Fixed-Income Types: Credit-Linked, PIK, and Deferred Coupon Bonds
A-Plus Cleaners is a small firm with bonds outstanding. They are not conventional bonds, although the indenture is not very complicated. It just contains a provision allowing the coupon of A-Plus Cleaners debt to change with the firm's credit rating. This is something that one of the bondholders suggested in advance of the issue, since it offers them some protection in case the firm's credit deteriorates.
So the bonds issued by A-Plus Cleaners are called __credit-linked notes__, for the straightforward reason that the bond coupon is linked to the firm's credit rating.
The issue currently has a coupon issued of 4.8%. However, the coupon is set to increase 40bp every time the firm's credit rating decreases a level, and to decrease 40bp every time the firm's credit rating increases a level.
And with the current state of their books, anything can happen.
What do you think would happen to the coupon rate of A-Plus Cleaners' bonds if they were unlucky enough to have three credit downgrades in the next couple of months?
No, this is the correct amount of the movement of the coupon, but not the coupon level itself.
No, this is the wrong direction. Consider that credit-linked notes increase the coupon with credit downgrades, as a protection for investors.
Yes!
Three credit downgrades would correspond to three increases of 40bp, making the new coupon rate:
$$\displaystyle 4.8 \% + 3 \times 0.40 \% = 6.0 \% $$
Think about the price, or value, of the bond itself. How would you characterize the bond's price movement if either some credit upgrades or downgrades of A-Plus Cleaners would take place?
No, there's no reason that changes in the firm's credit rating would have only downside price movement for the bond.
No, there's no reason that changes in the firm's credit rating would have only upside price movement for the bond's price.
That's right!
The fact that the bond's coupon adjusts according to the credit rating of the issuer means that it pays more when the bond is riskier, and pays less when the bond becomes less risky. This means that the price effect of the credit rating changes and the price effect of the coupon payment changes move in opposite direction, providing price stability.
No, think about the fact that bondholders wanted this provision as some added protection for themselves, and how would this best correspond with your understanding of risk.
One big caveat with this, though.
Suppose A-Plus Cleaners did have three downgrades. Suppose the coupon rate did increase to 6.0%. Look at these changes from the firm's perspective. The credit downgrades would have to have something to do with some operational or financial troubles, and then on top of that their interest expense jumps up.
This provision can sure make a bad situation worse for the firm. If it goes too far, there could be nothing left for the investor.
Owen Lots is a wholesaler that hasn't been doing so well lately. The company is racked with debt, and it's now in the middle of a large restructuring, which will take years, and it may or may not have a lot of cash to work with in the next five to 10 years.
So they decided to issue __payment-in-kind bonds__. It's a $1 million issue with a fixed coupon. Each year, the investors expect to collectively get those coupon payments, and they will, sort of.
The "in-kind" part of payment-in-kind means that the coupon payments might not be cash. Of course, that's the goal, and Owen Lots' management would like to get rid of the debt by simply paying it off, but it might have to get creative.
The bond indenture allows this. Instead of a cash payment, Owen Lots has the choice of simply giving investors additional bond issue if there's just no cash available.
What kind of yield do you think these bonds probably have?
No. This is certainly not the case.
Absolutely!
High debt levels, uncertainty, risky restructuring... these things all cry out for high yield. Investors will want to be well-compensated for all of this risk.
Suppose that the indenture included some very bad trigger events if the firm reached insolvency or crossed a debt-to-equity ratio of 50%, and Owen Lots was very close to both of these.
A coupon is due. How would you recommend the coupon be paid?
It might not be new bond issue. It's possible that the indenture allows shares of common stock to be paid instead. It's also possible that the issuer has the choice to create some combination of cash and an in-kind payment to satisfy the coupon.
No. This really might push them right into the insolvency trigger.
No. This additional debt issue could easily make them cross the 50% debt-to-equity ratio trigger point.
That's right! This will allow them to keep their cash and also keep them from expanding debt. Their debt-to-equity ratio will hold inside of 50%, and they will live to see another day.
It's not easy when you're Owen Lots.
Crafty Nation is a hobby supply store that is just starting to build a second store location. This is largely funded with a $4,000,000 bond issue that matures in eight years.
Since Crafty Nation will be using most of its cash for construction, and will not generate any new revenues until the store is able to open in two to three years, they really didn't want to be obligated to pay any sizable coupons until after they open.
So they issued __deferred coupon bonds__. This just means that the bonds don't pay coupons right away, but start sometime later. In the case of Crafty Nation's issue, the coupons start in year 5, with a 9% coupon rate.
| Year | Coupon | Principal |
|---|---|---|
| 1 through 4 | $0 | $0 |
| 5 | $360,000 | $0 |
| 6 | $360,000 | $0 |
| 7 | $360,000 | $0 |
| 8 | $360,000 | $4,000,000 |
How do you think this bond would compare in price to a conventional bond with the same maturity and par value, and a 4.5% coupon?
That's right!
Both of these bonds are scheduled to pay the same amount of total coupon payments, but the conventional bond offers some of those payments earlier. So with any positive discount rate, these early payments will be discounted less than the later payments of the deferred coupon bond. This means that these higher present value payments of the conventional bond will sum to a higher price.
Incorrect.
Think about the fact that the same coupons are paid, but the conventional bond offers those payments earlier than does the deferred coupon bond.
Incorrect.
Consider that both of these bonds would offer the same amount of total cash, but then consider the implication of the deferred bond offering those cash flows at a later average date.
Now consider this another way. Suppose that Crafty Nation wanted to issue bonds at par, but also wanted to issue them with a deferred coupon. How would you state the relationship between the deferral period and the coupon?
No, the longer the deferral period, the more money investors will miss out on. There has to be compensation for this if the investors are going to purchase the bonds at par.
Yes!
If Crafty Nations wants investors to pay par, and then wait for coupons, those coupons better be pretty hefty once they start.
But they usually aren't sold at par, and this feature is one of the benefits to investors of deferred coupon bonds—typically, a large discount price to par. They may like the deferred coupons for tax reasons as well. But of course, that depends on the investor's own tax situation and jurisdiction.
No, this would be a great deal for Crafty Nations. A later start to coupon payments, and lower coupon payments once they start are both good for Crafty Nations, and therefore both are bad for investors. These couldn't combine to make a bond worth par.
To summarize this discussion:
[[summary]]
Now take this to an extreme. Perhaps Crafty Nations should have deferred their coupon even longer. Perhaps deferred them forever. No coupons. It's an extreme example, but these do exist. They are simply called __zero-coupon bonds__, or "zeros" for short.
It would increase to 1.2%
It would move down to 3.6%
It would increase to 6.0%
The bond price could only decrease
The bond price could only increase
The bond price could go in either direction, but wouldn't move as much as the price of a conventional bond
The bond price could go in either direction, and would likely move a lot more than the price of a conventional bond
Low yield
High yield
Pay in cash
Pay additional bond issue
Pay the coupon fully in common stock
This conventional bond would have a higher price
This conventional bond would have a lower price
This conventional bond would have the same price
A deferral period will lower the coupon
The longer the deferral period, the higher the coupon
If the bond is sold at par, the coupon would be the same regardless of the deferral period
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