Designing a Bond Issue

Designing a Bond Issue

A corporation seeking to raise funds via a bond offering wants to issue a security with the lowest cost and the flexibility to retire the debt if inter- est rates fall. An investor wants a security that provides the highest yield, lowest risk, and the flexibility to sell it if other, more profitable investment opportunities arise. The best “package” of debt features will provide what investors are looking for (in terms of risk and return) and simultaneously what the firm is willing to offer (in terms of risk and cost).

There is a wide range of features available with respect to denomi- nation, type of coupon rate, security, call features for retiring a bond issue prior to the maturity date, and conversion options that make it possible to design a bond issue to meet both the needs of the issuer and investors. Features that make an issue more attractive to investors decrease the yield investors want. As a result, the issuer’s borrowing cost is reduced. For example, the inclusion of embedded options such as

a conversion feature and a put option make the issue more attractive to investors, so an issuer would expect that the inclusion of such features would reduce the yield at which it would have to offer a bond. In con- trast, features included in a bond issue that are an advantage to the issuer increase the yield investors want and therefore increase the cost of the bond issue. For example, the inclusion of covenants that favor the issuer or the inclusion of embedded options, such as the call option and the acceleration option, add to the cost of a bond issue.

In an efficient market, investors fairly price the value of the favor- able and unfavorable features into the offering price. Opportunities for an issuer to obtain a higher offer price for a bond issue (i.e., a lower cost) arise only if for some reason the market is not pricing these fea- tures properly. For example, suppose that investors buy a particular bond issue at issuance that is callable and is undervaluing the call option. This means that the issuer is buying a cheap call option and therefore the issuer’s cost for the bond issue is lower than if the call option is priced fairly. However, suppose that the same issuer did not want a call option. The issuer can take advantage of effectively buying a cheap call by issuing the callable bond and simultaneously entering into

a transaction to sell a call option in the over-the-counter market. Basi-

Intermediate and Long-Term Debt

cally, the issuer effectively bought a call option by issuing the callable bond and has sold a call option with the same terms as the embedded call option at a higher price. The net effect is that the proceeds realized from the sale of the call option in the market reduce the issuer’s cost for the bond issue relative to issuing a noncallable bond.

In an efficient market, there are opportunities to reduce the cost of a bond issue if a new, innovative bond structure can be designed that is not currently available in the marketplace. What type of innovation must that be? The innovation must be such that it either enables inves- tors to reduce a risk that previously could not have been reduced effi- ciently through currently available financial instruments, or takes advantage of tax or financial accounting loopholes that benefit the issuer and/or investors. The first type of innovation, risk-reducing fea- tures, eventually are introduced by other issuers so that only those issu- ers who are first to introduce those features will benefit. Investment bankers who see a new innovation introduced by a competitor firm promptly notify their clients about the opportunity to issue bonds with this feature. As a result, the uniqueness of the feature wanes and there is no advantage to issuing a bond with this feature—that is, the issuer gets

a fair market value for the feature. For innovations that result from tax or financial accounting loopholes, those advantages disappear once the Internal Revenue Service changes tax rules or the Financial Accounting Standards Board changes the financial accounting rules that created the loophole.

A good illustration of this is the zero-coupon bond structure. In the early 1980s when interest rates were at a historical high, investors came to appreciate the concept of reinvestment risk when investing in a bond. This is the risk that when coupon payments are made by the issuer, in order to realize the yield on the bond at the time of purchase, all the coupon payments would have to be reinvested at that yield. For exam- ple, if an investor purchased a 20-year bond in 1982 with a coupon rate of 16%, at par value so that its yield is 16%, then to realize that 16% each coupon payment must be reinvested to earn at least 16%. If the coupon payments are reinvested at a rate of less than 16%, then the investor would earn less than 16%. In fact, the investor could earn less than 16% if interest rates dropped. In fact, interest rates did drop sub- stantially since the early 1980s and investors holding a coupon bond purchased at that time would be realizing a lower return. Against this background, corporations began to issue zero-coupon bonds. This fea- ture eliminates reinvestment risk because there are no coupons to rein- vest. If an investor purchased a zero-coupon bond that was noncallable in 1982 with a yield of 16% and held the bond to maturity in 2002, the investor would have realized a 16% yield despite the fact that interest

FINANCING DECISIONS

rates dropped substantially from 1982 to 2002. As a result, when zero- coupon bonds were introduced, investors were willing to pay up for newly issued zero-coupon bonds. That is not the case a few years later, as it is today, as the supply of zero-coupon bonds issued by corporations does not justify a premium price (i.e., a lower cost).

Moreover, while we previously discussed the financial accounting advantage of a zero-coupon bond from the issuer’s perspective, the advantage was even greater prior to the change in the tax treatment in the mid-1980s. Specifically, the issuer prior to a change in the tax law could write off interest as an expense for tax purposes equal to the dif- ference between the maturity value and the price received divided by the number of years to maturity. This resulted in higher interest deductions in the early years and thereby reduced the effective cost of a bond issue. This tax advantage was wiped out by a change in the tax rules for deter- mining the annual interest expense from the issuance of a zero-coupon bond.