Introduction

• A bond is a debt instrument sold by the bond issuer (the borrower) to bondholders (the lenders). The bond issuer agrees to make payments of interest and principal to bondholders. The principal of a bond (also called its face value or par value) is the amount the issuer has promised to repay at maturity.
• Riskier bonds require higher interest rates to attract investors. The interest rate on a bond is termed the coupon rate. In the United States, coupons are usually paid every six months. In some other countries, coupons are paid with other frequencies (e.g., monthly, quarterly, or annually). A U.S. bond paying a coupon of 8% would pay interest to the holder equal to 4% of USD 1,000 (i.e., USD 40) every six months. For example, the interest might be payable on February 15 and August 15 of each year during the life of the bond.
• The face value of a bond in the United States is usually USD 1,000 and bond prices are typically quoted per USD 100 of principal. The value of the global bond market is approximately USD 100 trillion (as measured by the value of outstanding bonds), which is larger than the global equity market. This chapter focuses on bonds issued by corporations.

Bond Issuance

• Corporate bond issuances are typically arranged by investment banks. These banks have connections with many potential bond purchasers and will work with the issuing corporation to determine the appropriate terms for the issuance.
• The issuing corporation can choose between a private placement and a public issue. In a private placement, bonds are placed with a small number of large institutions (e.g., pension funds and insurance companies). Sometimes one institution will buy the entire bond issuance; on other occasions, bonds are sold to several different institutions. In either case, the bonds are not offered to the general public.
• A private placement has several advantages to the issuer:
  • There are fewer registration requirements. In the United States, for example, private placement issuances do not need to register with the Securities and Exchange Commission.
  • Rating agencies are not involved because they don't usually rate non-public issuances.
  • The issuance cost is lower.
  • The issuance can be completed quickly.
  • The issuance can be relatively small.
• Interest rates for private placement bonds are generally higher than those for equivalent publicly issued bonds. Hence there is a tradeoff between benefits of private placement and payment of a higher interest rate.
• In a public issue, the investment bank acts as the underwriter. This means that it buys the bonds from the corporation and then tries to sell them to investors. The investment bank's profit is earned from the difference between the price it pays to buy the bonds from the corporation and the price at which it sells the bonds to investors. Once issued, the bonds are traded and given ratings by rating agencies.
• The risks taken by the underwriter are defined in its contract with the issuer. The main risk is the possibility of an increase in interest rates, leading to a reduction in the value of the bonds before the bonds can be sold to investors.
• Bonds issued via private placements are often not traded and are held by the original purchasers until maturity. Bonds issued in a public offering, on the other hand, are typically traded in the over-the-counter market. This is in contrast to stocks, which are typically traded on exchanges. Bond prices (like those of any other financial security) are determined by supply and demand.

• Bond yield can be thought of as the return earned on a bond over its life assuming that all interest and principal payments are paid as promised. The yield is composed of a risk-free return (which is the return that would be earned on a similar risk-free instrument) and a credit spread (which is the extra return to compensate the investor for the possibility of a default. As the maturity of the bond increases, the credit spread for a bond with a good credit rating tends to increase. This is because the chance that the issuer will experience financial difficulties increases with the passage of time.
• If the price of a bond increases, its yield declines (and vice versa). If interest rates are likely to increase, investors will demand higher yields. This will lead to selling pressure in the bond market, and the prices of all bonds should decline. If interest rates are likely to decline, the yields required by investors will also decline and the prices of all bonds will increase. News about the financial health of a bond issuer may cause the market to adjust the required credit spread. This can also increase or decrease the price of a bond.
• Bond dealers are market makers who quote bid and ask prices for bonds on request as well as maintain inventory to facilitate trading. If risk-free interest rates and/or credit spreads increase, bond prices can decrease and dealers may lose money on their inventories.
• Liquidity is an important issue in bond trading. It can be defined as the ability to turn an asset into cash within a reasonable time period at a reasonable price. Markets where the trading volume is high tend to be highly liquid and have low bid-ask spreads, and vice versa. Liquidity in the bond market varies from bond to bond. Some bonds trade only a few times a year, while others trade several times a day. Part of the yield on a bond is compensation for its liquidity risk (or lack thereof). As a bond's liquidity declines, investors require a greater yield. The Volcker rule (part of the Dodd–Frank legislation in the United States) now restricts the extent to which banks can trade bonds (or other securities) for their own account. Some banks in the United States have had concerns that the Volcker rule is reducing bond liquidity because it restricts their ability to keep bonds in their inventories for market-making purposes.
• The price quoted for a bond is referred to as the clean price. The cash price for a bond is called the dirty price and is the clean price combined with accrued interest (i.e., the interest earned by the seller since the last coupon payment date). For corporate bonds in the United States, this interest is calculated with a 30/360-day convention (where it is assumed that there are 30 days in a month and 360 days in a year). For example, suppose that the coupon rate is 8% per year, today is June 4, and the last coupon payment date was February 15.
• Day count conventions can vary across countries.

• A bond indenture is a legal contract between a bond issuer and the bondholder(s) defining the important features of a bond issue. These features include the maturity date (i.e., when the principal must be repaid), the amount and timing of interest payments, callable and convertible features (if any), and the rights of bondholders in the event of contract violations. The bond indenture may also include several covenants. These can be categorized as:
  • Negative covenants (also known as restrictive covenants), which limit the issuer's ability to engage in further debt financing, asset sales, dividend payouts, and share buybacks;
  • Positive covenants, which require the issuer to produce regular financial statements, maintain properties, carry insurance, and use the money raised by the bond issuance in the manner stated in the offering document; and
  • Financial covenants, which may require the issuer to maintain certain financial ratios (such as interest coverage or leverage ratios).
• There may also be other covenants that outline what happens if there is a change of control (referred to as CoC) and a credit rating downgrade.
• Bonds issued by highly creditworthy firms generally contain few covenants, while those issued by riskier firms often have an extensive list of covenants.

Corporate Bond Trustee

• In a public bond issue, it is unrealistic to expect individual bondholders to monitor the issuer and ensure it follows the bond indentures. The issuer therefore appoints (and pays for) a corporate bond trustee. This is a financial institution (usually a bank or trust company) that looks after the interests of the bondholders and ensures that the issuer complies with the bond indentures.
• The trustee reports periodically to the bondholders and will act on behalf of bondholders if the need arises. It may also act as paying agent and registrar (i.e., it may handle record keeping and the disbursement of interest and principal to the bondholders). Its specific duties are itemized in the bond indentures and the trustee is under no obligation to exceed those duties.

Credit Ratings

• Ratings agencies such as Moody's, S&P, and Fitch provide opinions on the creditworthiness of bond issuers. The scales used by these rating agencies are shown in this table.

Investment Grade Bonds
Moody's	S&P and Fitch
Aaa	AAA
Aa1	AA+
Aa2	AA
Aa3	AA-
A1	A+
A2	A
A3	A-
Baa1	BBB+
Baa2	BBB
Baa3	BBB –

Non-Investment (Speculative) Grade Bonds
Moody's	S&P and Fitch
Ba1	BB+
Ba2	BB
Ba3	BB-
B1	B+
B2	B
B3	B-
Caa1	CCC+
Caa2	CCC
Caa3	CCC-
Ca	CC/C

• Public bond issuers normally pay rating agencies to rate their bonds (although they are not required to do so). In theory, this would appear to be a conflict of interest; agencies have an incentive to produce overly positive ratings to attract and retain paying clients (bond issuers) instead of the objective ratings sought by the non-paying users (bond investors). In practice, however, rating agencies know that their reputations would suffer if they allowed their relationships with bond issuers to influence their ratings; this creates an incentive for rating agencies to be as objective as possible.
• Bonds rated above a threshold are referred to as investment grade. Bonds below this threshold are given various names: high-yield, non-investment grade, speculative grade, or simply junk. There are several circumstances that can give rise to high-yield bonds.
  • High-yield bonds may be sold by young and growing companies. These firms may have good prospects, but they lack the track record and strong financial statements of more established companies.
  • Investment-grade bonds may become high-yield bonds as the financial situation of the issuing firm deteriorates. Such companies are sometimes referred to as fallen angels.
  • A company with stable cash flows increases its debt burden to benefit shareholders.

High-Yield Bonds

• High yield bonds sometimes have unusual features, such as the following examples
  • A deferred-coupon bond is a bond that pays no interest for a specified time period, after which time a specified coupon is paid in the usual manner.
  • A step-up bond is a bond where the coupon increases with time.
  • A payment-in-kind bond is a bond where the issuer has the option of providing the holder with additional bonds in lieu of interest.
  • An extendable reset bond is a bond where the coupon is reset annually (or more frequently) to maintain the price of the bond at some level (e.g., USD 101)
  • The issuer may have rights to call the bond from the proceeds of an equity issue.

Bond Risk

• Credit ratings measure default risk. Rating agencies produce tables showing:
  • The probability that a bond will default within n years after being given a certain rating for various values of n, and
  • The probability that a bond will move from one rating category to another during a certain period (e.g., one year or five years).

• Bondholders face the risks that arise from changes in the pricing of credit risk by the market (i.e., the credit spread). During normal times, the credit spread for a seven-year A rated bond is approximately 100 basis points. This means that if the seven-year risk-free rate is 3%, the yield on a seven-year A-rated corporate bond is 4%. During stressed periods (i.e., when investors are particularly averse to taking risks), this credit spread could rise to 2% or even 3%.
• Another measure sometimes used by analysts is spread duration. This is (approximately) the percentage change in the bond price for a 100-basis point increase in the credit spread (assuming that the risk-free rate remains unchanged). For example, a spread duration of four indicates that a 100-basis point increase in the credit spread will reduce the bond price by 4%.

Event Risk

• There are many events (e.g., natural disasters or the death of a CEO) that could adversely affect bonds.
  • An important type of event risk is that of a large increase in leverage. Firms can increase their leverage through activities such as leveraged buyouts, share buybacks, certain mergers and acquisitions, and other types of restructurings that benefit shareholders at the expense of bondholders. An example of an event that hurt bondholders (and had a negative effect on the whole bond market) is the 1988 leveraged buyout of RJR Nabisco by Kohlberg, Kravis, Roberts & Co. The USD 25 billion buyout (and the resulting increase in leverage) increased the credit spread on existing bonds from 100 basis points to 350 basis points.
  • Sometimes bond indentures for lower-rated issues anticipate the possibility of increased leverage and include a maintenance of net worth clause. This clause requires the firm to keep its equity value above a prescribed level. If it fails to do this, it has to retire its debt at par until the equity moves above the prescribed level. In some cases, the company just has to offer to retire debt at par, and bondholders choose to accept or decline the offer. Generally, bondholders accept the offer because it is unlikely that the market price of the bonds would be above par if the maintenance of net worth covenant has been breached.

Defaults

• Default occurs when a bond issuer fails to make the agreed upon payments to the bondholders. Those who are owed money by the bond issuer have a claim against the issuer's assets. The issuing company may then reorganize itself (in negotiation with its creditors) or sell its assets to meet creditor (including bondholder) claims. Bankruptcy laws in the US facilitate reorganizations. For example, a Chapter 11 bankruptcy filing gives a company time to negotiate a re-organization with bondholders and other creditors. During this period, the firm's executives remain in control of the business, but they can't take certain actions, such as selling fixed assets, arranging new loans, and stopping (or expanding) business operations. The reorganization may involve the sale of all or part of the business, a reduction in the amount owed on loans, and/or a reduction in the interest rate charged on the loans. Reorganizations can also result in debtholders becoming equity holders. Companies like General Motors, Kmart, and United Airlines have made Chapter 11 filings and survived.
• An important consideration when a default occurs is the ranking of claimants (i.e., which claims get satisfied first from available funds). Bondholders always rank above equity holders. The holders of some bond issues may rank ahead of others, while some bonds may rank ahead of trade creditors (e.g., suppliers of goods to the company that are owed money).

Classifications Of Bonds

1) Issuer based classification

There are five broad categories of issuers:

1. Utilities: Examples include electric, gas, water, and communications companies,
2. Transportation companies: Examples include airlines, railroads, and trucking companies,
3. Industrials: Examples include manufacturing, retailing, mining, and service companies,
4. Financial institutions: Examples include banks, insurance companies, brokerage firms, and asset management firms, and
5. Internationals: Examples include supranational organizations such as the European Investment Bank, foreign governments, and other non-domestic entities. The bonds that they issue are referred to as Yankee Bonds in the United States.

2) Maturity based classification

Corporate bonds have an original maturity of at least one year. (Instruments with an original maturity of less than one year are referred to as commercial paper.) Bonds with maturities of

• up to five years are usually referred to as short-term notes,
• between five and 12 years are referred to as medium-term notes,
• greater than 12 years are referred to as long-term bonds.

3) Interest Rates based classification

Bonds can also be categorized by how they structure their interest rates.

• Fixed-rate bonds pay same rate of interest throughout their lives. Occasionally, the interest is payable in foreign currency. For example, entities outside US sometimes issue bonds in USD.
• Floating rate bonds, also known as floating-rate notes (FRNs) or variable rate bonds, are bonds where the coupon equals a floating reference rate (e.g., Libor) plus a spread. To see how a floating-rate bond might work, consider a bond that pays a coupon every six months with interest equal to the six-month Libor plus 20 basis points. Thus, the Libor rate at the beginning of the six-month period would determine the size of the coupon paid at the end of the six-month period, with the 20-point spread remaining fixed. Some floating-rate bonds specify maximum or minimum (or both) levels for their coupons.
• Zero-coupon bonds (as their name implies) pay no coupons to the holder. Instead, they sell at a discount to the principal amount. For example, consider a five-year, zero-coupon bond that sells for USD 80. This means that an investor could pay USD 800 at the outset and get USD 1,000 in five years. The interest rate with annual compounding would be

The holder of a zero-coupon bond can hold a claim on the original price paid plus accrued interest. But the holder of a coupon-bearing bond in the United States can usually hold a claim only on the principal in the event of a bankruptcy.

One of the attractions of zero-coupon bonds is that they can turn one form of income into another under certain tax regimes. If the USD 200 difference between the price at which the bond in the previous example is bought and the final repayment of its par value is treated as a capital gain, the investor will have essentially converted what would normally be interest income into capital gain income. This is advantageous if capital gains are taxed at a lower rate.

Another advantage of zero-coupon bonds is that there is no reinvestment risk. With a coupon-bearing bond, however, the coupons received must be reinvested. If interest rates decline (increase), investors will be forced to reinvest at a relatively low (high) interest rate and thus a coupon bearing bond will lead to a worse (better) result than a zero-coupon bond.

4) Collateral based classification

Bonds can also be classified by the collateral provided, which becomes important in case of default by the company. Default leads to either a reorganization or an asset liquidation.

In either case, a bondholder with collateral will be in a better position than one without collateral. In the case of a liquidation, bonds with collateral will be paid first from the proceeds of the sale of the collateral. In the case of a reorganization, bonds with collateral will be in a stronger negotiating position than bonds without collateral.

• A mortgage bond provides specific assets (e.g., homes and commercial property) as collateral. In the event of a default, the bondholders have the right to sell the assets to satisfy unpaid obligations (although it is usually necessary to get permission of the courts first). The mortgage bondholder may impose conditions concerning future bond issues and the extent to which assets acquired in the future can be used as collateral for future bond issues. Sometimes there is an after-acquired clause that requires property acquired after the bonds are issued to be used as collateral for the bonds. This effectively prevents the collateral from being used for other mortgage bond issues.
• A collateral trust bond is a bond where shares, bonds, or other securities issued by another company are pledged as collateral. Usually, the other company is a subsidiary of the issuer. The issuer has the right to vote shares in the subsidiary if there has not been a default. But if there has been a default, the corporate bond trustee votes the shares. The corporate bond trustee will act in the best interests of the bondholders (which may not always be in the best interest of the company's shareholders). Sometimes, there are provisions requiring additional collateral to be provided if the appraised value of the collateral falls below a certain level.
• An equipment trust certificate (ETC) is a debt instrument used to finance the purchase of an asset. (They are commonly used to fund aircraft purchases.) The title to the property vests with the trustee, who then leases it to the borrower for an amount sufficient to provide the lenders with the return they have been promised. When the debt is fully repaid, the borrower obtains the title to the asset. An advantage an ETC to the lender is that the asset is already owned by the trustee. Thus, legal proceedings are not necessary to take possession of the asset in the event of a default. Instead, the trustee (acting in the interest of the investors) can simply lease the asset to another company.
• Debentures are unsecured bonds (i.e., bonds where no collateral has been posted by the issuer). They rank below mortgage bonds and collateral trust bonds and are likely to pay a higher interest rate. Often, a debenture bond's indenture will include provisions that limit the extent to which the issuing company can issue more debentures in the future. These provisions are needed because a new debenture issue weakens the position of existing debenture holders. For example, debenture holders might get 30 cents on the dollar (i.e., an amount equal to 30% of their principal) in the event of a default or liquidation. If the company had been allowed to issue twice as many debentures (and if there are no other significant general creditors), the 30 cents on the dollar would become 15 cents on the dollar. Debentures sometimes include a negative pledge clause preventing the issuer from pledging assets as security for new bond issues if doing so weakens the debenture holder's position.
• A subordinated debenture, as its name implies, ranks below other debentures and other general creditors in the event of a bankruptcy (which means that other debentures get paid first from available funds). Subordinated debentures require a higher rate of interest than unsubordinated debentures to compensate the holders for their inferior standing.

Debt Retirement – Call Provision

• If interest rates decline during the life of the bond, an issuer would prefer to replace an older bond issue with a new one before maturity. This benefits the bond issuer because its interest payments will be lowered. However, the bondholder is worse off because the funds received from the early retirement must be reinvested at a lower rate.
• Bond covenants can also prompt an issuer to replace an old bond issue with a new one. Changes in the nature of the issuer's business or improvements in its financial health can cause bond covenants to be unnecessarily burdensome (even if those covenants were reasonable when the bond was issued). Repaying bondholders early is a way to eliminate highly restrictive covenants.
• Bond indenture can sometimes allow the issuer to call the bond (i.e., buy it back from the bondholder) at a certain price at a certain time. Specifically, a schedule in the bond indenture specifies when bonds can be called and at what price. The price that the issuer must pay for the bond is known as the call price. Usually, the call price is greater than par when the bond is issued and declines towards par as the bond approaches maturity. Typically, a bond is not callable for the first few years of its life; this gives bondholders some protection against the possibility of early interest rate declines.

• Some bonds are convertible into equity on pre-agreed terms. The conversion option is usually combined with a call feature. Without the call feature, it is likely to be optimal for bondholders to delay conversion for as long as possible. To force conversion (so that bonds become equity and new debt can be raised), the issuer typically calls the bond as soon as (or shortly after) the price of its equity has risen to the point where it is better for a bondholder to convert the bond rather than sell it back to the issuer.
• A make-whole call provision occurs when the call price is calculated instead of being set in advance. The call price is typically set equal to the present value of the remaining interest and principal cash flows owed to the bondholder. The discount rate is typically the risk free rate plus a certain spread. For example, the call price for a U.S. bond with five years remaining could be the present value of the remaining cash flows discounted at the five-year Treasury rate plus 10-basis points. Make-whole bonds have been growing in popularity in recent years. The advantage of a make-whole call provision is that the call provision has no financial cost to bondholders and therefore they do not need to demand a higher return as compensation.
• A sinking fund is an arrangement where it is agreed that bonds will be retired periodically before maturity. The issuer may provide funds to the bond trustee so that the trustee can retire the bonds (usually at par value). Alternatively, the issuer can buy bonds in the open market and present them to the trustee. The latter is likely to be attractive to the issuer when bonds are selling below par. Accelerated sinking fund provisions allow the issuer to retire more bonds than the amount specified in the sinking fund. Certain assets pledged as collateral (such as plant and equipment) can depreciate in value. One advantage to sinking fund provisions is that they can be made so that the amount borrowed declines in lockstep with the declining value of the collateral.
• There are times that a company wants to sell assets that have been pledged as collateral. The bond indenture will normally allow a company to do this as long as the proceeds from the sale are used to retire the bonds. Selling property can therefore be a way to retire debt early.
• A final way in which bonds can be redeemed early is by the company making a tender offer to bondholders. A tender offer is simply an offer to purchase the bonds. The offer can be at a fixed price or it can be calculated as the present value of future cash flows. As in the case of a make-whole call price, the discount rate is the risk-free rate plus a prespecified spread.

Default Rate And Recovery Rate

• Two important statistics published by rating agencies are the default rate and the recovery rate. The default rate for a year can be measured in two ways –

1. Issuer default rate – This is the number of bonds that have defaulted in a given year divided by the number of issues outstanding.
2. Dollar default rate – This is the total par value of bonds that have defaulted in a given year divided by the total par value of all bonds outstanding.

The issuer default rate does not consider the size of the issues that defaulted, whereas the dollar default rate does. For example, suppose that there are 100 bonds with a total par value of USD 1 billion and that two bonds with a combined par value of USD 50 million default.

• When a bond defaults, the bondholder typically does not lose everything and some recovery is usually made. Because it is difficult to track the value of what is eventually received by claimants in the event of a default, the recovery rate is calculated as the value of the bond a few days after default as a percentage of its par value. For example, suppose that a bond sells for USD 40 per USD 100 of face value immediately after a default.

• Some properties of recovery rates which have been observed are –
  • The average recovery rate is 38%.
  • The distribution of recovery rates is bimodal.
  • There is no relationship between recovery rates and issue size.
  • There is a negative relationship between recovery rates and default rates.
  • Recovery rates are lower in an economic downturn or in a distressed industry.
  • Tangible asset-intensive industries have higher recovery rates.
• The expected loss rate on a bond in a given year can be defined as:

For example, suppose that the probability of default in a year is 0.5% and the recovery rate is 40%.

• The expected return from a bond is

Risk – free rate + Credit Spread – Expected Loss Rate

It might be thought that a bond with a credit spread of 100 basis points (i.e., 1%) would have an expected loss rate of 1% (and therefore the expected return on the bond is the risk-free rate). This is not usually the case, however, and the expected loss rate is lower than the credit spread.

Rating	Spread over Treasuries (%)	Loss Rate (%)	Excess of Spread over Loss Rate (%)
Aaa	0.78	0.02	0.76
Aa			0.81
A			0.99
Baa			1.44
Ba			2.92
B
Caa

• This table presents some results from Hull (Hull, Risk Management and Financial Institutions, 5th edition, Wiley, 2018) showing that the excess of the spread over the loss rate tends to increase as the credit quality of the issuer decreases. (An exception is that Ba issuers tend to have an excess greater than that of B issuers.)