Bondholders interests

It is common practice to link management s salary to the corporation s success. Stock options are an example. This increases the management focus on measures for raising the stock price, while bondholders interests are of secondary importance. Linking management s salary to the company s rating could counter this problem. 

After a bond is issued bondholders can do little to counter management s activities contrary to their interests. One possibility to commit management to bondholders interests is to include covenants in the bonds indentures. A covenant may restrain certain actions (e.g., forbid to sell part of the assets ). Covenants intend to protect investors from objectionable actions, e.g., a debt financed takeover of another company. 

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. 

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. ... 

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. 

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. 

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... 

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. 

In all major bond markets the convention is to quote price as a clean price. This is the price of the bond as given by the present value of its cash flows, but excluding coupon interest that has accrued on the bond since the last dividend payment. As all bonds accrne interest on a daily basis, even if a bond is held for only one day, interest will have been earned by the bondholder. However, we have referred already to a bond s all-in price, which is the price that is actually paid for the bond in the market. This is also known as the dirty price (or gross price), which is the clean price of a bond plus accrued interest. In other words, the accrued interest must be added to the quoted price to get the total consideration for the bond. 

As noted, a bond may contain an embedded option which permits the issuer to call or retire all or part of the issue before the maturity date. The bondholder, in effect, is the writer of the call option. From the bondholder s perspective, there are three disadvantages of the embedded call option. First, relative to bond that is option-free, the call option introduces uncertainty into the cash flow pattern. Second, since the issuer is more likely to call the bond when interest rates have fallen, if the bond is called, then the bondholder must reinvest the proceeds received at the lower interest rates. Third, a callable bond s upside potential is reduced because the bond price will not rise above the price at which the issuer can call the bond. Collectively, these three disadvantages are referred to as call risk. MBS and ABS that are securitized by loans where the borrower has the option to prepay are exposed to similar risks. This is called prepayment risk, which is discussed in Chapter 11. 

Clearly, the interest group of bond creditors has become more and more important. Bondholder value has gained prominence in the capital markets. 

This chapter defines the term bondholder value and contrasts it with shareholder value. In a second step, the different viewpoints of shareholders and bondholders are examined respectively. The discussion of both parties conflicts of interests concentrates on capital structure, share buybacks, dividend policy, and corporate strategy. As there are also similarities between shareholders and bondholders, instruments of the shareholder value concept that can be used to create bondholder value are described. That includes investor relations, risk management and the balanced scorecard. 

The most reasonable way to measure bondholder value appears to look at the spread versus government bonds financial markets process information in a fast and anticipative way. Additionally, considering the spread to an index or benchmark bond representing the sector of the corporation allows to largely eliminate sector specific and general interest market related factors. 

Conflicts of interest between shareholders and bondholders often relate to capital structure, share buybacks or dividend policy, and strategy. This section discusses these items. 

A conclusion is that the question of an optimal capital structure cannot be answered generally. Although high gearing neither serves the interest of shareholders (higher volatility of returns) nor bondholders (equity is a risk cushion), empirical data indicate that focussing on shareholder value comes at the expense of bondholders. 

A share buyback can be an advantage for bondholders, if a low stock price is lifted, thus reducing the danger of a takeover and a change of management. A stock buyback lowers future dividend payments. This may be advantageous for bondholders if there are, for example, high dividends on preferred stock which are de facto paid independently of the economic situation and thereby have the character of a fixed interest rate. Sometimes a share buyback can turn out to be more pleasant than invest-... 

The example in the preceding section showed that shareholders earn the residual income after satisfying the fixed claims of the bondholders. Creditors only want to cover their interest claims and avoid risky investments. From the shareholders perspective, risky investments promising high returns conform with their interests, because shareholders and not bondholders decide on further employment of management. Thus management will decide in favor of shareholders. Bondholders bear a similar risk but are excluded from participation in the growth of the company s value. 

Takeovers do not automatically come at bondholders expense if an acquisition secures and enhances the own market position or opens up new business areas, bondholders profit as well. Only a competitive company can generate the cash flows necessary to pay interest and principal. If an acquisition is cautiously financed (e.g., neutral with respect to debt ratios) or the issuer is bought by another company with a higher rating, bondholders will also benefit. ... 

The company s success not only has to be achieved, but has to be communicated to investors to have an impact on the company s securities prices. Communication is the central task of investor relations (IR). Many companies are aware of its significance and set up IR departments. Essential is the timely, regular, and transparent presentation of the company which is of interest to shareholders and bondholders Market participants have to understand how the company works. And the company should know about investors interests. 

Again motivated by their diverging interests, shareholders favor riskier investments. This includes for example debt financed acquisitions of other companies that squeeze up gearing. The increased risk is mirrored in higher financing costs of the issuer when capital markets are tapped again. Over the longer term shareholder value sinks, too. Acquisitions to keep the issuer competitive are equally of interest for bondholders. However, they should be cautiously financed. 

The last step in this process is to find the bond s value without accrued interest (called the clean price or simply price). To do this, the accrued interest must be computed. The first step is to determine the number of days in the accrued interest period (i.e., the number of days between the last coupon payment date and the settlement date) using the appropriate day count convention. For ease of exposition, we will assume in the example that follows that the actual/actual calendar is used. We will also assume there are only two bondholders in a given coupon period— the buyer and the seller. 

Once we know the full price and the accrued interest, we can determine the clean price. The clean price is the price that quoted in the market and represents the bond s value to the new bondholder. The clean price is computed as follows... 

Negative pledges. Negative pledges are common. They prohibit an issuer from creating security interests on its assets, unless all bondholders receive the same level of security. 

The original form of this call pricing mechanism was the Spens clause, which required the issuer to call in the bonds at an above-market price if certain events detrimental to the interests of the bondholders took place. Following a decision by the International Primary Markets Association (IPMA) in July 2001, the market convention is that the Spens clause is no longer used, although it remains in many ontstanding issues. Instead, the market now uses a formula to calculate the redemption yield of a bond in the event it is called prior to maturity. This is set out in the UK Debt Management Office (DMO) paper dated 8 June 1998. 

Covered bondholders, in the event of issner insolvency and provided that the covering assets continue to meet regulator requirements, will still receive interest and principal payments according to the contractual dates (with the exception of Spain). However, certain credit events such as deterioration in the quality of the underlying assets for example, would trigger the acceleration of ABS/MBS payments. 

In the event of a default, there will be no payment of accrued interest by the issuer since generally coupons are not recoverable, so we can ignore that aspect of the valnation. The only component left to the bond is its value upon a default or its recovery value. If a default occurs, the bondholder will lose all future cash flows of the instrument (i.e., they are at risk), but will be left with a nonperforming asset worth R. The same technique is used here as in the default swap—except this time the payout is R rather than 1 - R upon default. Conveniently, this formula is identical to equation (22.11), except that the term (1 - R) is replaced by R. 

From the investors point of view, it is important that an issuer should not be obliged by the law of its home jurisdiction to withhold tax on payments of interest to bondholders. Within Europe, there are many countries that benefit from double tax treaties which mean no income in the form of interest payments is subject to withholding tax. However, some treaties do impose a small levy. 

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