220 Part 3 Financial Assets
interest rate may be reduced, the term to maturity lengthened, or some of the debt
exchanged for equity. The point of the restructuring is to reduce the! nancial
charges to a level that is supportable by the! rm’s projected cash " ows. Of course,
the common stockholders also have to “take a haircut”—they generally see their
position diluted as a result of additional shares being given to debtholders in ex-
change for accepting a reduced amount of debt principal and interest. A trustee
may be appointed by the court to oversee the reorganization, but the existing man-
agement generally is allowed to retain control.
Liquidation occurs if the company is deemed to be worth more “dead” than
“alive.” If the bankruptcy court orders a liquidation, assets are auctioned off and the
cash obtained is distributed as speci! ed in Chapter 7 of the Bankruptcy Act. Web
Appendix 7B provides an illustration of how a! rm’s assets are distributed after liq-
uidation. For now, you should know that (1) the federal bankruptcy statutes govern
reorganization and liquidation, (2) bankruptcies occur frequently, (3) a priority of the
speci! ed claims must be followed when the assets of a liquidated! rm are distributed,
(4) bondholders’ treatment depends on the terms of the bond, and (5) stockholders
generally receive little in reorganizations and nothing in liquidations because the as-
sets are usually worth less than the amount of debt outstanding.SELF^ TEST Di# erentiate between mortgage bonds and debentures.
Name the major rating agencies and list some factors that a# ect bond ratings.
Why are bond ratings important to! rms and investors?
Do bond ratings adjust immediately to changes in credit quality? Explain.
Di# erentiate between Chapter 7 liquidations and Chapter 11 reorganiza-
tions. In general, when should each be used?7-9 BOND MARKETS
Corporate bonds are traded primarily in the over-the-counter market. Most bonds
are owned by and traded among large! nancial institutions (for example, life
insurance companies, mutual funds, hedge funds, and pension funds, all of which
deal in very large blocks of securities), and it is relatively easy for over-the-counter
bond dealers to arrange the transfer of large blocks of bonds among the relatively
few holders of the bonds. It would be more dif! cult to conduct similar operations
in the stock market among the literally millions of large and small stockholders, so
a higher percentage of stock trades occur on the exchanges.
The Wall Street Journal routinely reports key developments in the Treasury, cor-
porate, and municipal bond markets. The online edition of The Wall Street Journal
also lists for each trading day the most actively traded investment-grade bonds,
high-yield bonds, and convertible bonds. Table 7-4 reprints portions of the online
edition’s “Corporate Bonds Data” section which shows the most active issues that
traded on March 6, 2008, in descending order of sales volume.
Looking at Table 7-4, you will see the coupon rate, maturity date, bond rating, high
and low prices for the day, closing (last) price, change in price, and yield to maturity.
The table assumes that each bond has a par value of $100. Not surprisingly, the high-
yield bonds have much higher yields to maturity because of their higher default risk
and the convertible bonds have much lower yields because investors are willing to ac-
cept lower yields in return for the option to convert their bonds to common stock.
If you examine the table closely, you will also see that the bonds with a yield
to maturity above their coupon rate trade at a discount, whereas bonds with a