Evaluating corporate bonds and analyzing claim holders’ decisions with complex debt structure

Abstract

Although many different aspects of debt structures such as bond covenants and repayment schedules are empirically found to significantly influence values of bonds and equity, many theoretical structural models still oversimplify debt structures and fail to capture phenomena found in financial markets. This paper proposes a carefully designed structural model that faithfully models typical complex debt structures containing multiple bonds with various covenants. For example, the ability for an issuing firm to meet an obligation is modeled to rely on its ability to meet previous repayments, and the default trigger is shaped according to the characteristics of its debt structure such as the amount and schedule of bond repayments. Thus our framework reliably provides theoretical insight and concrete quantitative measurements consistent with extant empirical research such as the shapes of yield spread curves under various firm’s financial statuses, and the impact of payment blockage covenants on newly-issued and other outstanding bonds. We also develop the forest, a novel quantitative method to handle contingent changes in the debt structure due to premature bond redemptions. A forest consists of several trees that capture different debt structures, for instance those before or after a bond redemption. This method can be used to analyze how poison put covenants in the target firm’s bonds influence the bidder’s costs of debt financing for a leveraged buyout, or investigate how the presence of wealth transfer among the remaining claim holders due to a bond redemption influences the firm’s call policy, or further reconcile conflicts among previous empirical studies on call delay phenomena.