Advantages to issuers
Studies about the century bonds that have been issued indicate some common characteristics about their issuers. To begin with, these bonds do not have sinking fund requirements [1]. This is an indication that the firms issuing such bonds are large institutions, exhibiting more publicly available information and, therefore, low information asymmetry. At the same time, a sinking fund requirement could effectively reduce the maturity of such a bond, contradicting the original intentions of issuing such a long-term debt. Studies such as Diamond [5], [6] and Stiglitz & Weiss [7] indicate that firms have incentives to issue debt with longer maturity when liquidity risks are low. Again, large firms tend to have lower liquidity risks and should be able to issue debt with long maturity to reduce the cost of refinancing. Finally, for investors to participate in such a long-term borrowing the company issuing the bond should be credible, and therefore, have a low default risk. Using the debt-to-equity ratio to measure the default risk of a company, we reach again the conclusion that large firms are more likely to obtain such long-term financing.
The main reason behind issuing such long-term debt is taking advantage of low interest rates appearing in the credit market, while matching the asset base. An interesting fact is that century bonds offer tax benefits to their issuers. To illustrate the importance of these benefits, we can take into account the fact that approximately 82% [2] of the companies that have issued such bonds included an option to either redeem or shorten the maturity of the century bonds if there would be any change in tax laws to eliminate the tax deductibility of the interest payments of these bonds.
The “Sleeping Beauty” bonds
The Disney “Sleeping Beauty” bonds pay 7.55% in annual interest, with the principal to be repaid in the year 2093. Therefore, each $1,000 bond would entitle its owner to $7,555 in interest over its life. From this perspective, it seems that investing in these bonds is a great opportunity for whoever would be willing to bear the risk of such a long-term debt. However, there is a point of great differentiation in the Disney bonds, compared to other long-term debts such as the Coca-Cola bonds - the 1993 Disney bonds have a 30-year call provision, meaning that Disney can buy back the bonds in 2023. The callable nature of the bonds is discussed in the following section.
Pricing of callable bonds
As described above, the Sleeping Beauty bonds are callable - the company can “call” the bonds after 30 years if the prevailing interest rates are low, and replace them with a cheaper issue. To estimate the value of such a bond with an embedded option, we can use the Binomial Option pricing model, using the term structure volatility of interest rates to construct the Interest Rate Tree [4]. By using risk neutral valuation, we can back out the value of the bond. The method is described in detail in the Appendix (Exhibit 3). Since a callable bond offers optionality to the issuer – it is priced lower than a non-callable bond with the same maturity and coupon structure.
Evolution of the century bond market - Conclusion
After May 1998, deal pace for century bonds fell off quickly and since then there have been only nine deals. However, nowadays, we can expect a resurgence of such bonds as big institutions will take advantage of investor demand for higher-yielding investments against a backdrop of record-low interest rates in Europe and the US. In fact, recently, the Government of Mexico, the University of California and MIT have been able to release century bonds for which the offered yield was significantly higher than the 30-year U.S Treasury rate (around 1.50% higher).
Thus, we see that 100-year bonds, when properly managed, can form a beneficial component of many investment portfolios. Therefore, we conclude that the issuance of century bonds is not a novelty but a long term trend with specific advantages to both investors and issuers.
Appendix
Exhibit 1: Century bonds issued in the 90s
Exhibit 2: Comparing an 100-year with a 10-year bond
Exhibit 3: Callable bond valuation using a Binomial Tree Model
The Binomial Option pricing Model can be used to estimate the value of a Callable bond. To use this model, we first construct a Binomial Interest Rate tree.
Figure 1 Interest Rate tree for Binomial valuation
To find the rates R11 R12 R22 etc., we can use the following information:
1. We know R0, the current 1 year rate
2. The up and down moves are related by the interest rate term structure. Specifically, if the interest rate volatility is σ, R11 = e2σ R12.
3. The rates Rij can be thus be found iteratively such that the average discounted present value is the value (Vk) of the previous node by starting with V0 = 100 (since we used the 1 year rate at step 1).
Now that we have the interest rate tree, we can value a bond by simply filling in the terminal payoffs and backing out the present values. For the Sleeping Beauty bond, we can make a 100 period tree like this. To add the callable property, we evaluate all nodes at depth 30 and “call” the bonds when V30j > 103.02, and V30j = 103.02. The backed out present value thus obtained will give us the value of the callable bond.
Exhibit 4: Cover Sheet
References
[1] The Call, Sinking Fund, and Term-to-Maturity Features of Corporate Bonds: An Empirical Investigation, Karlyn Mitchell, University of Washington
[2] Century Bonds: Issuance Motivations and Debt versus Equity Characteristics, Kam C. Chan,
Lubin School of Business, Pace University
[3] Who should buy long term bonds, John Y. Campbell and Luis Viceira, Harvard University - Harvard Business School
[4] A Model for Valuing Bonds and Embedded Options, Andrew J. Kalotay, George O. Williams, Frank J. Fabozzi, Financial Analysts Journal
[5] Debt maturity structure and liquidity risk, DW Diamond, The Quarterly Journal of Economics
[6] Seniority and maturity of debt contracts, DW Diamond, Journal of Financial Economics
[7] Credit rationing in markets with imperfect information, JE Stiglitz, A Weiss, The American economic review