Advanced Corporate Finance

7. Long-Term Debt
 Objectives of the session

1. Understand the role of debt financing and the

various elements involved
2. Analyze the value of bonds with embedded
options
3. Analyze convertible bonds

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 Bond Financing
• Sovereign bonds: issued by Countries, Regions,…
• Corporate bonds: issued by companies and usually classified by
type of issuers (public utilities, transportations, banks and
finance and industrials)

• Issuers promise to repay a specified % of the face value on

designated dates (coupons) and to repay the face value at
maturity.
• Most corporate bonds in the US pay coupons semi-annually (in
Europe annually), in rare instances zero-coupon bonds have
been issued. Sovereign bonds: more often zero-coupon bonds.
• Failure to repay => legal default
• Green Bonds
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 Bond Financing
• Coupons are paid in one of the two ways:
• Bearer bonds => the owner has the right on the bond
coupons and principal
– Historically very frequent
– Extremely tiresome to retrieve the coupons
– Lack of security

• Registered bonds => the issuer has a list with all holders of its
bonds
– The most frequent (and recent)
– Easier for the state to collect taxes

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 Different forms of debts

• Main distinction between secured and unsecured debts => quite logically
in view of the guarantees offered to the bondholders

• Unsecured debts
• No specific asset pledged as collateral
– Notes: short- and medium-term debts
– Debentures: Longer-term debts (most bonds are due in 20 to 30 years)

• Secured debts
• Assets are pledged as collateral
– Mortgage bonds (secured by real estate)
– Asset-backed bonds (any kind of asset is assigned as collateral)

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 Different forms of debts

• On top of the existence or not of a collateral, seniority also

plays an important role
• Since many debentures and notes may be outstanding,
knowing who has priority in case of default is crucial
• Often clauses restricting the company’s rights in terms of
future issues
– Very often request that new issues be subordinated to the previous
one
– In case of default, subordinated bonds get repaid once all the more
senior debts have been cleared

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 Debts…
• May either be traded on the bond market
– Domestic bonds. Example: Solvay issuing a bond in € in Belgium
– Foreign bonds (Yankee bonds, Samurai bonds, Panda bonds, Bulldog
bonds…). Example: Solvay issuing a bond in $ in the USA
– Eurobonds. Bonds issued in a currency different from the currency of
the country where they are traded. Example: Solvay issuing a bond in
$ in Vietnam
– Global bonds. Sold in several countries at the same time
• Important decision and many implications
• Issued in the same way as equity (with a prospectus, etc.…)
• The prospectus must include an indenture: contract between
the bond issuer and a trust company representing the
bondholders’ interests = legal document that spells out terms
and conditions
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 Debts…

• … or be held Privately

• Term Loan : bank loan with a specific term, possibility to have

it issued by a syndicate (syndicated bank loan)
– Loan agreement with the principal borrowed, the IR (fixed or
variable), a collateral and the repayment schedule
• Line of credit : Credit commitment for a specific time-period
or up to some limit
• Private Placement : not traded on a market but sold to a small
group of investors => less costly than a public offering and
might be more tailored to a particular situation

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 Special Features

• Bonds may have call and refund provisions

• Sometimes the issuer wishes to be able to retire the issue before its
maturity (if they anticipate a decline in interest rates)
• Distinction between non-callable and non-refundable bonds => one
cannot be called before maturity, the other cannot be callable if the issuer
needs to issue new debt
• Non-callable bond = bullet bond

• Sinking fund provision

• Issuers may have to retire a proportion of the issue each year => sinking
fund requirement
• Purpose: reduce credit risk
• If by law allowed to retire more than stipulated: accelerated sinking fund
provision

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 Bonds and Ratings

• Heavily discussed during the financial crisis… have a long history

• Three main competitors (Fitch, Moody’s and S&P) with very similar
system, main distinction between investment and speculative (junk
bonds) grades

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 Impact on yields…

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 Ratings?

• To gauge their quality one may want to have a look at the correlation
between defaults and prior ratings

• One may also want to have some insights on the frequency and the
severity of the defaults

• Indeed, bondholders usually recover something in case of default!

• Default Loss Rate = Default Rate*(100% - Recovery Rate)

• If default rate = 6%, and recovery rate = 30%, then the default loss rate is
“only” 4.2%

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 Mortality rates and original rating

Source: Altman: [Link]

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 Bonds may have embedded options

• Callable and puttable bonds include an option (it is

embedded)
• The holder of a callable bond has given the right to the issuer
to call back the bond (at a call price) before its stated maturity
• Bondholders face a reinvestment risk as the issuer will call the
bonds when prices have gone up
– Price appreciation in a declining interest environment is
limited because the market increasingly expects the bond
to be called! => price compression
• Non-callable bonds = bullet bonds

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 Price-Yield relationship

• For option-free bonds, the relationship is convex

• When there are embedded call options, the relationship will
only partially be convex (for the part when the call is least
likely to be exercised i.e., for yields higher than a given
threshold y*)
• On the other hand, below that threshold investors consider
the likelihood that the bond might be called => so when the
yield decreases the price increases less than for a traditional
bond. For this region, the bond-price yield relationship is said
to be negatively convex

• Visually…

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 Callable versus non-callable bonds

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 When should the call be exercised

• Theoretically (Brennan and Schwartz, 1977 and Ingersoll,

1977): Call should be exercised as soon as the bond market
value reaches the call price
• Empirically (King and Mauer, 2000): Calls are most of the time
not happening as theory would suggest (when bond price =
call price). In 86% of cases, it happens later and on average 27
months after the theoretical date
• Mauer (1993) and Longstaff and Tuckman (1994): often
postponed because of:
– Refunding/transactions costs,
– Changes in capital structure

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 How to price callable bonds?

• Callable bonds are made out of two components: the call

option and a non-callable bond

• In other terms: Callable bond price = non-callable bond price

– call option

• Indeed, the owner of the callable bond has sold the call to the
issuer, so the value of his bond has to be inferior to an
equivalent non-callable bond

• The difference can be assessed on the previous graph

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 Computing the call value

• A seemingly reasonable way to attack the issue could be to use

Black&Scholes option pricing model. This would be wrong… Let’s see why?
• Example from Fabozzi (2010)
• Suppose a call on a ZC bond (face value of 100, to be paid back in 3 years),
maturity in 2 years, current ZC price = 83.96, strike price = 88, volatility =
0.1, risk-free rate 6%
• By using Black&Scholes call value = 8.116

• Same data but strike price = 100.25

• By using Black&Scholes call value = 2.79

• Is this reasonable???
• When will you exercise this call?
• How can we explain this result?
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 Black&Scholes and calls on bonds
• Black&Scholes associates a positive probability (even if very
small) that the price may reach any positive value => fixed-
income instruments have however an explicit upper bound (a
maximum price)
• Black&Scholes further assumes that short term rates remain
constant over the life of the option. However, the price of an
interest rate option will change as interest rates change!
• Black&Scholes further assumes that the volatility of the
underlying asset is constant over time. However as one draws
closer to maturity a bond’s price volatility declines…
• Need to consider interest rate volatility => introduction of an
interest rate lattice (tree) to model interest rates

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 Interest rate models

• Models should be close to reality and include statistical

properties of interest rate movements
– A drift
– Volatility
– And mean reversion

• Most common models (and most used): one-factor models

where only one factor tries to describe the behavior of short-
term interest rates

• Many different models (too long to be described)

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 Binomial interest rate tree

• Same principle as binomial trees used for the option valuation

viewed before (with a few adaptations though)
• Assumption from one period to the next, interest rates can
only take two values (Kalotay-Williams-Fabozzi, 1993)
– σ = assumed volatility of the one-year forward rate
and r1,L = the lower one-year rate one year from now
and r1,H = the higher one-year rate one year from now
– The one-year forward rate is assumed to follow a
lognormal random walk

=> Then 𝑟1,𝐻 = 𝑟1,𝐿 ∗ 𝑒 2σ Δ𝑡

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 Binomial interest rate tree

• Interest rate evolution

t=0 t=1 t=2
r2,HH = r2,LL(e4σ)

r1,H=r1,L(e2σ)

r0 r2,LH= r2,LL(e2σ)

r1,L

r2,LL

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 Callable Bond: An Example

• Example: 5.25% coupon bond with three years to maturity,

callable in one year (and in two years) for 100$ (= call price)
• First Step => modeling interest rates
• Suppose there is an on-the-run similar bond with two years of
maturity, volatility = 10%, price = 100$, coupon rate = 4%,
current (one-year) interest rate = 3.5%
– Iterative process where one tries to find the one-year
forward rate consistent with the observed price (100$), to
start a first figure is given to r1,L (let’s say 3%)
– Assumption high and low are equally probable
– Here example for year 1 rates, if one wants to extend,
need to have a three year on-the-run bond

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 Binomial interest rate tree

t=0 t=1 t=2

104

P?
r 1,H= r1,L(e2σ)
100
r0 104

P?
r1,L

104

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 Binomial interest rate tree

t=0 t=1 t=2

r2,HH = 6.757%

r 1,H= 4.976%

r0 = 3.5%
r2,HL= 5.532%

r1,L = 4.074%

r2,LL = 4.530%

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 Once interest rate is modelled…
• Second Step (see Excel file)
• Et each node where the price exceeds 100 (=call price), the
issuer will call the bond. In other terms, the maximum price is
100!
• Callable bond value = min(call price; PV(future CFs))
• In the same spirit as what we have seen before with one
additional complicated thing: need to have an interest rate
model
• Possibility to find the price of the non-callable bond and of the
call
• For the non-callable bond, just discount the future values by
the expected one-year forward rates
• Non-callable bond price – callable bond price = call option
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 Convertible bonds

• Convertible bonds are bonds which may be converted into a

predetermined number of shares of the issuer
• The holder of the convertible bond has thus an option: the
right but not the obligation to convert his bond into shares
• The number of shares received when exercising the right is
called the conversion ratio (# shares/bond)
• At issue, this option entitles the bondholder to purchase the
stock at the price given by:
– Strike or conversion Price = Face Value of Convertible
Bond / Conversion Ratio

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 Many different features

• Sometimes no clause at all => unprotected convertible bond

• In other cases, the issuer wants to be protected from
conversion. Conversion may then only be exercised if the
price of the underlying stock exceeds a given trigger price =>
protected convertible bond
• In some cases, not only does the price of the underlying
stocks need to exceed a given threshold but it needs to
remain above it for a specified number of trading days =>
contingent convertible bonds (CoCo Bonds)
• Conversion leads to the creation of new stock (= warrant) ≠
traditional options where the exercise leaves the number of
existing stock unchanged

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 Warrant
• Warrant (in this context): option written by the company
itself on new stocks (whereas a regular call option is written
on existing stocks)
• The creation of new stocks will have an impact on the stock
price (there is a dilution effect!)

• Convertible bond is similar to a straight bond + warrant

• Convertible bonds have two minimum values:
1) Conversion value = conversion ratio * post conversion price of
common stock
2) Value of the bond if it didn’t have a conversion option  straight
bond value

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 Convertible bond value

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 Why Convertible bonds?

• Convertible bonds are attractive for potential buyers: allow to

gain from a potential increase in stock price, but offers a
protection if price decline
• But if correctly priced (efficient markets), no special gain

• Often companies issue callable convertible bonds.

• For example, if a company considers that its share value is too
low to issue equity it may want to issue convertible bonds and
call these once the price has risen enough

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