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6.5 Some Bond History and More Bond Features 193 present the coupon to the bond s trustee for payment. The trustee was typically a bank. After clipping all the coupons, only the corpus, or body of the bond, remained. The bondholder presented the corpus to the trustee at maturity for repayment of the principal. Whenever one owner sold the bond to the next, the price was a reflection of the current yield and the remaining or unclipped coupons and bond principal. When the owner wished to sell the bond prior to maturity, the new potential owner could verify all remaining coupon payments and principal by examining the attached coupons and the corpus. As a result, these bonds earned the name coupon bonds. One problem with bearer bonds is there is no registered owner s name printed on the bond; therefore, a financial institution could pay interest and principal to anyone tendering a bond certificate, regardless of the true owner. To avoid problems with stolen bonds, companies started registering the owners and making coupon payments and principal repayment based on the list of registered owners. If an owner wanted to sell his or her bond before maturity, the holder would need to notify the company of the change in ownership for future coupon payments. A second problem with bearer bonds is that the company might not be able to notify the bondholder of a significant event, such as the calling in of the bond prior to its maturity. With registered bonds, the company can communicate with bondholders because the company has the official list of owners. Today an indenture or deed of trust a written contract between the bond issuer and the bondholder specifies bond agreement details. Among other things, it spells out the terms of the bond, the number of bonds for issuance, a description of any collateral supporting the bond, any special repayment provisions or call options, and details of protective covenants. We now turn to a brief consideration of some of these important terms. Collateral or security of a bond refers to the assets that support the bond, should the bond issuer fail to make the obligated coupon payments or principal repayment. Collateral can be physical assets such as company inventories, equipment, or real property. Collateral can also be financial assets such as common stock in the company. The use of physical assets to back loans is very common. For example, if you purchase a car and secure a loan through a bank to purchase the car, the bank requires that you place the car (title to the car) as collateral against the loan. The bank secures a lien against the title and retains this lien until you fully repay the loan. If you fail to make your monthly car payments, the bank can repossess the car as payment against the loan. If you faithfully make your car payments, however, the bank cannot repossess the car. The same is true of corporate bonds with assets pledged as security for the payment of interest and principal. As long as the company faithfully makes the coupon payments and repays the principal on time, the bondholder has no entitlement to the collateral. If the company should default that is, fail on its promised payments the bondholder is entitled to possess the pledged collateral as payment for the bond. When you use real property as collateral, we call it a mortgaged security. We call unsecured bonds debentures, which simply means that the bondholder has no recourse against specific assets of the issuing company, should the company fail on its promised payments. The majority of bonds issued in the United States today are debenture bonds. When a company gets into financial difficulty and cannot pay its creditors, creditors line up in a predetermined order for repayment of their claims. Creditors at the front of the line are senior to creditors behind them in line. It is also true that companies can issue more than one set of bonds at different points in time. The oldest bonds are senior debt over the more recently issued
194 Chapter 6 Bonds and Bond Valuation junior debt, so those holding the oldest bonds are entitled to coupon payments and principal repayment ahead of those holding the more recent As of 1-Aug-2008 bonds. The final principal payment of a bond issue OVERVIEW can be a substantial cash outflow for a company. To Price (% of par): 103.96 meet this obligation, a company may have to build Coupon rate: 6.625% a fund over time to aid in the principal payment. Maturity date: 15-Oct-2034 We call this a sinking fund. The company makes Yield to call: 6.277% annual payments into the sinking fund, usually Current yield: 6.340% managed by a trustee, to ensure that the company can retire the bonds at maturity. A company can Fitch ratings: B use the sinking fund to buy back some of the bonds Coupon payment over time or to call in bonds early, or it can let the frequency: Semiannual bond owners hold them until bond maturity. The First coupon date: 15-Apr-1994 specific details of the sinking fund are detailed in Type: Corporate the indenture. Callable: Yes Within the indenture of the bond is a set of protective covenants. The covenants spell out both required and prohibited actions of the bond Figure 6.9 Pacific Bell issuer. The covenants usually protect the bondholder semiannual callable corporate against actions that the company might take that would diminish the value of the bond. bond. For example, the indenture might state that the company may not sell and lease back assets that it uses as collateral for a bond. A sale and leaseback would effectively remove the collateral from the bond because the title for the collateral would transfer to a new owner, leaving the bondholder with no recourse to the promised collateral in case of default. In general, protective covenants protect the bondholder and enhance the value of the bond, thus helping the company sell the bond at a higher price. Issuers may sell bonds with attached options. These options entitle either the bondholder or the company to specific future actions. One of the most common options is a call option. A callable bond, as we briefly mentioned earlier, allows the bond issuer to call in the bond prior to maturity at a predetermined price. A bond issuer exercises this option when interest rates are falling so that the institution can reissue the debt at a lower cost. Typically, the issuer cannot exercise the call option in the first few years of the bond, and the call price is usually a premium over the par value. The size of the premium falls as the bond approaches its natural maturity date. Let s look at a current bond for Pacific Bell (Fig. 6.9), which the company originally issued on October 15, 1993, as a callable bond with a forty-one-year maturity. After twenty years, Pacific Bell can call the bond. Thus, the bond could be called as early as October 15, 2013. In this instance, the bondholder must sell the bond to Pacific Bell at a preset price. The preset price at the first call date might be the principal of the bond plus one extra coupon payment. How does one price this callable bond? The yield to call now replaces the yield to maturity as the discount rate for the bond. In Pacific Bell s case, it is 6.277%. The cash flow is the promised cash flow at the first call date. If Pacific Bell calls the bond on October 15, 2013, and pays the par value plus one extra interest payment, we can determine the cash flow, which the time line in Figure 6.10 illustrates. Again, the coupon payment Pacific Bell
6.5 Some Bond History and More Bond Features 195 T 0 T 1 T 2 T 3 T 4... T 9 T 10 T 11 Figure 6.10 Pacific Bell callable bond cash flow. $33.125 $33.125 $33.125 $33.125... $33.125 $33.125 $33.125 $1,033.125 is the coupon rate times the par value divided by 2 to reflect the semiannual payment of coupons: coupon = $1,000 0.06625 2 = $33.125 As of today, August 1, 2008, there are eleven coupon payments and a final repayment of the par value plus an extra interest payment. The bond is priced to this call date of October 15, 2013, and has a yield to call of 6.277%. We will use a spreadsheet and the TVM keys on a calculator to price this bond on October 15, 2013: Mode: P>Y = 2 and C>Y = 2 Input 11 6.277? 33.125 1,033.125 Key N I/Y PV PMT FV CPT 1,039.56 B6 fx =PV(B1,B2,B3,B4,B5) Use the present value function to find the price of the bond. A B C D E 1 Rate 0.031385 2 Nper 11 3 Pmt $ 33.125 4 Fv $1,033.125 5 Type 0 6 Pv ($1,039.56) The preset call price on a bond erodes as the callable bond approaches its maturity date. The extra premium for the early call will eventually fall to zero on October 15, 2034. The owner is not sure exactly when the issuer might call the bond, if at all, so pricing a callable bond is more difficult than pricing other bonds. It is prudent to assume the issuer will call the bond at the first available date and the bond s price will be the price with a maturity at the first call date. Two other options that the issuer might attach for the bondholder are put and conversion options. A putable bond gives the bondholder the right to sell the bond back to the company at a predetermined price prior to maturity. In effect, it is the reverse of a callable bond, and the bondholder would choose to exercise this right to sell when interest rates are rising. A convertible bond gives the bondholder the right to swap the bond for another asset. Common stock in the company is typical. A preset conversion ratio exists for the bond such that the bondholder will receive a stated number of shares of common stock for each bond one redeems.
196 Chapter 6 Bonds and Bond Valuation These options are valuable and have an effect on the bond s price. If the company holds the option a callable bond the bond s price is lower than an otherwise equal bond without this call option attached. If the bondholder holds the option a putable bond the bond s price is higher than an otherwise equal bond without this option. Pricing putable or convertible bonds is beyond the scope of this textbook, but note that we add the put s price or conversion option s price to the straight bond price. A bond issuer cannot take away options from the option holder, but it could force the bondholder to exercise the outstanding option. For example, if a bond is both callable by the bond issuer and convertible by the bondholder, the issuer could call in the bond and force the bondholder to either sell the bond at the call price or convert it to common shares. Although we have dealt only with fixed coupon rates, one feature that can change is the bond s coupon rate. If we allow this rate to change over time, the bond becomes a floating-rate bond. A floating-rate bond s annual interest rate adjusts based on a benchmark rate such as the prime rate. The prime rate is the rate that banks charge their best customers for money. When the prime rate increases, the bond s coupon rate and payment also increase. When the prime rate falls, the bond s coupon rate and coupon payment also falls. We can also tie the payment schedule and coupon amount to a company s income. We call these types of bonds income bonds. Income bonds pay coupons based on the company s income. During periods of low income, the company reduces or eliminates coupon payments, which reduces the probability of default on an income bond, but also reduces its attractiveness. The more creative the issuer gets with the bond s features, the more exotic the bond. In general, exotic bonds are bonds with special features distinct to that particular bond. For example, you could buy a bond in one currency, U.S. dollars, but receive your coupons and principal in euros. However, the more creative the issuer gets, the more difficult it is to price the bond and the harder it is to sell it. With these special features, the bond attracts fewer potential buyers and is less liquid. You may not be an expert in bonds yet, but you should now be proficient at pricing standard bonds with their promised set of future cash payments. We will leave these creative features of bonds for another finance class. 6.6 U.s. government bonds Both Treasury notes and Treasury bonds are semiannual bonds. Their only difference is the maturity or age of the financial asset. The U.S. government issues Treasury notes with maturities of between two years and ten years. It issues Treasury bonds with maturities of more than ten years. The Treasury bill is a short-term borrowing instrument with a maturity of less than one year. The Treasury issues one-month (four-week), three-month (thirteen-week), six-month (twenty-six-week), and one-year (fifty-two-week) Treasury bills. In addition to having shorter maturities than the notes and bonds, the Treasury bills are zero-coupon instruments in that they pay both the principal and the interest at maturity. There are also state bonds, issued by individual state governments, and municipal bonds (sometimes called munis), issued by county, city, or local government agencies. To see municipal bonds at work in a job setting, read the Putting Finance to Work feature in this chapter. In addition, foreign corporations and governments issue foreign bonds.
6.6 U.S. Government Bonds 197 putting Finance to WOrk Municipal Manager Whether you hail from a big city or a small town, you know that the financing of large capital projects is important to the smooth running of the community. There are schools, police stations, and libraries to renovate or build. The upkeep of water supplies and sewer systems and the paving and repair of roads can carry steep price tags. Current tax revenues cannot finance these items, and the availability of grants from the state or federal government is unpredictable. Enter the municipal manager, whose job is not unlike that of a corporate CFO. Among their many financial responsibilities, these managers need to raise funds, and one of the chief ways they do it is to sell bonds. Fortunately, municipalities have relatively easy access to capital markets. They cannot sell stock, of course, but even small and medium-size communities have better access to the bond markets than similar-sized corporations. High-income investors like to purchase municipal bonds and notes because the interest is often but not always exempt from federal, state, and city income taxes. The tax exemption means that the community can issue municipal bonds at lower coupon rates, yet still offer a higher after-tax yield than corporate bonds. When they need to issue bonds, municipal managers face the same rating system that corporations face. To be marketable, one or more of the major rating agencies Standard & Poor s, Moody s, or Fitch must rate the bonds. To obtain a good rating, communities must have their fiscal house in order, which means adequate capacity to raise revenues through taxes, balanced budgets, manageable existing debt, stable population, and a qualified financial team. In addition, agencies can downgrade municipal bonds in status just as they do corporate bonds. For example, in 2009, in the face of a declining local economy and a $300 million budget deficit, Moody s and Standard & Poor s lowered Detroit s rating to junk bond status. Municipal managers must decide whether to issue general obligation bonds, backed only by tax revenues; revenue bonds, which pay interest from some revenue source such as water and sewer fees; or mortgage bonds, secured by buildings or other assets. Then there is the marketing challenge: sewers and city streets are not as glamorous compared with most corporate assets. A good understanding of bonds and debt markets is a must to become a municipal manager, whether in a big city or a small town. Salaries for municipal managers may not equal those in much of the corporate world, but most have comfortable incomes and excellent benefit packages. The knowledge, experience, and political contacts that these managers acquire in their positions can result in lucrative opportunities to move to the private sector, especially to banks, insurance companies, construction companies, and consulting firms that do business with municipal governments. Pricing a U.S. Government Note or Bond Suppose the U.S. government has announced that it intends to raise funds by selling a seven-year Treasury note with a 6% coupon rate with a par value of $100,000. Let s assume you want to buy one of these notes and want to earn 8% on it over the coming seven years. What price should you pay? The same process applies here as with a corporate bond. The first step is to set up the cash flow from the note and then discount these future cash payments at the appropriate discount rate. The semiannual coupon payments are coupon payments = $100,000 0.06 2 Figure 6.11 depicts the timing of the cash flow. = $3,000