Use of Derivative Instruments in Designing Bonds The ﬂexibility in designing a bond issue today to meet the needs of

investors has increased due to availability of derivative instruments. We described the basic features of these instruments in Chapter 4. We just explained that issuers can synthetically create ﬁxed-rate or ﬂoating-rate bonds by using interest rate swaps. Next we show how this is done.

A bond issue with an unusual coupon structure (i.e., other than a traditional fixed or floating rate) that is created by using derivative instruments so that the issuer is synthetically creating the targeted fixed or floating rate is called a structured note. We will also show how and why an issuer can design a structured note by using a swap.

What is important to keep in mind is that any time a swap is used in

a transaction, there is counterparty risk; that is, the other party to the swap agreement may default on its obligation.

Creating a Synthetic Fixed- or Floating-Rate Security Suppose that two corporations are seeking bond financing. An independent finance company, Quick Funding Finance, and a manufacturing firm, Toys for Kids. The treasurers of both corporations want to raise $100 million for 10 years. Quick Funding Finance wants to raise floating-rate funds because the loans that it makes are floating-rate based and therefore floating-rate bonds are a better match against its assets (i.e., the loans it has made) than fixed-rate bonds. Toys for Kids wants to raise fixed-rate funds.

Suppose that the interest rates that must be paid by the two corporations in the ﬂoating-rate and ﬁxed-rate markets for a 10-year bond offering are as follows:

For Quick Funding Finance: Floating rate = 6-month LIBOR + 30 bp Fixed rate = 10.5%

For Toys for Kids: Floating rate = 6-month LIBOR + 80 bp Fixed rate = 12%.

Suppose Quick Funding Finance issued ﬁxed-rate bonds and Toys for Kids issued ﬂoating-rate bonds. Both issues are for $100 million par value and mature in 10 years. At the time of issuance, both corporations entered into a 10-year interest rate swap with a $100 million notional amount with Merrill Lynch, the swap dealer in our illustration. The interest rate swap is diagrammed in Exhibit 15.5. Suppose the terms of the interest rate swap are as follows:

Intermediate and Long-Term Debt

For Quick Funding Finance: Pay ﬂoating rate of 6-month LIBOR Receive ﬁxed rate of 10.6%

For Toys for Kids: Pay ﬁxed rate = 10.85% Receive ﬂoating rate = 6-month LIBOR

The cost of the bond issue for Quick Funding Finance would then

be as follows: Interest paid

On ﬁxed-rate bonds issued = 10.5% On interest rate swap

= 6-month LIBOR

Total = 10.5% + 6-month LIBOR Interest received

On interest rate swap

Net cost Interest paid

= 10.5% + 6-month LIBOR Interest received

Total = 6-month LIBOR – 10 bp Therefore, Quick Funding Finance has achieved its ﬁnancing objective

of ﬂoating-rate funding.

EXHIBIT 15.5 Diagram of the Interest Payments in an Interest-Rate Swap

Floating-rate interest payments

Quick Toys Funding

for Finance

Kids

Fixed-rate interest payments

Fixed-rate Floating-rate interest

interest payments

payments Creditors

Creditors

FINANCING DECISIONS

The cost of the issue for Toys for Kids would then be as follows: Interest paid

On ﬂoating-rate bonds issued = 6-month LIBOR + 80 bp On interest rate swap

Total = 11.65% + 6-month LIBOR Interest received

On interest rate swap = 6-month LIBOR Net cost

Interest paid = 11.65% + 6-month LIBOR Interest received

= 6-month LIBOR

Total

As can be seen, by using the interest rate swap Toys for Kids is able to obtain the type of coupon rate it sought, a ﬁxed rate.

In fact, a closer examination of both transactions indicates that both ﬁrms were actually able to reduce their funding cost below what the cost would have been had they issued directly into the market for the type of coupon they sought. A comparison of the two costs for the two corporations is summarized below:

Quick Funding Finance: Issue ﬂoating-rate bond: 6-month LIBOR + 70 b.p. Issue ﬁxed-rate bond + swap: 6-month LIBOR – 10 b.p.

Toys for Kids Issue ﬁxed-rate bond: 12.5% Issued ﬁxed-rate bond + swap: 11.65%

While the magnitude of the reduction in funding costs that we have just illustrated is not likely to occur in real world markets, there are opportunities to reduce funding costs for the reasons described earlier. In fact, the interest rate swaps market became the key vehicle for issuers in the United States to obtain lower funding cost in the Eurobond market in the early 1980s because of differences in the spreads demanded by fixed-rate and floating-rate investors in the U.S. bond market and in the Eurodollar bond market. In Chapter 25, we will see how a currency swap can be used to issue fixed-rate or floating-rate bonds outside of the United States where the bonds are denominated in a foreign currency.

Intermediate and Long-Term Debt

Creating an Equity Linked Coupon Payment There are different types of swaps that we discussed in Chapter 4—interest rate, currency, and commodity swaps. There are also swaps in which one party swaps a ﬁxed- or ﬂoating-rate in exchange for the rate of return on a common stock index. These swaps are called equity swaps. Let’s see how equity swaps can be used to design a bond issue with a coupon rate tied to the performance of an equity index. We then address why an issuer would want to do so.

Suppose the Universal Information Technology Company (UIT) seeks to raise $100 million for the next five years on a fixed-rate basis. UIT’s investment banker, Credit Suisse First Boston (CSFB), indicates that if bonds with a maturity of five years are issued, the interest rate on the issue would have to be 8.4%. At the same time, there are institutional investors seeking to purchase bonds but are interested in making a play (i.e., betting on) on the future performance of the stock market. These investors are willing to purchase a bond whose annual interest rate is based on the actual performance of the S&P 500 stock market index.

CSFB recommends to UIT’s management that it consider issuing a ﬁve- year bond whose annual interest rate is based on the actual performance of the S&P 500. The risk with issuing such a bond is that UIT’s annual interest cost is uncertain since it depends on the performance of the S&P 500. However, suppose that the following two transactions are entered into:

1. On January 1, UIT agrees to issue, using CSFB as the underwriter, a $100 million ﬁve-year bond issue whose annual interest rate is the actual performance of the S&P 500 that year minus 300 basis points. The minimum interest rate, however, is set at zero. The annual interest payments are made on December 31.

2. UIT enters into a ﬁve-year, $100 million notional amount equity swap with CSFB in which each year for the next ﬁve years UIT agrees to pay 7.9% to CSFB, and CSFB agrees to pay the actual performance of the S&P 500 that year minus 300 basis points. The terms of the swap call for the payments to be made on December 31 of each year. Thus, the swap payments coincide with the payments that must be made on the bond issue. Also as part of the swap agreement, if the S&P 500 minus 300 basis points results in a negative value, CSFB pays nothing to UIT.

Consider what has been accomplished with these two transactions from the perspective of UIT. Speciﬁcally, focus on the payments that must be made by UIT on the bond issue and the swap and the payments that it will receive from the swap. These are summarized below.

Interest payments on bond issue: S&P 500 return – 300 bp Swap payment from CSFB:

S&P 500 return – 300 bp

FINANCING DECISIONS

Swap payment to CSFB:

Net interest cost:

Thus, the net interest cost is a ﬁxed rate despite the bond issue paying an interest rate tied to the S&P 500. This was accomplished with the equity swap.

There are several questions that should be addressed. First, what was the advantage to UIT to entering into this transaction? Recall that if UIT issued a bond, CSFB estimated that UIT would have to pay 8.4% annually. Thus, UIT has saved 50 basis points (8.4% minus 7.9%) per year. Second, why would investors purchase this bond issue? In real world markets, there are restrictions imposed on institutional investors as to types of investment. For example, an institutional investor may be prohibited by a client from purchasing common stock, however it may

be permitted to purchase a bond of an issuer such as UIT despite the fact that the interest rate is tied to the performance of common stocks. Third, is CSFB exposed to the risk of the performance of the S&P 500? While it is difﬁcult to demonstrate at this point, there are ways that CSFB can protect itself.

Use of Warrants in a Bond Offering Some bond issues are offered with warrants attached. A warrant is the

right to buy the common stock of a company at a speciﬁed price, the exercise price. So a warrant is like a call option. It represents the right to buy the stock. How then is a warrant different from a convertible bond? With a convertible bond, the bond holder exchanges the bond issue for shares of stock. With a warrant, the bond holder exercises the warrant— buying the shares of stock at a speciﬁed price—but still has the bond!

Warrants may have a ﬁxed life (i.e., use it or lose it) or may have a perpetual life—called perpetual warrants. The bond and its warrant together are referred to as a unit. Some warrants can be separated from the debt— called detachable warrants—and sold by the bondholder. These warrants can be traded in the market just as shares of stock are traded.

A warrant is an option and, like other types of options, its value depends on many factors. (We discussed these factors in Chapter 9.) Sup- pose you buy a warrant that gives you a right to buy stock for $5 per share within the next ﬁve years. The $5 is the exercise price. If the current share price is $1 per share, this right is not very valuable. But it is still worth something. However small, there is some chance that the price of the stock will get above $5 and make exercising this warrant valuable.

Factors that affect a warrant’s value are:

Intermediate and Long-Term Debt

■ The common stock’s share price. The greater the share’s price, the more valuable the warrant. If the share’s price were $6 instead of $1, the warrant will be more valuable.

■ The exercise price. The lower the exercise price, the more valuable the warrant. The lower the warrant’s exercise price—$5 in our example— the more valuable the warrant. If the exercise price were $2 instead of $5, there is a greater chance that the warrant would gives you the right to buy shares for a price below the prevailing market price.

■ The warrant’s life. The longer the life of the warrant, the more valuable the warrant since there is more time for the share price to increase and the warrant become attractive. If the warrant expired in ten years instead of the five years, it would be more valuable since there is a greater chance of the share’s price rising above $5 in ten years than in five.

■ The opportunity cost of funds. The greater the opportunity cost, the more valuable the warrant, because it allows us to postpone our stock purchase to a later time. Suppose the underlying stock price were $6 instead of $1. We could hold onto the warrant and buy the stock at a later time. The value of the warrant will increase along with the stock’s price so we can share in the stock’s appreciation without laying out the cash.

■ The common stock’s share price volatility. The more volatile the share’s price, the more valuable the warrant since a more volatile price means that there is a greater chance the share’s price will change before our warrant expires. If the share’s price is very stable, there is little chance that it will go above $5. But if the share’s price is volatile, there is more chance that the share price will go above the exercise price, $5.

Using Financial Derivatives to Hedge Interest Rate Costs The CFO must determine the best time to sell bonds. If the CFO expects

interest rates to decline, then it may pay for an issuer to postpone a bond offering if possible. If the CFO expects interest rates to rise, then the best strategy may be for the firm to issue bonds now. Moreover, if the CFO expects that bonds will have to be issued at some future date, say six-months from now, and also expects that interest rates will be higher than they currently are, the CFO may find that the best strategy is to issue bonds now rather than wait six months. The tradeoff is that the firm will have the bond proceeds today that it will have to pay interest on. To partially offset that additional interest cost, the issuer can invest the proceeds received from the bond sale and earn interest. The CFO must evaluate the net additional cost of accelerating the bond offering versus the higher interest cost expected in the future.

FINANCING DECISIONS

While we have cast the timing of an offering in terms of interest rates, that is too general. As explained in Chapter 15, the CFO thinks in terms of two components that determine the cost of an issue: the Treasury rate (which we referred to as the base rate) and the spread. A CFO may believe that Treasury rates are declining but may want to issue a bond today because the CFO may believe that spreads in the market are widen- ing such that the interest rate that will have to be paid will increase. For example, suppose the Treasury rate is 6% and the spread is 100 basis points for an issuer. The interest rate that the issuer pays would then be 7% if it issues bonds now. Suppose that the CFO of this ﬁrm believes that the Treasury rate six months from now will decline to 5%. The question in deciding whether or not to postpone a bond issuance is what the CFO believes will happen to the spread. If the spread is expected to widen (i.e., increase), the CFO may want to lock in the current spread.

Financial derivatives have provided CFOs with the maximum ﬂexi- bility in timing their bond offerings. We will brieﬂy discuss how interest rate futures, options, interest rate swaps, and caps can be used. More- over, there are special products created by investment bankers as will be explained below.

There are several interest rate futures contracts. The one used by issuers to protect against a rise in interest rates in the future is a Trea- sury bond (or note) futures contract. This derivative instrument can be used to protect or hedge against changes in the Treasury rate. Speciﬁ- cally, the CFO planning a future offering of bonds and concerned with the possibility of a rise in Treasury rates uses the contract as follows. The price of a Treasury bond changes inversely with the change in Trea- sury rates. That is, if Treasury rates rise, the price of a Treasury bond declines. The price of a Treasury bond futures contract also falls if Trea- sury rates rise. So, by selling a Treasury bond futures contract, an issuer would realize a proﬁt if Treasury rates increase. This is because the CFO sold a contract and gets to repurchase the contract at a lower price if Treasury rates rise.

Now let’s combine the position in the Treasury bond futures contract with the sale of the bonds. If the CFO sells a Treasury bond futures contract and Treasury rates rise, then when the issuer issues the bonds, there will be higher interest cost that must be paid. However, there will

be a gain on the Treasury bond futures position. If the CFO sells the correct number of Treasury bond futures contracts, the additional cost of the bond issue will be offset by the gain in the Treasury bond futures position. As a result, a future bond offering will be protected against a rise in Treasury rates.

Note that the issuer would not beneﬁt from a decline in Treasury rates. This is because the lower cost of the bonds to be issued will be

Intermediate and Long-Term Debt

offset by the loss that results from the Treasury bond futures position. To overcome this problem, the CFO can buy put options on a Treasury bond rather than sell Treasury bond futures. Should Treasury rates fall, the issuer can issue bonds at a lower cost. However, this is not free. For this beneﬁt, the issuer must pay the price for the put options and this expense increases the cost of the bond issue. If Treasury rates rise, the issuer exercises the put option to sell Treasury bonds at a higher price than in the market. This gain is used to offset the higher interest rate that must be paid on the bond issue.

With an interest rate swap, the rate that the ﬁxed-rate payer pays is called the swap rate. The swap rate that the ﬁxed-rate payer pays is equal to the Treasury rate at the inception of the swap plus a spread. The spread is called the swap spread. An interest rate swap can be such that it does not start until some time in the future. This type of interest rate swap is called a forward start interest rate swap. The CFO can use

a forward start interest rate swap to lock in a spread in the future, which will be equal to the swap spread. For example, the CFO might like the spread at the time but is concerned that if 15-year bonds are issued six months from now, the spread will be higher. By entering into

a forward start interest rate swap with a start date six months from now and with a 15-year maturity, the CFO can lock in a spread. Taking the right position in a derivative instrument may not be sim- ple for the CFO or his staff. There are several factors that may cause the strategy to fall short of its objective. To overcome this problem, investment banking firms offer their clients an alternative—the opportunity to lock in the base rate or the spread, or both. Such an agreement for lock- ing in the spread is called a spread lock agreement. The investment banking firm then faces the risk of hedging the position. The benefit to the investment banking firm is that the issuer will agree to use the underwriter for the future offering of the firm.

For an issuer that seeks floating-rate financing, the concern of the CFO is that interest rates will rise. A CFO can protect itself against a rise in the reference rate used in the coupon reset formula by buying a cap agreement. This agreement results in a payment of a specified amount if the reference rate at the reset date rises above the cap rate. The issuer pays a fee for this and therefore this cost must be recognized in determining the effective cost of funds.

Bond Retirement

A bond issuer does not have to keep an issue outstanding for the bond’s entire life. Bonds can be retired prior to their maturity date by:

FINANCING DECISIONS

■ Calling in a bond if the issue is callable. ■

A sinking fund call if there is such a provision to retire part of the issue and in the case of an acceleration provision, up the maximum amount. ■ In the case of a convertible bond forcing conversion into common stock. ■ Purchasing the bonds from the investor either through direct negotia- tion or by buying the bond in the open market.

There are a number of reasons to retire a bond issue before its maturity date:

1. The issuer may want to eliminate the ﬁxed, legal obligations associ- ated with the bond issue. If the interest is too burdensome, or the issuer does not have enough taxable income to use to offset the interest tax deduction, bonds may be unattractive because they increase the ﬁrm’s default risk.

2. The issuer may find the indenture provisions too confining. Provisions, such as a covenant that the firm maintain a specified ratio of current assets to current liabilities, may restrict management decisions.

3. The issuer may no longer need the funds. The issuer may be generating more cash from operations than needed for other purposes, and hence will use the excess to reduce debt.

4. Market interest rates may have fallen, making the interest rate on the outstanding bonds too costly relative to the current rate.

Let’s take a closer look at this last reason. Suppose a corporation currently has $100 million par value of bonds outstanding with a 10% coupon rate. The bonds were issued five years ago and they will mature in five years. Looking at current rates, the treasurer figures she can issue bonds today that have a maturity of five years with a coupon rate of 6%. Should the treasurer buy back the outstanding 10% bonds and issue new 6% bonds in their place? This is called refunding a bond issue.

Let’s assume that it costs the ﬁrm $300,000 in fees to issue the new bonds. Does it pay to do this? It all boils down to comparing the cost of the old bonds versus the cost of the new bonds. Suppose the old bonds are trading in the market to yield 6% (that is, 3% per six-month period). The value of an old bond per $1,000 of par value is:

$1,000 Value of old bond =

+ ∑ -------------------------------

---------------------------- $50

1 + 0.03 t

Intermediate and Long-Term Debt

If the old bonds are not callable and the treasurer were to buy these bonds in the financial markets, the issuer would have to pay $1,170.60 per bond, or $117,060,000 for the entire issue. The premium on these bonds $170.60 (= $1,170.60 – $1,000.00) per bond or $17,060,000 in total and the flotation expenses—the $300,000 to pay the underwriters who sell the new bonds—are deductible for tax purposes. If the firm faces a 40% tax rate, this means that the premium to buy back the old bonds only costs the firm 60% of $17,060,000, or $10,236,000, and the flotation expenses only cost 60% of $300,000, or $180,000. The government pays for the difference by allowing the firm to lower its taxable income by $17,360,000 (= $300,000 + $17,060,000):

Firm’s Government’s Item Cost

Share Share

Premium on old bonds

$10,236,000 $6,824,000 Flotation costs on new bonds

$10,416,000 $6,944,000 Therefore, considering the ﬂotation costs, the treasurer has to issue new

6% bonds with a par value of $110,356,000 (= $117,060,000 – $6,824,000 + $120,000) to replace the 10% bonds. If the treasurer does this, the ﬁrm will have interest payments of 3% of $110,356,000 or $3,310,680 every six months instead of 5% of $100,000,000 or $5,000,000 on the old bonds.

With the old bonds, the firm had an interest expense of $5,000,000 each period. But since interest is deductible for tax purposes, this really costs the firm only 60% of $5,000,000, or $3,000,000. For the new bonds, the after-tax cost is 60% of $3,310,680, or $1,986,408 every six months. The firm is saving $1,013,592 every six months over the next five years by retiring the old bonds and issuing new bonds.

Is the firm better off with the old bonds or refunding them and issuing new bonds? The only way to figure this out is to look at the present value of the difference in cash flows between the old and the new bonds. How do they differ? In two ways. First, every six months they have a lower interest payment, which after taxes amounts to $1,013,592. Sec- ond, we have a different maturity value to pay in five years: $110,356,000 instead of $100,000,000. Thus, there is an additional cash outlay of $10,356,000. The present value of the difference in the cash flow, dis- counted at the yield on the new bonds (3% per six-month period), is as follows:

FINANCING DECISIONS

$10,356,000 Present value of difference =

------------------------------ – ∑ ---------------------------------

t = 1 1 + 0.03 t

Present value

of difference in

after-tax interest

maturity values

Therefore, the ﬁrm is better off by $940,308 if the treasurer buys back the old 10% bond issue and issues the new 6% bonds.

The refunding decision—whether to retire old debt and issue new debt—requires looking at whether or not it increases the value of the ﬁrm by providing increased cash ﬂows. The way this is done is as follows:

1. Determine the cash ﬂows with the old and with the new debt, considering the difference in interest payments, any tax effects, and any ﬂota- tion costs.

2. Calculate the differences in cash ﬂows between the old and the new bonds.

3. Calculate the present value of the differences of cash ﬂows. If the present value of the difference is positive, the new bond issue pro-

vides a benefit; if negative, the new bond issue represents a cost. However, even if there is an advantage in terms of the difference in the present value of the cash flow, a firm may be reluctant to retire bonds. The reason is that the premium paid to purchase the old bond issue in the market is treated as a current expense and thereby reduces current earnings. 3

Use of Derivative Instruments in Designing Bonds The ﬂexibility in designing a bond issue today to meet the needs of