FIN 684 Fixed-Income Analysis Corporate Debt Securities

Transcription

1 FIN 684 Fixed-Income Analysis Corporate Debt Securities Professor Robert B.H. Hauswald Kogod School of Business, AU 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 2/22/2016 Corporate Debt Robert B.H. Hauswald 2

2 Corporate Funding 2/22/2016 Corporate Debt Robert B.H. Hauswald 3 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. 2/22/2016 Corporate Debt Robert B.H. Hauswald 4

3 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 2/22/2016 Corporate Debt Robert B.H. Hauswald 5 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 2/22/2016 Corporate Debt Robert B.H. Hauswald 6

4 Commercial Paper Rates 2/22/2016 Corporate Debt Robert B.H. Hauswald 7 Commercial Paper Volume 2/22/2016 Corporate Debt Robert B.H. Hauswald 8

5 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 2/22/2016 Corporate Debt Robert B.H. Hauswald 9 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! 2/22/2016 Corporate Debt Robert B.H. Hauswald 10

6 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. 2/22/2016 Corporate Debt Robert B.H. Hauswald 11 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. 2/22/2016 Corporate Debt Robert B.H. Hauswald 12

7 Corporate Bonds 2/22/2016 Corporate Debt Robert B.H. Hauswald 13 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 bonds are secured with a property lien. Collateral trust bonds are debt secured with financial collateral. Equipment trust certificates are shares in a trust with income from a lease contract 2/22/2016 Corporate Debt Robert B.H. Hauswald 14

8 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 summary provided in the prospectus of 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 the Act is available at the SEC website: 2/22/2016 Corporate Debt Robert B.H. Hauswald 15 Protective Covenants A bond indenture is likely to contain a number of protective covenants. Protective Covenants are 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. 2/22/2016 Corporate Debt Robert B.H. Hauswald 16

9 Attributes of Corporate Bonds Registered Bonds Restrictive Covenants Call and repayment provisions Higher yield Sinking fund Interest of the stockholders Alternative opportunities Conversion 2/22/2016 Corporate Debt Robert B.H. Hauswald 17 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 2/22/2016 Corporate Debt Robert B.H. Hauswald 18

10 Call and Put Provisions A call provision allows 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 provision can be sold back to the issuer at a pre-specified price (normally set at par) on any of a sequence of pre-specified dates. bonds with put provisions are often called extendible bonds. 2/22/2016 Corporate Debt Robert B.H. Hauswald 19 price Call vs. Put Option: Yields? Negative convexity area non-callable callable yield Callable bond = noncallable call option price 2/22/2016 Corporate Debt Robert B.H. Hauswald 20

11 Convertibles Convertible bonds are 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). 2/22/2016 Corporate Debt Robert B.H. Hauswald 21 Maturity Term bonds are issued with a single maturity date, while serial bonds are 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. 2/22/2016 Corporate Debt Robert B.H. Hauswald 22

12 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 provide official prices: purpose? 2/22/2016 Corporate Debt Robert B.H. Hauswald 23 NYSE Bonds Quote 2/22/2016 Corporate Debt Robert B.H. Hauswald 24

13 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. 2/22/2016 Corporate Debt Robert B.H. Hauswald 25 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

14 How Does S&P Determine Ratings 2/22/2016 Corporate Debt Robert B.H. Hauswald 27 Ratings Distribution Corporate & Financial Institution as at 18 Aug FI Crop AAA AA A BBB BB B CCC CC D SD

15 Default Rates by Industry Consumer/Serv ice Leisure/Media Transport Aerospace/Auto/Cap Goods/Metal Forest/Builders Energy /Resources Telecom Health/Chemicals Tech/Computers/Office Equip Average Fin'l Institutions Utilities Insurance/Real estate S&P Default rates by industry: % 5.0% 10.0% 15.0% 20.0% 25.0% 2/22/2016 Corporate Debt Robert B.H. Hauswald 29 Market vs. Credit Returns Typical credit returns Frequency Typical market returns Source: CIBC Portfolio Value Comparison of the distributions of credit returns and market returns 2/22/2016 Corporate Debt Robert B.H. Hauswald 30

16 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%) greater than 5-year U.S. Treasury notes. 2/22/2016 Corporate Debt Robert B.H. Hauswald 31 Corporates vs. UST: Credit Spreads y zero Corporate A yield curve UST yield curve Time to maturity 0 3m 6m 1yr 3yr 5yr 10yr 30yr 2/22/2016 Corporate Debt Robert B.H. Hauswald 32

17 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 Allows for differences in cash flow characteristics 2/22/2016 Corporate Debt Robert B.H. Hauswald EU Credit Spreads: A and BBB over AAA Corporate Default Peak WTC Attack Nasdaq Collapse Triple-B Spread Over Triple-A Launch of ECL Single-A Spread Over Triple-A 0 Apr-98 May-98 Jul-98 Sep-98 Nov-98 Jan-99 Mar-99 Apr-99 Jun-99 Aug-99 Oct-99 Dec-99 Feb-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01 Feb-01 Apr-01 Jun-01 Aug-01 Oct-01 Dec-01 Jan-02 Mar-02 May-02 Jul-02 Sep-02 Nov-02 Jan-03 Feb-03 Apr-03 Jun-03 Aug-03 Oct-03 Dec-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Dec-04 Feb-05 Apr-05 Jun-05 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. 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 years (modified duration at inception years). ER30 Index consists of 567 issues. Current modified duration of years (modified duration at inception years). ER40 Index consists of 323 issues. Current modified duration of years (modified duration at inception 2.63 years). 2/22/2016 Corporate Debt Robert B.H. Hauswald 34

18 US Credit Spreads Source: Goldman Sachs. 2/22/2016 Corporate Debt Robert B.H. Hauswald 35 Benchmark: UST The benchmark is the Treasury term structure Term Structure 9.00% 8.50% 8.00% 7.50% 7.00% 6.50% 6.00% 5.50% 5.00% Term to Maturity 2/22/2016 Corporate Debt Robert B.H. Hauswald 36

19 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) ) t 2/22/2016 Corporate Debt Robert B.H. Hauswald 37 Static Spread Analysis The benchmark is the Treasury term structure. Term Spot Yield Zero Price Here s an example t R(0,t) B(0,t) % $ % $ % $ % $ % $ % $ % $ % $ % $ % $ % $ % $ % $ % $ % $ /22/2016 Corporate Debt Robert B.H. Hauswald 38

20 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 % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ Theoretical price $ /22/2016 Corporate Debt Robert B.H. Hauswald 39 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 for this bond, which implies a price differential of $ per $100 of face value. 2/22/2016 Corporate Debt Robert B.H. Hauswald 40

21 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 1 B (0,t) = ( 1+ R(0,t) + s) t 2/22/2016 Corporate Debt Robert B.H. Hauswald 41 Junk-Bond Pricing For example: In this case, the bond is priced at a 682 bp static spread (over the Treasury term structure) 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 % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ % $ $ $ Theoretical price $ Price spread $ /22/2016 Corporate Debt Robert B.H. Hauswald 42

22 Reuters Corporate Spreads for Banks 3/1/2006 Dynamic Spread Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr Aaa/AAA Aa1/AA Aa2/AA Aa3/AA A1/A A2/A A3/A Baa1/BBB Baa2/BBB Baa3/BBB Ba1/BB Ba2/BB Ba3/BB B1/B B2/B B3/B Caa/CCC UST Yield /22/2016 Corporate Debt Robert B.H. Hauswald 43 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 2/22/2016 Corporate Debt Robert B.H. Hauswald 44

23 Corporate Bond Interest Rates 2/22/2016 Corporate Debt Robert B.H. Hauswald 45 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. 2/22/2016 Corporate Debt Robert B.H. Hauswald 46

24 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 Annaert & DeCeuster (1999) 2/22/2016 Corporate Debt Robert B.H. Hauswald 47 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 2/22/2016 Corporate Debt Robert B.H. Hauswald 48

25 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 Return on equity 2/22/2016 Corporate Debt Robert B.H. Hauswald 49 12% Moody s Speculative-Grade Default Rate Forecast 10% 8% Actual 2005 Forecast Average 6% 4% 2% 0% Jan-98 Mar-98 May-98 Jul-98 Sep-98 Nov-98 Jan-99 Mar-99 May-99 Jul-99 Sep-99 Nov-99 Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 Jul-02 Sep-02 Nov-02 Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 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 Source: Moody s Monthly Default Report April 2005, 5 European speculative grade th May default rate at 1.7% in April 2005 versus 2.1% in April /22/2016 Corporate Debt Robert B.H. Hauswald 50

26 Moody s default rate forecasting model 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) Corporate Debt Robert B.H. Hauswald 51 Default rates Whither currently sending mixed default signals about rates? 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 Corporate Debt Robert B.H. Hauswald 52

27 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 2006 spec-grade default rate forecast Model: 3.0% Historical Average High: 4.5% Low: 1.6% Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03 Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 Corporate Debt Robert B.H. Hauswald 53 Forecast 2006 default & recovery rate 70% outlook Default Rate Recovery Rate Point 3.0% 45.9% Low 1.6% 50.4% High 4.5% 41.3% Average Recovery Rate 60% 50% 40% 30% 20% 10% y = e x R 2 = % 0% 2% 4% 6% 8% 10% 12% Annual Default Rate Corporate Debt Robert B.H. Hauswald 54

28 $ Merton (1974) Model firm equity debt D V 2/22/2016 Corporate Debt Robert B.H. Hauswald 55 Ratings Counts

29 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 different rating category. Default Rates Default rates are given on a marginal and cumulative basis. Cumulative Annual Default Rates

30 Average Cumulative15-Year Default Rates (%) AAA AA A BBB BB B CCC Source: Standard & Poor s Average Cumulative15-Year Default Rates (%): Investment vs. Speculative Investment Grade Specualtive Grade /22/2016 Corporate Debt Robert B.H. Hauswald 60

31 Recovery Rates