Secured Bonds

A secured bond refers to a security that holds a legal claim against certain assets should the company default on its obligation. Since the corporation has pledged certain collateral for the benefit of the bondholders, these bonds are generally considered more secure than bonds that hold no collateral. The waterfall of payments that a corporation adheres to is as follows:

• Secured (collateralized) bondholders
• Unsecured bondholders
• Subordinated debtholders
• Preferred stockholders
• Common shareholders

This additional security will cost the bondholders somewhat in a lower yield, as the security is considered to have a lower risk of default and/or higher recovery value in the event of default.

There are numerous types of secured bonds within the market, each distinguished by the different type of collateral securing the issue. Corporate first mortgage bonds (not to be confused with mortgage‐backed bonds) are securities that have some form of real estate provided as collateral. Proceeds may be used to construct or rehabilitate these facilities, which can vary from power plants to warehouses to factories. Utilities are some of the most common issuers of mortgage‐secured corporate bonds. Another form of secured debt is called an enhanced equipment trust certificate (EETC). The security for an EETC is large industrial equipment, with airplanes and railroad cars some of the most common types of collateral. EETCs are used by the companies to pay for the lease and eventual purchase of equipment.

An important part of the process of creating an equipment trust bond is the role of the trustee. The trustee serves as an intermediary between the corporation that builds the equipment and the corporation that uses the equipment. For example, an aircraft manufacturer may build aircraft for an airline. The airline does not need to purchase the jets outright, instead choosing to lease the planes. This can happen if the manufacturer provides lease financing or if the buyer finds a financial firm to provide lease financing. In the case of an EETC, the trustee has control of the planes, purchasing them from the manufacturer and leasing them to the airline. In order to facilitate the purchase of the aircraft, the trustee would sell EETCs, paying the interest and principal due on the securities with the lease payments made by the airline. The trust certificates are sold by the airline, even though they do not own the airplanes that are being used as collateral, with the aircraft remaining under the control of the trustee.

Another form of a secured bond is the collateral trust bond. These are similar to EETCs, except that instead of physical equipment, the bonds are secured by financial assets, such as other bonds or stocks. These securities arise when a company holds stocks or bonds of other companies on their balance sheet. If the company were to issue a collateral trust security, it would need to segregate the pledged financial assets with a trustee, who would control them for the benefit of the trust certificate holders. As the value of these assets will vary, there will likely be a requirement to provide additional security if the portfolio value drops below a certain level.

Unsecured Bonds

While secured bonds provide a lower default profile, the vast majority of corporate debt falls within the unsecured category. A debenture is a general term for an unsecured bond that is backed by the basic earning power of the corporation. That earning power is reflected in the issuer's credit rating and the bond's specific credit rating (if the issuer has paid a rating agency to rate the bond's creditworthiness). If revenues and earnings from operations are sufficient to cover the debt service (regular payment of the coupon interest), holders of the debentures will continue to receive their coupons and the principal when due. Should the corporation experience a business downturn that lowers its earnings to the point where there are insufficient funds to cover the next coupon payment, it may be in danger of defaulting on that payment. Without any backing other than the corporation's cash flow, the debentures carry the greatest risk of a downgrade in their credit rating. Since unsecured bonds carry more risk, they usually pay a higher interest rate than secured bonds. There are a number of reasons that a borrower would choose to issue unsecured debentures. A smaller borrower may find that it does not have enough assets to issue collateral debt, or larger borrowers may be well known enough to not need to encumber their assets in issuing debt. Just because a borrower issues unsecured debt, it does not mean they are not creditworthy. For instance, U.S. Treasury securities are essentially unsecured bonds, backed only by the pledge of the U.S. government to make required payments.

Unsecured debentures may be further divided into smaller subsections, with senior unsecured the highest in the unsecured credit stack and subordinated debentures at the lower end of the spectrum. Subordinated debentures may even be further divided into senior subordinated and junior subordinated debentures. Subordinated debentures (junior subordinated and senior subordinated) are forms of debenture that differ only in the hierarchy of their being redeemed should the corporation find itself in bankruptcy. As the names imply, the subordinated debenture is ranked next (lower) in line for claims over the corporation's assets. Of all of the corporation's creditors, those holding subordinated debentures come last in line and may receive very little once any banks, secured, and more senior unsecured bondholders have received their share of the remaining assets. The reason that a company may issue such delineated securities varies, but a large, lower credit borrower may find that the indenture of its more senior bonds does not allow the issuance of additional bonds. The issuance of junior bonds may allow the company to raise funds without violating these existing indentures. Financial firms often have many classes of bonds, but their need for subordinated bonds may be regulatory in nature. Capital levels are critical for a bank and the equity‐like features of certain subordinated debt may help satisfy regulator‐defined capital adequacy ratios. Of course, the investor in debentures and subordinated debentures is typically rewarded for the increased risk with a higher coupon and yield.

Variable‐Rate Bonds

Not all corporate bonds have a fixed coupon payment. Instead, some bonds have interest rates that change based on the market rate of interest. They are known as floating‐rate notes (FRNs) and first made their market appearance in the 1970s. The FRN was issued by Mortgage Investors of Washington in 1973, when they sold a $15 million, seven‐year floating‐rate senior subordinated note. This was followed by a $650 million issuance by Citicorp in 1974. Other financial firms followed, and the market exceeded $1.3 trillion by 1974. After this initial spurt, FRN issuance dried up rapidly and not one bond was offered for the next three years. Citicorp issued another bond in 1978 and, from there, issuance was sporadic. The early years of the 1980s saw double‐digit interest rates and increased market volatility, both of which contributed to increased investor demand for variable‐rate bonds. From there, the market for these types of bonds took off and today they are an established segment of the fixed‐income market. Issuance and demand, however, remains highly dependent on the expectations over the future path of interest rates, and as the chart in Figure 14.2: indicates, FRN issuance has varied from as much as 50% of total issuance in the mid‐2000s to as low as mid‐single digits in 2015.

Financial firms are the most active issuers within the floating‐rate universe as they often utilize asset/liability matching techniques by issuing floating‐rate debt in proportion to assets that have a floating‐rate component. Most floating‐rate debt has a maturity within 10 years and longer maturity FRNs often have call options or mandatory sinking fund provisions. The coupon for a floating‐rate bond is tied to some widely published index, such as LIBOR or the fed funds rate. There are also FRNs that are tied to an inflation index, such as the CPI, which gives investors a specific investment vehicle to express their inflation view. The interest rate is therefore determined by the underlying index and usually adds a spread to this index, which represents the credit risk of the borrower. For instance, Goldman Sachs has a 10‐year FRN that has quarterly interest payments that are established by adding 170 basis points to the three‐month LIBOR rate. If this three‐month LIBOR rate was 1% during the next reset period, the interest rate would be 1.00% + 1.70% or 2.7% per annum for the next quarterly interest cycle. Most FRNs reset the interest rate during their interest payment cycles, although they could theoretically be reset daily, weekly, monthly, quarterly, semiannually, or any other formula desired.

Many floaters are also structured with a “cap” or a “floor” or at times both caps and floors. A cap is the maximum rate that the borrower will pay regardless of how high the reference rate goes. This feature protects the issuer in the event that overall interest rates rise precipitously higher than expectations. A floor is the minimum rate that the borrower will pay, again regardless of how low the reference rate falls. This feature protects the lender or bondholder in the event that rates fall significantly. The cap and floor illustrates one of the primary risks for bondholders, in that unlike a fixed‐rate security, the income stream from the security will be variable. In addition, while the maturity of the security can be longer term in nature, short‐term interest rates, which form the basis of establishing the income stream, will generally be lower and therefore the initial income stream will also be lower. However, since the rate is reset fairly regularly, the volatility on the security will also be lower, and the price should not deviate very far from par unless there is a credit event.

Step‐Up Bonds

Step‐up bonds are similar to variable‐rate securities in that the interest rate of a bond may change during the life of the security. There is, however, a fundamental difference in that the changes in interest rate are not determined by an index, but rather these changes in rate are defined in the indenture. In its simplest form, a step‐up bond will have its interest rate rise based on a predetermined schedule. Most step‐up bonds also have a call feature, which introduces reinvestment risk to the investor. A step‐up bond will generally have a lower coupon at issuance, but provide the potential for a greater weighted average rate over the life of the bond. Of course, those higher coupons may not be realized if the security is called by the issuer. It is worth noting that the probability of a call for a step‐up is higher than a simple callable bond. If rates rise rapidly, the issuer may choose not to call the bonds if the stepped‐up coupon is below current market rates. For investors that expect the call to be exercised, they may face duration risk by owning a longer‐term security than they expected to be called. Certain step‐ups may also be triggered by a rating downgrade below a certain level, an event that will again be defined in the indenture. Such credit protection is usually demanded from borrowers rated triple‐B camp or lower. Other step‐ups are mostly found as a feature tied to a medium‐term note (MTN), with financial firms accounting for the bulk of the step‐up universe.

Medium‐Term Notes

One of the more burdensome aspects of issuing public debt securities, or any public securities for that matter, is the Securities and Exchange Commission registration process. Market conditions must also be cooperative as the timing of the registration process is difficult to predict. In an attempt to address these concerns, the SEC put Rule 415, the Shelf Registration Rule, into effect in 1982. Rule 415 allows that new securities can be sold for up to two years after an existing registration statement is approved, effectively allowing an issuer to sell an issue off the shelf. This allowed many corporations issuing bonds to register the issue with the SEC and then sell securities from the issue at any time during the next two years. Shelf registration substantially reduced the cost of offering new bonds and gave corporations far greater flexibility in selecting when to enter the market to raise additional funds.

One product that arose from the Shelf Registration Rule was the medium‐term note (MTN) program. An MTN program can take many forms, but they are usually notes that are sold by well‐known borrowers that have need for a regular and continuous flow of capital. Initially, MTN programs filled a void between shorter term funding opportunities, such as commercial paper, which was 1 year or shorter, and traditional longer‐term debt issuance. Therefore, much of the MTN universe evolved in the 2‐ to 5‐year maturity segment, which continues to be a sweet spot for MTN issuance. MTNs are not limited to these maturities, however, with 10‐year MTNs fairly common and the occasional appearance of the 100‐year MTN.

Investors should view MTNs as another form of corporate bond, with many of the same characteristics discussed in this chapter. As such, an investor needs to thoroughly understand the credit, structure, and payment mechanics as they would any other fixed‐income security. While most MTNs are fixed‐rate, non‐callable debentures, they could also be floating‐rate securities with either call or put features. One of the more popular features found in MTN programs is the survivor put option, where beneficiaries can sell the bond back to the company in the event of death, providing a useful estate planning tool. The flexibility of an MTN program also allows buyers to dictate certain features that they would like to see in the security. In these instances, a buyer could approach the investment bank that is running the MTN program and request certain attributes through a reverse‐inquiry process. If the issuing corporation is amenable to the terms of the structure and the interest and maturity schedule fits their balance sheet, a bond can be created for the specific investor. Many MTN programs are sold on a weekly basis and create the potential for a number of smaller, potentially specialized issues. This may impact the liquidity for the issue in the secondary market, with investors giving up active secondary market liquidity for the conveniences of buying an MTN.

Embedded Options

In its simplest form, a bond would have a fixed interest rate, which is paid in regular intervals until maturity, at which point the investor's original principal amount would be returned. This simplest bond has a fixed interest rate, is not callable, and therefore provides investors with a reliable income stream so long as there is no credit event. While there is no lack of these simple bullet structures (practically all Treasury securities fit into this category), the bullet has been joined by a litany of other structures. In the 1980s corporations began to issue bonds with various embedded options. As the name implies, these options are embedded in the bond and cannot be removed from the structure of the security. They are part of the entire package—fixed‐income instrument plus an option—and are not traded separately. Thus, the valuation of bonds with embedded options is an exercise in valuing the fixed‐income portion and the option separately and combining their values into the market price of the optionable bond.

Callable Bonds

Callable bonds are the most widely used embedded option associated with corporate bonds, as a simple Bloomberg search indicates over 24,000 USD‐denominated callable bonds trading in the market. An embedded call option on a bond gives the issuer the right, but not the obligation, to call the entire issue, or part of it, at the issuer's discretion. In the case of a bond, the issuer can be viewed as the owner of the option while the bondholder is the option writer. Of course, the issuer will only exercise the option when it is economically advantageous for them to do so. The most common reason for the option holder to exercise the call option would be when it is in the money. In the case of bonds, this occurs when the market interest rate falls below the level of the bond's coupon rate. In that event, the corporation would be able to reduce its interest charges by issuing a lower coupon bond and calling the existing higher coupon bond. Of course, options are a zero‐sum game, so the investor who wrote the option is now the loser in this scenario. Their loss is that they now face reinvestment risk, both losing the higher income stream and receiving the proceeds from the bond at the very time when interest rates are their lowest.

When an investor purchases a callable bond, he or she is essentially undertaking two simultaneous transactions. At the same time that the investor is purchasing a fixed‐income instrument from the issuer, he or she is also selling the issuer a call option on that bond. The investor becomes the writer of the option and must fulfill the obligation to deliver the bond at the predetermined call price if and when the issuer chooses to exercise the option. The call price and the dates upon which the call price changes over time (if any) are clearly spelled out in the bond's indenture.

The use of call options vary with the general tone of interest rates. When interest rates were high, such as in the 1980s and 1990s, bonds were often sold with call options that often also had provided features such as call premiums and call protection. In these instances, if an issuer were to exercise its call option, it would have to pay a premium over par to compensate the bondholder that would lose the bond, presumably at the worst possible moment. Additional protections were demanded by bondholders that would not allow the bonds to be called for a specific period of time. These bonds would be referred to as NC5, NC7, NC10, and so on, referencing that they were non‐callable for 5 years, 7 years, 10 years, or any other time period.

More recently, with overall interest rates at historical lows, corporations have not been as aggressive in pushing for scheduled calls. Instead, corporations have sought flexibility in the event of a merger that would require that they redeem existing debt. In order to maintain this flexibility, bonds would essentially need a continuous call feature, which would certainly be punished by investors who would demand a much higher interest rate. The make‐whole call (MWC) was subsequently developed as a way to give the company additional flexibility without paying a much higher interest rate. Under an MWC, a company can pay off its remaining debt early so long as investors are made whole. The most common structure of an MWC is to discount the remaining cash flows at a predetermined rate. That rate is often a spread to the relevant Treasury bond benchmark at the time of the redemption. So long as the spread is set below the rate at which the bonds are presently trading, the investor will theoretically gain economic value from the call. As an example, the Verizon 3.5% bonds due 11/1/2024 were sold in late 2014 as a callable bond with a make‐whole provision. The bonds would be callable at par on 8/1/2024, but could be called earlier if investors were made whole. In the case of these bonds, the make‐whole clause requires that the remaining principal and interest be discounted at a Treasury yield +25 basis points. Since the bonds were issued to yield 135 basis points over Treasuries, the make‐whole provision should sufficiently compensate investors. While there are examples of MWC provisions negatively impacting bondholders, many indentures have a greater of (a) par or (b) the MWC results to protect bondholders.

The market price of a callable bond must equal the value of the fixed‐income portion (the bullet, or non‐call bond) minus the value of the call option:

Why do we subtract the value of the call option? Think of the purchase of the callable bond this way: When you buy the callable bond, the issuer is paying you for the call option, thereby reducing the price of the bond. Let's say that the price of the bond is 98. If the bond had been a bullet, you would have paid a price of par. The existence of the call option lowers the market price of the callable bond relative to a bullet from a similar issuer with a similar credit rating, coupon, and maturity. Since you are selling a call option back to the issuer, you will receive the premium payment for that option. In our example, the option premium is 2. Thus, you pay 100 for the bullet and receive 2 for the option, making the net position in the transaction 98—the price of the callable bond. This lower price is your compensation for assuming the higher risk of investing in a bond that can be called away from you prematurely. The lower price also translates into a higher yield. The higher yield of the callable bond is the compensation you can and should expect for assuming call risk.

As we have seen in previous chapters, valuing a pure fixed‐income instrument is relatively straightforward. Valuing an embedded call option is not as simple. However, over the past 20 years, methods for valuing embedded bond options have been created and those methods are widely used today by traders, analysts, and institutional investors. The most common method makes use of the implied forward rates derived from the U.S. Treasury yield curve and an assumption of interest rate volatility to generate a series of future interest rate paths. These paths represent a set of possible up and down movements in the forward yield curve for U.S. Treasury securities. The method is often referred to as the binomial lattice or lognormal method. Working backward through time from maturity, when the bond's price is known to be par, the process computes the price one period prior to maturity using the forward rate generated for that point in time, the bond's coupon cash flow, and its next period price—par. When all of the points on the lattice have been populated with theoretical future bond prices, the final price at time zero—today—is the bond's theoretical price based on the model's initial assumptions.

The model's power rests in the fact that it can be used to take into account the existence of the embedded option. This cannot be accomplished using the classic discounted cash flow formula for the price of a bond. At those points in time when the bond is callable at a specific price, we can substitute the call price for the theoretical price based on the forward rate. Using the new call price, we end up computing a slightly different current market price from the model. This price should match the traded price of the callable bond. In this way, we can use the likelihood of the bond's being called because of a decrease in future interest rates as an input into where it should be trading today. If the model produces a theoretical price that differs from the current traded price of the callable bond, we can modify the assumptions that produced our implied forward rates. Assuming we have used the bond's future call prices in our valuation process, the reason for the price discrepancy would be that we have been using Treasury bond rates to discount corporate bond cash flows. Since Treasury yields are normally lower than corporate yields, we have been overvaluing this corporate bond. At this point, we must go back and compensate for the lower Treasury rates we have been using by increasing the forward rate each period by a certain number of basis points. This amount will be added to the forward rates until the average price of all the cash flows equals the bond's current market price. The basis point spread we have added to our forward Treasury rates is known as the option‐adjusted spread (OAS). OAS can be viewed as representing the bond's nominal yield spread over the entire Treasury curve after statistically removing the value of the embedded call option. Since the spread is positive and produces a yield that is higher than a Treasury yield, the resulting corporate bond price will be lower than that of a similar Treasury. This makes sense and is the reason why OAS is often considered a proxy for credit risk—the difference in price being due to the corporate bond's higher credit risk compared with the Treasury bond.

Putable Bonds

The opposite of a callable bond is a putable bond, where the investor is the owner of the option and the issuer is the writer of the option. Unlike callable bonds, which are fairly common, there are far fewer putable bonds in the market. A simple Bloomberg search list only 1,600 putable securities versus over 24,000 callable bonds. The disparity between these two embedded options is fairly straightforward in that putable bonds favor the bondholder, providing the issuers with a disincentive to issue them. While corporations certainly want to increase the likelihood of selling the entire par amount of the bond issue, they do not want to give potential investors any more incentives to purchase the bonds than are absolutely necessary. As further proof of this, many putable bonds are onetime puts, meaning the option to put (sell) the bond back to the issuer takes place on only one date at the predetermined price. If the option is not exercised, it expires and the bond essentially becomes a bullet.

When an investor purchases a putable bond, the two simultaneous transactions are the purchase of a fixed‐income instrument from the issuer and the purchase of a put option on that bond. In this case, the corporation becomes the writer of the option and must fulfill the obligation to purchase the bond at the predetermined put price when the bondholder chooses to exercise the option. The put price and the dates on which the put price changes over time are also spelled out in the bond's indenture. Because of the dual transaction, the market price of the putable bond must equal the value of the fixed‐income portion (the bullet bond) plus the value of the put option:

Why do we add the value of the put option? When you buy the putable bond, you are paying the issuer for the put option, thereby increasing the price of the bond. When you buy the putable bond, you pay a certain price for it. Let's say that price is 102. If the bond had been a bullet, you would have paid par. The existence of the put option increases the market price of the putable bond relative to a bullet from a similar issuer with a similar credit rating, coupon, and maturity. At the same time, you are purchasing a put option from the issuer. As the buyer of the put option, you pay the option premium to the seller (the issuer). Let's say the option premium is 2. Thus, you pay 100 for the bullet and pay 2 for the option, making the net position in the transaction 102—the price of the putable bond. The higher price is your cost for assuming the lower risk and the concomitant advantage of investing in a bond that can be sold back to the issuer at your discretion. Of course, that discretion can be quite limited, but it does exist and will cost something. The higher price also translates into a lower yield. The lower yield of the putable bond is what you can expect for the issuer's assumption of put risk. The binomial lattice method, which was outlined for callable bonds, can also be used to value an embedded put option. The same set of implied forward Treasury curves is generated but the put option is assumed to be exercised in the future at any time where interest rates have increased and the bond's theoretical price has fallen below the put price. After removing the value of the put option, the theoretical bond price is compared to its current market price and a certain number of basis points are added to each forward rate to make the two prices equal. The additional basis points are the bond's OAS.

Convertible Bonds

A convertible bond (or convert) is a security that starts its life with many bond‐like characteristics but also has an embedded option that allows the investor to convert the bonds into common stock of the issuer. We will limit our discussion to bonds that convert into equity of the issuer, although there are some instances where conversion could be into another company's stock. As such a convertible is best described as a hybrid security that exhibits different types of behavior depending on the value of the embedded option. The reasons an issuer may issue a convertible bond vary, but the lower interest rate paid on the issue will be one of the main issues. Depending on its credit quality and existing leverage ratio, a convert may help to raise funds when traditional debt issuance is overly restrictive. A convertible may also allow a company to avoid the immediate dilution created by an equity sale while also providing tax benefits from interest expense versus a dividend payment, which is not tax deductible. For an investor, a convertible can be viewed as a safer way to participate in the equity market, with some downside protection in the embedded interest payment and most of the upside from stock appreciation. This possible upside appreciation sets converts aside from traditional bonds in that their value could be much greater than par at maturity, versus other debentures that will only return par at maturity.

Before we begin our convertible discussion, there are a few distinct terms that are unique to the convertible world that that we have not used before.

Contingent Convertible Capital Bonds (CoCo Bonds)

Another type of security that could potentially be converted to equity is the contingent convertible capital bond or CoCo bond. Unlike the convertible bonds discussed earlier, a CoCo conversion is often an undesirable event for the bondholder. What is unique about CoCos is that the conversion may also be an undesirable event for the issuer. This is because CoCos are hybrid securities that were developed to absorb losses of the issuing banks when capital levels fall below certain levels. Since these securities are relatively new, having been conceived after the financial crisis, there are still only a limited number of CoCo bonds and we have not seen how they perform during periods of stress or upon conversion. The main reason for the development of the CoCo market has been to satisfy regularly capital requirements, without immediately raising expensive equity capital. The premise for the CoCo bond is that during periods of duress, a bank can increase its capital levels by triggering a contingent capital event with the CoCo bonds. The CoCo structure has been utilized more actively by European banks, although there are several U.S. dollar–based transactions that may find themselves in the corporate bond arena.

Among the most appealing aspects of the CoCo bond are the high yields that they offer, with most transactions priced with a 7%+ coupon, several 100 basis points above traditional bank debt. The most important features of a CoCo are what triggers a conversion and how the loss absorption mechanism works. As stated, the primary purpose of the CoCo is to be a readily available source of bank capital at a time of crisis. How that time of crisis is determined varies across deals, but generally falls into one of two camps. The more prevalent method is to rely on a formula to set off the trigger. This is usually some form of a capital ratio threshold being broached, such as the book value of common equity Tier‐1 capital as a ratio of risk‐weighted assets. Triggers that rely on the book value assumptions are only as effective as how often values are determined and vary across banks. As we learned during the financial crisis, many banks that were stressed or even defaulted were solvent from an accounting perspective that based the value of assets on a backward‐looking valuation.

Some of the shortcomings of book value triggers can be addressed by using market value triggers, such as the market value of a bank's equity to its total assets. While using market values ameliorates some of the inconsistences of using an accounting‐based trigger, it opens up additional complexities such as market manipulation. Concerns over a situation where short‐selling the stock causes the trigger to be exercised, thereby further diluting shares to the benefit of the short seller, have been raised by regulators and market participants.

Yet another trigger mechanism that does not rely on either accounting or market thresholds is to simply let bank regulators decide when the point of non‐viability is reached. This solution is also not without problems, as home regulatory bias may make the regulators hesitant to activate the trigger. The lack of clarity on when a trigger event will occur may also undermine the market confidence over a bank or banking system at a time of stress when CoCos are intended to add to confidence.

Once a trigger is activated, there are a few possible ways for the loss‐absorbing capital to be utilized. Earlier transactions focused on converting CoCo bonds into the issuing bank's equity at a conversation rate. This rate could either be based on the market price of the stock when the trigger is breached or a pre‐specified price when the issue was sold. The former would likely be more dilutive to shareholders, which would provide an incentive for existing shareholders to not influence the triggering event. The opposite is true if a predetermined ratio is used, which is less dilutive and would reduce the incentive to avoid triggering a conversion.

Another loss‐absorbing method is to have a principal write‐down of the CoCo if a triggering event occurs. These write‐downs could either be full or partial, although most have full write‐down provisions. Some of these write‐downs are either temporary or permanent, as defined in the indenture. As can be seen, there are many variations to this relatively new and untested asset class. While the coupon offered to investors is high, a thorough understanding of the conversion process is essential in determining an investor's comfort level. The market for CoCos has remained within the retail and high‐net‐worth space, with institutional investors taking a cautious approach for the moment.

Price

Let's say you are looking for a price on a corporate bond and you contact your broker. She will quote you a price for the bond, say 95½, which should not be confused as a monetary price for the security. In other words, you are not being told the bond will cost you $95.50. In the bond markets, prices are quoted as a percent of par, like the coupon interest payments. The 95½ quoted by the broker translates into “95½ percent of par.” With par being $1,000 on most U.S. corporate bonds, the actual dollar amount you will pay to purchase this bond will be $955, plus accrued interest.

Yield

The yield on a bond is the simple return one could expect to receive if the bond was purchased at a particular price and was held for a specific amount of time. Even though certain assumptions must be made in order for the promised yield to be the actual yield received on the investment, the concept of yield is one of a discount rate that equates the present value of the expected future cash flows to the current market price. Thus, price and yield are two sides of the same coin, and one can be calculated from the other. Indeed, the level of one will directly determine the level of the other. Instead of our hypothetical bond being quoted at a dollar price of 95½, it could just as easily have been quoted at a yield of, say, 5.2% percent. The 95½ dollar price produces a yield of 5.2% percent, so the trader can quote the bond to a buyer or seller either way. Traders often refer to price and yields as levels. Since there is more than one way to quote the market value of a bond, the term level is less confusing, especially if a yield is being quoted.

Spread

As we stated earlier, the investment‐grade market is often quoted as a spread to a Treasury security. Let's say that instead of a price of 95½ or a yield of 5.2% percent, the trader tells you the bond is trading at “200 over.” Since traders view the market in relative terms, neither price nor yield provides any relative value markers to compare. Both of those ways of quoting a bond's market value are measures of the bond's present value and discount rate. The value of Treasury bonds is not explicitly taken into account. However, when the trader says a bond is trading at “200 over,” it means that the yield of the corporate bond is 200 basis points higher than the yield of a comparable maturity Treasury bond—the corporate bond's benchmark. By expressing a bond's market value as the difference between its yield and the yield of a similar maturity Treasury, the trader is at once telling you the relative value between two securities and the market value of the corporate bond. That relative value—the difference between the yields of the two bonds—is known as the spread. That spread can quickly be translated into a yield for the corporate bond by adding the spread to the yield on the benchmark Treasury. For example, if the Treasury bond was yielding 3.5% and the spread was 200 basis points over (typically written as +200), the yield on the corporate bond would be 5.5% percent. The trader could then calculate the bond's price from the yield of 5.5% percent, which as expressed above prices the security at 95½.

Traders use the concept of spread because at a single time, they can transact in bonds and get a sense of relative value. It's the relative value they're after. If they see spreads widening (corporate bond yields increasing relative to Treasury yields) or tightening (corporate bond yields decreasing relative to Treasury yields), that information gives them insight into the market's perception and expectation of future movements in the economy and interest rates. Some traders hedge their corporate exposure by shorting the comparable Treasury bond, and therefore are only concerned with where the spread of a bond is moving. Ultimately, traders will not really know the exact price at which they are buying and selling. They only know they were done (consummated the transaction) at 200 over. The numerous trading systems in existence translate the settlement price based on the spread that is provided to the system. As long as both sides agree on the final spread and benchmark security, the trade takes place. One final note about spread: We all know that in any financial market the rule is to buy low and sell high. Thus, as in the stock market, we expect the bid price of a bond to be lower than its ask price. This is indeed the case. However, when quoting the bond's value in yield or spread, remember that the yield moves in the opposite direction from the price. The bid yield should therefore be higher than the ask yield. Likewise, the bid spread should be higher than the ask spread. If you are quoted 200/180 (often written +200/+180) on a bond, you are being given the bid–ask yield spread.

Dollar Pricing and Other Pricing Conventions

While most investment‐grade bonds are priced as a spread to Treasuries, this is not always true for all corporate bonds. The convention for high‐yield bonds has been to provide a straight dollar price for the security. Using our example, the dollar price of 95½ would be the quoted level for a high‐yield bond. As we have learned, with either the dollar price, yield, or spread (and the comparable benchmark being used for the spread), we could calculate the other components of the equation. Therefore, with a 95½ price, we would also be able to determine that the yield was 5.5% and the spread was +200, thereby allowing us to determine relative value of the high‐yield security. The main reason that high yield is not quoted in spread is that it typically does not correlate as closely to the Treasury market as higher quality bonds. Therefore, using the Treasury market to determine relative value is not as clear cut as with investment‐grade bonds. In fact, high yield is often viewed relative to the equity markets, with a greater correlation to the returns of the S&P 500 than returns of the government bond market. That does not mean that we cannot gather information by comparing high yield to Treasuries; it simply means that we will need to look at other factors in establishing a price for the bonds. This is why when an investment‐grade bond becomes distressed for any number of reasons, the price of its bonds will decline and may start to get quoted in dollar price rather than on a spread basis.

A final note on pricing conventions in the corporate bond market: As bonds have become more complex, with added optionality built into securities, traders may utilize different spread conventions. As we discussed earlier, the option‐adjusted spread can be used to gauge the implied cost of imbedded options. There are other spread calculations that an investor may come across, including G‐spread, Z‐spread, and I‐Spread. The G‐spread uses an interpolated point on the Treasury curve to calculate the spread. This may be useful for a longer‐term bond that is not correctly reflected by comparing its spread to either the 10‐year or 30‐year benchmark. Also, relatively large changes in yield across the Treasury curve may make using the G‐spread a more accurate reflection of corporate risk. The Z‐spread is a constant spread that will make the price of a security equal to the present value of each cash flow discounted to a curve of zero‐coupon bonds at each cash‐flow point. The I‐spread utilizes the benchmark swap curve rather than the cash curves. In each of these instances, these additional spread metrics are in addition to the Treasury spread information provided.

Additionally, floating‐rate securities are often priced to money market securities. There can be any number of money market indices that are used to spread‐off‐of to determine the current effective rate for a floater. While LIBOR is the most common, there are securities that use a constant maturity Treasury index (CMT), a specific Treasury bill rate (3m, 6m, or 12m), fed funds, prime rate, composite commercial paper rates, or foreign money market rates such as the Eurodollar synthetic forward rates. They key is to understand the spread and the index that will be used to calculate the interest rate that will be used to set the coupon rate.

Trustee

The issuance of a corporate bond includes several parties—the corporation (issuer) itself, an investment bank that assists the corporation in the creation and sale of the bond issue, and the corporate trustee. A trustee is typically a large commercial bank (or, more correctly, the trust department of such a bank) or a trust company that handles the general administrative functions of the bond issue. Included in these functions are payment of the coupons to the bondholders of record, assuring that the amount of the bonds sold by the investment bank does not exceed the total issuance specified by the corporation, notification of early redemption on the part of the issuer, handling the redemption of the bonds from current bondholders, holding the securities pledged as collateral in collateral trust bonds, and, perhaps most importantly, making sure the issuer complies with all the covenants in the bond's indenture. In this last function, the trustee acts as a fiduciary. That is, the trustee is responsible for acting exclusively in the best interest of the bondholders. Should the issuer fail to make the specified coupon or principal payments when due, the trustee may declare the company to be in default. The trustee must also make sure that any promise by the company to maintain adequate levels of debt service coverage is honored. Reporting requirements are also an important role for the trustee, where the inability of the company/issuer to file timely financial reports could be deemed as an event of default. In each of these cases, the trustee must act in such a way as to protect the rights and interests of the bondholders.

Rating Agencies

The two main risks to a corporate bond investor are interest rate risk and credit risk. Interest rate risk is borne by all fixed‐income investors, and one's view on the future path of interest rates determines the optimal maturity for an investor. The other risk for a corporate investor is changes in the bond's creditworthiness—in other words, credit risk. The obvious manifestation of this risk is a change in the bond's market value with no commensurate change in the general level of interest rates. What determines a bond's creditworthiness is the issuer's ability to make full and timely payment of interest and principal when due. Bond investors must have confidence that the bond they have purchased will provide the promised cash flows. If not, the market value of the bond will reflect a much higher required return (yield) to compensate for the additional risk of the issuer not making the expected payments.

While there is no substitute for doing individual credit work on bonds that you are considering buying, the large number of issuers and issues means that a helping hand is often useful. A corporation issuing a new bond will often hire a rating agency, such as Standard & Poor's (S&P), Moody's Investors Service, or Fitch, to analyze the credit risk of the bond prior to its issuance and assign a rating. These agencies look at many factors of the issuer's operations when making their determination. Because bonds from the same corporation can have different types of assets pledged as collateral, or varying degrees of seniority, the rating assigned to the bond is that of the bond itself—not the issuing corporation. The ratings agencies also provide a general corporate family rating for larger borrowers, with individual bonds notched upwards or downwards from the corporate rating based on collateral and seniority. Since the majority of the most liquid corporate bonds come with rating, utilizing the ratings agencies allows investors a method to compare the relative creditworthiness of different borrowers.

The general rating scale used by each ratings agency is unique to each ratings agency, although it is generally acknowledged that investment grade is considered for a bond in the triple‐B or better category, while a non‐investment‐grade, or junk bond carries a rating below triple‐B. Ratings agencies can disagree on ratings as they perform their credit analysis in isolation, utilizing factors that are unique to their firm. Therefore, it is not unusual for ratings for an individual bond to vary across the different agencies, although those variations generally do not drift more than a few ratings categories. A bond that has an investment grade rating from one agency and a junk rating from another agency is called a crossover bond. Some investors may utilize the lower of these ratings in determining its portfolio suitability, which in the case of a crossover bond would not be acceptable to a strictly investment‐grade investor. Other investors may blend the various ratings in coming up with a composite rating, which may be considered investment grade if two out of the three agencies rate a borrower IG while one has it as non‐investment grade. A few other ratings terms are fallen angels and rising stars. A fallen angel is an investment‐grade bond that has been downgraded into junk status, while a non‐investment‐grade borrower that gets upgraded into the IG area is called a rising star. Table 14.2 lists the rating categories for the major rating agencies and the definition of each one of these categories.

We will stress again that there is no substitute for doing individual credit work and fully understanding the investment that you are buying. Relying solely on the rating has had mixed results, particularly after some fairly high‐profile credit mistakes. Most recently this has included the generally high ratings for banks going into the financial crisis, which ultimately tested their solvency despite their investment‐grade ratings. The structured finance market has seen its fair share of incorrect ratings, with model assumptions around the housing market resulting in wholesale downgrades in that asset class. Going back into the middle 2000s, the ratings agencies were ultimately incorrect in their assessments of Enron and WorldCom, both very high‐profile borrowers. Having said this, the ratings agencies play an important role in the markets, and their ratings and ratings changes directly impact the prices of corporate bonds. Despite the incorrect ratings assessments listed previously, ratings remain a generally good barometer for credit performance. Moody's transition studies indicate that over a 40‐year period, over 90% of bonds with a triple‐B rating remain investment grade after one year. That figure declines to 60% after a 5‐year period, making the point that surveillance of a portfolio is as important as the original construction. Data from S&P indicates that the vast majority of defaults arise from the weakest single‐B and lower categories, again advocating for a regular review of existing bond positons.

In terms of what agencies look for when evaluating a bond's credit risk, we can look toward the five Cs of credit: capacity, capital, collateral, conditions, and character. Capacity refers to the ability of the company to generate sufficient cash flow to cover all of its required debt service (interest and principal payments on all bond issues and bank loans). Capital refers to the amount of equity invested in the company by its owners. Lenders will require a threshold minimum of equity in the company's capital structure (debt and equity) as an indication of the owners' confidence in the enterprise and their financial risk at stake in the enterprise's success or failure. Collateral refers to assets of the company pledged to the lender as a secondary source or repayment. Conditions refer to the economic climate in which the enterprise must conduct its business and whether it is currently favorable or unfavorable. Character refers to the borrower's willingness to repay and is an assessment of whether the borrower will try to honor or avoid their obligation under difficult circumstances. There are also sector‐specific nuances that either support or penalize the companies within the industry. The banking sector is a prime example of understanding industry‐specific factors, especially after the litany of new regulatory rules were passed after the financial crisis. The once assumed too‐big‐to‐fail ratings uplift has also been largely removed from a bank's ratings as regulators have distanced themselves from needing to provide emergency support in solvency situations.

While we have provided a detailed explanation of the ratings categories found in the corporate bond space, there are additional ratings applicable for short‐term ratings. Moody's utilizes Prime 1 (P‐1), Prime 2 (P‐2), Prime 3 (P‐3), and not Prime as its short‐term ratings while S&P utilizes an A‐1, A‐2, A‐3, B, C, and D scale. The short‐term market is very quality focused, with A‐1/P‐1 ratings often required to access the market.

Buyers

There are two broad categories of investors in the fixed‐income markets: institutional investors and individual investors. Within the institutional bucket, the composition of the various investors has varied over time, and more recently has shifted away from the traditional pension and insurance company buyers. Mutual funds and ETFs have become more active buyers recently, reflecting an interest from the retail investor that chooses not to own individual bonds. Other institutional investor classes have also seen growth over the past few years, such as investors. One constant for each of these investors in the investment‐grade arena is the desire to generate stable, lower‐volatility‐income, corporate and international that offers a spread pickup to increasingly low government yields.

Insurance companies and pension funds were once the predominant owners of corporate bonds, holding an estimated 70+% of outstanding issues in the 1970s. However, as pensions have become scarcer and alternative investment vehicles like ETF and mutual funds have grown, the share of these market participants has shrunk by over one half during the past several decades. The bond market nonetheless continues to be an important investment asset for these institutional investors. In the case of life insurance companies, bonds account for a major holding in the portfolios that back the company's life insurance policies. The coupon interest and reinvestment of that interest are used to pay death benefits on policies and to generate a level of return that creates the policies' cash value. The uncertainty of stock dividends makes equity investments more challenging to manage, although low yields have forced a greater use of stocks by insurance companies. Another reason insurance companies purchase bonds for their portfolios is to form the collateral for their investment products, such as guaranteed investment contracts (GICs). When an investor purchases a GIC, a guaranteed rate of return is promised by the contract. The upfront premium paid to the insurance company by the investor is used to purchase securities whose returns will allow the company to guarantee the promised return of the GIC. The insurance company must then immunize its liability by locking in a minimum rate of return regardless of subsequent changes in the general level of interest rates. Pensions also need to plan on making regular disbursements to members, and the stability of principal and income is tantamount to accomplishing this task. Pensions therefore must have sufficient cash on hand each period and will match their investment income to cash flow needs. The portfolio creation and management process allows the pension fund to ensure that cash will be available when retirement payments are due.

While pensions and insurance company market share in the corporate bond market have fallen, mutual fund and ETF assets have grown significantly during this period. It is estimated that these two investor groups presently own approximately 15% of outstanding corporates, growing from an almost de minimus level just a few decades ago. Since retail investors make up a large portion of the mutual funds and ETFs world, it is safe to say that retail has become a larger player in the corporate marketplace. Within these investor classes, there has been an increased use of passive investment strategies. Many ETFs track a broad‐based fixed‐income index, such as those compiled by Barclays Capital and Merrill Lynch/Bank of America. This greater focus on passive management has had an impact on the marketability of all bonds. There are now certain larger more liquid securities that are more frequently traded as part of passive strategies. As a result, these bonds are generally more liquid, carry a liquidity premium, but also may be more volatile given the easier ability to trade them during stressful market environments.

Other corporate borrowers and international buyers have also become larger investors in the corporate bond market. Other corporate borrowers are particularly interesting, in that companies are effectively investing excess cash in other companies, possibly competitors. The inability to generate returns on government yields is a primary reason for corporate treasurers to invest in other companies' debt. Many companies also find themselves cash rich, but many of those funds are locked offshore based on tax code. Therefore, a firm like Apple is a large issuer of corporate bonds despite the fact that it has over $30 billion in cash and investments on its balance sheet. Technology and pharmaceutical firms are some of the most cash‐rich sectors investing in the corporate market. Foreign buyers have also become active in the corporate market, as developed market yields plummet under the zero‐to negative rate regimes pursued by global central bankers. The desire to hold U.S.‐based assets also remains a theme for foreign buyers, particularly as the U.S. dollar has generally strengthened over the past several years.

Individual Investors

The goals of individual investors are similar to those of institutions even though the funds available for investment are generally much smaller. An individual investor in bonds may have a need for regular current income and/or longer‐term stability of principal. The minimum denomination of $1,000 for most U.S. corporate bonds puts them in reach of many smaller investors. Along with the relative size of their investments, the major difference between institutional and individual bond investors is the amount of market information, research, and analytical tools available to each. Institutions typically have the wherewithal to invest in systems that allow them to find and analyze various bonds for potential investment. They can also have their holdings valued on a regular basis, in many cases, daily. Individuals normally are not as focused on the daily movement of their bonds since they are typically held to maturity. Of course, this becomes somewhat problematic when the individual has purchased a bond with an embedded option. Without the systems to properly evaluate the potential risk and return characteristics of a given bond, many individuals are rudely awakened when they find their bond has been called. A general rule should be to make sure you receive a prospectus on the bond before you purchase it or you have a system or service that allows you to analyze the risk and return relative to other bonds. Most online brokerage accounts, as well as your broker or wealth manager, should have such systems available. Among individual investors, there are varying levels of both investing experience and relative wealth. For most individuals, bond investing comes in the form of indirect investment via mutual funds and, perhaps, a pension plan, 401(k), ETF, or other retirement vehicle. Mutual funds allow individuals to buy shares of a portfolio of securities. In this way, a small amount of money can be spread across a diversified group of bonds. Pension plans and 401(k) plans are similar in that the investor's retirement funds can be spread across a diversified set of holdings.

Investors with larger amounts to invest are sometimes called high‐net‐worth individuals. These people often take advantage of the growing business of private wealth management, which is provided by banks and investment firms. The private wealth manager will handle the bond investments of the individual and may suggest certain bonds as appropriate to the investor's risk and return requirements. At the end of the day, the vast majority of bond investing is done for the benefit of individuals, whether it is done personally or through institutions on their behalf.

Market Sizing

There are many ways to look at the EM debt market, although we will focus on the debt that USD corporate investors are most likely to encounter when constructing their investment portfolio. The EM debt markets have grown exponentially over the past decade, reaching over $6 trillion in 2013 according to the World Bank, a six‐fold increase since 2000. Hard currency debt, or bonds issued by these emerging markets borrowers denominated in currencies other than their home market was estimated to be between $1 and $3 trillion, with the U.S. dollar the major funding currency, although the euro and Japanese yen are also represented. Further dissecting this data reveals that USD EM corporate bonds market may be up to $1 trillion in size according to Bloomberg, equal in size to the high‐yield market. Various other studies have indicated that cross‐section of the bond market has been the fastest growing since the financial crisis, which therefore warrants investor consideration.

There are numerous reasons that EM corporate borrowers have been active issuers of hard currency bonds. Since the debt markets in many emerging markets are not overly developed, these borrowers have had to rely on bank debt as a primary source of capital. While bank lending remains the dominant source of funding in many markets, its share of total financing has declined over the past decade, consistent with the overall decrease in bank credit. This fall in bank balance sheets occurred at the same time as interest rates were falling globally as central banks pursued zero‐interest‐rate policy and other forms of quantitative easing. This created a demand for additional debt, especially higher yielding ones, as investors were suddenly competing against monetary authorities for debt. While central banks initially focused their bond‐buying efforts on sovereign bonds, this has been expanded to the corporate bonds in various jurisdictions. The U.S. dollar is the most common hard currency used for funding as the USD occupies a unique role in global finance. Not only are the U.S. capital markets the most developed in the world, the dollar's role as a reserve currency means that it is found in many markets outside of the United States. Therefore, it is estimated that over 80% of hard currency borrowing is in U.S. dollars.

Credit and Market Analysis

In many ways, analyzing an EM corporate credit is similar to analyzing domestic corporate obligations. Industry analysis, fundamental corporate analysis, financial statement review, and market pricing signals are variables that investors in both domestic and EM corporate bonds should consider. This financial analysis should also take into consideration the impact of changing exchange rates, as it may have an outsized impact on a company's ability to service its debt. This is particularly relevant as the U.S. dollar has strengthened over the past few years, which may make it more difficult for a company to service its debt. This occurs when a borrower must repay its liabilities in a foreign currency while collecting revenues in its local currency. In the case of the U.S. dollar, it has strengthened 18% over the past two years, possibly raising the debt service cost of an EM corporate by a similar proportion unless it generates USD‐based revenues or has hedged this exposure.

The rating agencies are active in the emerging markets, so using their ratings analysis while adhering to the caveats discussed earlier remains relevant for EM investors. The ratings of EM borrowers vary extensively, as a county's economic prospects have a direct bearing on EM corporate credit. For example, the country ratings for the four largest borrowers range from double‐A‐rated China to double‐B‐rated Brazil. How a country manages it finances has a direct bearing on these ratings, with China maintaining $3 trillion in reserves while Brazil maintains external debt at 2× its current account receipts. Since many EM economies are tied to the export of commodities, volatility in those products can also rapidly change the economic prospects for a country. The ratings agencies provide a rating for a country's local currency obligations and its foreign currency debt. This foreign currency rating is usually lower than the local currency rating, reflecting the risk associated with foreign currency translation. These ratings agencies often use these country ratings as a ceiling for all EM debt emanating from that jurisdiction, with the concept that there is risk associated. Country ratings often act as a ceiling for all EM debt obligations, reflecting the risk that possible capital and exchange controls could impact the ability to convert currency to pay external creditors. Since there are more non‐investment‐grade‐rated EM corporates, these sovereign‐specific issues must be taken into consideration along with the credit review process. While EM presents greater liquidity and risk issues than investment‐grade corporates, the rapid growth of this market and its potentiality to generate greater income and return prospects justifies its portfolio consideration.