CFA Level 1 - Fixed Income Investments
The rights of the bondholders are stronger than the equity holders of the firm. Bondholders get paid off before the equity holders in liquidation and they are first in line to receive new securities, cash or a mixture or both should a reorganization occur. Within the bondholder's group there is also a pecking order based on the seniority of each claim. Bondholders with more seniority, set forth in the indentures of the various classes of securities issued by the bankrupt firm, will receive their shares before the more junior holders. This is also known as the Absolute Priority Rule. This rule tends to hold up in courts for liquidations but not for reorganizations.
Determining Credit Rating
A credit rating can be determined for a single issue or for an entire corporation. The rating can be affected by how senior or junior the issue is compared to the structure of the entity.There are four main factors that rating agencies look at in developing their ratings:
Character is a factor that is used to determined the quality of management in a corporation. Character includes: strategic direction, financial philosophy, whether or not they are conservative, track record, control systems and succession planning.
Capacity describes a corporation's ability to pay its obligations. This factor includes: trends, regulatory environment, position in the industry, parent support and event risk.
Collateral is the assets pledged to secure the debt. This also includes the unpledged assets of the firm.
Covenants are the limitations or restrictions placed on the borrowers' activities. There are positive and negative covenants, both of which were discussed earlier in the chapter.
Secured debt is a type of corporate bond that has some form of collateral, which is pledged to ensure that there is payment of the debt. The collateral can be either real property or personal property the bondholder has a lien against in case of default.
Another form of secured debt is Collateral Trust Bonds.With these issues, a company may have no real assets and use stocks, bonds and other securities they own in other companies as the collateral. There tend to be limitations placed on how much a company can issue of this type of debt and this applies not only in the indenture but also through various tests. Such tests include issuance tests and earnings tests.
Unsecured debt is known as a debenture bond.It is the same as a secured bond only it doesn't have the collateral pledge. The holders fall in the same range as general creditors if a default occurs. In case of default, secured debt is paid first, unsecured is paid second and if there is anything left, subordinated debenture bonds, or those held junior holders are finally paid.
Credit enhancements are a way to reduce risk for the bondholders. This entails another company guaranteeing their loans, typical through a third-party guarantee. This helps finance special projects for the parent company, which may finance at higher rates but still uses the parent company to guarantee the debt to reduce those funding costs.
Letters of Credit (LOC) are another form of enhancement. The LOC requires that the bank that issued the LOC make payments to the trustee when requested so that funds will be available for the issuer to make its payments. Even though this may reduce a layer of risk, the issuer and the firm that grants the LOC should be analyzed to ensure the bond is a solid investment.