is due to dilution: 0.1m shares worth $81.82 sold to bondholders at $75. • Loss to old shareholders: (82.50 − 81.82) × 1m = $0.68m • Gain to debtholders: (81.82 − 75) × 0.1m = $0.68m Stock Dilution: Intuition • At the cut-off: Bondholders are indifferent between receiving the final bond payment vs converting; they receive an equal amount of value. • Above the cut-off: Bondholders make a profit. • Bondholders’ gain is a loss to existing equity holders. • Equity holders create more shares and sell them at lower than fair value. • This creates dilution. When Is Conversion Optimal? Recall (equity) options theory • Never exercise an American call on a non-dividend-paying stock early. • With dividends, exercise if dividend is the greater than the time premium (ie, option value minus intrinsic value). For convertible bonds • Stock may pay dividend but interest is similar to a negative dividend. • As long as interest payments are greater than dividend payments, conversion should be postponed. • Net dividend: Dividend − Interest • Time premium of convertible: mkt Pconvertible − max Vconversion , Vstraight • Exercise if net dividend greater than the time premium.
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