Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of Finance School of Management Yale University

Corporations issue various types of financial instruments to raise funds. In general, corporate financial instruments can be classified as either a debt obligation or equity. In turn, equity can be classified as either common stock or preferred stock. In Chapter 4, common stock is covered. In Chapter 12, preferred stock is explained. Basically, the common stockholders are the residual owners of the firm. Preferred stockholders have priority over common stockholders in the case of distribution of dividends and proceeds in the case of liquidation of the firm.

The debt obligations of a corporation include bonds, medium-term notes, asset-backed securities, commercial paper, and bank loans. The key feature of corporate debt obligations is that they have a priority over the claims of equity holders in the case of bankruptcy. In this chapter we will focus on corporate bonds and medium-term notes. Other than the way in which they are issued, there is no difference between corporate bonds and medium-terms notes. Asset-backed securities, commercial paper, and banks loans are covered in Chapters 17, 6, and 19, respectively.

CORPORATE BANKRUPTCY AND CREDITOR RIGHTS

The holder of a corporate debt instrument has priority over the equity owners in a bankruptcy proceeding. Moreover, there are creditors who have priority over other creditors. The law governing bankruptcy in the United States is the Bankruptcy Reform Act of 1978.

One purpose of the act is to set forth the rules for a corporation to be either liquidated or reorganized. The liquidation of a corporation means that all the assets will be distributed to the holders of claims of the corporation and no corporate entity will survive. In a reorganization, a new corporate entity will result. Some security holders of the bankrupt corporation will receive cash in exchange for their claims, others may receive new securities in the corporation that results from the reorganization, and others may receive a combination of both cash and new securities in the resulting corporation.

Another purpose of the bankruptcy act is to give a corporation time to decide whether to reorganize or liquidate and then the necessary time to formulate a plan to accomplish either a reorganization or liquidation. This is achieved because when a corporation files for bankruptcy, the act grants the corporation protection from creditors who seek to collect their claims. The petition for bankruptcy can be filed either by the company itself, in which case it is called a voluntary bankruptcy, or by its creditors, in which case it is called an involuntary bankruptcy. A company that files for protection under the bankruptcy act generally becomes a “debtor-in-possession,” and continues to operate its business under the supervision of the court.

The bankruptcy act comprises 15 chapters, each chapter covering a particular type of bankruptcy. Chapter 7 deals with the liquidation of a company; Chapter 11 deals with the reorganization of a company. When a company is liquidated, creditors receive distributions based on the “absolute priority rule” to the extent assets are available. The absolute priority rule is the principle that senior creditors are paid in full before junior creditors are paid anything. For secured and unsecured creditors, the absolute priority rule guarantees their seniority to equity-holders.

The Rights of Creditors: Theory versus Practice

What actually occurs in a bankruptcy? That is, does the absolute priority rule hold in a liquidation and a reorganization? In liquidations, the absolute priority rule generally holds. In contrast, studies of actual reorganizations under Chapter 11 have found that the violation of absolute priority is the rule rather than the exception.

There are several possible explanations suggested as to why in a reorganization the distribution made to claimholders will diverge from that required by the absolute priority principle. The first explanation is that the longer the negotiation process among the parties, the greater the bankruptcy costs and the smaller the amount to be distributed to all parties. This is because the longer the negotiation process among the parties, the more likely that the company will be operated in a manner that is not in the best interest of the creditors and, as a result, the smaller the amount remaining for distribution. Since all impaired classes including equityholders generally must approve the plan of reorganization, creditors often convince equityholders to accept the plan by offering to distribute some value to them.

A second explanation is that the violation of absolute priority reflects a recontracting process between stockholders and senior creditors that gives recognition to the ability of management to preserve value on behalf of stockholders. According to this view, creditors are less informed than management about the true economic operating conditions of the firm. Because the distribution to creditors in the plan of reorganization is based on the valuation by the firm, creditors without perfect information easily suffer the loss. Managers generally have a better understanding than creditors or stockholders about a firm’s internal operations, while creditors and stockholders can have better information about industry trends. Management may therefore use its superior knowledge to present the data in a manner that reinforces its position.

The essence of another explanation is that the increasing complexity of firms that declare bankruptcy will accentuate the negotiating process and result in an even higher incidence of violation of the absolute priority rule. The likely outcome is further supported by the increased number of official committees in the reorganization process, as well as the increased number of financial and legal advisors.

There are some who argue that creditors will receive a higher value in reorganization than they would in liquidation in part because of the costs associated with liquidation. These additional costs include commissions and Chapter 7-specific costs. The commissions associated with liquidation can be significant. The commission charged on the sale of a particular asset could be as high as 20% of the gross proceeds from the asset. Total liquidation costs can be significant.

Finally, the lack of symmetry in the tax system (negative taxes are not permitted, although loss deductions may be carried forward) results in situations in which the only way to use all current loss deductions is to merge. The tax system may encourage continuance or merger and discourage bankruptcy.

SECURED DEBT¹

A corporate debt issue can be secured or unsecured. Here we look at secured debt. By secured debt it is meant that some form of collateral is pledged to ensure repayment of the debt.

Utility Mortgage Bonds

Debt secured by real property such as plant and equipment is called mortgage debt. The largest issuers of mortgage debt are the electric utility companies. Other utilities, such as telephone companies and gas pipeline and distribution firms, have also used mortgage debt as sources of capital, but generally to a lesser extent than electrics.

Most electric utility bond indentures do not limit the total amount of bonds that may be issued. This is called an open-ended mortgage. The mortgage generally is a first lien on the company’s real estate, fixed property, and franchises, subject to certain exceptions or permitted encumbrances owned at the time of the execution of the indenture or its supplement. The after-acquired property clause also subjects to the mortgage property that is acquired by the company after the filing of the original or supplemental indenture.

To provide for proper maintenance of the property and replacement of worn-out plant, maintenance fund, maintenance and replacement fund, or renewal and replacement fund, provisions are placed in indentures. These clauses stipulate that the issuer spend a certain amount of money for these purposes. Depending on the company, the required sums may be around 15% of operating revenues. As defined in other cases, the figure is based on a percentage of the depreciable property or amount of bonds outstanding.

Another provision for bondholder security is the release and substitution of property clause. If the company releases property from the mortgage lien (such as through a sale of a plant or other property that may have become obsolete or no longer necessary for use in the business, or through the state’s power of eminent domain), it must substitute other property or cash and securities to be held by the trustee, usually in an amount equal to the released property’s fair value. It may use the proceeds or cash held by the trustee to retire outstanding bonded debt. Certainly, a bondholder would not let go of the mortgaged property without substitution of satisfactory new collateral or adjustment in the amount of the debt because the bondholder should want to maintain the value of the security behind the bond. In some cases the company may waive the right to issue additional bonds.

Although the typical electric utility mortgage does not limit the total amount of bonds that may be issued, certain issuance tests or bases usually have to be satisfied before the company can sell more bonds. New bonds are often restricted to no more than 60% to 66⅔% of the value of net bondable property. A further earnings test found often in utility indentures requires interest charges to be covered by pretax income available for interest charges of at least two times.

Mortgage bonds go by many different names. The most common of the senior lien issues are first mortgage bonds, first refunding mortgage bonds, first and refunding mortgage bonds, and first and general mortgage bonds.

There are instances when a company might have two or more layers of mortgage debt outstanding with different priorities. This situation usually occurs because companies cannot issue additional first mortgage debt (or the equivalent) under the existing indentures. Often this secondary debt level is called general and refunding mortgage bonds (G&R). In reality, this is mostly second mortgage debt.

Other Mortgage Debt

Nonutility companies do not offer much mortgage debt nowadays; the preferred form of debt financing is unsecured. In the past, railroad operating companies were frequent issuers of mortgage debt. In many cases, a wide variety of secured debt might be found in a company’s capitalization. One issue may have a first lien on a certain portion of the right of way and a second mortgage on another portion of the trackage, as well as a lien on the railroad’s equipment, subject to the prior lien of existing equipment obligations. Certain railroad properties are not subject to such a lien. Railroad mortgages are often much more complex and confusing to bond investors than other types of mortgage debt.

In the broad classification of industrial companies, only a few have first mortgage bonds outstanding. Mortgages may also contain maintenance and repair provisions, earnings tests for the issuance of additional debt, release and substitution of property clauses, and limited after-acquired property provisions. In some cases, shares of subsidiaries might also be pledged as part of the lien. Some mortgage bonds are secured by a lien on a specific property rather than on most of a company’s property, as in the case of an electric utility.

Other Secured Debt

Debt can be secured by many different assets. Collateral trust debentures, bonds, and notes are secured by financial assets such as cash, receivables, other notes, debentures, or bonds, and not by real property. Collateral trust notes and debentures have been issued by companies engaged in vehicle leasing. The eligible collateral is held by a trustee and periodically marked to market to ensure that the market value has a liquidation value in excess of the amount needed to repay the entire outstanding bonds and accrued interest. If the collateral is insufficient, the issuer must bring the value of the collateral up to the required amount by a designated date. If the issuer is unable to do so, the trustee would then sell collateral and redeem bonds.

Another collateralized structure allows for the defeasance or “mandatory collateral substitution,” which provides the investor assurance that it will continue to receive the same interest payments until maturity. Instead of redeeming the bonds with the proceeds of the collateral sale, the proceeds are used to purchase a portfolio of U.S. government securities in such an amount that the cash flow is sufficient to meet the principal and interest payments on the bond. Because of the structure of these issues, the rating agencies (discussed below) have assigned such issues their highest credit rating. The rating is based on the strength of the collateral and the issue’s structure, not on the issuer’s credit standing.

Equipment Trust Financing: Railroads

Railroads and airlines have financed much of their rolling stock and aircraft with secured debt. The securities go by various names such as equipment trust certificates (ETCs), in the case of railroads, and secured equipment certificates, guaranteed loan certificates, and loan certificates in the case of airlines. Railroads probably comprise the largest and oldest group of issuers of secured equipment financing.

The credit ratings for equipment trust certificates are higher than on the same company’s mortgage debt or other public debt securities. This is due primarily to the collateral value of the equipment, its superior standing in bankruptcy compared with other claims, and the instrument’s generally self-liquidating nature. The railroad’s actual creditworthiness may mean less for some equipment trust investors than for investors in other railroad securities or, for that matter, other corporate debt obligations.

Equipment trust certificates are issued under agreements that provide a trust for the benefit of the investors. Each certificate represents an interest in the trust equal to its principal amount and bears the railroad’s unconditional guarantee of prompt payment, when due, of the principal and dividends (the term dividends is used because the payments represent income from a trust and not interest on a loan). The trustee holds the title to the equipment, which when the certificates are retired, passes to, or vests in, the railroad, but the railroad has all other ownership rights. It can take the depreciation and can utilize any tax benefits on the subject equipment. The railroad agrees to pay the trustee sufficient rental for the principal payments and the dividends due on the certificates, together with expenses of the trust and certain other charges. The railroad uses the equipment in its normal operations and is required to maintain it in good operating order and repair (at its own expense). If the equipment is destroyed, lost, or becomes worn out or unsuitable for use (i.e., suffers a “casualty occurrence”), the company must substitute the fair market value of that equipment in the form of either cash or additional equipment. Cash may be used to acquire additional equipment unless the agreement states otherwise. The trust equipment is usually clearly marked that it is not the railroad’s property.

Immediately after the issuance of an ETC, the railroad has an equity interest in the equipment that provides a margin of safety for the investor. Normally, the ETC investor finances no more than 80% of the cost of the equipment and the railroad the remaining 20%. Although modern equipment is longer-lived than that of many years ago, the ETC’s length of maturity is still generally the standard 15 years (there are some exceptions).

The structure of the financing usually provides for periodic retirement of the outstanding certificates. The most common form of ETC is the serial variety. It is usually issued in 15 equal maturities, each one coming due annually in years 1 through 15. There are also sinking fund equipment trust certificates where the ETCs are retired through the operation of a normal sinking fund, one-fifteenth of the original amount issued per year.

The standing of railroad or common carrier ETCs in bankruptcy is of vital importance to the investor. Because the equipment is needed for operations, the bankrupt railroad’s management will more than likely reaffirm the lease of the equipment because, without rolling stock, it is out of business. Cases of disaffirmation of equipment obligations are very rare indeed, but if equipment debt were to be disaffirmed, the trustee could repossess and then try to release or sell it to others. Any deficiency due the equipment debtholders would still be an unsecured claim against the bankrupt railway company. Standard-gauge, nonspecialized equipment should not be difficult to release to another railroad.

The Bankruptcy Reform Act of 1978 provides specifically that railroads be reorganized, not liquidated, and subchapter IV of Chapter 11 grants them special treatment and protection. One very important feature found in Section 77(j) of the preceding Bankruptcy Act was carried over to the new law. Section 1168 states that Section 362 (the automatic stay provision) and Section 363 (the use, sale, or lease of property section) are not applicable in railroad bankruptcies. It protects the rights of the equipment lenders while giving the trustee the chance to cure any defaults. Railroad bankruptcies usually do not occur overnight but creep up gradually as the result of steady deterioration over the years. New equipment financing capability becomes restrained. The outstanding equipment debt at the time of bankruptcy often is not substantial and usually has a good equity cushion built in. Equipment debt of noncommon carriers such as private car leasing lines does not enjoy this special protection under the Bankruptcy Act.

Airline Equipment Debt

Airline equipment debt has some of the special status that is held by railroad equipment trust certificates. Like railroad equipment obligations, certain equipment debt of certified airlines, under Section 1110 of the Bankruptcy Reform Act of 1978, is not subject to Sections 362 and 363 of the Act, namely the automatic stay and the power of the court to prohibit the repossession of the equipment. The creditor must be a lessor, a conditional vendor, or hold a purchase money security interest with respect to the aircraft and related equipment. The secured equipment must be new, not used. It gives the airline 60 days in which to decide to cancel the lease or debt and to return the equipment to the trustee. If the reorganization trustee decides to reaffirm the lease in order to continue using the equipment, it must perform or assume the debtor’s obligations, which become due or payable after that date, and cure all existing defaults other than those resulting solely from the financial condition, bankruptcy, insolvency, or reorganization of the airline. Payments resume, including those that were due during the delayed period. Thus, the creditor will get either the payments due according to the terms of the contract or the equipment.

The equipment is an important factor. If the airplanes are of recent vintage, well-maintained, fuel efficient, and relatively economical to operate, it is more likely that a company in distress and seeking to reorganize would assume the equipment lease. However, if the outlook for reorganization appears dim from the outset and the airplanes are older and less economical, the airline could very well disaffirm the lease. In this case, releasing the aircraft or selling it at rents and prices sufficient to continue the original payments and terms to the security holders might be difficult. Of course, the resale market for aircraft is on a plane-by-plane basis and highly subject to supply and demand factors. Multimillion-dollar airplanes have a somewhat more limited market than do boxcars and hopper cars worth only a fraction of the value of an airplane.

The lease agreement required the airline to pay a rental sufficient to cover the interest, amortization of principal, and a return to the equity participant. The airline was responsible for maintaining and operating the aircraft, as well as providing for adequate insurance. It must also keep the equipment registered and record the ETC and lease under the Federal Aviation Act of 1958. In the event of a loss or destruction of the equipment, the company may substitute similar equipment of equal value and in as good operating condition and repair and as airworthy as that which was lost or destroyed. It also has the option to redeem the outstanding certificates with the insurance proceeds.

Do not be misled by the title of the issue just because the words “secured” or “equipment trust” appear. Investors should look at the collateral and its estimated value based on the studies of recognized appraisers compared with the amount of equipment debt outstanding. Is the equipment new or used? Do the creditors benefit from Section 1110 of the Bankruptcy Reform Act? Because the equipment is a depreciable item and subject to wear, tear, and obsolescence, a sinking fund starting within several years of the initial offering date should be provided if the debt is not issued in serial form. Of course, the ownership of the aircraft is important as just noted. Obviously, one must review the obligor’s financials because the investor’s first line of defense depends on the airline’s ability to service the lease rental payments.

UNSECURED DEBT

We have discussed many of the features common to secured debt. Take away the collateral and we have unsecured debt.

Unsecured debt, like secured debt, comes in several different layers or levels of claim against the corporation’s assets. But in the case of unsecured debt, the nomenclature attached to the debt issues sounds less substantial. For example, “general and refunding mortgage bonds” may sound more important than “subordinated debentures,” even though both are basically second claims on the corporate body. In addition to the normal debentures and notes, there are junior issues; for example, General Motors Acceptance Corporation, in addition to senior unsecured debt, had public issues designated as “senior subordinated” and “junior subordinated notes,” representing the secondary and tertiary levels of the capital structure. The difference in a high-grade issuer may be considered insignificant as long as the issuer maintains its quality. But in cases of financial distress, the junior issues usually fare worse than the senior issues. Only in cases of very well-protected junior issues will investors come out whole—in which case, so would the holders of senior indebtedness. Thus, many investors are more than willing to take junior debt of high-grade companies; the minor additional risk, compared to that of the senior debt of lower-rated issuers, may well be worth the incremental income.

Subordination of the debt instrument might not be apparent from the issue’s name. This is often the case with bank and bank-related securities. For example, the term “capital notes” would not sound like a subordinated debt instrument to most inexperienced investors unfamiliar with the jargon of the debt world. Yet capital notes are junior securities.

Credit Enhancements

Some debt issuers have other companies guarantee their loans. This is normally done when a subsidiary issues debt and the investors want the added protection of a third-party guarantee. The use of guarantees makes it easier and more convenient to finance special projects and affiliates, although guarantees are extended to operating company debt.

There are also other types of third-party credit enhancements. Some captive finance subsidiaries of industrial companies enter into agreements requiring them to maintain fixed charge coverage at such a level so that the securities meet the eligibility standards for investment by insurance companies under New York State law. The required coverage levels are maintained by adjusting the prices at which the finance company buys its receivables from the parent company or through special payments from the parent company. These supplemental income maintenance agreements, while usually not part of indentures, are very important considerations for bond buyers.

Another credit-enhancing feature is the letter of credit (LOC) issued by a bank. A LOC requires the bank to make payments to the trustee when requested so that monies will be available for the bond issuer to meet its interest and principal payments when due. Thus the credit of the bank under the LOC is substituted for that of the debt issuer. Insurance companies also lend their credit standing to corporate debt, both new issues and outstanding secondary market issues, a common practice for municipal bonds.

While a guarantee or other type of credit enhancement may add some measure of protection to a debtholder, caution should not be thrown to the wind. In effect, an investor’s job may become even more complex because an analysis of both the issuer and the guarantor should be performed. In many cases, only the latter is needed if the issuer is merely a financing conduit without any operations of its own. However, if both concerns are operating companies, it may very well be necessary to analyze both because the timely payment of principal and interest ultimately will depend on the stronger party. A downgrade of the enhancer’s claims-paying ability reduces the value of the bonds.

Negative Pledge Clause

One of the important protective provisions for unsecured debtholders is the negative pledge clause. This provision, found in most senior unsecured debt issues and a few subordinated issues, prohibits a company from creating or assuming any lien to secure a debt issue without equally securing the subject debt issue(s) (with certain exceptions). Designed to prevent other creditors from obtaining a senior position at the expense of existing creditors, “it is not intended to prevent other creditors from sharing in the position of debenture holders.”² Again, it is not necessary to have such a clause unless the issuer runs into trouble. But like insurance, it is not needed until the time that no one wants arrives.

Negative pledge clauses are not just boiler plate material added to indentures and loan agreements to give lawyers extra work. They have provided additional security for debtholders when the prognosis for corporate survival was bleak.

INDENTURES

As we have seen, corporate debt securities come with an infinite variety of features, yet we have just scratched the surface. While prospectuses may provide most of the needed information, the indenture is the more important document. The indenture sets forth in great detail the promises of the issuer. Here we will look at what indentures of corporate debt issues contain. For corporate debt securities to be publicly sold, they must (with some permitted exceptions) be issued in conformity with the Trust Indenture Act of 1939. This act requires that debt issues subject to regulation by the Securities and Exchange Commission (SEC) have a trustee. Also, the trustee’s duties and powers must be spelled out in the indenture.

Some corporate debt issues are issued under a blanket indenture or open-ended indenture; for others a new indenture must be written each time a new series of debt is sold. A blanket indenture is often used by electric utility companies and other issuers of general mortgage bonds, but it is also found in unsecured debt. The initial or basic indenture may have been entered into 30 or more years ago, but as each new series of debt is created, a supplemental indenture is written.

Covenants

Certain limitations and restrictions on the borrower’s activities are set forth in the indenture. Some covenants are common to all indentures, such as to pay interest, principal, and premium, if any, on a timely basis, to pay all taxes and other claims when due unless contested in good faith, and to maintain all properties used and useful in the borrower’s business in good condition and working order. These are often called affirmative covenants since they call upon the debtor to make promises to do certain things.

Negative covenants require the borrower not to take certain actions. Borrowers want the least restrictive loan agreement available, while lenders should want the most restrictive, consistent with sound business practices. A company might be willing to include additional restrictions (up to a point) if it can get a lower interest rate on the loan. When companies seek to weaken restrictions in their favor, they are often willing to pay more interest or give other consideration.

An infinite variety of restrictive covenants can be placed on borrowers, depending on the type of debt issue, the economics of the industry and the nature of the business, and the lenders’ desires. Some of the more common restrictive covenants include various limitations on the company’s ability to incur debt, since unrestricted borrowing can lead a company and its debtholders to ruin. Thus, debt restrictions may include limits on the absolute dollar amount of debt that may be outstanding or may require a ratio test (e.g., debt may be limited to no more than 60% of total capitalization or that it cannot exceed a certain percentage of net tangible assets).

There may be an interest coverage test or fixed-charge coverage test of which there are two types. One, a maintenance test, requires the borrower’s ratio of earnings available for interest or fixed charges to be at least a certain minimum figure on each required reporting date (such as quarterly or annually) for a certain preceding period. The other type, a debt incurrence test, only comes into play when the company wishes to do additional borrowing. In order to take on additional debt, the required interest or fixed-charge coverage figure adjusted for the new debt must be at a certain minimum level for the required period prior to the financing. Incurrence tests are generally considered less stringent than maintenance provisions. There could also be cash flow tests or requirements and working capital maintenance provisions.

CORPORATE BOND RATINGS

Many large institutional investors and many investment banking firms have their own credit analysis departments. Few individual investors and institutional bond investors, though, do their own analysis. Instead, they rely primarily on nationally recognized statistical rating organizations that perform credit analyses and issue their conclusions in the form of ratings. The three commercial rating companies are Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch.

Rating Symbols

The rating systems use similar symbols, as shown in Exhibit 11.1. In all systems the term high grade means low credit risk, or conversely, high probability of future payments. The highest-grade bonds are designated by Moody’s by the symbol Aaa, and by the other two rating systems by the symbol AAA. The next highest grade is denoted by the symbol Aa (Moody’s) or AA (the other two rating systems); for the third grade all rating systems use A. The next three grades are Baa or BBB, Ba or BB, and B, respectively. There are also C grades.

Bonds rated triple A (AAA or Aaa) are said to be prime; double A (AA or Aa) are of high quality; single A issues are called upper medium grade; and triple B are medium grade. Lower-rated bonds are said to have speculative elements or be distinctly speculative.

All rating agencies use rating modifiers to provide a narrower credit quality breakdown within each rating category. S&P and Fitch use a rating modifier of plus and minus. Moody’s uses 1, 2, and 3 as its rating modifiers.

Bond issues that are assigned a rating in the top four categories are referred to as investment-grade bonds. Issues that carry a rating below the top four categories are referred to as noninvestment-grade bonds or speculative bonds, or more popularly as high-yield bonds or junk bonds. Thus, the corporate bond market can be divided into two sectors: the investment-grade and noninvestment-grade markets.

A bond issue may be assigned a “dual” rating if there is a feature of the bond that rating agencies believe would alter the credit risk. For example, Standard & Poor’s assigns a dual rating to putable bonds. The first rating is the normal rating based on the likelihood of repayment of principal and interest as due in the absence of the put feature. The second rating reflects the ability of the issuer to repay the principal at the put date if the bondholder exercises the put option.

The Rating Process

The rating process involves the analysis of a multitude of quantitative and qualitative factors over the past, present, and future. Ratings should be prospective because future operations should provide the wherewithal to repay the debt. The ratings apply to the particular issue, not the issuer. While bond analysts rely on numbers and calculate many ratios to get a picture of the company’s debt-servicing capacity, a rating is only an opinion or judgment of an issuer’s ability to meet all of its obligations when due, whether during prosperity or during times of stress. The purpose of ratings is to rank issues in terms of the probability of default, taking into account the special features of the issue, the relationship to other obligations of the issuer, and current and prospective financial conditions, and operating performance.

In conducting its examination, the rating agencies consider the four Cs of credit—character, capacity, collateral, and covenants. The first of the Cs stands for character of management, the foundation of sound credit. In assessing management quality, the analysts at Moody’s, for example, try to understand the business strategies and policies formulated by management. Following are factors that are considered: strategic direction, financial philosophy, conservatism, track record, succession planning, and control systems.

The next C is capacity or the ability of an issuer to repay its obligations. In assessing the ability of an issuer to pay, an analysis of the financial statements is undertaken. In addition to management quality, the factors examined by Moody’s, for example, are industry trends, the regulatory environment, basic operating and competitive position, financial position and sources of liquidity, company structure (including structural subordination and priority of claim), and parent company support agreements.

The third C, collateral, is looked at not only in the traditional sense of assets pledged to secure the debt, but also to the quality and value of those unpledged assets controlled by the issuer. In both senses the collateral is capable of supplying additional aid, comfort, and support to the debt and the debtholder. Assets form the basis for the generation of cash flow that services the debt in good times as well as bad.

The final C is for covenants, the terms and conditions of the lending agreement. As discussed earlier, covenants lay down restrictions on how management operates the company and conducts its financial affairs.

Ratings of bonds change over time. Issuers are upgraded when their likelihood of default (as assessed by the rating company) decreases, and downgraded when their likelihood of default (as assessed by the rating company) increases. The rating companies publish the issues that they are reviewing for possible rating change.

To help investors understand how ratings change over time, the rating agencies publish this information periodically in the form of a table. This table is called a rating transition matrix. The table is useful for investors to assess potential downgrades and upgrades. A rating transition matrix is available for different holding periods. Typically these tables show that for investment-grade bonds, the probability of a downgrade is much higher than for an upgrade. Second, the longer the transition period, the lower the probability that an issue will retain its original rating.

SPECULATIVE-GRADE BONDS

Speculative-grade bonds are those rated below investment grade by the rating agencies (i.e., BB+ and lower by Fitch and S&P, and Ba1 and less by Moody’s). They may also be unrated, but not all unrated debt is speculative. Also known as junk bonds, promoters have given these securities other euphemisms such as high-interest bonds, high-opportunity debt, and high-yield securities. While some of these terms may be misleading to the uninitiated, they are used throughout the investment world, with “junk” and “high yield” the most popular. We will also use “junk” and “high yield” in this chapter.

Speculative-grade bonds may not be high-yielders at all because they may not be paying any interest, and there may be little hope for the resumption of interest payments; even the return expected from a reorganization or liquidation may be low. Some high-yield instruments may not be speculative-grade at all because they may carry investment-grade ratings. The higher yields may be due to fears of premature redemption of high-coupon bonds in a lower interest rate environment. The higher yields may be caused by a sharp decline in the securities markets, which has driven down the prices of all issues, including those with investment merit.

While the term “junk” tarnishes the entire less-than-investment-grade spectrum, it is applicable to some specific situations. Junk bonds are not useless stuff, trash, or rubbish as the term would imply. At times, investors overpay for their speculative-grade securities so they feel that they may have purchased junk or worthless garbage. But this is also the case when they have overpaid for high-grade securities. There are other times when profits may be made from buying junk bonds; certainly then, these bonds are not junk but something that may be quite attractive. Also, not all securities in this low-grade sector of the market are on the verge of default or bankruptcy. Many issuers might be on the fringe of the investment-grade sector. Market participants should be discriminating in the choice of their terminology.

Types of Issuers

Several types of issuers fall into the less-than-investment-grade high-yield category. These include original issuers, fallen angels, and restructuring and leveraged buyouts.

Original issuers may be young, growing corporations lacking the stronger balance sheet and income statement profile of many established corporations, but often with lots of promise. Also called venture capital situations or growth or emerging market companies, the debt is often sold with a story projecting future financial strength. From this we get the term “story bond.” There are also the established operating firms with financials neither measuring up to the strengths of investment-grade corporations nor possessing the weaknesses of companies on the verge of bankruptcy.

Fallen angels are formerly companies with investment-grade-rated debt that have come upon hard times with deteriorating balance sheet and income statement financial parameters.³ They may be in default or near bankruptcy. In these cases, investors are interested in the workout value of the debt in a reorganization or liquidation, whether within or outside of the bankruptcy courts. Some refer to these issues as “special situations.”

Restructurings and leveraged buyouts are companies that have deliberately increased their debt burden with a view toward maximizing shareholder value. The shareholders may be the existing public group to which the company pays a special extraordinary dividend, with the funds coming from borrowings and the sale of assets. Cash is paid out, net worth decreased and leverage increased, and ratings drop on existing debt. Newly issued debt gets junk bond status because of the company’s weakened financial condition.

In a leveraged buyout (LBO), a new and private shareholder group owns and manages the company.⁴ The debt issue’s purpose may be to retire other debt from commercial and investment banks and institutional investors incurred to finance the LBO. The debt to be retired is called “bridge financing” because it provides a bridge between the initial LBO activity and the more permanent financing.

Unique Features of Some Issues

Often actions taken by management that result in the assignment of a noninvestment-grade bond rating result in a heavy interest payment burden. This places severe cash flow constraints on the firm. To reduce this burden, firms involved with heavy debt burdens have issued bonds with deferred coupon structures that permit the issuer to avoid using cash to make interest payments for a period of 3 to 7 years. There are three types of deferred coupon structures: (1) deferred-interest bonds, (2) step-up bonds, and (3) payment-in-kind bonds.

Deferred-interest bonds are the most common type of deferred coupon structure. These bonds sell at a deep discount and do not pay interest for an initial period, typically from 3 to 7 years. (Because no interest is paid for the initial period, these bonds are sometimes referred to as zero-coupon bonds.) Step-up bonds do pay coupon interest, but the coupon rate is low for an initial period and then increases (“steps up”) to a higher coupon rate. Finally, payment-in-kind (PIK) bonds give the issuer an option to pay cash at a coupon payment date or give the bondholder a similar bond (i.e., a bond with the same coupon rate and a par value equal to the amount of the coupon payment that would have been paid). The period during which the issuer can make this choice varies from 5 to 10 years.

An extendible reset bond is a bond structure that allows the issuer to reset the coupon rate so that the bond will trade at a predetermined price. The coupon rate may reset annually or even more frequently, or reset only one time over the life of the bond. Generally, the coupon rate at the reset date will be the average of rates suggested by two investment banking firms. The new rate will then reflect (1) the level of interest rates at the reset date and (2) the credit spread the market wants on the issue at the reset date. The difference between an extendible reset bond and a floating-rate bond is that for the latter the coupon rate resets according to a fixed spread over the reference rate, with the index spread specified in the indenture. The amount of the index spread reflects market conditions at the time the issue is offered. The coupon rate on an extendible reset bond, in contrast, is reset based on market conditions (as suggested by several investment banking firms) at the time of the reset date. Moreover, the new coupon rate reflects the new level of interest rates and the new spread that investors seek.

The advantage to investors of extendible reset bonds is that the coupon rate will reset to the market rate-both the level of interest rates and the credit spread-in principle keeping the issue at par value. In fact, experience with extendible reset bonds has not been favorable during the recent period of difficulties in the high-yield bond market.

“Clawback provisions” in speculative-grade bond issues grant the issuer a limited right to redeem a portion of the bonds during the noncall period if the proceeds are from an initial public stock offering. The disadvantage of a clawback provision for the investor is that the bonds can be called at a point in time just when the issuer’s finances have been strengthened through access to the equity market.

Default and Recovery Statistics

We conclude our discussion of high-yield corporate bonds with a discussion of default and recovery statistics. From an investment perspective, default rates by themselves are not of paramount significance: it is perfectly possible for a portfolio of high-yield corporate bonds to suffer defaults and to outperform Treasuries at the same time, provided the yield spread of the portfolio is sufficiently high to offset the losses from default.

Furthermore, because holders of defaulted bonds typically recover a percentage of the face amount of their investment, the default loss rate can be substantially lower than the default rate. The default loss rate is defined as follows:

default loss rate = default rate × recovery rate

For example, a default rate of 5% and a recovery rate of 30% means a default loss rate of only 3.5% (70% of 5%).

Therefore, focusing exclusively on default rates merely highlights the worst possible outcome that a diversified portfolio of high-yield corporate bonds would suffer, assuming all defaulted bonds would be totally worthless.

In their 1987 study, Altman and Nammacher found that the annual default rate for low-rated corporate debt was 2.15%, a figure that Altman has updated since to 2.40%.⁵ The firm of Drexel Burnham Lambert (DBL), a major issuer of high-yield bonds at one time, also estimated default rates of about 2.40% per year.⁶ Asquith, Mullins, and Wolff, however, found that nearly one out of every three high-yield corporate bonds defaults.⁷ The large discrepancy arises because the studies use three different definitions of “default rate”; even if applied to the same universe of bonds (which they are not), all three results could be valid simultaneously.

Altman and Nammacher define the default rate as the par value of all high-yield bonds that defaulted in a given calendar year, divided by the total par value outstanding during the year. Their estimates (2.15% and 2.40%) are simple averages of the annual default rates over a number of years. DBL took the cumulative dollar value of all defaulted high-yield bonds, divided by the cumulative dollar value of all high-yield issuance, and further divided by the weighted average number of years outstanding to obtain an average annual default rate. Asquith, Mullins, and Wolff use a cumulative default statistic. For all bonds issued in a given year, the default rate is the total par value of defaulted issues as of the date of their study, divided by the total par amount originally issued to obtain a cumulative default rate. Their result (that about one in three high-yield bonds default) is not normalized by the number of years outstanding.

Although all three measures are useful indicators of bond default propensity, they are not directly comparable. Even when restated on an annualized basis, they do not all measure the same quantity. The default statistics from all studies, however, are surprisingly similar once cumulative rates have been annualized. Altman and Kishore find for the period 1971 to 1997 that the arithmetic average default rate for the entire period was 2.6%, and the weighted average default rate (i.e., weighted by the par value of the amount outstanding for each year) was 3.3%. For a more recent time period, 1985 to 1997, the arithmetic average default rate was higher, 3.7%.⁸

Next let’s look at the historical loss rate realized by investors in high-yield corporate bonds. Just as with default rates, there are different methodologies that can be used to compute recovery rates. For example, the methodology for computing the default loss rate by Altman and Kishore is as follows.⁹ First, the default loss of principal is computed by multiplying the default rate for the year by the average loss of principal. The average loss of principal is computed by first determining the recovery per $100 of par value. They quantify the recovery per $100 of par value using the weighted average price of all issues after default. The difference between par value of 100 and the recovery of principal is the default loss of principal.

Several studies have found that the recovery rate is closely related to the bond’s seniority. Altman and Kishore computed the weighted average recovery rate for 777 bond issues that defaulted between 1978 and 1997 for the following bond classes: (1) senior-secured, (2) senior-unsecured, (3) senior-subordinated, (4) subordinated, and (5) discount and zero-coupon. The recovery rate for senior-secured bonds averaged 59% of face value, compared with 49% for senior-unsecured, 35% for senior-subordinated, and 32% for subordinated bonds.

CORPORATE BOND INDEXES

The three broad-based U.S. bond market indexes are the Lehman Brothers U.S. Aggregate Index, the Salomon Smith Barney (SSB) Broad Investment-Grade Bond Index (BIG), and the Merrill Lynch Domestic Market Index. The three broad-based U.S. bond market indexes are computed daily and are “market-value weighted.” This means that for each issue, the ratio of the market value of an issue relative to the market value of all issues in the index is used as the weight of the issue in all calculations.

Each index is broken into sectors. The Lehman index, for example, is divided into the following six sectors: (1) Treasury sector, (2) agency sector, (3) mortgage passthrough sector, (4) commercial mortgage-backed securities sector, (5) asset-backed securities sector, and (6) credit sector. The credit sector in the Lehman Brothers index includes corporate issues. In all three indexes, the only issues that are included are investment-grade issues.

The three investment banking firms that created the broad-based bond market indexes have also created separate high-yield indexes. In addition, the firms of CS First Boston and Donaldson Lufkin and Jenrette have created indexes for this sector. The number of issues included in each high-yield index varies from index to index. The types of issues permitted (e.g., convertible, floating-rate, payment-in-kind) also varies.

MEDIUM-TERM NOTES

Medium-term notes (MTNs) are debt instruments with the unique characteristic that they are offered continuously to investors by an agent of the issuer. Investors can select from several maturity ranges: 9 months to 1 year, more than 1 year to 18 months, more than 18 months to 2 years, and so on up to any number of years. MTNs are registered with the Securities and Exchange Commission under Rule 415 (the “shelf registration rule”), which gives a corporation the maximum flexibility for issuing securities on a continuous basis. MTNs are also issued by foreign corporations, federal agencies, supranational institutions, and foreign countries. The MTN market is primarily institutional, with individual investors being of little import.

The term “medium-term note” to describe this corporate debt instrument is misleading. Traditionally, the term “note” or “medium-term” was used to refer to debt issues with a maturity greater than 1 year but less than 15 years. Certainly this is not a characteristic of MTNs since they have been sold with maturities from 9 months to 30 years, and even longer. For example, in July 1993, Walt Disney Corporation issued a security with a 100-year maturity off its medium-term note shelf registration.

Borrowers have flexibility in designing MTNs to satisfy their own needs. They can issue fixed-or floating-rate debt. The coupon payments can be denominated in U.S. dollars or in a foreign currency.

An issuer with an active MTN program will post the rates for the maturity ranges it wishes to sell. The purchaser may usually set the maturity as any business day within the offered maturity range, subject to the borrower’s approval. This is a very important benefit of MTNs because it enables a lender to match maturities with its own specific requirements. As they are continuously offered, an investor can enter the market when portfolio needs require and will usually find suitable investment opportunities.

There are issuers of MTNs that couple their offerings with transactions in the derivative markets (options, futures/forwards, swaps, caps, and floors) to create debt obligations with more interesting risk/return features than are available in the corporate bond market. These are called structured notes. Structured notes allow institutional investors who are restricted to investing in investment-grade debt issues the opportunity to participate in other asset classes to make a market play. For example, an investor who buys an MTN whose coupon rate is tied to the performance of the S&P 500 is participating in the equity market without owning common stock. If the coupon rate is tied to a foreign stock index, the investor is participating in the equity market of a foreign country without owning foreign common stocks.

YIELD AND YIELD SPREADS

Corporate bond yields trade at a spread (i.e., a higher yield) over Treasury securities with the same maturity (or duration). The spread reflects the credit risk and liquidity risk associated with corporate bonds relative to Treasury securities. The size of the spread varies over time depending on the market’s expectation regarding the concerns with defaults. For example, yield spreads for corporates tend to widen (i.e., increase) in recessions and narrow (i.e., decrease) in prosperous economic periods. At a given point in time, the spread varies with the credit rating. Specifically, the lower the credit rating of a corporate bond, the greater the spread. So, for example, a double A rated corporate bond will offer a lower spread than a single A rated corporate bond.

For corporate bonds that are callable, a portion of the spread reflects the call risk associated with holding a callable corporate bond relative to a Treasury security with a comparable maturity. The measure commonly used for a spread that adjusts for the risks associated with a bond being called is the option-adjusted spread.

Exhibit 11.2 shows the spread over Treasuries for corporate bonds issued by industrial, utility, finance, and bank entities as reported by Lehman Brothers. The spreads are for bullet issues (i.e., issues that are noncallable for life) and are reported by maturity and credit rating. The exhibit shows the 90-day high, low, and average for the week ending September 7, 2001. Basically, it is a term structure of credit spreads. For callable and putable securities, an option-adjusted spread is calculated. Exhibit 11.3 shows the estimated spread for the 20 largest issuers in the credit sector of the Lehman Brothers Index on September 7, 2001. Exhibit 11.4 shows the approximate spreads for the largest issues in the Lehman High Yield Index on the same date.

Within the corporate bond market there is a spread based on maturity for issues of the same credit quality. For example, 1-year single A corporate bonds will offer a different spread than 10-year single A corporate bonds. In the Treasury securities market we saw this type of relationship between yield and maturity which in graphical form is called the Treasury yield curve. There are corporate yield curves by credit rating. That is, there is a AAA corporate yield curve and a BBB corporate yield curve. Typically credit spread increases with maturity. In addition, the shape of the yield curve is not the same for all credit ratings. The lower the credit rating, typically, the steeper the yield curve. For each corporate yield curve, a corporate yield spread curve by credit rating can be obtained by simply subtracting the corresponding yield on the Treasury yield curve.

CONVERTIBLE BONDS

A convertible bond is a corporate bond issue that can be converted into common stock at the option of the bondholder. We conclude this chapter with a description of the basic features of convertible bonds and their investment characteristics.

Basic Features of Convertible Bonds

The conversion provision of a bond grants the bondholder the right to convert the security into a predetermined number of shares of common stock of the issuer. An exchangeable bond grants the bondholder the right to exchange the security for the common stock of a firm other than the issuer of the security. In our discussion, we use the term convertible bond to refer to both convertible and exchangeable bonds.

Conversion Ratio

The number of shares of common stock that the bondholder will receive from exercising the call option of a convertible bond is called the conversion ratio. The conversion privilege may extend for all or only some portion of the bond’s life, and the stated conversion ratio may change over time. It is always adjusted proportionately for stock splits and stock dividends.

Source: Lehman Brothers, Global Relative Value, Fixed Income Research, September 10, 2001, p. 144.

Source: Lehman Brothers, Global Relative Value, Fixed Income Research, September 10, 2001, p. 145.

For example, suppose that the Izzobaf Corporation issued a convertible bond with a conversion ratio of 25.32 shares. This means that for each $1,000 of par value of this issue the bondholder exchanges for Izzobaf’s common stock, he will receive 25.32 shares.

At the time of issuance of a convertible bond, the issuer effectively grants the bondholder the right to purchase the common stock at a price equal to:

Source: Lehman Brothers, Global Relative Value, Fixed Income Research, September 10, 2001, p. 145.

This price is referred to in the prospectus as the stated conversion price. Sometimes the issue price of a convertible bond may not be equal to par. In such cases, the stated conversion price at issuance is usually determined by the issue price.

The stated conversion price for the Izzobaf convertible issue is:

Call Provisions

Almost all convertible issues are callable by the issuer. Typically there is a noncall period (i.e., a time period from the time of issuance that the convertible bond may not be called). Some issues have a provisional call feature that allows the issuer to call the issue during the noncall period if the stock reaches a certain price.

Put Provision

A put option grants the bondholder the right to require the issuer to redeem the issue at designated dates for a predetermined price. Some convertible bonds are putable. Put options can be classified as “hard” puts and “soft” puts. A hard put is one in which the convertible bond must be redeemed by the issuer only for cash. In the case of a soft put, the issuer has the option to redeem the convertible bond for cash, common stock, subordinated notes, or a combination of the three.

Traditional Analysis of Convertible Bonds

There have been sophisticated models for valuing corporate bonds using option pricing theory since a convertible bond has several embedded options-the right to convert by the bondholder, the right to call by the issuer, and, if the issue is putable, the right to put the issue by the bondholder. In this section we discuss the traditional analysis used to analyze convertible bonds so that their investment characteristics can be appreciated.

Minimum Value of a Convertible Bond

The conversion value or parity value of a convertible bond is the value of the security if it is converted immediately. That is,

Conversion value = Market price of common stock × Conversion ratio

The minimum price of a convertible bond is the greater of

1. Its conversion value, or
2. Its value as a security without the conversion option-that is, based on the convertible bond’s cash flows if not converted. This value is called its straight value or investment value.

If the convertible bond does not sell for the greater of these two values, arbitrage profits could be realized. For example, suppose the conversion value is greater than the straight value, and the convertible bond is selling at its straight value. An investor can buy the convertible bond at the straight value and convert it. By doing so, the investor realizes a gain equal to the difference between the conversion value and the straight value. Suppose, instead, the straight value is greater than the conversion value, and the convertible bond is selling at its conversion value. By buying the convertible bond at the conversion value, the investor will realize a higher yield than a comparable straight security.

To illustrate, assuming that the market price per share of Izzobaf’s common stock is currently $33, then for Izzobaf’s convertible issue the conversion value per $1,000 of par value is equal to:

Conversion value = $33 × 25.32 = $835.56

Therefore, the conversion value per $100 of par value is $83.556.

Suppose that given the appropriate yield for a straight bond issued by Izzobaf’s convertible would result in a straight price of $98.19 per $100 par value. Since the minimum value of the Izzobaf convertible bond is the greater of the conversion value and the straight value, the minimum value is $98.19.

Market Conversion Price

The price that an investor effectively pays for the common stock if the convertible bond is purchased and then converted into the common stock is called the market conversion price or conversion parity price. It is found as follows:

The market conversion price is a useful benchmark because once the actual market price of the stock rises above the market conversion price, any further stock price increase is certain to increase the value of the convertible bond by at least the same percentage. Therefore, the market conversion price can be viewed as a breakeven price.

An investor who purchases a convertible bond rather than the underlying stock pays a premium over the current market price of the stock. This premium per share is equal to the difference between the market conversion price and the current market price of the common stock. That is,

Market conversion premium per share = Market conversion price - Current market price

The market conversion premium per share is usually expressed as a percentage of the current market price as follows:

Why would someone be willing to pay a premium to buy the stock? Recall that the minimum price of a convertible bond is the greater of its conversion value or its straight value. Thus, as the common stock price declines, the price of the convertible bond will not fall below its straight value. The straight value therefore acts as a floor for the convertible bond’s price. The straight value at some future date, however, is unknown; the value will change as interest rates in the market change.

Assuming the following for the Izzobaf convertible bond:

Market price per $1,000 of par value = $1,065.00

Conversion ratio = 25.32

Then the calculation of the market conversion price, market conversion premium per share, and market conversion premium ratio for the Izzobaf convertible bond is shown below:

Current Income of Convertible Bond versus Common Stock

As an offset to the market conversion premium per share, investing in the convertible bond rather than buying the stock directly generally means that the investor realizes higher current income from the coupon interest paid than would be received as common stock dividends paid on the number of shares equal to the conversion ratio. Investors evaluating a convertible bond typically compute the time it takes to recover the premium per share by computing the premium payback period (which is also known as the breakeven time). This is computed as follows:

where the favorable income differential per share is equal to the following for a convertible bond:

The premium payback period does not take into account the time value of money.

Assume for the Izzobaf convertible bond, the coupon rate is 5.75%. We know that the market conversion premium per share is $9.06. The favorable income differential per share is found as follows:

Coupon interest from bond = 0.0575 × $1,000 = $57.50

Conversion ratio × Dividend per share = 25.32 × $0.90 = $22.79

Therefore,

and

Without considering the time value of money, the investor would recover the market conversion premium per share in about 7 years.

Downside Risk with a Convertible Bond

Investors usually use the straight value as a measure of the downside risk of a convertible bond because the price of the convertible bond cannot fall below this value. Thus, the straight value acts as the current floor for the price of the convertible bond. The downside risk is measured as a percentage of the straight value and computed as follows:

The higher the premium over straight value, all other factors constant, the less attractive the convertible bond.

Despite its use in practice, this measure of downside risk is flawed because the straight value (the floor) changes as interest rates change. If interest rates rise, the straight value falls, making the floor fall. Therefore, the downside risk changes as interest rates change.

For our hypothetical convertible bond, the Izzobaf bond, since the market price of the convertible bond is $106.5 and the straight value is $98.19, the premium over straight value is:

The Upside Potential of a Convertible Bond

The evaluation of the upside potential of a convertible bond depends on the prospects for the underlying common stock. Thus, the techniques for analyzing common stocks on equity analysis should be employed.

Investment Characteristics of a Convertible Bond

The investment characteristics of a convertible bond depend on the common stock price. If the price is low, so that the straight value is considerably higher than the conversion value, the security will trade much like a straight bond. The convertible bond in such instances is referred to as a bond equivalent or a busted convertible.

When the price of the stock is such that the conversion value is considerably higher than the straight value, then the convertible bond will trade as if it were an equity instrument; in this case it is said to be a common stock equivalent. In such cases, the market conversion premium per share will be small.

Between these two cases, bond equivalent and common stock equivalent, the convertible bond trades as a hybrid security, having the characteristics of both a bond and common stock.

The Risk/Return Profile of a Convertible Bond

Let’s use the Izzobaf convertible bond to compare the risk/return profile from investing in a convertible bond or the underlying common stock. The stock can be purchased in the market for $33. By buying the convertible bond, the investor is effectively purchasing the stock for $42.06 (the market conversion price per share). Let’s look at the potential profit and loss, assuming that Izzobaf’s stock price rises to $50 and a scenario in which the stock price falls to $25.

If the stock price rises to $50, the direct purchase of the stock would generate a profit of $17 per share ($50 − $33), or a return of 34%. If the convertible bond is purchased, the conversion value is $1,266 per $1,000 of par value (conversion ratio of 25.32 times $50). Assuming that the straight value per $1,000 of par value is unchanged at $981.90, the minimum value for the convertible bond is $1,266. Since the initial price of the convertible bond per $1,000 of par value is $1,065, the profit is $201, and the return is 18.9% ($201/$1,065). The lower return by buying the convertible bond rather than the stock is because a higher price was effectively paid for the stock. Specifically, by buying the convertible bond, a per share price of $42.06 was paid. The profit per share is then $7.94, which produces the return of 18.9% ($7.94/$42.06).

Now let’s look at what would happen if Izzobaf’s stock price declines to $25. If the stock is purchased, there would be a loss of $8 per share or, equivalently, a return of −24%. For the convertible bond, the conversion value would be $633 (conversion ratio of 25.3 times $25). However, the convertible bond’s minimum price is the greater of the convertible bond value and the straight value. Assuming the straight value stays at $981.90, this would be the value of the convertible bond. The loss on the convertible bond is therefore $83.10 or 7.8% ($83.10/$1,065).

One of the critical assumptions in this analysis is that the straight value does not change except for the passage of time. If interest rates rise, the straight value will decline. Even if interest rates do not rise, the perceived creditworthiness of the issuer may deteriorate, causing investors to demand a higher yield.

The scenario clearly demonstrates that there are benefits and drawbacks to investing in convertible bonds. The disadvantage is the upside potential given up because a premium per share must be paid. An advantage is the reduction in downside risk (as determined by the straight value).