Bond Games

Corporate debt indentures are complex contracts that include a variety of restrictions and options. On one side, an issuing corporation can engineer game-based transactions to escape covenant restrictions or capture option value for its stockholders. On the other side, bondholders can form coalitions to resist a corporation's endeavors and capture option value for the coalition. This article analyzes several types of such strategic debt transactions. The examples show that corporate debt games can strongly influence corporate bond prices. Corporations can issue a myriad of financial claims—some pure equity, some straight debt, and some that combine elements of both. The various types of claims have embedded option features. Direct options are conveyed through specific contract provisions; indirect ones are conveyed through claims in restructuring, bankruptcy, and liquidation. The embedded options, although more or less clear in their apparent influence on pricing, can also have significant but less obvious valuation consequences. In particular, normal conflicts between issuers and investors can generate strategic trading games in which debt prices deviate substantially from their apparent option-based values even though a default is not part of the game. I show how some of these games work. I use three examples to illustrate the impact of strategic behavior on pricing—a bond indenture “freeze-out” or a defeasance alternative, a sinking-fund “squeeze,” and a forced bond conversion. The emphasis is on standard types of transactions that happen regularly in secondary corporate debt markets.Option-pricing techniques have brought an important element of realism to corporate claim pricing. Game analysis takes valuation a step further by showing how interested parties can find strategies to neutralize or capture the option features of other parties’ claims. Even fairly standard corporate bonds have indenture provisions that make strategic or game-based trading of the instruments an influence on their values. The examples in this article demonstrate how various groups can modify contingent-claim value through coordinated behavior. In each case, concerted action nullifies a contract option whose apparent value is based on uncoordinated action by dispersed investors. In some cases, a combination of strategies can be pursued. For example, a convertible bond transaction may require a freeze-out prior to a forced conversion. Conversely, a corporation’s convertible bond game can be defeated with a structured “corner.” These strategic transactions can strongly influence the values of a corporation’s bonds throughout the life of each issue.Effective management of a corporate bond portfolio requires a working knowledge of how such strategies and games work, how the trades create opportunities and risks, and what types of risks of strategic trades exist in any large corporate bond portfolio. This knowledge is particularly important because certain types of coordinated trading by the issuer or other owners can nullify indenture options that appear to offer risk protection.