Floating Rate Bonds

The conventional bonds we have talked about in this chapter have fixed-dollar obligations because the coupon rate is set as a fixed percentage of the par value. Similarly, the principal is set equal to the par value. Under these circumstances, the coupon payment and principal are completely fixed.

With floating-rate bonds (floaters), the coupon payments are adjustable. The adjustments are tied to an interest rate index such as the Treasury bill interest rate or the 30-year Treasury bond rate. The EE Savings Bonds we mentioned back in Chapter 5 are a good example of a floater. For EE bonds purchased after May 1, 1997, the interest rate is adjusted every six months. The rate that the bonds earn for a particular six-month period is determined by taking 90 percent of the average yield on ordinary five-year Treasury notes over the previous six months.

The value of a floating-rate bond depends on exactly how the coupon payment adjustments are defined. In most cases, the coupon adjusts with a lag to some base rate. For example, suppose a coupon rate adjustment is made on June 1. The adjustment might be based on the simple average of Treasury bond yields during the previous three months. In addition, the majority of floaters have the following features:

1. The holder has the right to redeem his/her note at par on the coupon payment date after some specified amount of time. This is called a put provision, and it is discussed in the following section.

2. The coupon rate has a floor and a ceiling, meaning that the coupon is subject to a minimum and a maximum. In this case, the coupon rate is said to be "capped," and the upper and lower rates are sometimes called the collar.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

7. Interest Rates and Bond Valuation

© The McGraw-Hill Companies, 2002

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

In Their Own Words

Edward I. Altman on Junk Bonds

One of the most important developments in corporate finance over the last 20 years has been the reemergence of publicly owned and traded low-rated corporate debt. Originally offered to the public in the early 1900s to help finance some of our emerging growth industries, these high-yield, high-risk bonds virtually disappeared after the rash of bond defaults during the Depression. Recently, however, the junk bond market has been catapulted from being an insignificant element in the corporate fixed-income market to being one of the fastest-growing and most controversial types of financing mechanisms.

The term junk emanates from the dominant type of low-rated bond issues outstanding prior to 1977 when the "market" consisted almost exclusively of original-issue investment-grade bonds that fell from their lofty status to a higher-default risk, speculative-grade level. These so-called fallen angels amounted to about $8.5 billion in 1977. At the end of 1998, fallen angels comprised about 10 percent of the $450 billion publicly owned junk bond market.

Beginning in 1977, issuers began to go directly to the public to raise capital for growth purposes. Early users of junk bonds were energy-related firms, cable TV companies, airlines, and assorted other industrial companies. The emerging growth company rationale coupled with relatively high returns to early investors helped legitimize this sector.

By far the most important and controversial aspect of junk bond financing was its role in the corporate restructuring movement from 1985 to 1989. High-leverage transactions and acquisitions, such as leveraged buyouts (LBOs), which occur when a firm is taken private, and leveraged recapitalizations (debt-for-equity swaps), transformed the face of corporate America, leading to a heated debate as to the economic and social consequences of firms' being transformed with debt-equity ratios of at least 6:1.

These transactions involved increasingly large companies, and the multibillion-dollar takeover became fairly common, finally capped by the huge $25+ billion RJR Nabisco LBO in 1989. LBOs were typically financed with about 60 percent senior bank and insurance company debt, about 25-30 percent subordinated public debt (junk bonds), and 10-15 percent equity. The junk bond segment is sometimes referred to as "mezzanine" financing because it lies between the "balcony" senior debt and the "basement" equity.

These restructurings resulted in huge fees to advisors and underwriters and huge premiums to the old shareholders who were bought out, and they continued as long as the market was willing to buy these new debt offerings at what appeared to be a favorable risk-return trade-off. The bottom fell out of the market in the last six months of 1989 due to a number of factors including a marked increase in defaults, government regulation against S&Ls' holding junk bonds, and a recession.

The default rate rose dramatically to 4 percent in 1989 and then skyrocketed in 1990 and 1991 to 10.1 percent and 10.3 percent, respectively, with about $19 billion of defaults in 1991. By the end of 1990, the pendulum of growth in new junk bond issues and returns to investors swung dramatically downward as prices plummeted and the new-issue market all but dried up. The year 1991 was a pivotal year in that, despite record defaults, bond prices and new issues rebounded strongly as the prospects for the future brightened.

In the early 1990s, the financial market was questioning the very survival of the junk bond market. The answer was a resounding "yes," as the amount of new issues soared to record annual levels of $40 billion in 1992 and almost $60 billion in 1993, and in 1997 reached an impressive $119 billion. Coupled with plummeting default rates (under 2.0 percent each year in the 1993-97 period) and attractive returns in these years, the risk-return characteristics have been extremely favorable.

The junk bond market in the late 1990s was a quieter one compared to that of the 1980s, but, in terms of growth and returns, it was healthier than ever before. While the low default rates in 1992-98 helped to fuel new investment funds and new issues, the market experienced its ups and downs in subsequent years. Indeed, default rates started to rise in 1999 and accelerated in 2000 and 2001. The latter year saw defaults reach record levels as the economy slipped into a recession and investors suffered from the excesses of lending in the late 1990s. Despite these highly volatile events and problems with liquidity, we are convinced that high yield bonds will be a major source of corporate debt financing and a legitimate asset class for investors.

Edward I. Altman is Max L. Heine Professor of Finance and vice director of the Salomon Center at the Stern School of Business of New York University. He is widely recognized as one of the world's experts on bankruptcy and credit analysis as well as the high-yield, or junk bond, market.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

III. Valuation of Future Cash Flows

7. Interest Rates and Bond Valuation

© The McGraw-Hill Companies, 2002

PART THREE Valuation of Future Cash Flows

Official information on U.S. inflation-indexed bonds is at www.publicdebt.treas. . gov/gsr/gsrlist.htm.

A particularly interesting type of floating-rate bond is an inflation-linked bond. Such bonds have coupons that are adjusted according to the rate of inflation (the principal amount may be adjusted as well). The U.S. Treasury began issuing such bonds in January of 1997. The issues are sometimes called "TIPS," or Treasury Inflation Protection Securities. Other countries, including Canada, Israel, and Britain, have issued similar securities.

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