Bondholders

A financial analyst looking at a company from a potential common stockholders point of view is hkely to classify preferred stock as debt. In contrast, bondholders and general creditors are likely to regard preferred stock as additional eqmty. Since preferred stock is a hybrid type of security, it may be issued by a company whose management is divided over the question of whether to use equity or debt to finance additional assets. However, preferred stock does have the disadvantage that the dividends are not allowed as a tax-deductible expense. 

If Ihe assets for the company whose balance sheet is given in Table 10-13 can only be sold at half their listed value, then after all the current liabilities and bonds have been paid off, there would be nothing left for the stockholders. In fact, some of the bondholders might not be totally reimbursed, since it would cost something to liquidate the company s assets. This company could not get a loan at prime interest rates. It would have a better chance of getting a good interest rate if its balance sheet resembled that given in Table 10-14. 

Bond A long-term debt-type of security generally issued by corporations or governments to generate cash. The coupon rate is the interest rate paid to the bondholder. The maturity date is when the face value of the bond will be paid to the bondholder. 

A bond is simply a long-term promissory note. It is a contract established between borrower and lender in a document called an indenture. A bond indenture includes a detailed description of assets that are pledged, together with any protective clauses and provisions for redemption. A trustee is appointed to look after the interest of the bondholders. The trustee is normally a commercial bank. Bonds may be issued with a call provision that enables a company to redeem its bonds at any date earlier than scheduled. Obviously, this would be an advantage to a company in times of falling interest rates. However, a company has to pay more than the par value of the bond for this privilege. The additional amount is called the bond premium. 

Capital structure is concerned with the ratio of borrowed capital to owner s equity. When inflation is low and the economy is stable, it is frequently cheaper to use borrowed money, if a company can secure lenders. However, a highly leveraged company—that is, one with a high debt-to-equity ratio—faces downside risk when business is bad. Stockholders receive high dividends when profits are good but bondholders expect the interest and principal to be paid on time, with the threat to a firm of insolvency and bankruptcy. Section 8.4.3 shows the effect of debt-to-equity ratio on company operations. Financial officers of companies are concerned with the optimum debt-to-equity ratio. 

Equity is only one kind of capital that companies raise. Debt financing is also used, and the cost of debt capital is generally lower than the cost of equity capital, because bondholders must be paid before stockholders are paid dividends.6 The weighted average cost of capital, r, is the blended cost of the firm s debt and equity capital (285,409) ... 

Financing charges. A company generating electricity that pays out Z dollars for fuel-cycle costs f years before it receives revenue from generation of electricity from that fuel must pay to the bondholders and stockholders who advanced the funds for the fuel the return they require on their investment, and must also pay income taxes to the government on the profits from which the stockholders return is obtained. It is possible to represent all of these financing charges as the product yZt, where y is known as the atmual cost of money before income taxes. For a privately owned U.S. electric company, a value of / = 0.151 per year is representative. 

Bonds trading above or below par Bonds that trade away from the par will affect the basis. In our example both bonds trade at premium, so, decreasing the loss in the case of default suffered by the protection seller in respect to one of the cash bondholder. This pushes down the basis. 

In a deflationary environment a conventional bond performs very well, while an inflation-linked bond gives negative returns. Some of inflation-linked bonds include deflation protection.In practice, in the event of deflation, the bondholder will receive at maturity the par value although the redemption value is less than 100. Therefore, the bondholder will obtain at least the par value. Note that the deflation floor applies to the redemption value only leaving coupon payments exposed to the deflation risk. 

Asset-swap spread It is determined by combining an interest-rate swap and cash bond. Generally, bonds pay fixed coupons therefore, it will be combined with an interest-rate swap in which the bondholder pays fixed coupons and receives floating coupons. The spread of the floating coupon over an interbank rate is the asset-swap spread. ... 

At the heart of the Merton s assumptions, equity holders have an embedded put option by which if at maturity the firm value is greater than promised obligation ox face value, the lender gets back the bond s amount and shareholder maintains the ownership of the company otherwise, if the firm value is lower than the promised payment, the bondholders receive an amount less than bond s face value and the firm defaults. Therefore, in the case of high-put option value, shareholders will have an advantage to walk away from the loan payment, leaving the asset value to the bondholders. 

Putting the strike price equal to the promised payment F, when the firm value is greater than that amount, the value of the option is 0 and the debt holder will receive the face value conversely, the value of debt at maturity is lower than face value and the option has value. In the second case, the bondholders receive a payment value equal to the firm value and shareholders get nothing. 

This equation can also be defined in terms of yield spread that reflects the yield premium required by a bondholder above the risk-free rate. The credit spread is given by Equation (8.17) ... 

First, the safety covenants that allow bondholders to force the firm into bankruptcy if the firm falls to a specified level. The level is given by Equation (8.19) ... 

At heart of the model, one of the main assumptions is that if the reorganization occurs the bondholder receives 1 w, where w is the percentage... 

In this chapter we present a discussion on convertible bonds, which have become popular hybrid financial instruments. Convertible bonds are financial instmments that give the bondholders the right, without imposing an obligation, to convert the bond into underlying security, usually common stocks, under conditions illustrate in the indenture at the time of issue. The hybrid characteristic defines the traditional valuation approach as the sum of two components the option-free bond and an embedded option (call option). The option element makes the valuation not easy, above all in pricing term sheets with specific contract clauses as the inclusion of soft calls, put options and reset features. The chapter shows practical examples of valuation in which financial advisors and investment banks adopts in different contexts. 

The main reason for a borrower to issue cmivertibles is the lower cost of financing than other financial instruments. In fact, the implied equity option feature allows the issuer to pay lower market coupons than a cmiventional bond. This is because the right of cmiversion is hold by the bondholder. In a different case, for instance with a callable issue, the coupons will be greater than a convertible... 

The put option gives at the bondholder the right, but not the obligation to redeem the convertible bond to the issuer at the price defined in the indenture, hi this case, the value of the convertible bond is greater (the yield is lower) than the one without embedded put option. Usually, the issuer is required to redeem the convertible bond for cash, shares or both elements. 

The reverse convertible bonds have increased popularity in Europe and United States. This type of instrument gives to the issuer (not the bondholder) at maturity the right to exchange the bond into shares or to redeem it at par value plus accrued interests. In the first case, the bond is exchanged if the share price is less than conversion price, or if the conversion value is less than par value. Conversely, the issuer can redeem the bond. They typically have a domestic stock as underlying security, but they can also include foreign shares and indexes. 

Therefore, theta measures the time decay of an option. Eor a bondholder, when the convertible approaches to maturity the option element tends to decrease its value decreasing theta value. 

In contrast, for putable bonds, the right to exercise the option is held by the bondholder. In fact, putable bonds allow the bondholder to sell the bond back before maturity. Conversely to callable bonds, this happens when interest rates go up (risk-free rate increases, or the issuer s credit quality decreases). In fact, the bondholders may have the advantage to sell the bond and buy another one with higher coupon payments. 

The pricing of putable bonds is performed with the same methodology exposed before. As introduced, putable bonds give the bondholder the right to seU the bond back before maturity. This is usually done if the interest rates go up. 

The different types of bonds in the European market reflect the different types of issuers and their respective requirements. Some bonds are safer investments than others. The advantage of bonds to an investor is that they represent a fixed source of current income, with an assurance of repayment of the loan on maturity. Bonds issued by developed country governments are deemed to be guaranteed investments in that the final repayment is virtually certain. For a corporate bond, in the event of default of the issuing entity, bondholders rank above shareholders for compensation payments. There is lower risk associated with bonds compared to shares as an investment, and therefore almost invariably a lower return in the long term. 

As noted, the coupon rate is the interest rate the issuer agrees to pay each year. The coupon rate is used to determine the annual coupon payment which can be delivered to the bondholder once per year or in two or more equal installments. As noted, for bonds issued in European bond markets and the Eurobond markets, coupon payments are made annually. Conversely, in the United Kingdom, United States, and Japan, the usual practice is for the issuer to pay the coupon in two semiannual installments. An important exception is structured products (e.g., asset-backed securities) which often deliver cash flows more frequently (e.g., quarterly, monthly). 

Some bonds include a provision in their offer particulars that gives either the bondholder and/or the issuer an option to enforce early redemption of the bond. The most common type of option embedded in a bond is a call feature. A call provision grants the issuer the right to redeem all or part of the debt before the specified maturity date. An issuing company may wish to include such a feature as it allows it to replace an old bond issue with a lower coupon rate issue if interest rates in the market have declined. As a call feature allows the issuer to change the maturity date of a bond it is considered harmful to the bondholder s interests therefore the market price of the bond at any time will reflect this. A call option is included in all asset-backed securities based on mortgages, for obvious reasons. 

A bond issue may also include a provision that allows the investor to change the maturity of the bond. This is known as a put feature and gives the bondholder the right to sell the bond back to the issuer at par on specified dates. The advantage to the bondholder is that if interest... 

A convertible bond is an issue giving the bondholder the right to exchange the bond for a specified amount of shares (equity) in the issuing company. This feature allows the investor to take advantage of favourable movements in the price of the issuer s shares. Exhibit 1.7 shows a Bloomberg Security Description screen of a convertible bond issued by Siemens Finance BV that matures in June 2010. This bond is convertible into 1,780.37 shares as can be seen in the upper left-hand corner of the screen in the box labeled Convertible Information. ... 

The interest rate that is used to discount a bond s cash flows (therefore called the discount rate) is the rate required by the bondholder. It is therefore known as the bond s yield. The required yield for any bond will depend on a number of political and economic factors, including what yield is being earned by other bonds of the same class. Yield is always quoted as an annualised interest rate. 

---