Optional Redemption - Corporate Bonds and Credit Agreement

Optional Redemption

Northwest Note Agreement, Section 8.2, 8.3

Petrohawk Indenture, Section 3.1-3.7, Exhibit, A, Section 5

• Redemption and Options

  • Mechanics

  • Redemption Price

• Redemption in “window”

• Little Mistakes can have Big Consequences (Problem Set 3A)

• How do courts deal with difficult provisions?

Problem Set # 3

1. Consider the Petrohawk Indenture and the Northwest Note Agreement. The Company wants to redeem/prepay $10 million in securities on January 5.

1. What is the latest day at which the Company must give notice of the redemption to the Trustee? What is the latest day at which the Company must give notice of the redemption to the holders?

• Kahan: Petrohawk:
  - Trustee: 60 days before redemption date unless trustee agrees to short notice
  - Holders: 30 days before redemption date

Optional Redemption

• Back go indentures and private placements

• Optional redemption/ prepayment, call

  • Different from revolving loans, bonds may not be redeemed

• Notice

  • To trustee

    • Petrohawk 3.1 Notice to Trustee “The Company shall give each notice to the Trustee and the Registrar provided for in this Section 3.1 at least 60 days before the Redemption Date unless the Trustee consents to a shorter period”

  • To holders

    • Petrohawk 3.3 Notice to holders for redemption “At least 30 days but not more than 60 days before a date for redemption of Securities, the Company shall mail a notice of redemption by first-class mail to each Holder of Securities to be redeemed at such Holder's registered address… Notice shall identify the Securities to be redeemed and shall state…

      • (4) that Securities called for redemption must be surrendered to the Paying Agent to collect the Redemption Price;

      • (6) that, unless the Company defaults in making such redemption payment, interest on Securities (or portion thereof) called for redemption ceases to accrue on and after the Redemption Date;”

      • Notice provision doesn’t contain any substance, the underlying substance must come from somewhere else

      • Notice shall state something doesn’t mean they are in fact correct should have another section to say (4) and (6)

2. By what method does the trustee select the Securities to be redeemed?

• Petrohawk: pro rataa

• Selection (in partial redemption)

• Petrohawk

  • 3.2 Partial redemption: if not all bonds are redeemed, trustee choose the bonds to be redeemed, size of notes being redeemed

  • 3.4 Effect of Notice of redemption cannot go back co. needs to deposit security price trustee issue new security for the rest

By what method are notes selected for prepayment under the Northwest Note Agreement?

• Allocate outstanding amount in proportion to respective unpaid principal amounts. First apply to payment due at final maturity, and then to any required prepayment closer to maturity

• 8.3 Allocation of Partial Prepayment “In the case of each partial prepayment of the Notes, the principal amount of the Notes to be prepaid shall be allocated among all of the Notes at the time outstanding in proportion, as nearly as practicable, to the respective unpaid principal amounts thereof not heretofore called for prepayment. Each partial prepayment pursuant to Section 8.2 shall be applied first to the payment due on such Notes at final maturity and thereafter to any required prepayments on such Notes, in inverse order of maturity.”

3. Assume that all securities are still outstanding; in the case of Petrohawk, that the trustee selects securities pro rata; and in the case of Northwest, that the yield referred to in (i) of the definition of Reinvestment Yield is 6.6%. Tamara holds $350,000 principal amount of securities. How much will she receive on the redemption/prepayment date?

Redemption price + accrued interest

How to calculate the Optional Redemption Price

• Petrohawk: 3.7 “Redemption Prices (expressed as percentages of the principal amount) plus accrued and unpaid interest on the Securities” Redemption price plus accrued interest

  • Accrued interest calculated based on 30 out of 360 days (1 month)

  • Where does schedule come from?

    • Redemption price - Security s.5 (standard practise)

    • Interest/ coupon rate of Petrohawk: 7.25%

    • 2014: 103.625%

    • 2015: 101.813% half of 3.625, of coupon rate

    • 2016 and thereafter: 100.000%

• Economics of redemption

Basics of Discounting

• Assume you receive money 1 year from now, 2 years from now, 3 years from now… n years from now. These cash flows resemble promised payments on a bond with annual interest and maturity in year n (we will ignore the fact that bonds pay interest semi-annually and pretend they pay interest annually)

• E.g. Bond X matures in 5 years with coupon rate 7%, maturity value $1,000, discount rate 5%

  • Cash flow:

    • Year 1 = 70 (7% of 1000)

    • Year 2 = 70

    • Year 3 = 70

    • Year 4 = 70

    • Year 5 = 1070 (maturity value + interest)

• Present Value and Yield

  • To obtain the present value of the bond, which should be about equal to its price, we discount by dividing future cash flows by (1+d)ⁿ

    • d = the discount rate

    • n = the year when you get the money and adding them up.

    • E.g., the $70 in year 3 would be discounted to $70/(1+d)³.

  • Present Value of the bond: Cashflow / (1 + discount rate)ⁿ

    • Year 1 = 70/ (1+0.05)^1 = 70/ 1.05^1= 66.67

    • Year 2 = 70/ 1.05^2 = 70/1.025 = 68.29

    • Year 3 = 70/ 1.05^3 = 70/1.58 = 60.47

    • Year 4 = 70/ 1.05^4 = 70/1.216 = 57.59

    • Year 5 = 70/ 1.05^5 = 1070/1.28 = 838.37

  • PV of the Bond: $66.67 + $63.49 + $60.47 + $57.59 + $838.37 = $1,086.59

    • If you have the price, the yield of a bond is the discount rate at which the present value of the future cash flow equals the price

  • Yield and (economically correct) discount rates for corporate bonds are determined by two components:

    1. the yield on treasury securities (market interest rates) and

    2. the “risk premium” of the borrower.

  • When bonds are issued for the first time, they are typically sold for par 100% (or close to it), i.e. the price is (approximately) equal to the principal amount (par).

• Yield/interest rate when the price is par

  • When the price of a bond is equal to par, then the yield of a bond is equal to the interest rate (or coupon rate).

  • E.g.: $70/(1+.07)^{1 +} $70/(1+.07)^{2 +} $70/(1+.07)^{3 +} $70/(1+.07)⁴ + $1,070/(1+.07)⁵ = $1,000.

  • Try this for other numbers and you will see it always holds.

  • When the discount rate/yield is higher than the coupon rate, the price is less than par.

    • Divided by a higher number would be less than $1000

  • When the discount rate/yield is lower than the coupon rate, the price is more than par.

  • Higher yield lower price; lower yield higher price.

  • Yield = how much you earn earn more paid less

• Redemption at a fixed price

  • Assume a company can issue new bond with a yield of y (i.e. issue new bonds at par with an interest rate to y).

  • Should the company redeem outstanding bonds that have a coupon of interest rate > yield (i > y)

    • [company would only want to replace a bond with higher interest rate with a lower interest rate].

  • This depends on how much the company would need to pay to redeem the bonds.

  1. If it can redeem the bonds at par the answer is simple: yes.

     • Pay par upon redemption, issue new bonds at par (to finance the redemption payment) and lower your interest rate from i to y.

  2. But assume that company has to pay 103% of par to redeem the outstanding bonds?

     • Intuitively, redemption now only makes sense if y is sufficiently lower than i.

     • Specifically, assuming (for simplicity) that redemption is a “now or never” decision, calculate the present value of the outstanding bonds using a discount rate d = y. If the present value exceeds 103% of par (or whatever the amount you need to pay to redeem) redemption is economically beneficial to the company (and detrimental to the holders).

     • Revolving credit agreement is different from bonds

       • Revolving credit – interest rate is not fixed, changes everyday

       • Bond – long term debt with fixed interest rate

     • Company can re-finance bond by calling old bonds, paying redemption price, refinancing old bonds by issuing new bonds with lower interest rate save difference in interest, enough to compensate the premium

     • Why not look at the market price reflect the PV of outstanding bond?

       • Market price also including the fact that the co. has redemption option should never exceed 103%

       • We want to know the PV assuming the bond is not redeemable

     • Recall that, when the outstanding bonds were issued, the required yield = i. fixed price redemption thus becomes beneficial to the company if, since such issuance, the yield the company needs to pay declined, either because market interest rates declined or (less commonly) because the company’s risk premium declined.

• Present value (PV) at time T = expected cashflow in period T/ (1+ interest)^T

• Value = PV at T1 + PV at T2 + PV at T^n

  • Economically correct discount rate: take each cash flow, interest rate that you could get on a risk-free bond that pays cash at the same amount of time

  • Present value of the bond: divide future cash flows by (1+d)ⁿ

    • d = discount rate

    • n = no. of years

  • Yield and interest rate are mostly identical at issuance if bond issued for par

    • When yield > interest price = less than par

      • Cashflow worth less as it would be divided by a higher no. (less than 1000)

    • When yield < interest price = higher than par

      • Divided by a smaller no. result = higher

  • If PV of outstanding bond > 103% of par (premium + 100%) redemption is a good deal for company (existing bond cost more than 103%)

• When does it pay to redeem?

  • Yield drops because risk premium declines or market interest rate declines

  • Market interest rate change by a lot more than co.’...