Is this question covered in the CFA at all?
I’m doing my own research for bonds right now. I want to learn more about what appears to be subsidiaries of big firms (GM, GE, Sprint, etc.) that are issuing junk bonds. I want to know how this capital system works. Also I know nothing about bond seniority which is important for default loss…
I need some leads, looking for comments from both an academic and real-world perspective.
Well, I don’t know the details, but I believe the idea is simply to build a legal firewall between the subsidiary and the parent company. Then you put all the high-risk bonds in the subsidiary. If the subsidiary can’t pay, then it defaults, and the subsidiary goes into either liquidation or reorganization (or gets bailed out by a capital injection from the parent to avoid bankruptcy, which can probably be disguised as equity raising). Basically, it looks like a legal structure that gives the parent company an option to bail out the subsidiary or let it fail in bankruptcy without placing the parent company in danger of bankruptcy. Then you use slick marketers to convince investors that these are actually bonds of the parent company rather than the subsidiary. It’s like saying - hey, Greek bonds are just as good as German bonds, because Greece is a wholly owned subsidiary of Germany (legally separated in 1945).
Wow, this new forum is whack. cb1021, there are several ways to answer your question: 1) The bond could be held in a subsidiary as bchad said. However, I don’t agree with bchad’s comment about marketing. If the bond is held by a subsidiary with a legal firewall, that has to be disclosed in the offering memorandum that accompanies the bond issue. If that is excluded, it would be a great way for the company’s executive officers to end up in jail or at least face serious fines. bchad may have been joking anyway. Either way though, it may be tough to float a bond without some meaningful assets backing the bond – that would certainly increase the coupon investors would require. 2) Bond default can happen a number of ways – but it’s helpful to differentiate between bank debt and public bonds. They both show up as debt on the balance sheet, but the nature of the debt is much different. Public bonds are just that – bonds you can get a quote on from Bloomberg or your broker. They trade freely in the market, and the price fluctuates while the coupon remains fixed (this is the interest amount the company has agreed to pay). Publicly traded debt is much less onerous than bank debt, and a company can default (miss a payment or pay late) without automatically going into bankruptcy. For a bankruptcy to occur, the debt holders would need to make a legal motion to seize the company. Since the holders are often widely distributed (could be hundreds or even thousands of holders), it’s not that easy to make a joint motion. Secondly, the holders are incentivized to consider potential legal costs of forcing a bankruptcy – the vampire lawyers could potentially take a decent sized bite out of the value of the company (especially if it is not a pre-negotiated bankruptcy, which it almost certainly would not be). So if the bondholders expect to get paid and the coupon is merely late, the math would be to calculate the time value of money opportunity cost for the missed payment and compare that to the expected legal fees and headache. Mostly, bankruptcy would not happen in that case, though it is almost certain to happen if bondholders develop an expectation of not getting paid the coupons they are owed. Bank debt is worse (at least from an equity holder perspective) because the bank can much more easily seize the company in the event of default, and will often move very swiftly in the event of a missed payment or covenant violation. Covenants are usually things like minimum fixed charge coverage ratio, maximum debt to adjusted EBITDA leverage ratio, minimum liquidity or cash balance on hand, etc. that are pre-negotiated with the bank during the time of bank debt issuance – these are benchmarks the bank uses to evaluate a company’s financial standing. Covenants must be reported in a company’s public filings even though the debt isn’t publicly traded (although it can be in distressed cases – the bank may decide to sell the debt on the market, giving hedge funds and other participants a chance to buy the debt if they think there is value relative to a possible post-restructuring value of the company). My favorite book on the topic is Distressed Debt Analysis by Moyer. It’s pricey, but it has some extremely good case studies on bankruptcy scenarios from both a legal and a financial perspective. The CFA doesn’t cover important topics such as how the capital markets actually work.
Thanks to both of you for quick responses. I’m extremely curious these days about markets and the street-level operation side of finance, as opposed to the typical statistics-based market theory shit in all the finance textbooks. Bromion, you hit a lot of points, thanks a lot. One thing strikes me the most. If we’re talking about real life, tell me if I got this right (highly simplified, feel free to fill in gaps): assume a subsidiary issues 15 mil at 9% and suddenly skips a couple of coupon payments. The market at this time will assume that the subsidiary is “in default” of this specific debt obligation and will most likely not pay ANY future coupons nor the principle at maturity. At this time, the bond holder can take the subsidiary to court in order to try to recover assets. Based on my understanding, I have these following questions which are all independent from one another. Some are for clarification, some are for further probing: 1. A firm must default on their debt by seniority right? Bank loans have the highest seniority, so any cash available must be used to pay that obligation first. This means that junior debt is most likely to be defaulted on right? 2. Has there been a case where the firm missed a coupon payment (either by accident or insufficient cash balance), but continued to pay future payments? Assume this is a plain bond, not a deferred interest bond. 3. How do interest payment transactions look like? Is it: Firm cash balance—>broker—>investors every 6 months? Google just aint working for these questions. Thanks in advanced.
I believe every bond issue has a trustee that is the one who declares whether the bond is in default or not. So if a payment is missed, but it looks like a temporary cash flow issue that will be resolved imminently, the trustee may decide to wait to declaring default. An interesting question is whether this means that the trustee can be sued for not declaring default quickly enough. My guess is that it’s been tried, but I don’t know what the legal precedents are. I’m sure there are bonds that have missed payments but then gotten back on track before default is declared. I’m not a FI guy, but I can’t imagine that in the history of bonds (even if limited to the last 30-40 years) that’s never happened. The development of credit derivatives may have changed some of those rules - a credit event may be defined independently of whether the trustee declares default.
Yeah, feel free to ignore the statistics garbage – that stuff is all wrong. The company that misses coupons IS in default. That’s the definition of default. But default does not equal automatic bankruptcy. Usually the bonds will sell off prior to the first missed coupon because the market anticipates that the limited amount of cash on hand / weak cash flow the company has been reporting could lead to a missed payment. The scenario you outlined is correct – I don’t know the specific legal steps required, but the company’s assets are seized through the courts. A firm doesn’t default on the debt by seniority necessarily in the sense that I suppose they could choose to pay whatever coupons they wanted to pay. But practically speaking, during the restructuring process, the senior parts of the capital structure get priority and have a higher likelihood of being paid in full. The junior parts of the capital structure may get little or nothing. The equity is usually wiped out. If you buy senior debt at a low price (distressed debt), the reorganization can be an extremely profitable investment because the debt will be converted to equity in the new capital structure as the company exits bankruptcy. So if you have a good business that for whatever reason had too much debt, and that debt becomes equity, thereby wiping the slate clean, and then the company goes public or is bought by another firm at some point, you can make a large return on that. Companies have missed a coupon or been delayed but ultimately paid. I am more on the equity side, so I can’t quote a lot of examples. Seth Klarmann talks about one example in his book Margin of Safety (I think it was Texaco in the early '90s) which you can find online (there is a copy on WallStreetOasis that you should track down and read). Coupon payments depend on the nature of the debt, but what you said would be a common example. Another type is PIK notes (pay in kind), which don’t pay any interest, but accrue interest to the principal amount on a periodic basis (i.e., the amount of debt outstanding increases and that outstanding amount is paid in full at the maturity of the PIK note). There are other types as well. Mostly you have standard bonds and working capital revolvers provided by banks, which charge interest based on the amount of capital drawn down at any one time. I don’t know what the actual payment delivery method is, but it goes through some clearing house or something and ends up in the account holding the bond, which they can somehow track electronically I guess.
Yeah, feel free to ignore the statistics garbage – that stuff is all wrong. The company that misses coupons IS in default. That’s the definition of default. But default does not equal automatic bankruptcy. Usually the bonds will sell off prior to the first missed coupon because the market anticipates that the limited amount of cash on hand / weak cash flow the company has been reporting could lead to a missed payment. The scenario you outlined is correct – I don’t know the specific legal steps required, but the company’s assets are seized through the courts. A firm doesn’t default on the debt by seniority necessarily in the sense that I suppose they could choose to pay whatever coupons they wanted to pay. But practically speaking, during the restructuring process, the senior parts of the capital structure get priority and have a higher likelihood of being paid in full. The junior parts of the capital structure may get little or nothing. The equity is usually wiped out. If you buy senior debt at a low price (distressed debt), the reorganization can be an extremely profitable investment because the debt will be converted to equity in the new capital structure as the company exits bankruptcy. So if you have a good business that for whatever reason had too much debt, and that debt becomes equity, thereby wiping the slate clean, and then the company goes public or is bought by another firm at some point, you can make a large return on that. Companies have missed a coupon or been delayed but ultimately paid. I am more on the equity side, so I can’t quote a lot of examples. Seth Klarmann talks about one example in his book Margin of Safety (I think it was Texaco in the early '90s) which you can find online (there is a copy on WallStreetOasis that you should track down and read). Coupon payments depend on the nature of the debt, but what you said would be a common example. Another type is PIK notes (pay in kind), which don’t pay any interest, but accrue interest to the principal amount on a periodic basis (i.e., the amount of debt outstanding increases and that outstanding amount is paid in full at the maturity of the PIK note). There are other types as well. Mostly you have standard bonds and working capital revolvers provided by banks, which charge interest based on the amount of capital drawn down at any one time. I don’t know what the actual payment delivery method is, but it goes through some clearing house or something and ends up in the account holding the bond, which they can somehow track electronically I guess.
I’m still trying to figure out how Greece managed to “renegotiate” their loans without triggering a CDS event.
It’s good to have friends who write the laws.
Bromion, that is impressive. Well done.
Hi all.
Interesting topic.
Dont you think that defaut bonds will be further downgraded , and thus the firm might be lead to the bankruptcy?
I need some opinions.
Thank you
As a real life example, watch the bonds on Countrywide. They came damn close to defaulting earlier this year even though BoA was in no real danger of going under… In that case, BoA would have bankrupted their Countrywide subsidiary.
Another way to think about it is looking at Merrill Lynch bonds. Last I checked (it’s been a while) they trade in line with BoA debt since they’re under the same corporate umbrella. But, Merrill debt could be said to be much riskier…similar situation with Countrywide. Could be some good arbritrage opportunities there if you have the resources.