Question

Why is it that, if firms pay out cash, bondholders get hurt, when the cash is used to pay dividends to shareholders? My understanding is, that the increased risk pushes up corporate bonds (e.g. from 10% to 15%, for example), which means bondholders gain more as a result in increased risk.

Answer 1

Bondholders do not gain more with the increased risk. Since Bond Holders are entitled to the same payments (coupons and par at maturity), increased risk results in lower Net Present Value.

As you might already know, the Net Present Value of the bond investment is the Present Value of future cash flow, discounted at the required rate of return (to compensate for risk-free rate and default risk). Since the Payments does not change with increase risk, higher risk will result in higher required rate of return, and hence, lower NPV.

Answer 2

good answer jennyang.

Also here is a different way to look at it and answer it, 8hgk2 :
Firms have a limited amount of assets, Firms have a limited amount of free cash flow available. The claims on that cash are to pay (amongst others), Bond holders and Equity holders.

The more cash there is in the company, the more likely Bond holders will get paid at the maturity date of the bonds. The way they see it, they should get paid first (they rank ahead of shareholders. shareholders get paid last in the event of a liquidation).

When company management pay out more dividend, they are paying that cash to shareholders. Shareholders are happy - but Bond holders are not. There is less cash available to pay the bondholders at the (future) maturity date of the bonds. Therefore, there is a slightly increased risk that the bondholders might not get everything they are due. Less cash - more risky. More risky - less valuable is the bond I bought.

The key thing to remember here is, they are talking about existing bondholders who already purchased the bonds, when the information they had about the company was different (when it had more cash). Not how much a new bond investor would like to receive (higher yield). If the existing bondholder sells to the new bond investor, the new bond investor will offere a _lower price_ to get the higher yield. (Price and yield are inversely related).

Answer 3

Firstly, I would like to thank you both for clarifying this issue with bonds, I think I am getting the gist of it.

@jennyang87. To summarize, corporate bonds pay par at maturity plus coupon payments. Coupon payments are not reduced at all even it the default would increase, but rather the required rate of return will increase to compensate for the increase in default?

A more technical follow up question: How do debt capital market experts estimate the required rate of return on corporate debt, when corporates raise it in the capital markets? Do they look at the operating cash flow and designate a certain percentage for the amount of cash in hand? (e.g. default risk estimate)

@EdwardDeR. So, if I'm the first person to purchase tranche 1 of corporate bond MSF and MSF pays out cash to shareholders and reduces its cash at hand, then selling my corporate bond onto another person would mean he pays less for the bond than I originally paid with higher yields? Doesn't that mean that I make a loss?

Answer 4

Hi 8hgk2
"selling my corporate bond onto another person would mean he pays less for the bond than I originally paid" - yes exactly, so you would make a loss in this case.
Remember price and yield are *inversely related*
so saying: I paid $100 for a $5 coupon, at 5% YTM
and now I sold it for $90 - I made a loss
is pretty much the same as saying:
I bought the bond at 5% YTM and now I had to sell it at a discount, the new buyer is getting an 7% YTM. - I made a loss.
If you hold a bond, you make money if yields go down / if prices go up.

coming back to the original problem: if management pay out the cash reserves of the company to shareholders, then default risk goes up for bondholders, which drives the required yields up (and pushes prices down). If you bought at the original issue (before management misbehaved) then you would be showing a loss.

Answer 5

Very interesting and valuable information. I think I'm getting the bigger picture! Great help!