Suppose a company decides to issue bonds at $1000 par value with $50 annual coupon (5% yield). Suppose these bonds were considered "investment grade" when issued. Suppose the company subsequently decides to engage in risky and questionable activities with the aim of making the bonds unattractive. The bonds are subsequently downgraded and become junk bonds. As a result of the junk status, investors on the secondary market demand an increased yield of 8%, so the bond sells for $625 ($50 ÷ 0.08 = $625) on the secondary market. The company, now having an opportunity to retire debt at a price lower than par, buys as many bonds as it can. For each retired bond, the company gains $375 ($1000 - $625 = $375) as a result of the downgrade to junk status. This benefits shareholders at the expense of the bondholders.

My concerns are:

  • Can the situation above happen? Are companies able to deliberately cause a drop in bond prices in order to retire debt at a low cost?
  • As a bond investor, how do I protect myself against such situations? The board of directors represents shareholders but not bondholders.

Your yield calculations are oversimplified, but that's not the point of your question. The question is - could a company buy back it's debt for a discount and screw over bondholders.

It would be highly unlikely. There are some assumptions that would have to be made in this scenario:

First, the company would need to have the cash on hand to buy the bonds. If the company had that kind of cash, it's unlikely that the bonds would be downgraded in the first place, since the price of a bond mostly reflects the companies ability to repay the debt. With that much cash on hand, the risk of default would be very small.

Second, the buyback would require willing sellers (companies cannot forcibly prepay bonds without some sort of call option which is almost always done at or above the par value). Now you could argue that sellers would misled into thinking that their bonds are now worth less than they are, but they would still have to agree to sell their bonds back.

Third, it would probably not be in the company's best interest to buy back the debt. Debt is typically the cheapest form of financing, so the company would almost certainly be better off reinvesting that money in the company to get a higher rate of return than what they're paying on the debt. At worst, they could just use the cash to continue paying on the debt rather than prepaying it. Credit downgrades also hurt other aspects of the company's financing, including getting favorable credit terms with vendors, lines of credit for day-to-day operations, etc. So it's not something that only affects bond prices.

As a bond investor, how do I protect myself against such situations?

Don't sell your bonds if you think that they are worth more than they actually are. Your only risk at that point is default, which would be catastrophic for a company.

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