CHAPTER 7: CORPORATE DEBT SECURITIES

PROBLEMS AND QUESTIONS WITH SOLUTIONS

1. What are the major benefits and costs to a corporation of financing its operations
with debt instead of equity?

Benefits: (1) Since debt instruments have provisions that give creditors legal protection in
the case of default, the rate corporations pay creditors is typically smaller than the rate their
shareholders require. (2) The interest payments on debt are treated as an expense by the
Internal Revenue Service and are therefore tax deductible, whereas the dividends a
corporation pays its shareholders are not tax deductible. Costs: The obligations of debt
instruments are required by law to be made.

2. Define and briefly explain the following terms:

a. Amortization
b. Deep discount bond
c. Floater
d. Protective covenants
e. Serial bond
f. Option redemption provision
g. Deferred call feature
h. Nonrefundable clause
i. Debenture
j. Sinking fund requirement
k. Average life
l. Registered bond
m. Bearer bond

a. Amortization: Refers to periodic payment of both interest and principal.

b. Deep discount bond: Bond that pays very low coupon interest.
c. Floater: A bonds with an interest rate that is adjusted periodically.
d. Protective covenants: Rules and restriction specified in the bond indenture that are
aimed at protecting the bondholders against activities by the issuer that could be
detrimental to the bondholders.
e. Serial bond: This is a bond issue consisting of a series of bonds with different
maturities.
f. Option redemption provision: A provision in an indenture that gives the issuer the right
to redeem some or all of the issue for a specific amount before maturity.
g. Deferred call provision: A provision in a bond that prohibits the issuer from calling
the bond before a certain period of time has expired.
h. Nonrefundable clause: A clause that prohibits the issuer from buying bonds back
during a specified period (the nonrefundable period) from certain sources of
financing.
i. Debenture: This is a bond not secured by specified asset.

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j. Sinking fund requirement: A sinking fund requirement is provision in the bond
contract requiring that the issuer make scheduled payments into a fund often
maintained by the trustee or make an orderly retirement of the issue by buying up a
certain portion of bonds each year either at a stipulated call price or in the market.
k. Average life: The average life is the average amount of time the debt will be
outstanding. It is equal to the weighted average of the time periods, with the weights
being relative principal payments.
l. Registered bond: A bond whose owners are registered with the issuer or Trustee;
interest and principal are paid to those registered.
m. Bearer bond: A bond that makes coupon and principal payments to those who have
physical possession of the bond.

3. Explain some of the common features included in a sinking fund requirement.

Features:
(1) A sinking fund call gives the issuer the right to buy up the requisite amount in the
market or at a stipulated call price.
(2) The sinking fund typically applies to a specific issue; an exception is a tunnel
bond in which the sinking fund requirement applies to the other issues.
(3) Periodic sinking fund payments are usually the same amount each year, although
there are some sinking fund agreements that allow the issuer to increase the
amount.

4. Comment on the following statement: By reducing the investors principal risk, a

sinking fund provision benefits the investor.

Although it is true that a sinking fund provision benefits bondholders by allaying their
concern over the ability of the issuer to pay the principal, many sinking funds have a
provision that allows the issuer to buy up the requisite amount of bonds either at a
stipulated call price or in the secondary market at its market price. This sinking fund call
option provision benefits the issuer and is a disadvantage to the bondholder.

5. What is the average life of a debt issue with a $100 million par value and 10-year
maturity that has a sinking fund that makes equal payments in years 7 through 10?

The average life is 8.5 years:

t (A t )
7($25m) 8($25m) 9($25m) 10($25m)
Average Life t 1
8.5
F $100m

6. What feature of a zero-coupon or deep discount bond does an institutional investor

such as a pension fund find attractive?

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Fund managers find zero-coupon and deep-discount bonds attractive investments for
matching their future liabilities because they have little or no reinvestment risk

7. In the early 1980s, Beatrice Foods issue a 10-year, $250 million zero-coupon issue
priced at $255 per $1,000 face value. What was the bonds initial YTM?

YTM = [F/P0]1/M 1 = [$1,000/$255]1/10 1 = 14.64%

Assume annual compounding.

8. What is the difference between call protection and refunding protection?

Call protection means that the bond cannot be called. Refunding protection means that
the bond cannot be called from the proceeds of certain types of refunding debt. Bonds
that have refunding protection may still be called.

9. ABC is issuing a bond with a maturity of 25 year and 10% coupon. The bond is
callable with the first year call price equal to the offering price plus the coupon;
thereafter the call price decreases by equal amounts to equal par at year 20;
thereafter the call price is equal to par. If the bond were sold at 95 ($950 for F =
$1,000), what would be the call prices for each year?

The initial years call price is equal to the offering price of $950 plus the $100 coupon:
$1.050. The call price will then decrease by $2.50 each year (= $1,050 $1,000)/20) to
equal $1,000 at the end of year 20. The call price will be equal to $1,000 for years 21
through 25.

Year Call Price

1 $1,050.00
2 $1,047.50
3 $1,045.00
4 $1,042.50
5 $1,037.50


20 $1,002.50
21-25 $1,000

10. Define the major types of secured bonds.

(1) Mortgage Bond: Bond that has a lien on real property or buildings.
(2) Equipment-Trust Bond: Bond that has a lien on specific equipment, such as
airplanes, trucks, or computers.

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 (3) Collateral-Trust Bond: Bond that is secured by a lien on equity shares of a
company's subsidiary, holdings of other company's stocks and bonds, government
securities, and other financial claims.
(4) Personal Property Bond: Bond secured with personal property, such as the
corporation's cash or liquid assets, accounts receivables, or inventory. Since these
assets are short term in nature, they are usually used as collateral for short-term
debt obligations.

11. What is a release and substitution provision?

A release and substitution provision allows the issuer of a mortgage bond to sell the
collateral in order to retire the bond; that is the proceeds from the asset sale are used to
retire the bonds.

12. Explain how an equipment-trust bond is created as part of a lease-and-buy-back

arrangement.

Equipment-trust bonds formed through lease-and-buy-back agreements are often done with
a third party or trustee (e.g., bank, leasing company, or the manufacturer). Under this type of
agreement, the third party might purchase the equipment and lease it to the company who
would agree to take title to the equipment at the termination date of the lease. Alternatively,
the company could buy the equipment and sell it the trustee who would then lease it to them.
The third party would finance the equipment purchase from the company or the
manufacturer by selling equipment trust bonds or certificates. Each period the trustee would
then collect rent from the company and pay the interest and principal on the certificates. At
maturity, the certificates would be paid off, the trustee would transfer the title of the
equipment to the company, and the lease would be terminated.

13. What are some of the provisions that are included in a collateral-trust bond?

(1) A provision requiring the issuer to deliver to the trustee the pledged securities.
(2) A provision allowing the company to retain its voting rights if the collateral is the
stock of one of its subsidiaries.
(3) A provision requiring the company to maintain the value of its securities, positing
addition collateral if the collateral decreases in value.
(4) A provision allowing the company to withdraw the collateral provided there is an
acceptable substitute.

14. Define the following:

a. Priority of claim
b. Closed-end bond
c. Open-end bond
d. After-acquired property clause
e. Subordinate debenture
f. Guaranteed bond
g. Credit enhancement

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 a. Priority of claim: When a company has more than one bond issue or debt obligation
secured by the same asset, the debt obligations must be differentiated in terms of the
priorities of their claims. A senior lien, or first lien, has priority over a junior lien
(second or third lien).
b. Closed-end bond: A secured bond that prohibits the company from incurring any
additional debt secured by a first lien on the assets already being used as security.
c. Open-end bond: A secured bond that allows the company to use the collateral
securing the bond to be used to secure other debt.
d. After-acquired property clause: A clause that stipulates that all property or assets
acquired after the issue be added to the property already pledged.
e. Subordinate debenture: A debenture that has a general claim on the assets only
after the senior claims has been met.
f. Guaranteed bond: A bond issued by one company and guaranteed by another
economic entity. The guarantor could be a parent company, another company, or
financial institution. The guarantor ensures that the bondholders will be paid interest
and principal in the event of default.
g. Credit enhancement: Term used to refer to provisions or guarantees on a bond
that improve its creditworthiness or lower its default risk.

15. What are some of the provisions in a debenture that enhance its creditworthiness?

The creditworthiness of debentures can be improved with protective covenants,

subordination, and credit enhancements:
(1) Protective Covenants: The indenture might include a restriction on additional
debt that can be incurred or specifications that new debt can only be incurred if
earnings grow at a certain level or if certain financial ratios are met.
(2) Subordination: Debentures can have other claims subordinate to it.
(3) Credit Enhancement: Third-party guarantees or letters of credits guaranteeing
interest payments.

16. Why are guaranteed bonds not considered risk free?

The guarantee does not eliminate the risk, but shifts it from the corporation to the insurer.

17. G&P is planning to construct a $250 million manufacturing and processing plant
for the national production of it patented calorie-free chips. G&Ps Marketing
Research Division has estimates that G&P will gain a significant market share of
the U.S. snack-food market and should maintain that share for a period of at least
10 yearsa period extending beyond the expiration of its patent. Suppose you work
for a large investment-banking firm that advises G&P on its debt issues and who
would like to eventually bid on underwriting the issue. To help you in providing
advice on the debt issue, identify the pertinent features of the debt issue that need to
be considered, the alternatives, and factors that need to be considered in
structuring the bond issue.

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Outline

Feature Alternative Considerations

Maturity Short-term, Degree of market risk
Intermediate, long-term

Coupon Coupon, zero, discount, Low interest rate; type of asset being
floater financed.

Sinking Fund, No sinking fund, Call option advantage with SF; level
SF sinking fund, or sinking of rates and size of SF call spread.
fund with a call option

Call Callable, noncallable, or Level of interest rates and expectation

deferred call; refunding of future rates; option spread
provisions

Collateral Debentures, mortgage, Improvement in quality ratings;

or collateral trust bonds reduction in yields

Credit Guarantees and Cost of enhancement; improvement

Enhancements subordination in quality rating; reduction in yield

Protective Put option, net-worth The inclusion of covenants may

Covenants clause, and dividend improve the credit worthiness of the
and interest limitations bond; lower rates; covenants may
constrain the company

18. Define each of the following bonds and their features:

a. Income bond
b. Participating bond
c. Deferred coupon bond
d. Payment-in-kind bond
e. Tax-exempt bond
f. Bonds with warrants
g. Convertible bond
h. Voting bonds
i. Assumed Bond
j. Bonds with put options
k. Credit-sensitive notes
l. Extendable notes
m. Commodity-linked bonds

a. Income bond: Bond that pays interest only if the earnings of the firm are sufficient
to meet the interest obligations.

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 b. Participating bond: Bond that provide a guaranteed minimum rate, as well as
additional interest up to a certain point if the company achieves a certain earnings
level.
c. Deferred interest bond: A bond that has its coupon interest deferred for a specified
period.
d. Payment-in-kind bond: A bond that gives the issuer the option on the interest-
payment date to pay the coupon interest either in cash or in-kind, usually by
issuing the bondholder a new bond.
e. Tax-exempt bond: A bond that qualifies for tax-exempt status because of the type
of project it is financing (e.g., construction of solid and hazardous waste disposal
facilities).
f. Bonds with warrants: A bond with an attached warrant (security that gives the
holder the right to buy a specified number of shares of stock or another designated
security at a specified price).
g. Convertible bond: A bond that has a conversion provision that grants the
bondholder the right to exchange the bond for a specified number of shares of the
issuer's stock or some other specified security.
h. Voting bond: A bond that gives voting privileges to the holders. The vote is
usually limited to specific corporate decisions under certain conditions.
i. Assumed bond: A bond whose obligations are taken over or assumed by another
company or economic entity. In many cases such bonds are the result of a merger.
j. Putable bond: A bond that gives the holder the right to sell the bond back to the
issuer at a specified price.
k. Credit-sensitive note: A bond with coupons that are tied to the issuers credit
ratings.
l. Extendable note: A bond that gives the issuer the option to extend the maturity of
the bond.
m. Commodity-linked bond: A bond that has its coupons and possibly principal tied to
the price of a particular commodity.

19. Discuss the nature of protective covenants.

The board of directors hires the managers and officers of a corporation. Since the board
represents the stockholders, this arrangement can create a moral hazard problem in which
the managers may engage in activities that could be detrimental to the bondholders.
Since bondholders cannot necessarily seek redress from managers after they have make
decisions that could harm them, they need to include in the bond indenture protective
covenants that place restriction on the company.

20. Discuss the types of protective covenants that can be found in a bond contract.

Some of the standard covenants specify the financial criterion that must be met before
borrowers can incur additional debt (debt limitation) or pay dividends (dividend
limitations). Other possible covenants include limitations on liens, borrowing from
subsidiaries, asset sales, mergers and acquisitions, and leasing.

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21. Define event risk and the protective covenants that can be used to protect
bondholders against such risk.

Event risk is the uncertainty that certain events will occur that will benefit the
stockholders at the expense of the bondholders, resulting in a downgrade in a bonds
quality ratings and a lowering of its price. Some of the protective covenants used to
minimize event risk are poison puts, net worth maintenance clauses, and offer-to-redeem
clause. A poison put clause in the indenture gives the bondholders the right to sell the
bonds back to the issuer at a specified price under certain conditions arising from a
specific event such as a takeover, change in control, or an investment rating downgrade.
A net worth maintenance clause, in turn, requires that the issuer redeem all or part of the
debt, and an offer-to-redeem clause gives bondholders the right to sell their bonds back to
the issuer if the companys net worth falls below a stipulated level.

22. Explain the distinction between

a. Insolvency and default
b. Insolvency and illiquidity

a. A company is considered insolvent if the value of its liabilities exceeds the value
of its assets; it is considered in default if it cannot meet its obligations.
Technically, default and insolvency are dependent: A company with liabilities
exceeding assets will inevitably be in default when the future income from its
assets is insufficient to cover future obligations on its liabilities.

b. A company can be illiquid and not insolvent. A company with assets that are not
expected to generate a return for some time in the futures, may very well be a
solvent company, with the value of its assets exceeding its liabilities, and yet
illiquid, with current cash flow problems.

23. Explain the steps in a bankruptcy process that are taken to determine
reorganization.

(1) Filing: A bankruptcy filing by creditors or the debtor is done in the appropriate
circuit and district court.
(2) Debtor-in-possession: When a company files for protection it becomes a debtor-
in-possession. As a debtor-in-possession, the company continues to operate, but
under the supervision of the court: All debt is frozen, creditors are precluded from
trying to enforce collection, and lawsuits are suspended.
(3) Formulation of a plan: A committee consisting of officers and representatives for
creditors and possibly shareholders is formed to formulate a plan of
reorganization. The plan usually considers reorganization, the creation of new
financial securities, elimination or changing expensive contracts, and substantial
consolidation.
(4) Disclosure and reorganization: Once the committee approves the plan for
reorganization, the debtor produces and files for approval a disclosure statement.
The disclosure statement summarizes the plan. It also includes pro formas and a

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 liquidation analysis supporting the claim that the creditors will receive more
under the reorganization plan than liquidation. If the court approves the disclosure
statement, then it is sent to all impaired parties for approval. If approved, the court
sets a date for the reorganization.

24. List the steps involved in an open market sale of a new bond issue.

(1) Select investment banker

(2) Prepare indenture
(3) File registration forms
(4) Establish selling group
(5) Issue preliminary prospectus (red herring)
(6) Issue securities either by underwriting or best effort

25. What is underwriting risk? Provide an example.

The investment banker underwriting a bond issue bears the risk that the price of the issue
could decrease during the time the bonds are being sold. A classic example discussed in the
chapter was the $1 billion bond issue of IBM in 1979. This issue was underwritten by a
syndicate just before the announcement by the Federal Reserve System of a major change in
the direction of monetary policy. The Fed announcement, in turn, led to a substantial
increase in interest rates and a decrease in bond prices, causing substantial losses for the
underwriters. To avoid such underwriting risk, the investment banker may choose to hedge
the issue by taking a position in the futures market.

26. Define SEC Rule 415. What is significance of the rule?

SEC Rule 415, known as the shelf registration rule, allows a firm to register an inventory
of securities of a particular type for up to two years. The firm can then sell the securities
whenever it wishes during that timethe securities remain on the shelf. To minimize costs,
a company planning to finance a number of projects over a period of time, could register a
large issue, and then sell parts of the issue at different times.

27. What is a privately placed bond issue and how does it differ from an open market
issue?

Privately placed bonds are sold through direct negotiation with the buyer. Compared to
publicly issued bonds, privately-placed bond have fewer restrictive covenants and are more
tailor-made to both the buyer's and seller's particular needs. One of the disadvantages of
privately placed bonds is their relative lack of marketability.

28. Define SEC Rule 144A. What is the significance of the rule?

SEC Rule 144A allows issuers to sell unregistered securities to one or more investment
bankers who could resell the securities to qualified investment buyers (QIBs). QIBs can
then sell freely with each other in securities that have not been registered.

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29. List some of the features that characterize the secondary market for corporate
bonds.

(1) Many corporate bonds are traded on the OTC market

(2) Many bonds are listed on the NYSE but are traded by dealers on the OTC market
(3) Some corporate bonds are thinly traded with relatively wide bid-ask spreads

30. List some of important features of commercial paper.

(1) Commercial paper is usually sold as a zero-coupon bond

(2) Many have maturities less than 270 days to avoid registration
(3) CP is sold either directly (direct paper) or through dealers (dealer paper)
(4) Many CP issues include credit enhancements such as lines of credit

31. Explain the typical process a corporation would go though in selling medium-term
notes.

(1) Shelf registration: A corporation planning to issue a MTN usually files a shelf
registration form with the SEC. The filing includes a prospectus of the MTN
program (different notes, their maturities, par values, and the like).
(2) Agents: MTNs are typically sold through investment banking firms who act as
agents.
(3) Setting offering price: The agents will often post the maturity range for the
possible notes in the program and their offering rates. The rates are often quoted
in terms of a spread over a Treasury security with a comparable maturity. An
investor interested in one of the note offerings will notify the agent who, in turn,
contacts the issuing corporation for a confirmation.
(4) Reloading: Once a MTN issue is sold, then the company can file a new
registration to sell a new MTN issue.

32. What is meant by reverse inquiry?

Reverse inquiry is when institutional investors indicate to the agents of a MTN program
the type a maturity they want. The agent will inform the corporation of the investors
request; the corporation could then agree to sell the notes with that maturity from its
MTN program, even if they are not posted.

33. What is the main feature contributing to the growth of the MTN market?

As a source of financing, MTNs provide corporations with flexibility in their financing

choices. Corporations selling a MTN through a shelf registration are able to enter the
market constantly or intermittently, with the flexibility to finance a number of different
short-, intermediate-, and long-term projects over a two-year period.

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34. Define the following markets:
a. Eurobond
b. Foreign Bond
c. Global bond

a. Eurobonds are bonds issued in a number of countries through

an international syndicate.
b. Foreign bonds are bond of a foreign government or corporation
being issued or traded in the local country.
c. Global bonds are bonds that are sold in both the external and internal markets.

35. List some of the popular foreign bonds and their names.

(1) U.S. foreign bonds are referred to as Yankee bonds.

(2) Japan foreign bonds are called Samurai bonds.
(3) Spain foreign bonds are called Matador bonds.
(4) United Kingdom foreign bonds are called Bulldog bonds.
(5) Netherlands foreign bonds are called Rembrandt bonds

36. Explain how Eurobonds are issued in the primary market through a syndicate?

A corporation or government wanting to issue a Eurobond will usually contact a

multinational bank that will form a syndicate of other banks, dealers, and brokers from
different countries. The members of the syndicate usually agree to underwrite a portion
of the issue, which they usually sell to other banks, brokers, and dealers. The
multinational makeup of the syndicate allows the issue to be sold in many countries

37. Describe the secondary market for Eurobonds.

Market makers handle the secondary market for Eurobonds. Many of them are the same
dealers that are part of syndicate that helped underwrite the issue, and many belong to the
Association of International Bond Dealers (AIBD). This association oversees an
international OTC market consisting of Eurobond dealers. An investor who wants to buy
or sell an existing Eurobond can usually contact several market makers in the
international OTC market to get several bid-ask quotes, before selecting the best one.

38. Explain the following features associated with Eurobonds:

a. Currency denomination
b. Non-registered (implication for US investors and issuers)
c. Dual currency clauses

a. Currency Denomination: Dollar-denominated, euro-denominated, yen-

denominated, and British pound-denominated Eurobonds dominate the market.
b. Non-Registered: Many Eurobonds are issued as bearer bonds.

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 c. Dual currency clause: Eurobond that pays coupon interest in one currency and
principal in another.

39. How does the U.S. security law requiring the registration of bond investors apply to
the issuing of non-register Eurobonds by corporations? How does the law apply to
U.S. investors?

In 1984, U.S. corporations were allowed to issue bearer bonds directly to non-U.S.
investors. To accommodate U.S. investors, the SEC allows U.S. investors to purchase
non-registered Eurobonds bonds after they are seasoned. Thus, U.S. investors are locked
out of initial offerings of Eurobonds, but can acquire them in the secondary market.

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