Both the issuing corporation and the investor are concerned about the rating their bond is assigned by the two major bond rating agencies—Moody’s Investor Service and Standard & Poor’s Corporation. The higher the rating assigned a given issue, the lower the required interest payments are to satisfy potential investors. This is because highly rated bonds carry lower risk. A major industrial corporation may be able to issue a 30-year bond at 5.5 to 6 percent yield to maturity because it is rated Aaa, whereas a smaller, regional firm may only qualify for a B rating and be forced to pay 9 or 10 percent.
As an example of bond rating systems, Moody’s Investor Service provides the following nine categories of ranking:
Aaa Aa A Baa Ba B Caa Ca C
The first two categories of bond ratings represent the highest quality (for example, IBM and Procter & Gamble); the next two, medium to high quality; and so on. The first four categories are considered investment grade, while bonds below that are labeled “junk bonds.” Moody’s also applies numerical modifiers to categories Aa through B: 1 is the highest in a category, 2 is the midrange, and 3 is the lowest. Thus, a rating of Aa2 means the bond is in the midrange of Aa. Standard & Poor’s has a similar letter system with + and − modifiers.
Bonds receive ratings based on the corporation’s ability to make interest payments, its consistency of performance, its size, its debt-equity ratio, its working capital position, and a number of other factors. The yield spread between higher- and lower-rated corporate bonds changes with the economy. If investors are pessimistic about economic events, they will accept as much as 3 percent less return to go into securities of very high quality, whereas in more normal times the spread may be only 1.5 percent.
Examining Actual Bond Ratings
Three actual bond offerings are presented in Table 16-3 to illustrate the various terms we have used.
Table 16-3 Outstanding bond issues
Source: Bloomberg, March 2015.
Recall that the true return on a bond is measured by yield to maturity (the last column of Table 16-3). The Coca-Cola Enterprises bonds are unsecured, as indicated by the term debenture. The bonds are rated AA−, or investment grade, and carry a price of $1,470.63. This price is higher than the par value of $1,000 because the interest rate at time of issue (7.00 percent coupon) is higher than the demanded yield to maturity of 4.72 percent in April 2015. The Microsoft bonds shown are unsecured but senior to other unsecured debt that has been issued. These bonds are rated AAA with a yield to maturity of 3.45 percent. Apple and Toyota bonds have lower credit ratings and slightly higher yields to maturity.
The bonds in Table 16-3 can be refunded if the companies desire. The meaning and benefits of refunding will be made clear in the following section.
“Open Sesame”—The Story of Alibaba and the Six Bond Tranches Finance in ACTION Managerial
One of the most memorable tales from One Thousand and One Nights is the story of Ali Baba, who opened a door to great riches with the passwords, “Open Sesame.” China’s richest man, Jack Ma, certainly knew the story when he launched the Chinese e-commerce company Alibaba.com in 1999. In September 2014, Alibaba Group Holding executed the largest initial public offering in history, raising $25 billion. Two months later, they were raising capital again in the bond market.
Alibaba provides services similar to Amazon and eBay, but its market value is greater than either one. The company’s biggest market is China, but it has aspirations to expand and compete all over the world. While the company now has other web portals for business-to-consumer and consumer-to-consumer transactions, the group began with Alibaba.com, now the world’s largest business-to-business e-commerce site. Before Alibaba.com, if you wanted to find a Chinese supplier of 5000 tiny electric motors, you needed a contact in China who could visit manufacturers to negotiate a price. Now, you go to Alibaba.com where dozens of suppliers post product availability for 500 or 500,000 units.
Alibaba’s big bond offering was for $8 billion, but the offering consisted of six “tranches.” Each tranche was a specific class of bond within the offering with a different due date and different terms. The five fixed-rate tranches were:
• $1,000 million 1.625% notes due in 3 years
• $2,250 million 2.500% notes due in 5 years
• $1,500 million 3.125% notes due in 7 years
• $2,250 million 3.600% notes due in 10 years
• $700 million 4.500% notes due in 20 years
By spreading out the maturities in the offering, Alibaba locked in its financing costs for several years. The company also issued a sixth tranche of $300 million in floating rate notes denominated in Singapore dollars.
One of the challenges faced by multinational corporations is matching financing decisions with their expected operating activities. Alibaba’s use of multiple tranches that mixed fixed-rates with floating rates, offered multiple maturities with differing coupon amounts, and promised repayments in a mix of currencies suggests a significant level of financial sophistication, either by the firm or by its investment bank.
The Refunding Decision
Assume you are the financial vice president for a corporation that has issued bonds at 11.75 percent, only to witness a drop in interest rates to 9.5 percent. If you believe interest rates will rise rather than sink further, you may wish to redeem the expensive 11.75 percent bonds and issue new debt at the prevailing 9.5 percent rate. This process is labeled a refunding operation. It is made feasible by the call provision that enables a corporation to buy back bonds at close to par, rather than at high market values, when interest rates are declining.