CH-19-20 Analysis of Convertible Bonds – Bond Markets, Analysis and Strategies : Book Guide

This Document Contains Chapters 19 to 20 CHAPTER 19 ANALYSIS OF CONVERTIBLE BONDS CHAPTER SUMMARY This chapter focuses on convertible bonds. We explain methodologies for analyzing convertible bonds, beginning with a review of the basic provisions. CONVERTIBLE BOND PROVISIONS A convertible bond is a corporate bond with a call option to buy the common stock of the issuer. Exchangeable bonds grant the bondholder the right to exchange the bonds for the common stock of a firm other than the issuer of the bond. The number of shares of common stock that the bondholder will receive from exercising the call option of a convertible bond or an exchangeable bond is called the conversion ratio. Upon conversion, the bondholder typically receives from the issuer the underlying shares. This is referred to as a physical settle. There are issues where the issuer may have the choice of paying the bondholder the cash value of the underlying shares. This is referred to as a cash settle. At the time of issuance of a convertible bond, the issuer has effectively granted the bondholder the right to purchase the common stock at a price equal to: . Along with the conversion privilege granted to the bondholder, most convertible bonds are callable at the option of the issuer as of a certain date. This standard type of call option in a convertible bond is called an unprotected call. There is another type of call feature that is included in some convertible bond issues: The bond may only be called if the price of the underlying stock (or the average stock price over some number of days) exceeds a specified trigger price. This type of call is known as a protected call. Some convertible bonds are put able. Put options can be classified as hard puts and soft puts. A hard put is one in which the convertible security 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 security for cash, common stock, subordinated notes, or a combination of the three. Another convertible that was at one time issued for its favorable tax treatment is one with a contingent payment provision, nicknamed “CoPa” bonds. Unlike a traditional convertible bond whose coupon rate is fixed over the bond’s life, a CoPa bond pays a higher coupon rate if the price of the underlying stock prices reaches a specified threshold (say, 125% of the conversion price). Special Conversion Provisions An investor must look carefully at the conversion privilege because not all bonds allow a straightforward conversion privilege. Two types of convertible bonds issued prior to 2008 that departed from the traditional conversion privilege are the net share settlement convertible and the contingent conversion convertible. For a convertible bond that includes a net share settlement provision, upon exercise of the conversion option to convert, the issuer pays the par value in cash to retire the bonds but the bond will be trading above its par value. Issuer motivation for the issuance of convertible bonds with this provision (also called cash-par settlement provision) was that from a financial accounting perspective, convertible bonds with net share settlement provisions were treated favorably in the calculation of the issuer’s earnings per share. With a contingent convertible provision, the holder only has the right to convert when the price of the underlying stock exceeds a specified threshold price for a specified number of trading days. Typically, the threshold was 130% of the conversion price. Until that time, the bondholder is not entitled to convert. Bonds with this provision, nicknames “CoCo” bonds, were introduced in late 1999 and by 2003. CATEGORIZATION OF CONVERTIBLE SECURITIES The U.S. convertible bond market is by far the largest convertible bond market. Most U.S. convertible bonds are issued as private placements under Securities and Exchange Commission (SEC) Rule 144A. Lehman Brothers publishes the Lehman U.S. Convertible Indices. The main index is the Lehman Convertible Composite Index. With respect to “type” of convertible security, cash-pay bonds, also referred to as traditional convertible bonds, are a convertible bonds that pay coupon interest. Zero-coupon convertible bonds are like any other bonds that pay no coupon interest. A popular type of zero-coupon bond is a Merrill Lynch product called LYON, which stands for Liquid Yield Option Notes. An original issue discount (OID) convertible bond is issued at a discount from par but has some coupon interest: the coupon interest rate is a below market rate. A convertible preferred is a preferred stock that can be converted into common stock. A mandatory convertible is a convertible security that converts automatically at maturity into shares of the issuer’s common stock. This automatic conversion differs from convertible bonds where conversion is optional. The market capitalization of a corporation is the product of its common stock outstanding and the price per share of common stock. Credit quality is simply based on the rating of the convertible issue. According to Barclays Capital, as of mid-2009, 31% of all convertibles issued by U.S. corporations had an investment-grade rating, 32% an intermediate-grade rating, 7% a junk bond rating, and 29% were nonrated. The three largest sectors that issued convertible bonds were consumer non-cyclicals (23%), financial institutions (21%), and technology (19%). BASIC ANALYTICS AND CONCEPTS FOR CONVERTIBLE BOND ANALYSIS Consider the following convertible bond with dividends per share = $1; current market price of XYZ common stock = $17; current market price of XYZ bond = $950; par value = $1,000; conversion ratio = 50; coupon rate = 10%; and, maturity = 10 years. If this convertible bond is neither callable nor put able, then the conversion price for the XYZ bond is: conversion price = = = $20. If the market price is greater than $20 there will be an incentive by the owner of the convertible bond to convert. This is especially true if the dividends received from converting would be large relative to the coupon payments being received. Minimum Value of a Convertible Bond The conversion value of a convertible bond is the value of the bond if it is converted immediately. It is expressed as: conversion value = market price of common stock × conversion ratio. The minimum price of a convertible bond is the greater of its conversion value or its value as a corporate bond without the conversion option—that is, based on the convertible bond’s cash flows if not converted (i.e., a plain vanilla bond). This latter value is called its straight value. To estimate the straight value, we must determine the required yield on a nonconvertible bond with the same quality rating and similar investment characteristics. Given this estimated required yield, the straight value in conventionally computed as the present value of the bond’s cash flows using this yield to discount the cash flows. Illustration For the XYZ bond given above that has a current market price of $17 and a conversion ratio of 50, what is its conversion value? We have: conversion value = market price of common stock × conversion ratio = $17 × 50 = $850. To determine the straight value, it is necessary to determine what comparable bonds are trading for in the market. Suppose that comparable bonds are trading to yield 14%. The straight value is then the price of our XYZ bond with a coupon rate of 10% and a maturity of 10 years selling to yield 14%. The price for such a bond would be $788. Given a conversion value of $850 and a straight value of $788, the minimum price for the convertible bond is $850. To eliminate an arbitrage profit, the convertible bond would have to sell for its conversion value of $850. Suppose, instead, that comparable nonconvertible bonds are trading to yield 11.8% so that the straight value of the convertible bond would be $896. The minimum price for the convertible bond must be its straight value in this case because that is a value higher than the conversion value of $850. 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. It is found as follows: market conversion price = . An investor who purchases a convertible bond rather than the underlying stock typically 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: market conversion premium ratio = . The market conversion premium per share can be seen as the price of a call option. The difference between the buyer of a call option and the buyer of a convertible bond is that the former knows precisely the dollar amount of the downside risk, whereas the latter knows only that the most that can be lost is the difference between the convertible bond price and the straight value. Illustration At a market price of $950 for convertible bond XYZ, a stock price of $17 and a conversion ratio of 50, what is its market conversion price, market conversion premium per share, and market conversion premium ratio? Using the above formulas and inserting in our values, we have: market conversion price = = $19 market conversion premium per share = $19 – $17 = $2 market conversion premium ratio = = 0.117647 or about 11.76% CURRENT INCOME OF CONVERTIBLE BOND VERSUS 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 on the convertible bond than would be received as dividends paid on the number of shares equal to the conversion ratio. Analysts 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 break-even time). This is computed as follows: premium payback period = where the favorable income differential per share is equal to where the coupon interest = coupon rate × par value and the premium payback period does not take into account the time value of money. Illustration For the XYZ convertible bond where the coupon rate is 10%, the conversion ratio is 50, the dividend per share is $1, and the market conversion premium per share is $2, how long would it take an investor to recover the market conversion premium per share? We first compute the favorable income differential per share, which is found by first computing the coupon interest from the bond. We have: coupon interest from bond = (coupon rate)(par value) = 0.10($1,000) = $100. Inserting the given values, the favorable income differential per share is: = = $1. The premium payback period can now be computed. We have: premium payback period = = = 2 years. Thus, without considering the time value of money, the investor would recover the market conversion premium per share in two years. Downside Risk with a Convertible Bond Investors usually use the straight value of the bond 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: premium over straight value = . The higher the premium over straight value, all other factors constant, the less attractive the convertible bond. Illustration Earlier, we said that if comparable nonconvertible bonds are trading to yield 14%, the straight value of the XYZ bond would be $788. The premium over straight value for bond XYZ would be: premium over straight value = = = 1.2055838 – 1 = 0.2055838 or about 21%. If the yield on a comparable nonconvertible bond is 11.8% instead of 14%, the straight value would be $896 and the premium over straight value would be premium over straight value = ($950 / $896) – 1 = 0.06 or 6%. OPTION MEASURES Because a convertible bond embeds a call option on the underlying common stock, we can estimate the sensitivity of a convertible bond’s price from measures used in option theory. The measures we describe are delta, gamma, vega, and implied volatility. Basically, these measures relate to the factors that affect the value of an option. The first three measures show the sensitivity of the option’s price to changes in a particular factor that is known to affect the price. Several of these factors, in the case of an option on a stock, include: the price of the underlying stock; the expected volatility of the underlying stock’s price; and, the amount of time remaining to the expiration of the option. The measures are calculated by using a theoretical model to value the price of an option (the most common for options on common stock is the well-known Black–Scholes option pricing model) and determining how the theoretical value changes when a factor (holding all other factors constant) changes. Delta An option’s delta measures the sensitivity of an option’s price to a change in the price of the underlying. For an option on common stock, the underlying is common stock. In the case of a convertible bond, the underlying is the common stock of the issuer. Hence, a convertible bond’s delta is the sensitivity of its value to a change in the underlying stock’s price. (Another name used for delta is hedge ratio or neutral hedge ratio.) More specifically, delta is the ratio of the change in the convertible’s value to the change in the price of the underlying shares. The delta is used to estimate the impact of a change in the price per share of the underlying stock on the convertible bond’s value as follows: approximate change in a convertible bond’s value = change in stock price per share × conversion ratio × delta For example, consider convertible bond, bond XYZ described earlier with a conversion ratio of 50. Suppose that the delta is 0.60. For a price change of $0.125 for the stock price per share, the approximate change in the convertible bond’s value is $0.125 × 50 × 0.60 = $3.75 Multiplying the delta by the conversion ratio of 50 gives 30. This means that 30 shares must be shorted in order to obtain a market neutral position. For example, suppose the price of the underlying shares increases by $0.128. This means the short position consisting of 30 shares of stock will lose $0.128 × $30 = $3.75. There are two important points to know about delta. First, delta is only an approximation of the change in the value of a convertible bond for a small change in the price of the stock. Second, an option’s delta changes over time. It changes due to a change in the price of the underlying stock and changes in the other factors that are known to affect the value of an option such as the amount of time remaining until the option expires. So, if an investor wanted to maintain a hedged position (i.e., market neutral position) in the convertible bond and short stock position, the short position would have to be changed as delta changes. Gamma Duration is the first approximation of how the bond’s price will change when interest rates change. The convexity measure shows for larger change in interest rates what the additional change in the bond’s price will be. Basically, convexity relates to the benefit associated with larger interest rate movements or interest rate volatility. In option theory, gamma plays the same role as convexity. In the case of a convertible bond, gamma is the additional change in the convertible bond’s value for a larger change in the price of the underlying stock. Vega An option’s vega is the sensitivity of the option’s price to a change in expected volatility for the underlying. For a convertible bond, it is an estimate of the sensitivity of the convertible bond’s price to a change in the expected volatility of the stock’s price. Implied Volatility In an option pricing model, the only unknown input that must be estimated is expected volatility. A common practice in the option market is to “back out” what the expected volatility is given the observed market price for the option and the option pricing model. The volatility so obtained is referred to as implied volatility. The difference between implied volatility and historical volatility often is the basis for trading strategies in the options market and is also used for that purpose in the convertible bond market. PROFILE OF A CONVERTIBLE BOND In describing how to categorize convertible securities at the outset of this chapter, one way to categorize is by the convertible’s profile. Basically, by profile we mean the factors that dominate the performance of the convertible such as the stock price of the issuer or the level of interest rates and spreads. The categories according to Lehman Brothers are (1) typical, (2) equity sensitive, (3) busted, and (4) distressed. By a “typical” convertible, it can refer to a balanced convertible with hedge ratios, or equivalently, their correlation with stock price changes, ranging from roughly 55% to 80%. An equity sensitive convertible, also referred to as an equity substitute convertible by practitioners, is one in which the underlying stock price exceeds the conversion price of the stock. When the price of the underlying stock is very far below the conversion price, the convertible is said to be a busted convertible. A distressed convertible can be viewed as a special type of busted convertible where the price of the underlying stock has fallen so far below the conversion price that it is likely that the issuer will be forced into bankruptcy. PROS AND CONS OF INVESTING IN A CONVERTIBLE BOND One disadvantage of buying the bond is that the conversion price is higher than the price at the time the convertible bond is purchased. Thus, the return will be lower unless the interest payments for the length of ownership of the convertible bond are great enough to cover (i) the higher price paid per share and (ii) any dividends that are forgone for the length of time. An advantage of buying the bond is that its value will likely fall less than that of stock if a firm runs into financial distress difficulties. Call Risk Convertible issues are callable by the issuer. This is a valuable feature for issuers, who deem the current market price of their stock undervalued enough so that selling stock directly would dilute the equity of current stockholders. The firm would prefer to raise equity funds over incurring debt, so it issues a convertible, setting the conversion ratio on the basis of a stock price it regards as acceptable. Takeover Risk Corporate takeovers represent another risk to investing in convertible bonds. As the stock of the acquired company may no longer trade after a takeover, the investor can be left with a bond that pays a lower coupon rate than comparable-risk corporate bonds. CONVERTIBLE BOND ARBITRAGE Because of the investment characteristics of convertible bonds that we have described in this chapter, their payoff characteristics allow the creation of different positions that can benefit from the mispricing of a convertible bond. Seeking to capitalize on the perceived mispricing of a convertible bond issue is referred to as convertible bond arbitrage. The first step in all convertible bond arbitrage strategies is to identify convertible bonds that are trading at a price that substantially deviates from the theoretical value indicated by the manager’s convertible bond model. Hence, the process is heavily dependent on this valuation model. For those convertible bonds that are identified as substantially misvalued in the market, a position is taken in the convertible bond, the underlying common stock, and derivative instrument needed to hedge market risks that could otherwise adversely impact the objective of the convertible bond arbitrage strategies. Attributes of Issues for Use in a Convertible Bond Arbitrage Strategy In screening the candidate list of convertible bond issues for a convertible bond arbitrage strategy, the manager will prefer those with certain attributes for the underlying common stock and for the convertible bond issue itself. For the convertible bond itself, the following attributes are desirable in a convertible bond arbitrage: (1) good liquidity, (2) low conversion premium, (3) high convexity, and (4) low implied volatility. With respect to the underlying common stock, the following attributes are desirable: (1) high expected price volatility, (2) can be easily borrowed, and (3) pay little or no dividends. Types of Strategies The idea behind a cash flow arbitrage strategy is to create equivalent positions in the convertible bond and underlying stock so that any additional cash flow available from the convertible bond can be captured while eliminating or mitigating any risks. In convertible bond arbitrage trades, typically a long position is established in the convertible bond, and simultaneously, a short position is established in the underlying stock. The objective in a volatility trading strategy is that regardless of how the price of the underlying stock price changes, the mispriced convertible bond’s value will outperform the value of the short position in the underlying stock’s value. As with most option trading strategies, the position of a strategy must be changed as the price of the underlying changes. There are option strategies that involve capitalizing on the expected change in the delta of an option. In a convertible bond arbitrage gamma trading strategy, instead of adjusting the short position in the underlying stock as specified by the delta, the manager takes a position based on the expected change in the delta. The expectation is to generate additional income when the stock price changes. OPTIONS APPROACH TO VALUATION An investor who purchases a noncallable/non-put able convertible bond would be entering into two separate transactions: (i) buying a noncallable/non-put able straight bond, and (ii) buying a call option on the stock, where the number of shares that can be purchased with the call option is equal to the conversion ratio. The fair value for the call option depends on the factors that affect the price of a call option. One key factor is the expected price volatility of the stock: the more the expected price volatility, the greater the value of the call option. As a first approximation to the value of a convertible bond, the formula would be convertible bond value = straight value + price of the call option on the stock. The price of the call option is added to the straight value because the investor has purchased a call option on the stock. Consider a common feature of a convertible bond: the issuer’s right to call the bond. If called, the investor can lose any premium over the conversion value that is reflected in the market price. Therefore, the analysis of convertible bonds must take into account the value of the issuer’s right to call the bond. This depends, in turn, future interest rate volatility, and economic factors that determine whether it is optimal for the issuer to call the bond. The Black-Scholes option pricing model cannot handle this situation. Instead, the binomial option pricing model can be used simultaneously to value the bondholder’s call option on the stock and the issuer’s right to call the bonds. The bondholder’s put option can also be accommodated. To link interest rates and stock prices together, statistical analysis of historical movements of these two variables must be estimated and incorporated into the model. KEY POINTS • A convertible bond grants the bondholder the right to convert the bond into a predetermined number of shares of common stock of the issuer. The number of shares is called the conversion ratio. • Provisions in convertible bonds issued prior to 2008 have provisions that an investor should be aware of that are unique with respect to the conversion privilege: net share settlement provision and contingent conversion provision. • Analysis of a convertible bond requires calculation of the conversion value, straight value, market conversion price, market conversion premium ratio, and premium payback period. • The downside risk of a convertible bond usually is estimated by calculating the premium over straight value. The limitation of this measure is that the straight value (the floor) changes as interest rates change. • Because a convertible bond is basically a bond with an embedded call option on the underlying stock, option theory and measures used by players in the option market are used in describing the investment characteristics of convertibles. These measures include delta, gamma, vega, and implied volatility. • Convertibles are classified according to their investment profile: typical convertibles (also referred to as balanced convertibles), equity sensitive convertibles (also referred to as equity substitute convertibles), busted convertibles, and distressed convertibles. • There are several strategies that can be used to capitalize on any perceived mispricing of convertible bonds. These strategies are referred to as convertible bond arbitrage strategies. • The option pricing approach can be used to determine the fair value of the embedded call option. The value of the call option following this approach is estimated using an equity option pricing model such as the Black–Scholes model. ANSWERS TO QUESTIONS FOR CHAPTER 19 (Questions are in bold print followed by answers.) 1. In the October 26, 1992, prospectus summary of the Staples 5% convertible subordinated debentures due 1999, the offering stated: “Convertible into Common Stock at a conversion price of $45 per share . . .” If the par value is $1.000, what is the conversion ratio? Let us rearrange the equation for conversion price to solve for the conversion ratio. We have: conversion price =  conversion ratio = . Inserting in our given values, we have: conversion ratio = = = 22.22. 2. What is the difference between a soft put and a hard put? Along with the conversion privilege granted to the bondholder, most convertible bonds are callable at the option of the issuer. Some convertible bonds are put able. Put options can be classified as hard puts and soft puts. For a soft put, the issuer has the option to redeem the convertible security for cash, common stock, subordinated notes, or a combination of the three. A hard put is one where the convertible security must be redeemed by the issuer only for cash. 3. Upon exercise of the conversion option for a convertible bond, all issuers must exchange shares of stock for the bond. Explain whether you agree or disagree. When the holder of a convertible bond exercises the option to convert, the traditional outcome was that the issuer exchanged the bond for the number of shares as indicated by the conversion ratio. So in terms of a “traditional” bond, one could agree with the statement. However, one can disagree with the above statement in that there can exist bonds that do not allow the straightforward conversion privilege of only using shares in exchange for bonds. For example, for a convertible bond that includes a net share settlement provision, the issuer pays the par value in cash to retire the bonds upon exercise of the conversion option to convert. Also, this type of bond will be trading above its par value. The difference between the conversion value and the par value is additional compensation owed to the holder. That difference is made up by the issuer providing shares of stock to the holder. In some issues, the issuer will have the option to settle by providing a combination of cash and stock. Issuer motivation for the issuance of convertible bonds with this provision (also called cash-par settlement provision) was that from a financial accounting perspective, convertible bonds with net share settlement provisions were treated favorably in the calculation of the issuer’s earnings per share. However, the change in the financial accounting rules that were put into place in 2008 no longer made this type of financing attractive to corporations. To see the popularity of these bonds before then, since 2005 when they first became popular, $120 billion of the $171 billion of U.S. convertible bonds contained this provision. 4. What is a mandatory convertible? Mandatory convertible is a convertible security that converts automatically at maturity into shares of the issuer’s common stock. This automatic conversion differs from convertible bonds where conversion is optional. 5. This excerpt is taken from an article titled “Caywood Looks for Convertibles,” which appeared in the January 13, 1992, issue of Bond Week, p. 7: Caywood Christian Capital Management will invest new money in its $400 million high-yield portfolio in “busted convertibles,” double- and triple-B rated convertible bonds of companies. . . ., said James Caywood, CEO. Caywood likes these convertibles as they trade at discounts and are unlikely to be called, he said. (a) What is a busted convertible? If the price of the stock is low, so that the straight value is considerably higher than the conversion value, the bond will trade much like a straight bond. The convertible bond in such instances is referred to as a busted convertible or a bond equivalent. (b) What is the premium over straight value at which these bonds would trade? This premium per share is equal to the difference between the market conversion price and the current market price of the common stock. Because the price of the stock is low, there is a low probability of the stock being converted. Thus, the premium would be close to zero. (c) Why does Mr. Caywood seek convertibles with higher investment-grade ratings? A higher investment-grade implies a lower probability of default. This means that the convertible bond will be around for a while and longevity implies a longer horizon for achieving conversion. In our problem, it is also noted that these bonds are selling at a discount. Since the call price is probably significantly greater that the discount price, Caywood is less worried about the bonds being called when it is disadvantageous to his company. (d) Why is Mr. Caywood interested in call protection? Call protection insures the bond will not be called when it is at a disadvantage to the investor. Thus, this is something Caywood is interested in because it gives the convertible bond’s option time to increase in value. 6. Explain the limitation of using premium over straight value as a measure of the downside risk of a convertible bond. Investors usually use the straight value of the bond 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: premium over straight value = . The higher the premium over straight value (all other factors constant), then 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 (fall), the straight value falls (rises) making the floor fall (rise). Therefore, the downside risk changes as interest rates change. 7. This excerpt comes from an article titled “Bartlett Likes Convertibles” in the October 7, 1991, issue of Bond Week, p. 7: “Bartlett & Co. is selectively looking for opportunities in convertible bonds that are trading cheaply because the equity of the issuer has dropped in value, according to Dale Rabiner, director of fixed income at the $800 million Cincinnati-based fund. Rabiner said he looks for five-year convertibles trading at yields comparable to straight bonds of companies he believes will rebound.” Discuss this strategy for investing in convertible bonds. As discussed below the strategy offers upside potential but has more inherent risk. Typically, convertible bonds pay interest that is less than nonconvertible bond. This is because nonconvertible bonds don’t have the conversion privilege found in convertible bonds. Rabiner wants to buy convertible bonds that pay a rate of return similar to nonconvertible bonds. Rabiner may be able to achieve this if it is true convertible bonds are selling at a steep enough discount. For example, a nonconvertible bond selling at 100 and paying a 10% coupon payment gives a per dollar rate of return that is equivalent to a convertible bond selling at 80 and paying an 8% coupon payment. For example, each pays 10 cents on the dollar. Besides paying the same rate of return, the convertible bond has a conversion option so that it shares in upside potential whereas a nonconvertible bond does not. However, nonconvertible bonds typically have prior claims if firms default. Thus, in this case, buying convertible bonds offers a greater potential return but is also a more risky strategy. 8. Consider a convertible bond as follows: par value = $1,000; coupon rate = 9.5% market price of convertible bond = $1,000 conversion ratio = 37.383 estimated straight value of bond = $510 yield to maturity of straight bond = 18.7% Assume that the price of the common stock is $23 and that the dividend per share is $0.75 per year. Answer the below questions. (a) Calculate each of the following (1) conversion value, (2) market conversion price, (3) conversion premium per share, (4) conversion premium ratio, (5) premium over straight value, (6) favorable income differential per share, and (7) premium payback period. (1) conversion value = market price of common stock × conversion ratio = $23 × 37.383 = $859.809 or about $859.81. (2) market conversion price = = = $26.750127 or about $26.57. (3) market conversion premium per share = market conversion price – current market price = $26.5701127 – $23 = $3.5701127 or about $3.57. (4) market conversion premium ratio = = = 0.155217 or about 15.52%. (5) premium over straight value = = = 1.96078 – 1 = 0.96078 or about 96.08%. (6) Noting that the conversion ratio = = = 37.383, we can insert all of our given values into our favorable income differential per share to get: = = $1.7912621 or about $1.79. (7) premium payback period = = = 1.993071 or about 1.99. (b) Answer the below questions if the price of the common stock increases from $23 to $46. (1) What will be the approximate return realized from investing in the convertible bond? First, we need to compute the conversion value for the bond. We have: conversion value = market price of common stock × conversion ratio = $46 × 37.383 = $1,719.62. Assuming the purchase price of the bond is $1,000, we can compute the realized return. The rate of return is: = = = 0.71962 or about 71.92%. The return would probably be slightly higher because the convertible bond would trade at a slight premium to its conversion value. For example, at the time of the conversion, the rate of return is: = = 0.71962 or about 71.96%. (2) What would be the return realized if $23 had been invested in the common stock? The rate of return is: = = 1.0000 or 100.00%. (3) Why would the return on investing in the common stock directly be higher than investing in the convertible bond? The reason for the lower return by buying the convertible bond rather than the stock directly is that the investor has effectively paid $26.57 – $23 = $3.57 per share more for the stock. Thus the convertible bond investor realizes a gain based on a stock price of $26.57 rather than $23. [NOTE. Also, if one took into account interest paid of $95 per year then the difference would be less. This is because the interest of $95 per year is greater than the dividends that would have been received: ($1,000 / $23)($0.75) = $32.61.] (c) Answer the below questions if the price of the common stock declines from $23 to $8. (1) What will be the approximate return realized from investing in the convertible bond? There is currently no conversion value and with such a low price of $8 it is doubtful if the convertible bond is selling at much of a premium. However, there is a 9.5% coupon payment so that would be realized each year it is paid even if there nothing to be gained from conversion or selling the bond at a premium. (2) What would be the return realized if $23 had been invested in the common stock? The realized return would be negative: ($23 – $8) / $23 = –$15 / $23 = 0.652175 or 65.22%. (3) Why would the return on investing in the convertible bond be higher than investing in the common stock directly? The convertible bond has little downside risk as bond values do not have as much volatility of common stock. This is because they have senior claims on cash flows compared to common stock. The firm would likely have to undergo prolonged earnings problems before the coupon claims of the convertible bondholders would be seriously affected. 9. A Merrill Lynch note structure called a liquid yield option note (LYON) is a zero-coupon instrument that is convertible into the common stock of the issuer. The conversion ratio is fixed for the entire life of the note. If investors wish to convert to the shares of the issuer, they must exchange the LYON for the stock. As a result, the conversion price increases over time. Why? The formula for conversion ratio is: conversion ratio = par value of bond / conversion price. Rearranging we get: conversion price = (par value of bond)(conversion ratio). For a zero-coupon bond, the par value of the bond increases over time since interest is not paid in cash but increases the par value of the bond. Thus, from the above formula for the conversion price, we can see that as the par value of the bond increases that the conversion price must increase proportionally since the conversion ratio is constant. 10. Answer the below questions. a. Suppose that a convertible bond has a conversion ratio of 20 and a delta of 0.70. For a price change of $0.125 for the stock price per share, what is the approximate change in the convertible bond’s value? The delta is used to estimate the impact of a change in the price per share of the underlying stock on the convertible bond’s value as follows: approximate change in a convertible bond’s value = change in stock price per share * conversion ratio * delta For our problem, we have a conversion ratio is 20, a delta of 0.70, and a price change of $0.125 for the stock price per share. Inserting in these values, the approximate change in the convertible bond’s value is: $0.125 * 20 * 0.70 = $1.75 b. How many shares of the stock must be shorted in order to create a market neutral position by holding the convertible bond and shorting the stock? The combined position of the convertible bond and the short position in the stock is said to be delta hedged, delta neutral, or market neutral. The number of shares that should be shorted is given by: delta times the conversions ration. For our problem, the delta is 0.70 and the conversion ratio of 20. Multiplying these values gives 0.70 × 20 = 14. This means that 14 shares must be shorted in order to obtain a market neutral position. 11. Why would you expect that a distressed convertible would have a delta of zero? Delta ranges from 0 to 1. The delta can help describe the character of the convertible bond. At one end of the spectrum is a delta of 1, which means that the convertible bond will mirror the movement in the underlying stock. If the delta is 0, basically the bond is a straight bond since a change in the price of the underlying stock has no impact on the convertible bond’s price. A distressed convertible is like a straight bond because there is no real possibility of conversion. Thus its delta is essentially zero. 12. Suppose that the price of the underlying stock for a convertible bond is considerably higher than the conversion price. What would expect that convertible bond’s delta to be? Delta ranges from 0 to 1. The delta can help describe the character of the convertible bond. At one end of the spectrum is a delta of 1, which means that the convertible bond will mirror the movement in the underlying stock. Thus, for our situation where the stock price is considerably above the conversion price, we would expect a high that could be near one. Another way of understanding that delta should be near one is to consider the meaning of delta and its application. For example, an option’s delta measures the sensitivity of an option’s price to a change in the price of the underlying. For an option on common stock, the underlying asset is common stock. In the case of a convertible bond, the underlying asset is the common stock of the issuer. Hence, a convertible bond’s delta is the sensitivity of its value to a change in the underlying stock’s price. For our situation where the stock price is considerably above the conversion price the sensitivity is almost a one to one relation. 13. The following quotes are from Mihir Bhattacharya, “Convertible Securities and Their Valuation,” Chapter 51 in Frank J. Fabozzi (ed.), The Handbook of Fixed Income Securities: Sixth Edition (New York: McGraw-Hill, 2001). (a) Bhattacharya states: “Increased debt market volatility has driven home the point of duration risk inherent in any security with a fixed income component, including convertibles. The increased volatility of the spreads (over Treasury or other interest rate benchmarks) has heightened investor sensitivity to the reliability of the fixed income floor or bond value of the convertible.” What message is the author is trying to convey to investors? The author is conveying that investors in convertible debt (or any fixed income security) should not take lightly the value of its straight debt component, i.e., the straight value therefore acts as a floor for the convertible bond price. As long as the firm is solvent, a minimum level of cash flow (as given by the coupon rate) can be relied upon even when volatility in interest rates negatively affects the call option privilege of convertible securities. (b) Bhattacharya states: “Convertibles have equity and interest rate options, and occasionally, currency options, embedded in them. Issuers and investors are becoming even more aware that option valuation is driven by, among other factors: (a) equity volatility; (b) interest rate volatility; and (c) spread volatility. In some situations the embedded options may easily be separated and valued. However, in the vast majority of cases, they interact with other and so prove difficult, if not impossible, to separate. Investors should be aware of the inherent danger of attempting to value the embedded options as if they were separable options.” Explain why the factors mentioned in the quote affect the value of a convertible bond and why the factors interact. First, convertibles have equity options. The convertible can be converted at a profit into equity if the price of equity rises above the conversion price. The probability of converting increases as the volatility increases. As debt, a convertible issue can fall in value as interest rates increase. This is because bond prices are inversely related to changes in interest rates. Spread volatility means there is uncertainty in reinvesting either interest payments or principal received. As spreads decrease the profit above what one would receive on a comparable Treasury deceases. These factors interact. For example, stock prices tend to fall as interest rates increase. This is because corporate profits decline as costs of borrowing go up. The end result is that the value of convertibles will fall in value due to a decrease in upside potential. An increase in the volatility of the spread is a sign of uncertainty in the economic climate associated with negative prospects for companies. This will lead to lower stock prices and thus the value of convertibles decline due to a decrease in upside potential. The straight value of a convertible can change for a variety of interrelated reasons. For example, if interest rates rise in the economy, the straight value will decline. Even if interest rates do not rise, the perceived credit worthiness of the issuer may deteriorate, causing investors to demand a higher yield from an increase in spreads. In fact, the stock price and the yield required by investors are not independent. When the price of the stock drops precipitously, the perceived credit worthiness of the issuer may decline, causing a decline in the straight value. In any event, although the straight value may decline, it still is a floor (albeit a moving floor) for the convertible bond price. 14. Why is a volatility trading strategy considered to be a non-directional strategy? The objective in a volatility trading strategy is that regardless of how the price of the underlying stock price changes, the mispriced convertible bond’s value will outperform the value of the short position in the underlying stock’s value. Hence, this convertible bond strategy is a non-directional strategy. That is, the performance of the strategy is based purely on the volatility of the underlying stock price not the direction in which the stock price moves. Effectively, this strategy is a bet on the volatility of the underlying stock and hence the name given to this type of convertible bond arbitrage strategy, volatility trading. As with most option trading strategies, the position of a strategy must be changed as the price of the underlying changes. Hence, in implementing this strategy, the transaction cost associated with the shorting of the stocks must be taken into account. There are risks associated with this strategy, and they can be quantified using other measures taken from option theory. 15. What is the difference between a busted convertible and a distressed convertible? When the price of the underlying stock is very far below the conversion price, the convertible is said to be a busted convertible. A distressed convertible can be viewed as a special type of busted convertible where the price of the underlying stock has fallen so far below the conversion price that it is likely that the issuer will be forced into bankruptcy. Thus, the difference between a busted convertible and a distressed convertible is one of degree. Both are below the conversion price but a distress convertible is the only convertible that is in imminent danger of bankruptcy. 16. What is a cash flow arbitrage strategy involving convertible bonds? The cash flow from a convertible bond differs from the cash flow from a stock. The idea behind a cash flow arbitrage strategy is to create equivalent positions in the convertible bond and underlying stock so that any additional cash flow available from the convertible bond can be captured while eliminating or mitigating any risks. More specifically, the convertible bond is purchased with funds obtained from shorting the underlying stock. In convertible bond arbitrage trades, typically a long position is established in the convertible bond, and simultaneously, a short position is established in the underlying stock. The number of shares shorted is such that any change in the value of the convertible bond will be equal to the change in the position of the stocks shorted. This is determined by the delta of the convertible bond, and the resulting position is said to be market neutral. CHAPTER 20 CORPORATE BOND CREDIT ANALYSIS CHAPTER SUMMARY Since the credit rating companies (Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings) have well-developed methodologies for analyzing the default risk of a corporate bond, we will describe factors that they consider in this chapter. The framework for analysis that we describe in this chapter is referred as “traditional credit analysis.” Available online at www.pearsonhighered.com/fabozzi is the appendix to this chapter, which is a report on Lear Corporation. OVERVIEW OF CORPORATE BOND CREDIT ANALYSIS In the analysis of the default risk of a corporate bond issuer and specific bond issues, there are three areas that are analyzed by bond credit analysts. These are: (1) the protections afforded to bondholders that are provided by covenants limiting management’s discretion; (2) the collateral available for the bondholder should the issuer fail to make the required payments; and, (3) the ability of an issuer to make the contractual payments to bondholders. Analysis of Covenants An analysis of the indenture is part of a credit review of a corporation’s bond issue. The indenture provisions establish rules for several important areas of operation for corporate management. These provisions are safeguards for the bondholder. Indenture provisions should be analyzed carefully. There are two general types of covenants. Affirmative covenants call upon the corporation to make promises to do certain things. Negative covenants, also called restrictive covenants, require that the borrower not take certain actions. There are an infinite variety of restrictions that can be placed on borrowers in the form of negative covenants. Some of the more common restrictive covenants include various limitations on the company’s ability to incur debt. Consequently, bondholders may want to include limits on the absolute dollar amount of debt that may be outstanding or may require some type of fixed charge coverage ratio test. The two most common tests are the maintenance test and the debt incurrence test. The 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 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. Debt incurrence tests are generally considered less stringent than maintenance provisions. There could also be cash flow tests (or cash flow requirements) and working capital maintenance provisions. Some indentures may prohibit subsidiaries from borrowing from all other companies except the parent. Restricted subsidiaries are those considered to be consolidated for financial test purposes; unrestricted subsidiaries (often foreign and certain special-purpose companies) are those excluded from the covenants governing the parent. Analysis of Collateral A corporate debt obligation can be secured or unsecured. In the case of the liquidation of a corporation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule. What is typically observed is that the corporation’s unsecured creditors may receive distributions for the entire amount of their claim and common stockholders may receive some distribution, while secured creditors may receive only a portion of their claim. The claim position of a secured creditor is important in terms of the negotiation process. Assessing an Issuer’s Ability to Pay The ability of an issuer to generate cash flow goes considerably beyond the calculation and analysis of a myriad of financial ratios and cash flow measures that can be used as a basic assessment of a company’s financial risk. An evaluation of an issuer’s ability to pay involves analysis of business risk, corporate governance risk and financial risk ANALYSIS OF BUSINESS RISK Business risk is defined as the risk associated with operating cash flows. Operating cash flows are not certain because the revenues and the expenditures comprising the cash flows are uncertain. An analysis of industry trends is important because it is only within the context of an industry that company analysis is valid. Industry consideration should be considered in a global context. The need for many companies to become globally competitive increases as the barriers to international trade are broken down. It has been suggested that the following areas will provide a credit analyst with a sufficient framework to properly interpret a company’s economic prospects: economic cyclicality, growth prospects, research and development expenses, competition, sources of supply, degree of regulation, and labor. These general areas encompass most of the areas that the rating agencies have identified for assessing business risk. One of the first areas of analysis is investigating how closely the industry follows gross domestic product (GDP) growth. This is done in order to understand the industry’s economic cyclicality. Related to the analysis of economic cyclicality are the growth prospects of the industry. This requires an analysis as to whether the industry’s growth is projected to increase and thereafter be maintained at a high level or is it expected to decline. To assess the growth prospects, a credit analyst will have to investigate the dependence on research and development (R&D) expenditures for maintaining or expanding the company’s market position. With respect to regulation, the concern should not be with its existence or absence in an industry perse. Rather, the focus with respect to regulation should be on the direction of regulation and its potential impact on the current and prospective profitability of the company. Regulation also encompasses government intervention in non–U.S. operations of a company. A key component in the cost structure of an industry is labor. In analyzing the labor situation, the credit analyst will examine if the industry is heavily unionized. In nonunionized companies, the credit analyst will look at the prospect of potential unionization. CORPORATE GOVERNANCE RISK Corporate governance issues involve (1) the ownership structure of the corporation, (2) the practices followed by management, and (3) policies for financial disclosure. The underlying economic theory regarding many of the corporate governance issues is the principal-agency relationship between the senior managers and the shareholders of corporations. The agent, a corporation’s senior management, is charged with the responsibility of acting on behalf of the principal, the shareholders of the corporation. There are mechanisms that can mitigate the likelihood that management will act in its own self-interest. The mechanisms fall into two general categories. The first is to more strongly align the interests of management with those of shareholders. This can be accomplished by granting management an economically meaningful equity interest in the company. Also, manager compensation can be linked to the performance of the company’s common stock. The second category of mechanism is by means of the company’s internal corporate control systems, which can provide a way for effectively monitoring the performance and decision-making behavior of management. What has been clear in corporate scandals is that there was a breakdown of the internal corporate control systems that lead to corporate difficulties and the destruction of shareholder wealth. Because of the important role played by the board of directors, the structure and composition of the board are critical for effective corporate governance. The key is to remove the influence of the CEO and senior management on board members. Several organizations have developed services that assess corporate governance and express their view in the form of a rating. Generally, these ratings are made public at the option of the company requesting an evaluation. One such service is offered by S&P, which produces a Corporate Governance Score based on a review of both publicly available information, interviews with senior management and directors, and confidential information that S&P may have available from its credit rating of the corporation’s debt. FINANCIAL RISK Having achieved an understanding of a corporation’s business risk and corporate governance risk, the analyst is ready to move on to assessing financial risk. This involves traditional ratio analysis and other factors affecting the firm’s financing. Some of the more important financial ratios are: interest coverage, leverage, cash flow, net assets, and working capital. Once these ratios are calculated, it is necessary to analyze their absolute levels relative to those of the industry. Before performing an analysis of the financial statement, the analyst must determine if the industry in which the company operates has any special accounting practices, such as those in the insurance industry. If so, an analyst should become familiar with industry practices. Interest Coverage An interest coverage ratio measures the number of times interest charges are covered on a pretax basis. Typically, interest coverage ratios that are used and published are pretax as opposed to after-tax because interest payments are a pretax expense. Pretax interest coverage ratio is calculated by dividing pretax income plus interest charges by total interest charges. The higher this ratio, the lower the credit risk, all other factors the same. A calculation of simple pretax interest coverage would be misleading if there are fixed obligations other than interest that are significant. In this case, a more appropriate coverage ratio would include these other fixed obligations, and the resulting ratio is called a fixed charge coverage ratio. Leverage While there is no one definition for leverage, the most common one is the ratio of long-term debt to total capitalization. If there is a higher level of debt then a higher percentage of operating income must be used to satisfy fixed obligations. In analyzing a highly leveraged company (i.e., a company with a high leverage ratio), the margin of safety must be analyzed. The margin of safety is defined as the percentage by which operating income could decline and still be sufficient to allow the company to meet its fixed obligations. Recognition must be given to the company’s operating leases. The existence of material operating leases can therefore understate a company’s leverage. Operating leases should be capitalized to give a true measure of leverage. Two other factors should be considered: the maturity structure of the debt and bank lines of credit. Cash Flow The statement of cash flows is required to be published in financial statements along with the income statement and balance sheet. The statement of cash flows is a summary over a period of time of a company’s cash flows broken out by operating, investing, and financing activities. Analysts reformat this information, combining it with information from the income statement to obtain what they view as a better description of the company’s activities. S&P calculates what it refers to as funds from operations (defined as net income adjusted for depreciation and other noncash debits and credits). Operating cash flow is funds from operations reduced by changes in the investment in working capital (current assets less current liabilities). Subtracting capital expenditures gives what S&P defines as free operating cash flow. It is from this cash flow that dividends and acquisitions can be made. Deducting cash dividends from free operating cash flow gives discretionary cash flow. Adjusting discretionary cash flow for managerial discretionary decisions for acquisition of other companies, the disposal of assets (e.g., lines of business or subsidiaries), and other sources or uses of cash gives prefinancing cash flow. As stated by S&P, prefinancing cash flow “represents the extent to which company cash flow from all internal sources have been sufficient to cover all internal needs.” Cash flow measures can then be used to calculate various cash flow ratios. The ratio used often depends on the type of company being analyzed. Net Assets A fourth important ratio is net assets to total debt. In the analysis of this ratio, consideration should be given to the liquidation value of the assets. Liquidation value will often differ dramatically from the value stated on the balance sheet. Consideration should be given to several other financial variables including intangible assets, pension liabilities, and the age and condition of the plant. Working Capital Working capital is defined as current assets less current liabilities. Working capital is considered a primary measure of a company’s financial flexibility. Other such measures include the current ratio (current assets divided by current liabilities) and the acid test (cash, marketable securities, and receivables divided by current liabilities). The stronger the company’s liquidity measures, the better it can weather a downturn in business and reduction in cash flow. CORPORATE BOND CREDIT ANALYSIS AND EQUITY ANALYSIS The analysis of business risk, corporate governance risk, and financial risk involves the same type of analysis that a common stock analyst would undertake. Many fixed income portfolio managers strongly believe that corporate bond analysis, particularly high-yield bond analysis, should be viewed from an equity analyst’s perspective. If analysts think about whether they would want to buy a particular high yield company’s stock and what will happen to the future equity value of that company, they have a useful approach because, as equity values go up, so does the equity cushion beneath the company’s debt. KEY POINTS • Corporate bond credit analysis involves an assessment of bondholder protections set forth in the bond indenture, the collateral available for the bondholder should the issuer fail to make the required payments, and the capacity of an issuer to fulfill its payment obligations. • Covenants contained in the bond indenture set forth limitations on management and, as a result, provide safeguard provisions for bondholders. While collateral analysis is important, there is a question of what a secured position means in the case of a reorganization if the absolute priority rule is not followed in a reorganization. • In assessing the ability of an issuer to service its debt, analysts look at a myriad of financial ratios as well as qualitative factors such as the issuer’s business risk and corporate government risk. • In assessing the ability of an issuer to service its debt, analysts assess the issuer’s business risk, corporate governance risk, and financial risk. Business risk is the risk associated with operating cash flows. In assessing business risk, some of the main factors considered are industry characteristics and trends, the company’s market and competitive positions, management characteristics, and national political and regulatory environment. • Corporate governance risk involves assessing (1) the ownership structure of the corporation, (2) the practices followed by management, and (3) policies for financial disclosure. • Assessing financial risk involves traditional ratio analysis and other factors affecting the firm’s financing. The more important financial ratios analyzed are interest coverage, leverage, cash flow, net assets, and working capital. • Some fixed income portfolio managers strongly believe that corporate bond analysis should be viewed from an equity analyst’s perspective. This is particularly the case in analyzing high-yield bonds. ANSWERS TO QUESTIONS FOR CHAPTER 20 (Questions are in bold print followed by answers.) 1. Answer the below questions. (a) What is the difference between a positive and negative covenant? There are two general types of covenants. Positive (or affirmative) covenants call upon the corporation to make promises to take certain actions. Negative (or restrictive) covenants differ because they require that the borrower not take certain actions. There are an infinite variety of restrictions that can be placed on borrowers in the form of restrictive covenants. More details are given below on these restrictive covenants. Some of the more common restrictive covenants include various limitations on the company’s ability to incur debt since unrestricted borrowing can be highly detrimental to the bondholders. Consequently, bondholders may want to include limits on the absolute dollar amount of debt that may be outstanding or may require some type of fixed charge coverage ratio test. The two most common tests are the maintenance test and the debt incurrence test. There could also be cash flow tests (or cash flow requirements) and working capital maintenance provisions. Some indentures may prohibit subsidiaries from borrowing from all other companies except the parent. Indentures often classify subsidiaries as restricted or unrestricted. Restricted subsidiaries are those considered to be consolidated for financial test purposes; unrestricted subsidiaries (often foreign and certain special-purpose companies) are those excluded from the covenants governing the parent. Often, subsidiaries are classified as unrestricted in order to allow them to finance themselves through outside sources of funds. (b) What is the purpose of the analysis of covenants in assessing the credit risk of an issuer? An analysis of covenants found in a bond indenture is part of assessing the credit risk of a bond issuer. The purpose of analyzing the covenants (or provisions) is to examine the procedures for areas of corporate management operatives. These covenants are safeguards for the bondholder. Covenants must also be analyzed for ambiguity. Thus, analyst must pay careful attention to the definitions in indentures because they vary from indenture to indenture. 2. Answer the below questions. (a) What is a maintenance test? A maintenance test is a check and balance measure to help the bondholder monitor the company. In particular, the bondholder wants to make sure the covenants are being followed. The maintenance helps achieve this by requiring 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. (b) What is a debt incurrence test and when does it come into play? The 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. Debt incurrence tests are generally considered less stringent than maintenance provisions. 3. Some credit analysts place less emphasis on collateral compared to covenants and business risk. Explain why. Some analysts place less emphasis on collateral compared to covenants and business risk due the observation that bankruptcy often only allows secured creditors to receive part of their claim in terms of assets pledged by a borrower to secure a loan. Thus, the both covenants found in the indenture and also the business risk (under which the company operates) takes on added significance. More details are given below. A corporate debt obligation can be secured or unsecured. In the case of the liquidation of a corporation, proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule. In contrast, seldom do the absolute priority rules hold in a reorganization. What is typically observed in such cases is that the corporation’s unsecured creditors may receive distributions for the entire amount of their claim and common stockholders may receive some distribution, while secured creditors may receive only a portion of their claim. Secured creditors are willing to allow distribution to unsecured creditors and common stockholders in order to obtain approval for the plan of reorganization, a plan that requires approval of all parties. The question is then, what does a “secured position” mean in the case of a reorganization if the absolute priority rule is not followed in a reorganization? The claim position of a secured creditor is important in terms of the negotiation process. However, because absolute priority is not followed and the final distribution in a reorganization depends on the bargaining ability of the parties, some analysts place less emphasis on collateral compared to covenants and business risk. 4. Why do credit analysts begin with an analysis of the industry in assessing the business risk of a corporate issuer? An analysis of the industry (and its trends) is important for credit analysts because it is only within the context of an industry that company analysis is valid. All proper analysts have to take into consider both some standard and how that standard changes over time or might be influenced by global competition. For example, suppose that the growth rate for a company over the past three years was 20% per year. In isolation, that may appear to be an attractive growth rate. However, suppose that over the same time period, the industry in which the company operates has been growing at 45% over the same period. While there could be many factors to explain the discrepancy in the relative performance, one might conclude that the company is competitively weak. As an example of the need to look at an industry within a global contexts consider the automobile industry. For this industry, it is not sufficient for a company to examine its competitive position in its industry but also investigate its competitive position from a global perspective. 5. What is the purpose of a credit analyst investigating the market structure of an industry (e.g., unregulated monopoly, oligopoly, etc.)? A credit analyst will look at the market structure of an industry (e.g., unregulated monopoly, oligopoly, etc.) because of its implications regarding factors such as price, supply, product quality, distribution capabilities, image, product differentiation, or service. With respect to pricing, the credit analyst will look at the market structure of an industry because of its implications on pricing flexibility. As concerns supply, a credit analyst should examine whether or not a company is self-sufficient in its factors of production. For example, the analyst will want to know if the firm is sufficiently powerful in its industry to pass along increased costs. 6. What should be the focus of an analyst with respect to the regulation of an industry? In regards to regulation, a credit analyst’s concern should not be with just the existence or absence of regulation in an industry. Rather, the focus with respect to regulation should be on the direction of regulation and its possible impact on the current and prospective profitability of the company. Regulation also encompasses government intervention in non-U.S. operations of a company. 7. In analyzing the labor situation in an industry in which a corporate issue operates, what should the credit analyst examine? Because labor is a key component in the cost structure of an industry, a credit analyst will want to know the affect that labor can have a firm’s profitability through its ability to manage cost. In analyzing the labor situation in an industry in which a corporate issue operates, the credit analyst will examine if the industry is heavily unionized. If so, the analyst will examine: (1) whether management has the flexibility to reduce the labor force, (2) when does the prevailing labor contract come up for renewal, and (3) the historical occurrence of strikes. In nonunionized companies, the credit analyst will look at the prospect of potential unionization. Also in analyzing an industry, the requirements for particular specialists are examined. 8. The underlying economic theory regarding many corporate governance issues is the principal-agency relationship between the senior managers and the shareholders of corporations. Explain this relationship. Standard agency theory advocates that principals must monitor agent’s to insure that they will properly carry out their duties. In our situation, the agent is senior managers who are charged with the responsibility of acting on behalf of the principal (who are the shareholders of the corporation). There is the potential for the senior managers not to pursue the best interest of the shareholders, but instead pursue a policy in their own self-interest. This policy may include a variety of behaviors including the use of company resources for their own enjoyment, doctoring the books to achieve a stock price to maximize their benefits through a salary increase or exercise of expiring stock options. To help alleviate this problem, the principals try to align incentives so as to maximize stockholder value. This cannot be done without costs. The costs of monitoring the agent’s behavior are called agency costs. 9. With respect to corporate governance, what are the mechanisms that can mitigate the likelihood that management will act in its own self-interest? The mechanisms (that can mitigate the likelihood that management will act in its own self-interest) fall into two general categories. The first category involves strongly aligning the interests of management with those of shareholders. This can be accomplished by granting management an economically meaningful equity interest in the company. Also, manager compensation can be linked to the performance of the company’s long-run common stock price. The second category involves the company’s internal corporate control systems, which can provide a way for effectively monitoring the performance and decision-making behavior of management. For example, it would allow the timely removal of the CEO by the board of directors who believe that a CEO’s performance is not in the best interest of the shareholders. In general, there are several critical features of an internal corporate control system that are necessary for the effective monitoring of management. What has been clear in corporate scandals is that there was a breakdown of the internal corporate control systems that lead to corporate difficulties and the destruction of shareholder wealth. More details are given below. Because of the important role played by the board of directors, the structure and composition of the board are critical for effective corporate governance. The key is to remove the influence of the CEO and senior management on board members. This can be done in several ways. First, while there is no optimal board size, the more members there are, the less likely the influence of the CEO. With more board members, a larger number of committees can be formed to deal with important corporate matters. At a minimum, there should be an auditing committee, a nominating committee (for board members), and a compensation committee. Second, the composition of the committee should have a majority of independent directors, and the committees should include only independent directors. There are two classes of members of the board of directors. Directors who are employees of management or have some economic interest as set forth by the SEC (for example, a former employee with a pension fund, the relative of senior management, or an employee of an investment banking firm that has underwritten the company’s securities) are referred to as “inside directors.” Board members who do not fall into the category of inside directors are referred to as “outside directors” or “independent directors.” Finally, there are corporate governance specialists who believe that the CEO should not be the chairman of the board of directors because such a practice allows the CEO to exert too much influence over board members and other important corporate actions. This is a position that has been taken by the Securities and Exchange Commission. 10. Answer the below questions. (a) What are corporate governance ratings? Corporate governance ratings refer to the ratings received by corporation in regard to their adherence to the standards and codes of best practice for effective corporate governance. The standards of best practice that have become widely accepted as a benchmark to rate companies on corporate govern are those set forth by the Organization of Economic Cooperation and Development (OECD) in 1999. Other entities that have established standards and codes for corporate governance are the Commonwealth Association for Corporate Governance, the International Corporate Governance Network, and the Business Roundtable. Countries have established their own code and standards using the OECD principles. The standards and codes of best practice go beyond applicable securities law. The expectation is that the adoption of best practice for corporate governance is a signal to investors about the character of management. There is empirical evidence supporting the relationship between corporate governance and bond ratings (and hence bond yields). (b) Are corporate governance ratings reported to the investing public? Several organizations have developed services that assess corporate governance and express their view in the form of a rating. Generally, these ratings are made public at the option of the company requesting an evaluation. One such service is offered by S&P, which produces a Corporate Governance Score based on a review of both publicly available information, interviews with senior management and directors, and confidential information that S&P may have available from its credit rating of the corporation’s debt. (c) What factors are considered by services that assign corporate governance ratings? For a look at the factors considered by services that assign corporate governance ratings, consider S&P’s Corporate Governance Score. This score is based on information attained both privately and publicly and includes interviews with managers and knowledge attained from its credit rating of the corporation’s debt. The score takes into consider the following factors. First is the ownership structure and external influences. This factor includes the transparency of ownership structure and the concentration and influence of ownership and external stakeholders. Second factor involves shareholder rights and stakeholder relations. This factor consists of shareholder meetings and voting procedures, ownership rights and takeover defenses and stakeholder relations. The third factor is transparency, disclosure, and audit that include content of public disclosure, timing of and access to public disclosure, and the audit process. The fourth factor is the board structure and effectiveness that consists of the board structure and independence, the role and effectiveness of the board, and the director and senior executive compensation. Based on S&P’s analysis of these four key factors, its assessment of the company’s corporate governance practices and policies and how its policies serve shareholders and other stakeholders is reflected in the Corporate Governance Score. The score ranges from 10 (the highest score) to 1 (the lowest score). In addition to corporate governance, credit analysts look at the quality of management in assessing a corporation’s ability to pay. Moody’s notes the following regarding the quality of management: Although difficult to quantify, management quality is one of the most important factors supporting an issuer’s credit strength. When the unexpected occurs, it is a management’s ability to react appropriately that will sustain the company’s performance. Assessment of management’s plans in comparison with those of their industry peers can also provide important insights into the company’s ability to compete, how likely it is to use debt capacity, its treatment of its subsidiaries, its relationship with regulators, and its position vis-à-vis all fundamentals affecting the company’s long-term credit strength. In assessing management quality, Moody’s tries to understand the business strategies and policies formulated by management. The factors Moody’s considers are: strategic direction, financial philosophy, conservatism, track record, succession planning, and control systems. 11. Explain what a credit analyst should do in preparation for an analysis of the financial statements. Before performing an analysis of the financial statement, the credit analyst must determine if the industry in which the company operates has any special accounting practices, such as those in the insurance industry. If so, an analyst should become familiar with industry practices. Moreover, the analyst must review the accounting policies to determine whether management is employing liberal or conservative policies in applying generally accepted accounting principles (GAAP). An analyst should be aware of changes in GAAP policies by the company and the reason for any changes. Since historical data are analyzed, the analyst should recognize that companies adjust prior years’ results to accommodate discontinued operations and changes in accounting that can hide unfavorable trends. This can be done by assessing the trends for the company’s unadjusted and adjusted results. 12. Answer the below questions. (a) What is the purpose of an interest coverage ratio? The purpose of an interest coverage ratio is to measure the number of times interest charges are covered by earnings. (b) What does an interest coverage ratio of 1.8 × mean? If a company has a pretax interest ratio that is 1.8 ×, it means it does not need to borrow or use cash flow or proceeds from the sale of assets to meet its interest payments. It has a cushion of safety since a company with a pretax interest ratio that is equal to 1 × would have just enough so that it would not have to borrow or use cash flow or proceeds from the sale of assets to meet its interest payments. Although a precise interpretation must take into account a norm or standard (such as the industry average), the general understanding is that a company must consistently maintain a ratio greater than one to avoid financial distress that could eventually lead to default. (c) Why are interest coverage ratios typically computed on a pretax basis? Interest coverage ratios are typically computed on a pretax basis because interest payments are a pretax expense. Because interest payments lower a company’s taxes there is no need to adjust the interest payment for taxes to get an after-tax accounting of its effect. Pretax interest coverage ratio is calculated by dividing pretax income plus interest charges by total interest charges. The higher this ratio, the lower the credit risk, all other factors the same. (d) Why would a fixed charge coverage ratio be materially different from an interest coverage ratio? A fixed charge coverage ratio would be materially different from an interest coverage ratio calculation of simple pretax interest coverage if there are fixed obligations other than interest that are significant. If there are other fixed obligations, a more appropriate coverage ratio would include these other obligations, and should compute a fixed charge coverage ratio. An example of other significant fixed obligations is lease payments. An analyst must also be aware of any contingent liabilities, such as a company’s guaranteeing another company’s debt. 13. Answer the below questions. (a) What is the purpose of a leverage ratio? The purpose of a leverage ratio is to determine what proportion of a firm’s financing is composed of debt. While there is no one definition for leverage, the most common one is the ratio of long-term debt to total capitalization. The higher the level of debt, the higher the percentage of operating income that must be used to satisfy fixed obligations. Everything else equal, a higher leverage ratio indicates a greater the probability of default. (b) What measures are used in a leverage ratio for total capitalization? In calculating a leverage ratio for total capitalization, it is common to use the company’s capitalization structure as stated in the most recent balance sheet. To supplement this measure, the analyst should calculate capitalization using a market approximation for the value of the common stock. (c) What is the margin of safety measure? The margin of safety is defined as the percentage by which operating income could decline and still be sufficient to allow the company to meet its fixed obligations. The degree of leverage and margin of safety varies dramatically among industries. It is especially important to know the margin of safety if the company is believe to be highly leveraged company relative to some standard like an industry norm. More details are given below. In computing a margin of safety, recognition must be given to other factors to make sure the margin of safety is accurately calculated. For example, one must see if the company has operating leases. Such leases represent an alternative to financing assets with borrowed funds. The existence of material operating leases can therefore understate a company’s leverage causing the margin of safety to be overestimated. Thus, operating leases should be capitalized to give a true measure of leverage. Two other factors should be considered: the maturity structure of the debt and bank lines of credit. With respect to the first, the one would want to know the percentage of debt that is coming due within the next five years and how that debt will be refinanced. For the latter, a company’s bank lines of credit often constitute a significant portion of its total debt. 14. Why do analysts investigate the bank lines of credit that a corporation has? Analysts investigate the bank lines of credit because a firm’s bank lines of credit often constitute a significant portion of its total debt. These lines of credit should be closely analyzed in order to determine the flexibility afforded to the company. The lines of credit should be evaluated in terms of undrawn capacity as well as security interests granted. The analysis also involves a determination as to if the line contains a “material adverse change” clause under which the bank may withdraw a line of credit. 15. Answer each of the below questions. (a) Explain the meaning of funds from operation. Funds from operation are the net income adjusted for depreciation and other noncash debits and credits. From this definition, we see that the meaning involves trying to get a true picture of the cash generated by the company’s operations for the period being considered. (b) Explain the meaning of operating cash flow. Operating cash flow is funds from operations reduced by changes in the investment in working capital (current assets minus current liabilities). If a company has undergone a change in working capital for the period being considered, the operating cash flow will give a better picture of the cash generated by the company’s operations. (c) Explain the meaning of free operating cash flow. Free operating cash flow is operating cash flow minus capital expenditures. If a company has undergone a change in capital expenditures for the period being considered, the free operating cash flow will give an improved picture of the cash generated by a firm’s operations. (d) Explain the meaning of discretionary cash flow. The discretionary cash flow is free operating cash flow minus cash dividends. If the company pays dividends, the discretionary cash flow will reveal how much cash is available to spend on sources or uses of cash determined by the company. (e) Explain the meaning of prefinancing cash flow. Adjusting discretionary cash flow for managerial discretionary decisions for acquisition of other companies, the disposal of assets (e.g., lines of business or subsidiaries), and other sources or uses of cash gives prefinancing cash flow. As stated by S&P, prefinancing cash flow “represents the extent to which company cash flow from all internal sources have been sufficient to cover all internal needs.” 16. In the analysis of net assets, what factors should be considered? In the analysis of net assets (and any financial ratio involving net assets such as “net assets to total debt”), consideration should be given to the liquidation value of the assets. Liquidation value will often differ dramatically from the net asset value stated on the balance sheet. If the liquidation value per share for a company is less than the current share price, then it usually means that the company should go out of business. A company with a high percentage of its assets in cash and marketable securities is in a much stronger asset position than a company whose primary assets are illiquid real estate. Finally, consideration should be given to several other financial variables including intangible assets, pension liabilities, and the age and condition of the plant. Companies with greater intangible assets will typically have a lower liquidation value. Pension liabilities are a major concern if a company’s pension fund is underfunded. Plants that are in poor condition will have lower liquidation value. 17. Answer the below questions. (a) What is meant by working capital? Working capital is considered a primary measure of a company’s financial flexibility. It is defined as current assets less current liabilities. Working capital measures include the current ratio (current assets divided by current liabilities) and the acid test (cash, marketable securities, and receivables divided by current liabilities). The stronger the company’s liquidity measures, the better it can weather a downturn in business and reduction in cash flow. (b) Why is an analysis of working capital important? An analysis of working capital is important in order to determine a firm’s capacity to meet current obligations. In analyzing working capital, the normal working capital requirements of both a company and industry should be considered. In addition, the components of working capital (such as accounts receivable, accounts payable and so forth) should be assessed. For example, although accounts receivable are considered to be liquid, an increase in the average days receivables (which is accounts receivable divided by annual sales on credit times 365) that are outstanding may be an indication that a higher level of working capital is needed for the efficient running of the operation. In addition, companies frequently have account receivable financing, some with recourse provisions. In this scenario, comparisons among companies in the same industry may be distorted. 18. Why do analysts of high-yield corporate bonds feel that the analysis should be viewed from an equity analyst’s perspective? For high-yield bonds, the analysis of business risk, corporate governance risk, and financial risk all involve the same type of analysis that a common stock analyst would undertake. Thus, many fixed income portfolio managers strongly believe that corporate bond analysis, particularly high-yield bond analysis, should be viewed from an equity analyst’s perspective. Using an equity approach, especially for high yield debt, can be used to verify the findings of traditional credit analysis. If analysts think about whether they would want to buy a particular high yield company’s stock and what will happen to the future equity value of that company, they have a useful approach because, as equity values go up, so does the equity cushion beneath the company’s debt. Solution Manual for Bond Markets, Analysis and Strategies Frank J. Fabozzi 9780132743549, 9780133796773