Chapter 7 Corporate Debt Instruments

1. What is the significance of a secured position if the absolute priority rule is typically not
followed in a reorganization? (Hint: Answer Question 4 first.)
A corporate debt obligation can be secured or unsecured. In the case of a liquidation,
proceeds from a bankruptcy are distributed to creditors based on the absolute priority rule
where senior claimants are paid first. For example, debtholders are paid before stockholders.
However, in the case of a reorganization, the absolute priority rule rarely holds. That is, an
unsecured creditor may receive distributions for the entire amount of his or her claim and
common stockholders may receive something, while a secured creditor may receive only a
portion of its claim. The reason is that a reorganization requires approval of all the parties.
Consequently, secured creditors are willing to negotiate with both unsecured creditors and
stockholders in order to obtain approval of the plan of reorganization.
Even though the absolute priority rule is not typically followed, it is still significant because
senior claimants can use it to exercise clout in the reorganization process to insure they get
the best possible deal. Even though the amount of cash owed may not be received
immediately, the bargaining process can allow for future claims on assets that might make the
senior claimants better off than if the assets were just liquidated.
2. Answer the below questions.
(a) What is the difference between a liquidation and a reorganization?
First, there is a difference in how the absolute priority rule holds. A corporate debt
obligation can be secured or unsecured. In the case of a liquidation, proceeds from a
bankruptcy are distributed to creditors based on the absolute priority rule. However, in
the case of a reorganization, the absolute priority rule rarely holds. That is, an unsecured
creditor may receive distributions for the entire amount of his or her claim and common
stockholders may receive something, while a secured creditor may receive only a portion
of its claim.
The reason is that a reorganization requires approval of all the parties. Consequently,
secured creditors are willing to negotiate with both unsecured creditors and stockholders
in order to obtain approval of the plan of reorganization.
Second, there is a difference in outcome as to what happens to the company being
liquidated versus the company being reorganized.
The liquidation of a corporation means that all the assets will be distributed to the holders
of claims of the corporation and no corporate entity will survive. In a reorganization, a
new corporate entity will result. Some holders of the claim of the bankrupt corporation
will receive cash in exchange for their claims; others may receive new securities in the
corporation that results from the reorganization; and still others may receive a
combination of both cash and new securities in the resulting corporation.
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(b) What is the difference between a Chapter 7 and Chapter 11 bankruptcy filing?
The law governing bankruptcy in the United States is the Bankruptcy Reform Act of 1978.
The bankruptcy act is composed of 15 chapters, each chapter covering a particular type of
bankruptcy. Chapter 7 deals with the liquidation of a company. Chapter 11 deals with the
reorganization of a company.
3. What is a debtor in possession?
The term a debtor in possession refers to the company filing for protection while
continuing to carry on business. One purpose of the Bankruptcy Reform Act of 1978 is to
give a corporation time to decide whether to reorganize or liquidate and then the necessary
time to formulate a plan to accomplish either a reorganization or liquidation. This is achieved
because when a corporation files for bankruptcy, the act grants the corporation protection
from creditors who seek to collect their claims. A company that files for protection under the
bankruptcy act generally becomes
a debtor in possession, and continues to operate its business under the supervision of the
court.
4. What is the principle of absolute priority?
When a company is liquidated, creditors receive distributions based on the absolute priority
rule to the extent that assets are available. The absolute priority rule is the principle that
senior creditors are paid in full before junior creditors are paid anything. For secured
creditors and unsecured creditors, the absolute priority rule guarantees their seniority to
equity holders. In liquidations, the absolute priority rule generally holds. In contrast, there is
a good body of literature that argues that strict absolute priority has not been upheld by the
courts or the SEC. Studies of actual reorganizations under Chapter 11 have found that the
violation of absolute priority is the rule rather the exception.
5. Comment of the following statement: A senior secured creditor has little risk of
realizing a loss if the issuer goes into bankruptcy.
When a company goes bankrupt there are varying degrees of risk for all creditors. Even
though the risk can be little or small relatively speaking compared to junior unsecured
claimants, there is still some risk for senior secured creditors. This is because seniority does
not always insure that payments owed will be made for the following reasons. First, the
assets of the bankrupt firm may not provide sufficient payments even for senior secured
creditors who must compete with other entities including the IRS and unpaid employees.
Second, the seniority ranking can be at least partially overturned so that junior claimants
receive some payments at the expense of more senior claimants. In conclusion, it is important
to recognize that the superior legal status of any debt obligation will not prevent creditors
from suffering financial loss when the issuers ability to generate cash flow adequate to pay
its obligations is seriously eroded.

6. What is meant by an issue or issuer being placed on a credit watch?

Credit Watch means the issue (or issuer) is under review for a possible change in rating. Rating
agencies monitor the bonds and issuers that they have rated and at any time may change its
rating. It may go even further and state that the outcome of the review may result in a
downgrade or upgrade.
7. Comment on the following statement: An investor who purchases the mortgage bonds
of a corporation knows that should the corporation become bankrupt, mortgage
bondholders will be paid in full before the common stockholders receive any proceeds.
When a company is liquidated, creditors receive distributions based on the absolute priority
rule to the extent that assets are available. The absolute priority rule is the principle that
senior creditors are paid in full before junior creditors are paid anything. For secured
creditors and unsecured creditors, the absolute priority rule guarantees their seniority to
equity holders.
In liquidations, the absolute priority rule generally holds. In contrast, there is a good body of
literature that argues that strict absolute priority has not been upheld by the courts or the
Securities and Exchange Commission (SEC). Studies of actual reorganizations under Chapter
11 have found that the violation of absolute priority is the rule rather the exception.
Consequently, although investors in the debt of a corporation may feel that they have priority
over the equity owners and priority over other classes of debtors, the actual outcome of a
bankruptcy may be far different from what the terms of the debt agreement state.
8. Answer the below questions.
(a) What is the difference between refunding protection and call protection?
Call Protection is much more absolute than Refunding Protection.
Call Protection completely prohibits the issuer from redeeming the bonds before a
certain time for any reason.
Refunding protection only prevents redemption in one circumstance: using the
proceeds of a new debt issues sold at a lower cost of money. So a bond might
have five or ten years of refunding protection but be immediately callable.
(b) Which protection provides the investor with greater protection that the bonds will
not be acquired by the issuer prior to the stated maturity date?
Call protection is much more absolute than refunding protection. Although there may be
certain exceptions to absolute or complete call protection in some cases (such as sinking
funds and the redemption of debt under certain mandatory provisions), it still provides
greater assurance against premature and unwanted redemption than does refunding
protection.

9. Answer the below questions.

(a) What is a bullet bond?
Beginning in early 1986 a number of industrial companies issued long-term debt with
extended call protection, not refunding protection. In Wall Street, these noncallable-forlife issues are referred to as bullet bonds.
(b) Can a bullet bond be redeemed prior to the stated maturity date?
Some bullet bonds are noncallable for the issues life as the prospectus expressly
prohibits redemption prior to maturity. Other issues carry limited call protection and can
be called after a period of time.
10. Answer the below questions.
(a) What is meant by a make-whole call provision?
With a make-whole call provision, the payment when the issuer calls a bond is determined
by the present value of the remaining payments discounted at a small spread over a
maturity-matched Treasury yield. The specified spread which is fixed over the bonds life is
called the make-whole premium. Because the spread is small relative to the market spread
at issuance, the bondholder is highly likely to benefit when the issuer invokes this option.
(b) What is the make-whole premium?
As seen in part a, the specified spread which is fixed over the bonds life is called the
make-whole premium. Because the spread is small relative to the market spread at
issuance, the bondholder is highly likely to benefit when the issuer invokes this option.
(c) How does a make-whole call provision differ from a traditional call provision?
With a traditional call provision, the call price is fixed and is either par or a premium over
par based on the call date. With a make-whole call provision, the payment when the
issuer calls a bond is determined by the present value of the remaining payments
discounted at a small spread over a maturity-matched Treasury yield.
(d) Why is a make-whole call provision probably a misnomer?
With a make-whole call provision, the payment when the issuer calls a bond is determined
by the present value of the remaining payments discounted at a small spread over a
maturity-matched Treasury yield. The specified spread which is fixed over the bonds life is
called the make-whole premium. Because the spread is small relative to the market spread
at issuance, the bondholder is highly likely to benefit when the issuer invokes this option.
Thus, the term make-whole misrepresents this provision and is probably a misnomer. It is
highly likely that when the issuer invokes the option the bondholder will be made more
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than whole to compensate for the issuers action. As of mid 2010, about 7% of the 50,000
corporate bonds have a make-whole call provision.
11. Answer the below questions.
(a) What is a sinking fund requirement in a bond issue?
Corporate bond indentures may require the issuer to retire (call) a specified portion of an
issue each year. This is referred to as a sinking fund requirement. This kind of provision
for repayment of corporate debt may be designed to liquidate all of a bond issue by the
maturity date, or it may be arranged to pay only a part of the total by the end of the term.
If only a part is paid, the remainder is called a balloon maturity.
Generally, the issuer may satisfy the sinking fund requirement by either (i) making a cash
payment of the face amount of the bonds to be retired to the corporate trustee, who then
calls the bonds for redemption using a lottery, or (ii) delivering to the trustee bonds
purchased in the open market that have a total face value equal to the amount that must
be retired.
(b) A sinking fund provision in a bond issue benefits the investor. Do you agree with
this statement?
The sinking fund provision means a portion of the issue retired periodically. This could
be disadvantageous if interest rates fall.
However, the purpose of the sinking fund provision is to reduce credit risk. This is
advantageous to investors because it lowers the probability of investors not eventually
receiving their interest and principal payments.
Without a sinking fund, investors can lock in rates for a long period of time but increase
default risk.
12. What is the difference between a fallen angel and an original-issue high-yield bond?
A fallen angel is a bond with a noninvestment grade rating (below BBB) that once had an
investment grade rating (BBB or above) but was downgraded.
Fallen angel is usually applied to bonds that that have been downgraded because of financial
distress of the issuer and not downgraded because of an increased debt as a result of a
leveraged buyout or a recapitalization.
13. A floating-rate note and an extendable reset bond both have coupon rates readjusted
periodically. Therefore, they are basically the same instrument. Do you agree with this
statement?
Both floating rate and extendable reset bonds allow issuers secure a long-term source of
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funds based on short-term (usually lower) rates.

Floating-rate bond coupon rates reset according to a fixed spread over some benchmark, with
the spread specified in the indenture. The amount of the spread reflects market conditions at
the time the issue is offered.
The new coupon rate on an extendable reset bond reflects the new level of interest rates and
the new spread that investors seek at the time of the reset. The coupon rate at reset time will
be the average of rates suggested by two investment banking firms in order to keep the bond
trading at a predetermined price (usually par). For investors, the advantage of extendable
reset bonds is that the coupon rate will reset to the market interest rate and market credit
spread.
14. What is a payment-in-kind bond, a deferred-interest bond and a Step-up bond?
In an LBO or a recapitalization, the heavy interest payment burden that the corporation
assumes places severe cash flow constraints on the firm. To reduce this burden, firms
involved in LBOs and recapitalizations have issued bonds with deferred coupon structures
that permit the issuer to avoid using cash to make interest payments for a period of three to
seven years. There are three types of deferred coupon structures
I.

Deferred-interest bonds, the most common type of deferred coupon structure, sell at a
deep discount and do not pay interest for an initial period, typically from three to seven
years.

II.

Step-up bonds do pay coupon interest, but the coupon rate is low for an initial period
and then increases (steps up) to a higher coupon rate

III.

Payment-in-kind bonds give the issuer an option to pay cash at a coupon payment date
or give the bondholder a similar bond (i.e., a bond with the same coupon rate and a par
value equal to the amount of the coupon payment that would have been paid). The period
during which the issuer can make this choice varies from 5 to 10 years.
Answer the below questions regarding MTNs and Structured Notes.
a

In what ways does a medium term note (MTN) differ from a corporate bond?
I

Corporate bonds generally have a longer maturity than a medium term note
(MTN). With shorter maturities and an upward sloping yield curve, MTNs tend to
have lower coupon rates if everything else is equal.

II

MTNs differ from corporate bonds in the manner in which they are distributed to
investors when they are initially sold. Although some investment-grade corporate
bond issues are sold on a best-efforts basis, typically they are underwritten by
investment bankers. Traditionally, MTNs have been distributed on a best-efforts
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basis by either an investment banking firm or other broker/dealers acting as

agents.
III

MTNs are usually sold in relatively small amounts on a continuous or an

intermittent basis, whereas corporate bonds are sold in large, discrete offerings.
MTNs are offered continuously to investors by an agent of the issuer. Investors
can select from several maturity ranges: 9 months to 1 year, more than 1 year to
18 months, more than 18 months to 2 years, and, on rare occasions, up to 30 years
and even longer.

IV

Sometimes MTNs can offer advantages in terms of cost and flexibility. When the
treasurer of a corporation is contemplating an offering of either an MTN or
corporate bonds, there are two factors that affect the decision.
The first is the cost of the funds raised including registration and distribution
costs. This is referred to as the all-in-cost of funds. The second is the flexibility
afforded to the issuer in structuring the offering.

The tremendous growth in the MTN market is evidence of the relative advantage of
MTNs with respect to cost and flexibility for some offerings. However, the fact that there
are corporations that raise funds by issuing both bonds and MTNs is evidence that there
is no absolute advantage in all instances and market environments.
b What derivative instrument is commonly used in creating a structured MTN?
MTNs created when the issuer simultaneously transacts in the derivative markets are
called structured notes. The most common derivative instrument used in creating
structured notes are swaps, but futures, forwards or options can be used.
The addition of a swap (or other derivative) to an MTN to create a structured note allows
the holder of the note to be paid a return that varies according to a benchmark interest
rate (floating rate bond), a domestic equity index, an international debt or equity index or
a commodity index.
By using issuing structured notes tied to derivatives, companies (the borrowers) are able
to create investment vehicles that are more customized for institutional investors (lenders
who are often restricted to investing in investment-grade debt issues) to satisfy the
investment objectives especially if the lender is forbidden from investing in equity
markets or using derivatives. Institutional investors who are restricted to investing in
investment-grade debt issues can participate in other market plays. For example, an
investor who buys an MTN whose coupon rate tied to the performance of the S&P 500 is
participating in the equity market without owning common stock. If the coupon rate is
tied to a foreign stock index, the investor is participating in the equity market of a foreign
country without owning foreign common stock. In exchange for this, the borrower that
creates a structured note product can reduce its cost of funds.
By using the derivative markets in combination with an offering, borrowers are able to
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create investment vehicles that are more customized for institutional investors to satisfy
their investment objectives, even though they are forbidden from using swaps for
hedging.
Because of the small size of an MTN or structured note offering and the flexibility to
customize the offering using derivatives, investors (institutional lenders) can approach an
issuer through its agent about designing a security for their needs. This process of
customers inquiring of issuers or their agents to design a security is called a reverse
inquiry. Transactions that originate from reverse inquiries account for a significant share
of MTN transactions.
20. Answer the below questions.
(a) Why is commercial paper an alternative to short-term bank borrowing for a
corporation?
Commercial paper is an alternative to short-term bank borrowing for a corporation because it
gives them another way of borrowing or acquiring funds needed in the immediate future. For
companies able to issue commercial paper, the rate is often below the rate that banks require.
More details are given below.
Commercial paper is a short-term unsecured promissory note that is issued in the open
market and that represents the obligation of the issuing corporation. The primary purpose of
commercial paper was to provide short-term funds for seasonal and working capital needs.
However, corporations now use commercial paper for other purposes such as bridge
financing. For example, suppose that a corporation needs long-term funds to build a plant or
acquire equipment. Rather than raising long-term funds immediately, the corporation may
elect to postpone the offering until more favorable capital market conditions prevail. The
funds raised by issuing commercial paper are used until longer-term securities are sold.
(b) What is the difference between directly placed paper and dealer-placed paper?
Commercial paper is classified as either direct paper or dealer-placed paper. Directly placed
paper is sold by the issuing firm directly to investors without the help of an agent or an
intermediary. (An issuer may set up its own dealer firm to handle sales.) A large majority of
the issuers of direct paper are financial companies. These entities require continuous funds in
order to provide loans to customers. As a result, they find it cost-effective to establish a sales
force to sell their commercial paper directly to investors. Dealer-placed paper requires the
services of an agent to sell an issuers paper. The agent distributes the paper on a best efforts
underwriting basis by commercial banks and securities houses.
(c) What does the yield spread between commercial paper and Treasury bills of the same
maturity reflect?
In brief, the yield spread between commercial paper and Treasury bills of the same maturity
reflects differences in credit risk, taxability, and liquidity. More details are included below.
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Like Treasury bills, commercial paper is a discount instrument. That is, it is sold at a price
that is less than its maturity value. The difference between the maturity value and the price
paid is the interest earned by the investor, although there is some commercial paper that is
issued as an interest-bearing instrument. For commercial paper, a year is treated as having
360 days.
The yield offered on commercial paper tracks that of other money market instruments. The
commercial paper rate is higher than that on Treasury bills for the same maturity. There are
three reasons for this. First, the investor in commercial paper is exposed to credit risk.
Second, interest earned from investing in Treasury bills is exempt from state and local
income taxes. As a result, commercial paper has to offer a higher yield to offset this tax
advantage. Finally, commercial paper is less liquid than Treasury bills. The liquidity premium
demanded is probably small, however, because investors typically follow a buy-and-hold
strategy with commercial paper and so are less concerned with liquidity.
(d) Why does commercial paper have a maturity of less than 270 days?
In the United States, commercial paper ranges in maturity from 1 day to 270 days. The
reason that the maturity of commercial paper does not exceed 270 days is as follows. The
Securities Act of 1933 requires that securities be registered with the SEC. Special provisions
in the 1933 act exempt commercial paper from registration as long as the maturity does not
exceed 270 days. Hence, to avoid the costs associated with registering issues with the SEC,
firms rarely issue commercial paper with maturities exceeding 270 days. Another
consideration in determining the maturity is whether the commercial paper would be eligible
collateral for a bank that wanted to borrow from the Federal Reserve Banks discount
window. To be eligible, the maturity of the paper may not exceed 90 days. Because eligible
paper trades at lower cost than paper that is not eligible, issuers prefer to issue paper whose
maturity does not exceed 90 days.
(e) What is meant by tier-1 and tier-2 commercial paper?
A major investor in commercial paper is money market mutual funds. However, there are
restrictions imposed on money market mutual funds by the SEC. Specifically, Rule 2a-7 of
the Investment Company Act of 1940 limits the credit risk exposure of money market mutual
funds by restricting their investments to eligible paper. To be eligible paper, the issue must
carry one of the two highest ratings (1 or 2) from at least two of the nationally
recognized statistical ratings agencies. Tier-1 paper is defined as eligible paper that is rated
1 by at least two of the rating agencies; tier-2 paper security is defined as eligible paper
that is not a tier-1 security. Money market funds may hold no more than 5% of their assets in
tier-1 paper of any individual issuer and no more than 1% of their assets in the tier-2 paper of
any individual issuer. Furthermore, the holding of tier 2 paper may not represent more than
5% of the funds assets.
25 Why is a default rate not a good sole indicator of the potential performance of a
portfolio of high-yield corporate bond?
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To assess the potential return from investing in corporate debt obligations, more than just
default rates are needed. The reason is that default rates by themselves are not of paramount
significance. It is perfectly possible for a portfolio of corporate debt obligations to suffer
defaults and to outperform a portfolio of U.S. Treasuries at the same time, provided the yield
spread of the portfolio is sufficiently high to offset the losses from default. Furthermore,
holders of defaulted bonds typically recover a percentage of the face amount of their
investments. This is called the recovery rate. Therefore, an important measure in evaluating
investments in corporate debt is the default loss rate, which is defined as follows:
Default loss rate = Default rate (100% Recovery rate).
26 What is the difference between a credit rating and recovery rating?
Recovery ratings were developed in response for the markets need for more information for
particular bond issues than could be supplied by a credit rating. While a credit rating can
provide guidance on recovery if a firm is in default, a recovery rating corresponds to a
specific range of recovery values. More details are given below.
While credit ratings provide guidance for the likelihood of default and recovery given
default, the market needed better recovery information for specific bond issues. In response
to this need, two ratings agencies, Standard & Poors and Fitch, developed recovery rating
systems for corporate bonds. Standard & Poors introduced recovery ratings in December
2003 for secured debt using an ordinal scale of 1+ through 5.
In July 2005, Fitch introduced a recovery rating system for corporate bonds rated single B
and below. The factors considered in assigning a recovery rating to an issue by Fitch are (1)
the collateral, (2) the seniority relative to other obligations in the capital structure, and (3) the
expected value of the issuer in distress. The recovery rating system does not attempt to
precisely predict a given level of recovery. Rather, the ratings are in the form of an ordinal
scale and referred to accordingly as a Recovery Ratings Scale. Despite the recovery ratings
being in relative terms, Fitch also provides recovery bands in terms of securities that have
characteristics in line with securities historically recovering current principal and related
interest.
27 What is a rating transition matrix?
The rating agencies accumulate statistics on how ratings change over various periods of time.
A table that specifies this information is called a rating transition matrix. It shows the number
of downgrades, upgrades, and the ratio of upgrades to downgrades for a period of time as
given by a commercial rating company such as Moodys Investors Service, Standard &
Poors Corporation, or Fitch Ratings.

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28 What is the difference between event risk and headline risk?

There are two unique risks that that can change corporate credit spreads:
event risk and headline risk. The difference between these two risks is as follows. In
the case of event risk, upon the announcement of some event there is an almost immediate
credit rating downgrade for the adversely impacted corporation, sector, or industry. Hence,
event risk is tied to downgrade risk. With headline risk, on the other hand, the
announcement results in an adverse impact on the credit spread, as with event risk, but does
not result in an immediate downgrade of debt. More details are given below.
An example of event risk is a corporate takeover or corporate restructuring. A specific
example of event risk is the 1988 takeover of RJR Nabisco for $25 billion through a
financing technique known as a leveraged buyout (LBO). The new company took on a
substantial amount of debt incurred to finance the acquisition of the firm. In the case of RJR
Nabisco, the debt and equity after the leveraged buyout were $29.9 and $1.2 billion,
respectively. Because the corporation must service a larger amount of debt, its bond quality
rating was reduced; RJR Nabiscos quality rating as assigned by Moodys dropped from A1
to B3. The impact of the initial LBO bid announcement on the credit spreads for RJR
Nabiscos debt was an increase from 100 basis points to 350 basis points. Event risk can have
spillover effects on other firms. Consider once again the RJR Nabisco LBO. An LBO of $25
billion was considered impractical prior to the RJR Nabisco LBO, but the RJR transaction
showed that size was not an obstacle, and other large firms previously thought to be unlikely
candidates for an LBO became fair game resulting in an increase in their credit spread.
An example of headline risk is a natural or industrial accident that would be expected to have
an adverse economic impact on a corporation. For example, an accident at a nuclear power
plant is likely to have an adverse impact on the credit spread of the debt of the corporation
that owns the plant. Just as with event risk, there may be spillover effects.

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