the quoted interest rate includes a default risk premium—the greater the default risk,
the higher the bond’s yield to maturity. The default risk on Treasury securities is zero,
but default risk can be substantial for corporate and municipal bonds.
Suppose two bonds have the same promised cash flows, coupon rate, maturity, li-
quidity, and inflation exposure, but one bond has more default risk than the other. In-
vestors will naturally pay less for the bond with the greater chance of default. As a
result, bonds with higher default risk will have higher interest rates: rdr* IP
DRP LP MRP.
If its default risk changes, this will affect the price of a bond. For example, if the
default risk of the MicroDrive bonds increases, the bonds’ price will fall and the yield
to maturity (YTM rd) will increase.
In this section we consider some issues related to default risk. First, we show that
corporations can influence the default risk of their bonds by changing the type of
bonds they issue. Second we discuss bond ratings, which are used to measure default
risk. Third, we describe the “junk bond market,” which is the market for bonds with a
relatively high probability of default. Finally, we consider bankruptcy and reorganiza-
tion, which affect how much an investor will recover if a default occurs.
Bond Contract Provisions That Influence Default Risk
Default risk is affected by both the financial strength of the issuer and the terms of the
bond contract, especially whether collateral has been pledged to secure the bond. Sev-
eral types of contract provisions are discussed below.
Bond Indentures Anindentureis a legal document that spells out the rights of
both bondholders and the issuing corporation, and atrusteeis an official (usually a
bank) who represents the bondholders and makes sure the terms of the indenture are
carried out. The indenture may be several hundred pages in length, and it will in-
cluderestrictive covenantsthat cover such points as the conditions under which
the issuer can pay off the bonds prior to maturity, the levels at which certain of
the issuer’s ratios must be maintained if the company is to issue additional debt, and
restrictions against the payment of dividends unless earnings meet certain specifi-
cations.
The trustee is responsible for monitoring the covenants and for taking appropriate
action if a violation does occur. What constitutes “appropriate action” varies with the
circumstances. It might be that to insist on immediate compliance would result in
bankruptcy and possibly large losses on the bonds. In such a case, the trustee might
decide that the bondholders would be better served by giving the company a chance to
work out its problems and thus avoid forcing it into bankruptcy.
The Securities and Exchange Commission (1) approves indentures and (2) makes
sure that all indenture provisions are met before allowing a company to sell new secu-
rities to the public. Also, it should be noted that the indentures of many larger corpo-
rations were actually written in the 1930s or 1940s, and that many issues of new bonds
sold since then were covered by the same indenture. The interest rates on the bonds,
and perhaps also the maturities, vary depending on market conditions at the time of
each issue, but bondholders’ protection as spelled out in the indenture is the same for
all bonds of the same type. A firm will have different indentures for each of the major
types of bonds it issues. For example, one indenture will cover its first mortgage
bonds, another its debentures, and a third its convertible bonds.
Mortgage Bonds Under a mortgage bond,the corporation pledges certain assets
as security for the bond. To illustrate, in 2002 Billingham Corporation needed $10
170 CHAPTER 4 Bonds and Their Valuation
166 Bonds and Their Valuation
