LONG-TERM DEBT
A major source of financing for companies is long-term debt. Some of the terminology associated with debt should be distinguished first.
· Indenture – The indenture to a bond issue is the actual contract that delineates the obligations of the borrow, the rights of the lender, and the actions to be taken in the event of default. In short, if it is not in the indenture, it does not apply. The indenture will state the interest that must be paid (and when) as well as the principal payments. Oftentimes, the indenture will include restrictive, or negative, covenants designed to protect the lenders. For instance, the firm may be required to maintain a minimum current ratio or quick ratio, set a maximum for the debt ratio, or restrict dividend payments as long as the specific debt is outstanding. Violating any of these covenants is a technical default and the debt can become immediately due and payable upon such default.
· Debenture – Most long-term bonds of corporations are debentures which are not secured by the pledge of any specific asset. Rather, they are secured by the general assets of the firm.
· Subordinated Bonds – A subordinated bond is one that is made secondary to the claims of some other obligation. For instance, a mortgage bond is one that is secured by the pledge of specific real property (land and buildings). In the event of bankruptcy, the property securing the mortgage bond is sold. If the property is sold form more than the amount of mortgage debt, the extra money goes toward paying off other obligations. If there is insufficient funds to pay off the mortgage balance, any amount that remains unpaid becomes a general claim against other assets. Hence, a debenture is subordinated to a mortgage bond. A debenture can also be subordinated to other debentures and would be referred to as a junior debenture.
· Call Provision – A call provision gives the company the right to recall the bonds (buy them back) at a stated price, the call price. The call price is composed of par plus a call premium. If a bond has a call provision, how would you find out about it? Look in the indenture. As an investor, would you like to see a call provision on a bond? No. If interest rates fall, the company is likely to recall the bond issue and issue a new bond at the lower rate of interest. Consequently, the investor who had a good investment (one that paid a higher rate of interest than the new market rate) loses it and must reinvest the cash at lower interest rates. Typically, a bond with a call provision will not be callable in the first few years.
· Sinking Fund Provision – A sinking fund provision is used to provide for the orderly retirement of a bond issue. A sinking fund provision will require that regular payments be made to a trustee. For example, if a firm issued $50 million of 30-year bonds with a sinking fund provision, it would be typical if no payment were required in the first five years, but then an annual payment of $2 million would have to be made for the remaining 25 years of the bond issue’s life so that the $50 million would have accumulated by the time the bonds matured. The trustee could then invest the money (so that, actually, an amount less than $2 million per year would be needed since interest would be earned), or use the proceeds to retire outstanding bonds. The bonds could be retired through a lottery process if they were callable (since each bond has a unique serial number), or the trustee could buy them in the open market. Buying them in the open market would be advantageous if interest rates had risen since they could then be bought at a discount to par value (as shown below in the valuation of bonds). This would also put upward pressure on the bond’s price and perhaps help keep the firm’s cost of debt slightly lower. Would an investor like to see a sinking fund provision? Yes, because it provides more assurance that the principal will be repaid by the company.
· Income Bond – An income bond only pays interest if the corporate income exceeds a certain dollar level. Typically, an income bond is issued during a financial reorganization of a company near bankruptcy. It will formalize past due obligations without forcing the company into bankruptcy if income is low (which is likely since it is trying to turn itself around anyway). Income bonds are generally cumulative (that is, unpaid interest accumulates and must be paid in the future when the company has sufficient liquidity) and typically are convertible into common stock.
· Ratings Agencies – Many companies pay ratings agencies to rate their outstanding bonds. The most well-known of the agencies is Moody’s and Standard and Poor’s, although other agencies exist but tend to specialize in the type of bond that they will rate.
Advantages of Debt to the Bondholder
· The risk is reduced – the bondholder receives fixed income and there is a definite maturity when the principal is to be repaid.
· The bondholder has a prior claim to income over stockholders.
· The bondholder has a prior claim in the event of liquidation of the firm.
Disadvantages of Debt to the Bondholder
· The bondholder has no vote and, hence, no say in how the company is run.
· The bondholder does not participate in the growth of the company.
Advantages of Debt to the Company
· The cost is limited and known and cheaper than the cost of equity (because it is less risky to the investor who therefore requires a lower required rate of return).
· The interest is tax-deductible, unlike dividend payments, which makes the cost even cheaper in comparison to equity.
· There is no dilution of control when debt is issued.
· The debt can be terminated (if a call provision was included).
Disadvantages of Debt to the Company
· There is always the possibility of default if income is low. The company must pay interest, even if it means taking out additional debt to do so.
· The cost of equity rises as more debt is used. The higher leverage results in higher risk to shareholders who will require a higher rate of return.
Bond Valuation
The easiest thing to value (conceptually) is a bond since the promised cash flows are known with certainty.
Consider a bond that pays a 10% coupon (or stated) rate of interest, has a par (or stated or face) value of $1,000 and matures in 5 years. Suppose also that the market rate of interest for such a bond (i.e., your required rate of return, r) is 8%. Thus,
Par = $1,000
Coupon Rate = 10%
Maturity = 5 years
r = 8%
The cash flows that are promised by the company include interest payments of $100 per year (although most corporate bonds pay interest semi-annually, we will assume annual payments—we have already seen how to adjust for semi-annual cash flows) for five years and the payment of the face value (stated, or par, value) of $1,000 at the end of five years.
0 1 2 3 4 5
100 100 100 100 100
1,000
1,100
PVIFA 8%,4 = 3.3121
331.21
PVIF 8%,5 = .6806
748.66
$1,079.87
On your calculator,
PMT = 100
FV = 1,000
N = 5
I/Y = 8
PV = ?????? = 1,079.87 (ignoring the negative sign for an investment)
The value of the bond is $1,079.87 which is selling at a premium relative to the par value of $1,000. (A bond selling at less than par is said to be selling at a discount.)
What does the premium represent? As we saw when we looked at present values, it represents the present value of the additional interest of $20 per year (because it pays $100 in interest when we only require $80 for a $1,000 investment ($20 * 3.9927 = $79.85 with two cents rounding error). Any time the market rate of interest is less than the coupon rate of interest, the bond will sell at a premium. Similarly, when market rates of interest are greater than the coupon rate, the bond will sell at a discount. Recall from economics that, when interest rates go up, bond prices go down, and when interest rates go down, bond prices go up. This is a consequence of the mathematics of present value calculations.
Suppose we purchase the bond for $1,079.87. After one year, we collect $100 in interest. The $100 represents a 9.26% return on our investment of $1,079.87, not an 8% rate of return. What are we ignoring?
The 9.26% is referred to as the current yield (as in accounting, where “current” refers to within one year). What is being ignored is the fact that we paid a premium for the bond which, at maturity will be worth only $1,000. Thus, over the five years to maturity, the value of the bond will decrease. Let’s look at what the bond will be worth one year from now. In one year, there will only be four years left to maturity:
0 1 2 3 4
100 100 100 100
1,000
PVIFA 8%,4 = 3.3121
331.21
PVIF 8%,4 = .7350
735.00
$1,066.21
On your calculator,
PMT = 100
FV = 1,000
N = 4
I/Y = 8
PV = ?????? = $1,066.21
Note that this time, the interest payment in the last year was included as a part of the present value of an annuity calculation while the par value was discounted as a lump sum of $1,000. As indicated, the value of the bond when only four years to maturity remain is only $1,066.21. This is a decrease in value of $13.66. When expressed as a percentage of the original value of $1079.87, this represents a loss of 1.26%. The total return of 8% that we built into our valuation when the bond had five years left to maturity is comprised of two components:
Total Yield = Current Yield + Capital Gain Yield
Current Yield = One Year’s Interest/Current Price
Total Yield = 9.26% + <1.26%>
= 8.00%
Note that the premium for the four-year bond is smaller than the premium for the five-year bond since we are only paying for four years’ worth of additional interest payments.
Bond Maturities & Premiums/Discounts
If a five-year bond sells at a premium of $1,079.87, what do you think the premium for a ten-year bond will be? (Recall that the premium is the present value of the additional amount of interest being paid.) A ten-year 10%, $1,000 par value bond should sell at a larger premium since we are paying for ten years’ worth of an extra $20 per year of interest. For example,
Par = $1,000
Coupon Rate = 10%
Maturity = 10 years
K = 8%
0 1 2 3 4 5 6 7 8 9 10
100 100 100 100 100 100 100 100 100 100
PVIFA 8%,10 = 6.7101 1,000
671.01
PVIF 8%,10 = .4632
$ 463.20
$1,134.21
On your calculator,
PMT = 100
FV = 1,000
N = 10
I/Y = 8
PV = ?????? = $1,134.21
As was expected, the additional five years’ worth of an extra $20 per year in interest payments results in a larger premium for a ten-year bond relative to a five-year bond.
Sensitivity to Changes in Interest Rates
As we determined previously, as interest rates fall, bond prices rise. Which type of bond rises more, short-term or long-term bonds? (Hint: Do we really care what interest rates do today for a bond that matures tomorrow?)
Suppose that interest rates fall from 8% to 6%. Let’s see what happens to the values of our five-year and ten-year bond prices.
0 1 2 3 4 5
100 100 100 100 100
1,000
PVIFA 6%,5 = 4.2124
421.24
PVIF 6%,5 = .7473
747.30
$1,168.54
On your calculator,
PMT = 100
FV = 1,000
N = 5
I/Y = 6
PV = ?????? = $1,168.54
The value of the five-year bond has increased from $1,079.87 to $1,168.54 or $88.67 due to the fall in market rates of interest from 8% to 6%. The $88.67 increase in price represents an 8.2% appreciation relative to its original value.
The ten-year bond’s increase in price is calculated in the following manner:
0 1 2 3 4 5 6 7 8 9 10
100 100 100 100 100 100 100 100 100 100
PVIFA 6%,10 = 7.3601 1,000
736.01
PVIF 6%,10 = .5584
$ 558.40
$1,294.41
On your calculator,
PMT = 100
FV = 1,000
N = 10
I/Y = 6
PV = ?????? = $1,294.41
The increase in price for the ten year bond amounts to $160.20 or 14.1%. Why do we calculate the change in price as a percent of its original value?
The reason the change in price is much larger for a long-term bond is due to the fact that the longer period of time for compounding has a more pronounced effect on the ten-year bond than it does on a five-year bond since, on average, the five-year bond is generating cash flows much sooner than the ten-year bond. If long-term bonds are more sensitive to changes in interest rates than short-term bonds, can you guess whether a high coupon bond or a low coupon bond is more sensitive to changes in interest rates? (See Handout #2.)