Lyondell's Bond A Rating Of B 2 example essay topic

Lyondell Chemical Company (NYSE: LO), a global company with headquarters located in Houston, Texas, is a leading manufacturer and marketer of a variety of intermediate and performance chemicals including propylene oxide, propylene glycol, propylene glycol ethers, butane diol, toluene diisocyanate, styrene monomer, tertiary butyl alcohol and its derivative, methyl tertiary butyl ether. The company was incorporated in Delaware on November 15, 1985 as Lyondell Petrochemical Corporation, a subsidiary of ARCO. On January 25, 1989, Lyondell issued common stock to the public. Today, the company's two main subsidiaries include Equistar Chemicals LP (70.5% ownership) and LYONDELL-CITGO Refining LP (58.7% ownership), which has made Lyondell a producer of methanol and one of the largest refiners of petroleum products in the U.S. The company also operates petrochemical and polymer businesses. In addition, Lyondell Chemical Company operates throughout the world in Europe, Asia Pacific, Middle East, and Africa. Lyondell Chemical Company operates in the Chemical (Basic) Industry with other companies such as Dow Chemical, Olin and Solu tia, DuPont, and Millennium.

In 2002, the industry's total sales were $69.16 billion; the company held only 5.35% of the market with $3.7 billion in sales. Lyondell Chemical Company is operating with approximately 3,350 employees and 1,789 stakeholders. The company is calculated to have $7.448 billion in annual total assets and its market value is presently estimated at $2.189 billion. Lyondell has been under financial duress for the past two years, with reports of negative earnings.

There may be additional financial pressure on the company in 2003. In 2002, the company's reported loss increased from the 2001 reports. One explanation for the negative earning is the high raw material costs, particularly crude oil, affecting profit margin. Another explanation is high factory maintenance, which has caused the company to shut down several plants for weeks at a time. Since raw materials and energy prices are likely to remain high this year, therefore even though the company has announced price increases for several of its products, its uncertain whether these prices will be realized. The troubles facing Lyondell Chemical Company may perhaps be a reflection of the industry's struggles overall.

The industry is experiencing high raw materials and natural gas costs, a significant part of chemical company's cost structure. Yet these companies are facing difficulties raising their prices due to a weak economy and tight demands. These pressures are reducing 2003 earning estimates for most of the companies in the industry. However, an increase in earnings in 2004 looks hopeful. In addition, the remaining 41.3% of its subsidiary, Equistar Chemicals, is held evenly between Millennium Chemicals Inc. and Occidental Chemical Corporation, a subsidiary of Occidental Petroleum Corporation. The joint venture has contributed to the expansion and growth of Equistar.

Millennium has publicly announced its intentions of selling its interest in Equistar and is actively seeking buyers. Though there can be no assurance that such a sale would take place, the company does not expect the sale to affect Equistar's operations or bottom line. Recently, Equistar formed a limited partnership with Sunoco. Sunoco will purchase Equistar's propylene facility in Texas and give $190 million cash in exchange for Equistar to supply Sunoco propylene at discounted prices. Although the deal does not boost the company's near-term liquidity, it would likely limit Equistar's long-term profit potential.

Bond Issue Characteristics Call Date Call Price 05/01/04 105.438 05/01/05 103.625 05/01/06 101.812 05/01/07 100.000 05/01/08 100.000 On May 17, 1999, Lyondell Chemical Company issued unsecured bonds, ranked junior in right of payment to all senior indebtedness of company, and scheduled to mature on May 1, 2009, and valued in $1,000 face. Our bondholder purchased 100 shares of these bonds; the total face value of the purchased bonds is $100,000. The bondholder purchased the bonds on July 15, 2003 (the purchase settled July 18, 2003) at a price of $970.62 each or $97,062 total. However, the bonds accrue interest on a daily basis. This bond has accrued 77 days of interest, at a total of $2,236. The bond bears a fixed coupon rate of 10.875%, paying interest semi-annually on May 1st and November 1st.

The bond is callable, with the first call date on May 1, 2004. If the bond is called on this date, the bondholder will receive a 5.438% premium on the bond. The table to the right is the schedule for future call dates and the premium, if any, that the bondholder will receive. In our case, if the bond is called on May 1, 2004, the bondholder will receive $105,438 (excluding the coupon payment) at the call date. Moody's gives Lyondell's bond a rating of B 2. There are two aspects to this rating, the alphabetic character and the numerical character.

The 'B' puts this bond into the class with description " [bonds] generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small". The '2's imply means that within the whole class of 'B' bonds that Moody's rates, this particular bond is in the mid range. Moody's, using a universal approach to risk analysis, examines all relevant risk factors. Their methodology focuses on the issuer's long-term ability to meet debt payments, level of predictability of cash flow, how the company will perform under adverse scenarios, and sector specific analysis. Since May 14, 1999, Lyondell has been consistently assigned as a B 2 bond with Moody's.

For a brief period beginning November 16, 1999, Lyondell was listed On-Watch with Moody's for a possible upgrade, but it was reconfirmed to be a B 2 bond on April 18, 2000. S&P gives this bond a rating of B+. Similar to Moody's there are two characteristics of the rating. Having a rating of 'B' puts the bond into the class described as " [the] obligor currently has the capacity to meet its financial commitment on the obligation. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitment on the obligation" and is more vulnerable to nonpayment than the classes above BB. The '+'s ign signifies that this bond is rated relatively higher than to the majority of other bonds in category 'B'.

When S&P rates bonds, they consider "the nature of the company's business and its operating environment, evaluation of the company's strategic and financial management, financial analysis and the terms of the indenture". Lyondell has consistently been rated a B+ bond for the past five months in its monthly reports without being On-Watch by S&P for a possible upgrade or downgrade. Standard & Poors and Moody both put this issue into the second class of "speculative characteristics" bonds. However, they differ in the fact that Moody's has the bond in the middle of the class and S&P has the bond at the higher end of the class.

Moody's and S&P both use their own proprietary system, so there is no way of knowing for sure what makes the difference, but it is apparent that Moody's ratings tend to focus on a more comprehensive scope of elements affecting the bond, whereas Standard and Poor's ratings are focused more on possible outcomes affecting the bondholders. When comparing literature from S&P and Moody's, it seems that S&P puts more emphasis on financial formula factors than does Moody's. Yields and Duration To Maturity To First Call Nominal Yield 10.875% 10.875% Current Yield 11.204% 11.204% Yield to Maturity 11.5767% - Yield to Call - 21.7527% Duration 4.320719746 0.760325506 Modified Duration 4.084306446 0.684607268 We have computed the yields and duration of the Lyondell Chemicals bond, as shown in the exhibits following this report. These results are summarized in the table to the right as well as below. The nominal yield of this bond is 10.875%, which is equal to the bond's coupon rate. This indicates that the coupons pay 10.875% of the face value each year.

Because this bond makes coupon payments semi-annually, bondholders receive two coupon payments of 5.4375% of face value, or $5,437.50, every six months. The bond's current yield is represented by its current income as a percentage of the bond price. In other words, the current yield is the annual return on the dollar amount paid for a bond. The Lyondell Chemicals bond has a current yield of 11.204%, which is computed by dividing 10.875% nominal yield by its current price of $97.062. A more meaningful figure is a bond's yield to maturity, which represents the total return a bondholder will receive, provided that the bond is held to maturity. Yield to maturity is a useful evaluation tool, as it allows investors to compare bonds with different maturities and coupons.

We have calculated the yield to maturity of the Lyondell Chemicals bond to be 11.5767%. Because the settlement date of this bond does not occur exactly at a date of coupon payment, it was necessary for us to make adjustments to the time factor in this calculation, reflecting the partial holding period. Also, due to this time factor, interest of $2,326.04 accrued during the period from the most recent past coupon date to the settlement date. This accrued interest of $2,326.04 will be received in the new bondholder's next coupon payment; however, it will also be included in the total price, or invoice price, which he / she pays to purchase the bond.

A bond's yield to call represents the rate of return a bondholder would receive if he / she bought a bond and held it until the call date. Therefore, this figure is calculated by using the first call date, rather than the maturity date. The Lyondell Chemicals bond is first callable on May 1, 2004. If the bond is called on this date, the bondholder will receive a 21.7527% yield on this bond.

Volatility of a bond is measured by duration, which is measured in years. Duration is the weighted average of the term to maturity of a bond's cash flows. We have calculated the duration (to maturity) of the Lyondell Chemicals bond to be 4.3207 years. The duration (to first call) of the Lyondell Chemicals bond is 0.7603 years, which indicates less sensitivity to interest rate fluctuations, as compared to the duration (to maturity). Sensitivity Analysis Modified duration of a bond represents the change in the value of a bond that will result from a 1% change in interest rates.

According to our calculations, the modified duration (to maturity) of the Lyondell Chemicals bond is 4.0843. This indicates that the bond will increase in value by 4.0843% if interest rates fall by 1%, and decrease in value by 4.0843% if interest rates rise 1%. The price of this bond is moderately volatile to small changes in interest rates. The modified duration (to first call) of this bond is 0.6846, which indicates significantly less sensitivity to interest rate fluctuations, as compared to the duration (to maturity).

Volatility, which is represented by modified duration, is the change in price due to a change in yield. The volatility represents a bond's price sensitivity. As shown in Exhibit 3, the Lyondell Chemicals bond is more price sensitive to 1% interest changes in the 0%-15% yield range (the top left section of the price yield curve). At 16% and above, this bond is less sensitive. The percentage price change caused by a 1% interest change represents the bond's volatility.

In addition, the price yield curve on the bond to the first call date is located in Exhibit 4. The price yield curve on the bond to call is steeper than that of the price yield curve on the bond to maturity. As a result, the Lyondell Chemicals bond is more price sensitive to 1% interest changes in the 0%-34% yield range, which is a much wider range than before. At 35% and above, this bond is slightly less sensitive. It is unlikely that this high of a return will ever be realized, therefore, we can conclude that this bond is extremely price sensitive when it is analyzed based on the idea that it will be called on the first call date. This information proves valuable to the client who is concerned about how they will be affected if this bond is called before maturity.

Conclusion In the current interest rate environment, corporate bonds rated B+ are averaging approximately 10.65%. This approximation was calculated using the comparable treasury security yield of 3% and adding the B+ bond yield spread of 7.65%. The yield spread is how many points a corporate bond is above the yield of a similar treasury security. As a result, we can use the treasury yield and the yield spread to effectively estimate the yields for B+ bonds as 10.65%.

The Merge nt Manual states that the total outstanding debt on this particular bond issue is $500,000,000, but in order to buy back the bonds at the first call, Lyondell must pay a premium, which would cause them to pay out $527,190,000. In addition, if Lyondell calls these bonds and reissues bonds at the lower coupon rate, it will still lose money to the amount of $885,368 annually on coupon payments. Even though the coupon rate is lower, the company loses money because the principal amount is higher. Over all, it is unlikely that Lyondell will call the bonds because it will lose money on coupon payments and it will be taking on more debt.

According to a Moody's May 2002 report, B bonds have a 3.39% risk of default. By multiplying the success probability (0.9661) and the current yield to maturity (11.57%) we can determine that the expected return for Lyondell's issue is 11.18%. Using this number we can also ascertain the default premium. Subtracting the expected yield to maturity (11.18%) from the current yield to maturity (11.57%), we get a default premium of 39 basis points. This number reflects the company specific risk.

We recommend that investors buy this bond and current bondholders hold this bond. We base our conclusion on several factors. First, the Lyondell bond has a higher yield than other similarly rated bonds. Second, the duration of the Lyondell bond is shorter than the time to maturity. Third, the bond is B rated which means that it is not too high of a risk.

Finally, the default risk is only 3.39%. In conclusion, Lyondell Chemical Company's bond is a fair bond to purchase.