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318 Part THREE Debt Securities


Much of the credit for this innovation is given to Drexel Burnham Lambert, and especially
its trader, Michael Milken. Drexel had long enjoyed a niche as a junk bond trader and had
established a network of potential investors in junk bonds. Firms not able to muster an invest-
ment grade rating were happy to have Drexel (and other investment bankers) market their
bonds directly to the public, as this opened up a new source of financing. Junk issues were a
lower-cost financing alternative than borrowing from banks.
High-yield bonds gained considerable notoriety in the 1980s when they were used as fi-
nancing vehicles in leveraged buyouts and hostile takeover attempts. Shortly thereafter, how-
ever, the legal difficulties of Drexel and Michael Milken in connection with Wall Street™s
insider trading scandals of the late 1980s tainted the junk bond market.
At the height of Drexel™s difficulties, the high-yield bond market nearly dried up. Since
then, the market has rebounded dramatically. However, it is worth noting that the average
credit quality of high-yield debt issued today is higher than the average quality in the boom
years of the 1980s.

Determinants of Bond Safety
Bond rating agencies base their quality ratings largely on an analysis of the level and trend of
some of the issuer™s financial ratios. The key ratios used to evaluate safety are:
1. Coverage ratios. Ratios of company earnings to fixed costs. For example, the times-
interest-earned ratio is the ratio of earnings before interest payments and taxes to interest
obligations. The fixed-charge coverage ratio adds lease payments and sinking fund
payments to interest obligations to arrive at the ratio of earnings to all fixed cash
obligations. Low or falling coverage ratios signal possible cash flow difficulties.
2. Leverage ratio. Debt-to-equity ratio. A too-high leverage ratio indicates excessive
indebtedness, signaling the possibility the firm will be unable to earn enough to satisfy
the obligations on its bonds.
3. Liquidity ratios. The two common liquidity ratios are the current ratio (current
assets/current liabilities) and the quick ratio (current assets excluding inventories/current
liabilities). These ratios measure the firm™s ability to pay bills coming due with cash
currently being collected.
4. Profitability ratios. Measures of rates of return on assets or equity. Profitability ratios are
indicators of a firm™s overall financial health. The return on assets (earnings before
interest and taxes divided by total assets) is the most popular of these measures. Firms
with higher return on assets should be better able to raise money in security markets
because they offer prospects for better returns on the firm™s investments.
5. Cash flow-to-debt ratio. This is the ratio of total cash flow to outstanding debt.
Standard & Poor™s periodically computes median values of selected ratios for firms in sev-
eral rating classes, which we present in Table 9.3. Of course, ratios must be evaluated in the
context of industry standards, and analysts differ in the weights they place on particular ratios.
Nevertheless, Table 9.3 demonstrates the tendency of ratios to improve along with the firm™s
rating class.


Bond Indentures
indenture
The document In addition to specifying a payment schedule, the bond indenture, which is the contract be-
defining the contract
tween the issuer and the bondholder, also specifies a set of restrictions on the issuer to protect
between the bond
the rights of the bondholders. Such restrictions include provisions relating to collateral, sink-
issuer and the
ing funds, dividend policy, and further borrowing. The issuing firm agrees to these so-called
bondholder.
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




319
9 Bond Prices and Yields


U.S. Industrial Long-Term Debt,
TA B L E 9.3 Three-Year (1997 to 1999) Medians AAA AA A BBB BB B
Financial ratios by
EBIT interest coverage ratio 17.5 10.8 6.8 3.9 2.3 1.0
rating class
EBITDA interest coverage ratio 21.8 14.6 9.6 6.1 3.8 2.0
Funds flow/total debt (%) 105.8 55.8 46.1 30.5 19.2 9.4
Free operating cash flow/total debt (%) 55.4 24.6 15.6 6.6 1.9 (4.6)
Return on capital (%) 28.2 22.9 19.9 14.0 11.7 7.2
Operating income/sales (%) 29.2 21.3 18.3 15.3 15.4 11.2
Long-term debt/capital (incl. STD) (%) 15.2 26.4 32.5 41.0 55.8 70.7
Total debt/capital (incl. STD) (%) 26.9 35.6 40.1 47.4 61.3 74.6

EBIT”Earnings before interest and taxes.
EBITDA”Earnings before interest, taxes, depreciation, and amortization.
STD”Short-term debt
Source: www.standardandpoors.com/ResourceCenter/CorporateFinance, December 2000.


protective covenants in order to market its bonds to investors concerned about the safety of the
bond issue.

Sinking funds Bonds call for the payment of par value at the end of the bond™s life. This
payment constitutes a large cash commitment for the issuer. To help ensure that the commit-
ment does not create a cash flow crisis, the firm agrees to establish a sinking fund to spread sinking fund
the payment burden over several years. The fund may operate in one of two ways: A bond indenture
that calls for the
1. The firm may repurchase a fraction of the outstanding bonds in the open market each
issuer to periodically
year. repurchase some
2. The firm may purchase a fraction of outstanding bonds at a special call price associated proportion of the
outstanding bonds
with the sinking fund provision. The firm has an option to purchase the bonds at either
prior to maturity.
the market price or the sinking fund price, whichever is lower. To allocate the burden of
the sinking fund call fairly among bondholders, the bonds chosen for the call are selected
at random based on serial number.9
The sinking fund call differs from a conventional call provision in two important ways.
First, the firm can repurchase only a limited fraction of the bond issue at the sinking fund call
price. At best, some indentures allow firms to use a doubling option, which allows repurchase
of double the required number of bonds at the sinking fund call price. Second, the sinking fund
call price generally is lower than the call price established by other call provisions in the in-
denture. The sinking fund call price usually is set at the bond™s par value.
Although sinking funds ostensibly protect bondholders by making principal repayment
more likely, they can hurt the investor. The firm will choose to buy back discount bonds (sell-
ing below par) at their market price, while exercising its option to buy back premium bonds
(selling above par) at par. Therefore, if interest rates fall and bond prices rise, firms will bene-
fit from the sinking fund provision that enables them to repurchase their bonds at below-
market prices. In these circumstances, the firm™s gain is the bondholder™s loss.
One bond issue that does not require a sinking fund is a serial bond issue. In a serial bond
issue, the firm sells bonds with staggered maturity dates. As bonds mature sequentially, the
principal repayment burden for the firm is spread over time just as it is with a sinking fund.


9
While it is uncommon, the sinking fund provision also may call for periodic payments to a trustee, with the payments
invested so that the accumulated sum can be used for retirement of the entire issue at maturity.
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




320 Part THREE Debt Securities


Serial bonds do not include call provisions. Unlike sinking fund bonds, serial bonds do not
confront security holders with the risk that a particular bond may be called for the sinking
fund. The disadvantage of serial bonds, however, is that the bonds of each maturity date are
different bonds, which reduces the liquidity of the issue. Trading these bonds, therefore, is
more expensive.

Subordination of further debt One of the factors determining bond safety is the
total outstanding debt of the issuer. If you bought a bond today, you would be understandably
distressed to see the firm tripling its outstanding debt tomorrow. Your bond would be of lower
quality than it appeared when you bought it. To prevent firms from harming bondholders in
this manner, subordination clauses restrict the amount of their additional borrowing. Addi-
subordination
tional debt might be required to be subordinated in priority to existing debt; that is, in the
clauses
event of bankruptcy, subordinated or junior debtholders will not be paid unless and until
Restrictions on
the prior senior debt is fully paid off. For this reason, subordination is sometimes called a
additional borrowing
“me-first rule,” meaning the senior (earlier) bondholders are to be paid first in the event of
that stipulate that
senior bondholders bankruptcy.
will be paid first in the
event of bankruptcy.
Dividend restrictions Covenants also limit firms in the amount of dividends they are
allowed to pay. These limitations protect the bondholders because they force the firm to retain
assets rather than paying them out to stockholders. A typical restriction disallows payments of
dividends if cumulative dividends paid since the firm™s inception exceed cumulative net in-
come plus proceeds from sales of stock.

Collateral Some bonds are issued with specific collateral behind them. Collateral can
collateral
take several forms, but it represents a particular asset of the firm that the bondholders receive
A specific asset
if the firm defaults on the bond. If the collateral is property, the bond is called a mortgage
pledged against
bond. If the collateral takes the form of other securities held by the firm, the bond is a collat-
possible default
on a bond. eral trust bond. In the case of equipment, the bond is known as an equipment obligation bond.
This last form of collateral is used most commonly by firms such as railroads, where the
equipment is fairly standard and can be easily sold to another firm should the firm default and
the bondholders acquire the collateral.
Because of the specific collateral that backs them, collateralized bonds generally are con-
sidered the safest variety of corporate bonds. General debenture bonds by contrast do not pro-
debenture
vide for specific collateral; they are unsecured bonds. The bondholder relies solely on the
A bond not backed by
general earning power of the firm for the bond™s safety. If the firm defaults, debenture owners
specific collateral.
become general creditors of the firm. Because they are safer, collateralized bonds generally of-
fer lower yields than general debentures.
Figure 9.9 shows the terms of a bond issued by Mobil as described in Moody™s Industrial
Manual. The terms of the bond are typical and illustrate many of the indenture provisions we
have mentioned. The bond is registered and listed on the NYSE. Although it was issued in
1991, it was not callable until 2002. Although the call price started at 105.007% of par value,
it falls gradually until it reaches par after 2020.


Yield to Maturity and Default Risk
Because corporate bonds are subject to default risk, we must distinguish between the bond™s
promised yield to maturity and its expected yield. The promised or stated yield will be real-
ized only if the firm meets the obligations of the bond issue. Therefore, the stated yield is the
maximum possible yield to maturity of the bond. The expected yield to maturity must take into
account the possibility of a default.
For example, in November 2001, as Enron Corp. approached bankruptcy, its 6.4% coupon
bonds due in 2006 were selling at about 20% of par value, resulting in a yield to maturity of
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




321
9 Bond Prices and Yields




F I G U R E 9.9
Callable bond
issued by Mobil
Source: Moody™s Industrial
Manual, Moody™s Investor
Services, 1997.




about 57%. Investors did not really expect these bonds to provide a 57% rate of return. They
recognized that bondholders were very unlikely to receive all the payments promised in the
bond contract and that the yield based on expected cash flows was far less than the yield based
on promised cash flows.

Suppose a firm issued a 9% coupon bond 20 years ago. The bond now has 10 years left un-
til its maturity date but the firm is having financial difficulties. Investors believe that the firm
EXAMPLE 9.9
will be able to make good on the remaining interest payments but that at the maturity date,
the firm will be forced into bankruptcy, and bondholders will receive only 70% of par value. Expected versus
The bond is selling at $750. Promised Yield
Yield to maturity (YTM) would then be calculated using the following inputs:

Expected YTM Stated YTM

Coupon payment $45 $45
Number of semiannual periods 20 periods 20 periods
Final payment $700 $1,000
Price $750 $750


The yield to maturity based on promised payments is 13.7%. Based on the expected payment
of $700 at maturity, however, the yield would be only 11.6%. The stated yield to maturity is
greater than the yield investors actually expect to receive.
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




322 Part THREE Debt Securities




F I G U R E 9.10 20
Yields on long- 18
term bonds 16
Yield to maturity (%)



14
12 High-yield
10
Baa-rated
8

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