3. Debt Financing
Warning
This workbook is the product of, and copy-
righted by, Citibank N.A. It is solely for the
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used for any other purpose. It is unlawful to
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Please sign your name in the space below.
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INTRODUCTION: DEBT FINANCING
COURSE OVERVIEW
This workbook provides a broad introduction to the debt markets, the participants in
the markets, and some of the more common securities being issued and traded. The
student completing this course will gain a basic working vocabulary of the key terms
currently being used in the debt markets. Because this is an introductory course, we
will cover a wide range of topics without going into great detail. Additional study
will be necessary to gain a more complete knowledge of debt securities and the
markets in which they are traded.
UNIT 1: Fundamentals of Debt Financing
Types of markets in which debt securities are traded are presented in the first
unit. Some of the more common features found in debt securities are also
introduced, including the provisions for making interest payments and repaying
the principal. The unit also discusses different types of securities, based on the
backing that the issuer provides for the bonds. The main focus is to introduce
key terms and ideas that will be helpful in evaluating securities.
UNIT 2: Raising Debt Capital
Unit Two provides a discussion of the processes necessary to issue debt
securities. Relative advantages and disadvantages of several methods for raising
debt capital are discussed. These methods include a public offering of debt, a
private offering, and securing a bank loan. Costs associated with each method
are also presented. Once again, the unit focuses on introducing key terms and
processes.
UNIT 3: Valuing Debt
The third unit focuses on the mathematics associated with debt instruments. The
student learns how to calculate the appropriate yield of an instrument and how to
compare the yields of different instruments. Formulas are provided for estimating
an instrument's market price and the accumulated interest of an interest-bearing
security. The unit concludes with an introduction to the concepts of duration and
convexity and describes their applications. The student will find a financial
calculator useful in making the required calculations.
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UNIT 4: Debt Instruments
Some common debt securities are described in Unit Four. The securities are
grouped according to their relative maturity. Some more complex securities are
also discussed, including equity-linked debt instruments. The discussion of each
security includes typical issuers of the security, common investors buying the
instruments, and methods for pricing the securities. This unit focuses on building
a useful vocabulary and developing an understanding of the securities.
UNIT 5: Derivative Securities
The last unit provides an introduction to some common derivative securities,
including options, swaps, and forward agreements. Brief descriptions of each
security and the types of market participants who might use each type of security
are presented along with reasons for their use. This unit is included so that
students not only can begin to understand how debt, equity, and derivative
securities are linked together, but also how investors can hedge the risk created
by investing in one security by investing in another security. This unit briefly
touches on some of the characteristics of derivative securities. For a more
thorough discussion of these instruments, you should refer to the appropriate
Citibank self-study course.
As mentioned earlier, this course is designed to introduce a wide range of topics
with a brief discussion of each. Additional study will be necessary to gain a more
complete understanding of debt securities, how they are issued, and how they are
evaluated by investors. Students should focus on learning the basic terms and
understanding the concepts behind the calculations and relationships discussed in
the workbook.
COURSE OBJECTIVES
When you complete this workbook, you will be able to:
Understand the fundamentals of debt markets, the participants, and the
securities being issued and traded
Understand some of the more common features found in debt instruments
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Understand the basic mathematical calculations necessary for pricing
debt securities, finding the appropriate measure of yield, and finding the
accumulated interest on a coupon-paying instrument
Describe the features of some of the more common debt instruments,
grouped according to their relative maturity
Identify some complex securities that combine debt and equity features
Identify some common derivative securities, and describe their
characteristics and uses
THE WORKBOOK
This self-instruction workbook has been designed to give you complete control
over your own learning. The material is broken into workable sections, each
containing everything you need to master the content. You can move through the
workbook at your own pace, and go back to review ideas that you didn't
completely understand the first time. Each unit contains:
Unit Objectives – which point out important elements in
the unit that you are expected to learn.
Text – which is the "heart" of the workbook
where the content is presented in detail.
Key Terms – which also appear in the Glossary. They
appear in bold face the first time they
appear in the text.
Instructional
Mapping –
terms or phrases in the left margin which
highlight significant points in the lesson.
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✔ Practice Exercises
and Progress
Checks –
help you practice what you have learned
and check your progress. Appropriate
questions or problems are presented at
strategic places within Unit Three and at
the end of all units. You will not be
graded on these by anyone else; they are
to help you evaluate your progress. Each set
of questions is followed by an Answer Key.
If you have an incorrect answer, we
encourage you to review the corresponding
text and then try the question again.
In addition to these unit elements, the workbook includes the:
Glossary – which contains all of the key terms
used in the workbook.
Index – which helps you locate the glossary
item in the workbook.
This is a self-instructional course; your progress will not be supervised. We expect
you to complete the course to the best of your ability and at your own speed. Now
that you know what to expect, you are ready to begin. Please turn to Unit One.
Good Luck!
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UNIT 1: FUNDAMENTALS OF DEBT FINANCING
INTRODUCTION
In this unit, you are introduced to basic concepts that will help you understand the use of
debt as a source of capital and as an investment vehicle. We discuss the sources of debt
capital — bank financing and debt markets — and describe how debt financing is arranged
from each source. We introduce two key considerations for any debt agreement: how debt
is paid off and how security is provided for a loan.
UNIT OBJECTIVES
When you complete Unit One, you will be able to:
n Identify two sources of debt capital for a company
n Recognize the major types of debt markets and the types of transactions that
occur
n Identify the factors that affect the interest rate borrowers pay for debt capital
n Recognize the conventions for paying interest and repaying principal
n Recognize two methods for classifying debt
KEY TERMS
Let's begin by defining some key terms that we will use throughout the course. You will
find it helpful to familiarize yourself with them now.
Basis Point One one-hundredth of one percent (0.01%). Fifty basis points equal
1/2 of one percent. A basis point is sometimes referred to as a "tick."
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Loan A debt agreement between two parties: a borrower and a lender
Principal The amount of money the lender provides for the borrower to use;
also known as the face value, or par value, of the security
Maturity Length of time in days, weeks, months, or years before a loan or a
debt security becomes due for repayment. The total length of time
that the agreement is in force is sometimes called the security's
"term" or "tenor."
Bond A debt agreement in the form of a security issued by a company or
a unit of government. The issuer promises to pay interest on the
principal over the maturity of the bond and repay the principal when
the bond becomes due.
Note A debt agreement in the form of a security issued by a company or
unit of government with a maturity of one to five years
Because notes are similar to bonds in every aspect except maturity,
analysts often group notes and bonds together when referring to
debt securities.
WHAT IS DEBT FINANCING?
Definition of
debt financing
Debt financing is a major source of capital for most firms. Debt
financing occurs when:
n Investors provide capital in the form of loans for the managers
of a company to use to operate the business
n The company, in return, promises to repay the capital to the
investors plus a rate of interest for the use of the capital
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SOURCES OF DEBT CAPITAL
Debt markets
and bank
financing
Debt markets and bank financing are the two primary sources of debt
capital. In bank financing, the company and the lending institution
negotiate a debt agreement directly. In debt markets, the company
issues securities representing the loan for investors to purchase.
There are many types of debt securities with different structures and
maturities. Most debt financing transactions take place through the sale
of marketable securities (such as notes or bonds) or the sale of a
securitized instrument (discussed later in this unit).
Debt Markets
To give you an overview of debt markets, we will introduce the
participants and the types of debt markets, and discuss how securities
are traded.
Participants
The major participants in debt markets are the same as those in equity
markets: issuers (borrowers) and investors (lenders). These two
parties may contact each other directly (i.e., when a company borrows
money from a bank) or the two parties may use a financial
intermediary (broker or dealer) when the issuer wishes to raise
capital by selling securities to investors.
Issuers sell
marketable
securities
Technically, an issuer of debt is any entity that borrows capital in the
debt markets. However, general practice reserves the term "issuer" for
companies that sell marketable securities in debt markets. You would
not call an individual who borrows money to build a home an issuer, but
you would call a corporation selling bonds to fund the expansion of its
business an issuer.
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The largest issuers in the debt markets are companies, corporations,
governments, and government agencies. Together, these groups account
for nearly all of the debt securities sold to investors, either directly or
through intermediaries. We will discuss the process for issuing
securities in Unit Two.
Investors lend
capital to the
debt markets
An investor is any entity that loans capital in debt markets. Investors
may loan money directly on specific terms negotiated with the
borrower, as a bank may do for an individual buying an automobile, or
investors may provide capital by purchasing the securities issued by a
company or a government.
The largest investors in the debt markets are institutional investors —
including insurance companies, mutual funds, pension funds, and banks.
Institutional investors provide the majority of the capital raised in debt
markets. Individual investors are also important sources of capital, but
they have less influence than institutional investors over market activity.
Wholesale /
retail markets
The wholesale (institutional) market refers to the purchase of
securities by institutional investors. The retail market focuses on
individual investors.
Targeting
a market
Sometimes, issuers will target a specific market to sell their
securities. If a company wishes to generate name recognition, it may
target the retail market so that its securities are placed with many
investors. A company issuing a complicated security may target the
wholesale market to take advantage of the high degree of
sophistication of institutional investors.
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Types of Markets
While there is no classification system for global debt markets, there
are some commonly used conventions. From the perspective of a
given country, analysts usually divide the global debt market into
two groups: national markets and international markets. This
classification is based on the location of the debt issuer relative to
the country where the investor resides.
Internal debt
market
1. National Markets
The national debt market is often called the internal debt market —
the market where debt instruments are being traded within a country.
The national market has two parts: domestic market
and foreign market.
n Domestic market
In the domestic market, securities are issued by companies
based in the country where the securities trade. For example,
a Mexican company issues peso-denominated bonds. If these
bonds are traded in Mexico City, they are part of the Mexican
domestic market.
n Foreign market
In the foreign market of a country, a company based outside
that country issues securities in that country. For example,
yen-denominated bonds issued by a Mexican company and
traded in the Tokyo markets are considered foreign bonds.
Foreign bond
nicknames
Foreign bonds may have specific nicknames, i.e., analysts call
the bonds in our example Samurai bonds. Dollar-
denominated bonds issued by non-U.S. companies trading
in the U.S. are called Yankee bonds. Foreign bonds in the
United Kingdom are known as Bulldog bonds; in Spain they
are called Matador bonds; in the Netherlands, Rembrandt
bonds.
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Foreign bond
regulation
Most national governments regulate the issue of securities by
companies outside the country. Usually their rules specify the:
n Types of securities that may be issued
n Size of the issue
n Waiting period for the issue
n Credit standard for the issuer
n Standard for information disclosure
n Possible restrictions on the types of institutions that
may underwrite the issue. (For more information about
underwriting, see Unit Two in the Equity Financing
workbook.)
As markets become more global and efficient, and investors
become more sophisticated, governments are gradually
eliminating these regulations.
2. International Markets
Euromarket The international debt markets may be referred to as the external
debt markets or offshore markets. However, the most common
name for the international markets is Euromarket. International
market issues can take place in any location, although London is
the most important issuing market. Most Euromarket issues are
listed on the London or Luxembourg exchanges. These markets
are not subject to the direct control of any government.
Classified by
currency of
issue
The Euromarket is divided into groups based on the currency
in which the issue is denominated. For example, a Eurobond
denominated in Japanese yen is referred to as a Euroyen bond
issue; dollar-denominated bonds are called Eurodollar bonds.
Eurodollar bonds represent the largest share of this market, but
other important currencies include the Deutschemark, British
pound sterling, Dutch guilder, Swiss franc, Japanese yen, Canadian
dollar, and European Currency Unit (ECU).
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Key features
of Eurobonds
Several features distinguish Euromarket bonds.
n An international syndicate of investment banks usually
underwrites the issue and offers securities to investors in
several countries at the same time.
n Euromarket issues generally do not fall under the jurisdiction
of any single country and have relatively few regulations for
investors or issuers. This is a great advantage to issuers
because the Euromarket enables companies to avoid many
of the foreign market regulations mentioned earlier.
n International bonds are issued in an unregistered, or bearer,
form. This is an advantage to investors seeking tax avoidance,
since the investor's identity is not listed anywhere.
Consult Unit One in the Equity Financing workbook for more
information about bearer shares and listing an issue on a
particular exchange.
Trading Debt Securities
Types of
transactions
There are two types of transactions in debt markets:
1. Primary market transactions take place when an investor
provides capital to a borrower in return for an agreement outlining
the payment of interest and the repayment of the principal.
Primary market transactions directly affect the capital structure
of the borrower.
2. Secondary market transactions take place when investors
buy and sell debt securities in the open market with other
investors. Secondary market transactions have no direct effect on
the original issuer of the security.
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Location of
markets
There is no single clearinghouse that processes debt security trades.
Most open economy countries have at least one market where debt
securities may be bought and sold (provided the specific security is
listed on that exchange).
The major debt markets have a large number of sophisticated investors
that participate in the buying and selling of the securities. There are
relatively few regulations for investors and issuers. The largest debt
security markets are found in New York, Tokyo, Frankfurt, London,
Zurich, and Amsterdam. As mentioned earlier, most Eurobond issues
are listed in London, but some trade in Luxembourg.
Multiple market
issues and
listings
With the growth of the Eurobond market, many companies issue debt
in several markets simultaneously. Investors sometimes are able to
trade a single security around the clock because that security may be
listed in Tokyo, New York, and London. U.S. Treasury instruments are
examples of securities traded in more than one market. The investor
simply buys or sells in the market that is open at the time
the trade is desired.
In this section, we presented an overview of the primary and secondary,
national and international debt markets. The other source of debt
capital is bank financing.
Bank Financing
Direct
agreement
Bank financing is a loan arrangement between a company and a lending
institution. The two entities negotiate the maturity of the loan, the
interest rate, and the payment schedule. Sometimes the agreement
involves a syndicate, or group of banks, in order to spread the risk.
Easier to
renegotiate
Banks require the company to have collateral (an asset that is used to
secure the loan), but this requirement often is negotiable. If a company
is having trouble meeting its obligations, it usually is easier to negotiate
new terms for bank financing than for issued securities. This flexibility
results from the ongoing relationship between the bank and the company.
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More costly
to borrower
Generally, bank financing is more costly to the borrower than a public
issue in the national or Eurobond markets because the bank requires a
higher interest rate to compensate for the perceived illiquidity (lack
of a secondary market where the bank could sell the loan to another
investor) and default risk. Small, lesser-known companies rely on bank
financing to provide debt capital until they are able to access the debt
securities markets.
PROVISIONS FOR PAYING OFF DEBT
Let's shift our focus from how companies access debt capital to how
they repay the debt. The terms of a debt agreement specify the manner
in which the borrower will repay the investor for the use of the capital.
Debt agreements require the borrower to:
n Make interest payments in return for the use of the funds
n Repay the borrowed principal
First, let's look at the factors that determine interest rates and the
types of interest payments that may be made.
Interest Payments
An issuer must pay the investor for the use of borrowed funds. An
interest rate is used to calculate the amount of interest the borrower
must pay.
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Determining the Rate of Interest
Factors affecting
the interest rate
The rate of interest a firm pays depends on several factors, including the
real risk-free rate, expected inflation, credit standing of the issuer, and
length of time the funds are borrowed.
n Real, risk-free rate
The base component of interest rates, the real, risk-free rate,
is determined by the conditions of the economy and the time
preference of consumers for current-versus-future
consumption. The real, risk-free rate is difficult to isolate from
other factors, but most researchers believe that it has fluctuated
between 2% and 4% in recent years.
Analysts often use the interest rate paid on short-term U.S.
Treasury securities as an approximation for the real, risk-free
rate.
n Expected inflation
Expected inflation is an important factor affecting the general
level of interest rates. Investors' expectations concerning the
future level of inflation in an economy often influence current
interest rates.
n Credit standing
Another influential factor in determining the rate of interest an
issuer will pay is the credit standing of the issuer. Companies
and units of government that are rated as good credit risks pay a
lower rate of interest on borrowed funds, all other factors being
equal.
Several services rate the creditworthiness of companies. In
U.S. markets, the two major companies providing credit
rating services are Standard & Poor's and Moody's.
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n Length of time the funds are borrowed
The length of time funds are borrowed also affects the interest
rate. Companies that borrow for 30 years pay a different rate
than companies borrowing for 30 days, all other factors being
equal.
The relationship between short-term and long-term rates is
called the yield curve. For a more thorough discussion on the
relationship between interest rates and their determination,
consult the self-study course on corporate finance or any
finance textbook.
Benchmark
interest rates
Many issuers and investors use key interest rates as benchmarks to set
interest rates on their agreements. These include Treasury yield, U.S.
prime lending rate, federal funds rate, and international benchmark rates.
n Treasury yield
The rate of interest earned on U.S. Treasury securities is one
important benchmark rate. Often referred to as the Treasury
yield, it is usually quoted with the maturity (e.g., the six-month
Treasury yield). Investors consider this rate a good proxy for a
risk-free rate because they consider the U.S. Government to
have no default risk.
n U.S. prime lending rate
This common benchmark rate is the short-term rate of interest
U.S. banks charge their best, or "prime," customers.
n Federal funds rate
Most governments require banks to maintain a minimum
percentage of deposits on reserve. Banks that find themselves
temporarily short on reserves can borrow reserves from banks
that have excess reserves. The interest rate charged on these
short-term loans is called the federal funds rate. This rate is
also used as a benchmark for other types of loans.
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n International benchmark rates
There are other important interest rates outside the U.S. market.
The London Interbank Offer(ed) Rate (LIBOR) is the rate at
which Eurobanks lend money to each other in the Eurodeposit
market. LIBOR is the most common benchmark used in the
Euromarkets. The London Interbank Bid Rate (LIBID) is the rate
of interest paid on interbank deposits in London in the
Eurocurrency market. LIBID is a few basis points lower than
LIBOR and is used less frequently as a benchmark. Other
benchmarks include HIBOR (Hong Kong Interbank Offer Rate)
and SIBOR (Singapore Interbank Offer Rate), although they are
much less common than LIBOR.
Determining Interest Payments
Calculations Having set the interest rate, the interest payment is calculated by
multiplying the rate of interest by the principal of the loan. For example,
a loan with a principal of $100,000 and annual interest rate
of 7% requires a $7,000 interest payment each year the loan agreement
is in force. For debt securities, such as bonds, this interest payment is
called a coupon and the interest rate is referred to as the coupon rate.
Payment
conventions
There are three standard ways for the borrower to pay interest to the
lender: fixed rate payment, floating rate payment, and no interest
payment (discounted securities).
1. Fixed Rate Payment
In some loan agreements, the borrower and investor agree on
the rate of interest at the time the agreement is entered. If the
rate of interest remains the same for the entire maturity of the
loan, it is a fixed-rate loan. The borrower makes a periodic
interest payment at a fixed rate during the time the agreement is
in effect.
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2. Floating Rate Payment
Some loan agreements charge a rate of interest that changes
over the period of the agreement. Such loans are called floating
rate loans. The interest rate is based on a benchmark, such as
the Treasury yield or LIBOR, plus a premium based on the
creditworthiness of the borrower. The premium is usually
quoted as a number of basis points or additional percentage (3-
month LIBOR plus 60 basis points or 6-month Treasury plus
2%). The agreement may set the interest rate at the beginning
of the interest-paying period or at the time the interest payment
is due, depending on the type of security.
3. No Interest Payment
Zero-coupon
securities
Zero-coupon securities require no interest payments during
the time of the agreement. The borrower receives less than the
face value of the loan at the time of the agreement (i.e., the
bonds are sold at a discount). A zero-coupon security charges
an implied interest rate that is represented by the rate of return
earned by the investor.
Example For example, an issuer sells a $1,000 bond at a discount and
receives an amount that is less than $1,000 from the investor at
the time of the transaction. During the time the loan agreement
is in force, the borrower makes no interest payments. When the loan
is due at maturity, the borrower repays the investor $1,000.
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Principal Payments
Payment
conventions
There are several ways to repay the principal (face value) of a loan,
including the bullet payment, sinking fund, and callable debt methods.
n Bullet Payment
Face value
at maturity
The most common method is the bullet payment. During the
course of the loan, the borrower pays only interest and makes no
payment on principal until the loan matures. At maturity, the
borrower repays the investor the entire face value of the loan.
Most government securities and many corporate bonds use a
bullet payment.
n Sinking Fund
Gradual
repayment
Because the issuer is likely to need a large amount of cash to
repay the principal at the end of a loan agreement, many debt
agreements set up a sinking fund that gradually repays the
principal. A trustee is appointed to ensure the appropriate
amount is deposited into the account, and the issuer makes
periodic payments into the fund. The payment into the sinking
fund is usually based on the depreciation schedule of the assets
that were purchased with the borrowed capital.
Requires early
retirement of
some bonds
Sinking fund provisions require the issuer to retire some of the
bonds before maturity. This may be done either by repurchasing
them in the open market or by purchasing them from investors at
a specified price, depending on which price is lower. When the
issuer purchases directly from investors, the bonds are chosen
randomly based on their serial numbers. If all of the bonds have
not been retired before maturity, the issuer typically makes a
bullet payment in the amount of the outstanding bonds to retire
the issue.
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n Callable Debt
Call price Some bonds have a provision that gives the issuer an option to
repurchase the bonds from investors at a specified price. The
price is referred to as the "call" price. Let's use an example to
explain the process.
Example If a company issues bonds when interest rates are relatively
high, the debt is considered expensive to the company when
interest rates move to lower levels. The price of a bond in the
open market represents the present value of the payments that
the bond is expected to make over the maturity of the
instrument.
Bonds pay
higher
interest rate
A callable bond allows the issuer to repurchase the old bonds
at a price that is usually lower than market price. Thus, investors
may not get the full market value for the bonds as they would in
an open market transaction. Investors require issuers to
compensate them for the possibility that the bonds may be
called. Issuers compensate investors in callable bonds most
often by paying a higher interest rate than they would pay on
bonds of similar risk without the call provision.
In some callable bond situations, the borrower issues lower-
priced debt, then uses the proceeds to call the higher-priced
bonds. We will discuss the pricing of bonds in more detail in
Unit Three.
CLASSIFYING DEBT SECURITIES
According to
investor's
rights to make
claims
Debt securities are often classified according to the investors' rights to
make claims on specific assets or cash flows in the event of default or
bankruptcy by the firm. "Secured" debt securities are backed by more
than just the company name. In general, debt instruments that have
specific backing, or collateral, will pay a lower rate of interest than
those not backed by specific assets.
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According to
relative
priority of
claims
Debt securities also may be classified by the relative priority of the debt
security claims on the assets of the issuer in a reorganization or
bankruptcy by the firm.
Claims on Assets
Debt securities that are classified by their claims on specific assets
fall into five categories:
1. Mortgage bonds
2. Collateral trust bonds
3. Guaranteed bonds
4. Debentures
5. Asset-backed securities
Mortgage Bonds
Backed by
fixed assets
A mortgage bond gives the bondholders a lien, or claim, against the
pledged assets (generally property owned by the firm). In other words,
the bondholder has a legal right to sell the mortgaged property to
satisfy unpaid obligations to the bondholders.
Even though the bondholders have a right to this asset, it is unusual for
the assets to be sold. In most default cases, the company undergoes a
financial reorganization that provides a settlement of the debt for the
bondholders. The mortgage provides a strong bargaining position for the
bondholders in the reorganization negotiations. Generally, mortgage
bonds pay the lowest rate of interest, all other factors
being equal.
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Collateral Trust Bonds
Backed by
other assets
Some companies do not own any fixed assets (such as property or
equipment) to which a mortgage can be attached. Many of these
companies are holding companies that own the securities of other
companies.
These holding firms can satisfy their debt holders' demands for
backing by issuing collateral trust bonds. The issuer pledges
whatever assets (stocks, notes, bonds) are necessary to provide
security and collateral for investors. These investors have claim on the
collateral assets in the case of default. Once again, default generally
results in some type of reorganization rather than a direct sell-off of
the assets.
Backed by
another firm's
guarantee
Guaranteed Bonds
Bonds that are backed with the guarantee of a firm other than the issuer
are called guaranteed bonds. In most cases, a parent company will
guarantee the bonds of a subsidiary. The guarantee may be for the
interest payments on the bonds, the principal repayment, or both.
This arrangement provides security for the investors buying the bond
and lowers the interest rate the issuer pays. In case of default, the
guarantor provides the necessary funds to satisfy the investors.
Backed by
earnings
potential
Debentures
Debentures are not secured by any specific assets owned by the issuer.
Only the earnings potential of the issuer backs these debt instruments.
The investor in debentures is a general creditor of the company. In the
event of default or bankruptcy, debenture holders have a claim on the
assets of the defaulting firm only after all of the secured bondholders
have been satisfied. In a financial reorganization, these bondholders
have relatively little bargaining power.
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Debenture holders do have claim on assets before equity holders. To
compensate investors for these disadvantages, debentures typically pay
a higher rate of interest, all other factors being equal.
Backed by cash
flows from
high-quality
loan pool
Asset-backed Securities
Lending institutions pool high-quality loans that they have made and use
them as collateral for raising capital through the sale of asset-backed
securities. Investors buying the securities receive their earnings from
the interest and principal payments generated by the loans in the pool.
There are many types of asset-backed securities. The most common
assets being securitized include automobile loans, credit card
receivables, residential and commercial mortgages, and computer and
truck leases.
Process of
securitization
The term "securitization" refers to the process of packaging groups
of small, illiquid assets into a marketable security with an active
secondary market. Let's summarize the process of securitization, which
involves several participants.
n The party who creates the loans to be pooled is called the
originator. This is typically a lending or financing institution
that wishes to sell its claim on a future set of cash flows
(interest on the loans or leases plus principal repayment) for an
immediate cash payment.
n The issuer of the asset-backed security is usually a trust
created by the originator for this special purpose. The issuer
acquires the assets from the originator and pools them together
as marketable securities. The issuer raises money for this
purchase by selling the securities to investors.
n One party acts as the servicer to look after the day-to-day
details of the loans. Most often, the originator fills this role to
maintain its relationship with its customers.
n The investment bank acts as the trustee for the transaction.
Its role is essentially a policing one to ensure that the security
holders are being treated fairly, that the assets are being
collected, and that investors are paid on time.
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n The enhancer serves to guarantee against default for the
underlying assets. This ensures that the investors will receive
interest and principal payments in a timely manner. An
investment bank or insurance company fulfills the role of
enhancer.
n Finally, the investment bank that assists in the issue of the asset-
backed securities helps provide liquidity in the secondary
market. This allows investors to buy and sell the securities on
the secondary market in a timely manner and at fair prices.
Relative Priority of the Claim
An alternative method for classifying debt securities is by the priority
of the claim on the assets of the issuer in a reorganization
or bankruptcy.
Senior and
subordinated
debt
The terms "senior debt" and "subordinated debt" refer to the relative
position of the bondholders in a reorganization or bankruptcy. Senior
debt has the highest priority. Generally, secured debt is senior;
however, the prospectus specifies the claims to which the investor is
entitled. (See Unit One in the Equity Financing workbook for more
information about the prospectus.) Subordinated bonds are usually last
in the line of creditors for a claim on the assets of the issuer.
The terms "senior" and "subordinated" are sometimes used with the
classification system that describes claims on assets. For example, a
subordinated debenture has claim after senior debentures.
Remember, the issuer pays a higher rate of interest to compensate
investors for relinquishing their claims on specific assets.
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UNIT SUMMARY
In this unit, we introduced some key ideas necessary to understand debt
financing. We looked at two sources of debt capital: debt markets and
bank financing.
n The debt market is where borrowers needing capital
sell securities to investors willing to lend capital. We
introduced some of the key terms used in debt markets,
the participants, and the major national and international
markets.
n Bank financing involves a loan arranged directly between
the company needing capital and the financial institution
willing to lend that capital.
We discussed the provisions for paying off debt. You learned how
interest payments compensate investors for the use of their funds
and explored the factors affecting interest rates. We explained that
interest payments can be made at a fixed rate, floating rate tied to a
benchmark rate, or implied in the price of a zero-coupon bond selling
at a discount. We also explained bullet, sinking fund, and callable debt
provisions for repaying the principal.
Finally, we looked at two methods for classifying debt securities: one
based on the investors' claims on assets or cash flows; the other based
on the relative position of the bondholders in a reorganization or
bankruptcy. We summarized the rights of investors holding mortgage
bonds, collateral trust bonds, guaranteed bonds, debentures, and asset-
backed securities. We also summarized the process of securitization.
You now have a broad understanding of the fundamentals of debt and
are ready to focus on the issuer's concerns in raising capital through
the debt markets. In Unit Two, we will look at the process
of issuing debt.
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You have completed Unit One, Fundamentals of Debt Financing. Please complete the
Progress Check to test your understanding of the concepts and check your answers with the
Answer Key. If you answer any questions incorrectly, please reread the corresponding text to
clarify your understanding. Then, continue to Unit Two, Raising Debt Capital.
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4 PROGRESS CHECK 1
Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
Question 1: A corporation that sells bonds to fund an expansion of operations is:
____ a) directly negotiating a debt agreement.
____ b) issuing securities that represent loans.
____ c) securitizing loans for sale in the secondary market.
____ d) selling ownership interest in the company.
Question 2: The major advantage of the Eurobond market is that:
____ a) the bonds are traded in London and Luxembourg.
____ b) the markets are not directly controlled by any government entity.
____ c) issuers can borrow in many currencies.
____ d) Eurobonds make only one interest payment per year.
Question 3: Many floating rate instruments use a benchmark rate of interest to determine
the rate paid by the instrument. Which of the following is most commonly
used as a benchmark in the Euromarkets?
____ a) Prime rate
____ b) London Interbank Bid Rate (LIBID)
____ c) London Interbank Offered Rate (LIBOR)
____ d) Eurocurrency rate
Question 4: Which type of bond requires the issuer to pledge a fixed asset (such as
property or equipment) as security for the bond?
____ a) Mortgage bond
____ b) Collateral trust bond
____ c) Guaranteed bond
____ d) Debenture
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ANSWER KEY
Question 1: A corporation that sells bonds to fund an expansion of operations is:
b) issuing securities that represent loans.
Question 2: The major advantage of the Eurobond market is that:
b) the markets are not directly controlled by any government entity.
This is an advantage because Euromarket issues have relatively few
regulations and are not subject to taxation.
Question 3: Many floating rate instruments use a benchmark rate of interest to determine
the rate paid by the instrument. Which of the following is most commonly
used as a benchmark in the Euromarkets?
c) London Interbank Offered Rate (LIBOR)
Other common benchmarks include the U.S. Treasury rate, prime lending
rate, HIBOR, and SIBOR.
Question 4: Which type of bond requires the issuer to pledge a fixed asset (such as
property or equipment) as security for the bond?
a) Mortgage bond
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PROGRESS CHECK 1
(Continued)
Question 5: When investors refer to a debt security's term, or tenor, they are
discussing its:
____ a) par value.
____ b) basis points.
____ c) interest payments.
____ d) maturity.
Use the following example to respond to Questions 6 and 7.
Casaco Homebuilding, based in Venezuela, plans to issue dollar-denominated bonds
in the U.S. to fund a new, 200-home housing development outside of Caracas.
Question 6: In terms of its effects on the capital structure of Casaco, how would you
classify this transaction?
____ a) Primary market transaction
____ b) Eurodollar transaction
____ c) Secondary market transaction
____ d) Open-economy transaction
Question 7: In which type of market is Casaco issuing its bonds?
____ a) Foreign market of the U.S.
____ b) Foreign market of Venezuela
____ c) Euromarket
____ d) Domestic market
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ANSWER KEY
Question 5: When investors refer to a debt security's term, or tenor, they are
discussing its:
d) maturity.
Maturity, term, and tenor all refer to the length of time before a debt
becomes due for repayment.
Question 6: In terms of its effects on the capital structure of Casaco, how would you
classify this transaction?
a) Primary market transaction
Primary market transactions (new issues of debt) directly affect the capital
structure of the borrower, whereas secondary market trades among investors
have no direct effect on the capital structure of the original issuer.
Question 7: In which type of market is Casaco issuing its bonds?
a) Foreign market of the U.S.
Casaco's issue would be considered the foreign component of the U.S.
national market because Casaco is domiciled outside the country where the
securities will trade.
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PROGRESS CHECK 1
(Continued)
Question 8: The major advantage of bank financing over capital from debt markets is:
____ a) greater liquidity for the investor.
____ b) the borrower generally pays a lower interest rate for bank financing.
____ c) the terms of the loan may be easier to renegotiate.
____ d) bank financing does not link interest payments to any benchmark rate.
Question 9: What is the effect of a good Standard and Poor's credit rating on a borrower's
interest payments, all other factors being equal?
____ a) It increases the interest payment.
____ b) It decreases the interest payment.
____ c) There is no effect.
Question 10: Select four factors that affect the rate of interest a firm will pay to borrow
funds.
____ a) Interest paid on short-term U.S. securities
____ b) Trends in the company's industry
____ c) Credit standing
____ d) Expectations of future level of inflation
____ e) Macroeconomic conditions in the bond market
____ f) Expectations of future consumerism
____ g) Length of the borrowing
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ANSWER KEY
Question 8: The major advantage of bank financing over capital from debt markets is:
c) the terms of the loan may be easier to renegotiate.
This flexibility stems from the ongoing relationship between the bank and the
company and the greater ease in negotiating with one or a few parties, rather
than a large pool of investors.
Question 9: What is the effect of a good Standard and Poor's credit rating on a borrower's
interest payments, all other factors being equal?
b) It decreases the interest payment.
A borrower with a good credit rating would pay a lower interest rate and,
therefore, have lower interest payments.
Question 10: Select four factors that affect the rate of interest a firm will pay to borrow
funds.
a) Interest paid on short-term U.S. securities
c) Credit standing
d) Expectations of future level of inflation
g) Length of the borrowing
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PROGRESS CHECK 1
(Continued)
Question 11: If a borrower pays interest at the rate of LIBOR plus 100 basis points, it
means that the:
____ a) rate of interest will remain fixed during the period of the agreement.
____ b) funds are borrowed at a discount from face value and repaid at face value.
____ c) rate is based on the Treasury yield.
____ d) interest rate will be reset for each interest-paying period.
Question 12: One advantage of issuing callable bonds is that:
____ a) the company can refinance high-priced debt in a period of falling interest
rates.
____ b) investors are willing to buy the bonds at a discount.
____ c) the gradual repayment of principal reduces the cost of retiring the issue.
____ d) the issuer must pay higher interest rates than similar bonds without the
call provision.
Question 13: If your car loan has been "securitized," that means:
____ a) you are using it as collateral for a loan.
____ b) it has been pooled with other loans into a marketable security.
____ c) the originator continues to hold its claim on your interest and principal
payments.
____ d) it has a relatively high position in the line of creditors.
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ANSWER KEY
Question 11: If a borrower pays interest at the rate of LIBOR plus 100 basis points, it
means that the:
d) interest rate will be reset for each interest-paying period.
Question 12: One advantage of issuing callable bonds is that:
a) the company can refinance high-priced debt in a period of falling
interest rates.
When interest rates drop, callable debt enables companies to repurchase
expensive debt at a lower-than-market price.
Question 13: If your car loan has been "securitized," that means:
b) it has been pooled with other loans into a marketable security.
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PROGRESS CHECK 1
(Continued)
Question 14: DFA Company issues $1,000 bonds to investors and receives $960 from
each investor at the time of the transaction. DFA Company pays no interest
during the life of the bond and returns $1,000 to the investor at maturity. The
interest rate is:
____ a) calculated as a ratio of the difference between the original amount paid by
investors and the face value divided by the face value.
____ b) implied by the rate of return earned by the investor.
____ c) zero because no interest payments were made.
____ d) discounted at maturity.
Question 15: Select two ways that debt securities may be classified.
____ a) Level of interest rates
____ b) Relative priority of debt security investors
____ c) Credit rating of the investors
____ d) Claims on specific assets
____ e) Lien vs. non-lien securities
____ f) Relative collateral value of assets
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ANSWER KEY
Question 14: DFA Company issues $1,000 bonds to investors and receives $960 from
each investor at the time of the transaction. DFA Company pays no interest
during the life of the bond and returns $1,000 to the investor at maturity. The
interest rate is:
b) implied by the rate of return earned by the investor.
Question 15: Select two ways that debt securities may be classified.
b) Relative priority of debt security investors
d) Claims on specific assets
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UNIT 2: RAISING DEBT CAPITAL
INTRODUCTION
In Unit One, we described two common ways of raising capital in the debt market: bank
financing and selling debt securities in the public market. Another method for raising
debt capital is by placing securities privately. The size of the company and its
creditworthiness are the most important factors in determining a company's debt-
raising options.
The advantages and disadvantages of each process often dictate which method a company
uses. In this unit, we briefly describe each process and highlight the relative advantages,
disadvantages, and costs associated with each method for raising debt capital.
UNIT OBJECTIVES
When you complete Unit Two, you will be able to:
n Identify differences between methods of raising debt capital
n Recognize the process for raising debt capital through public offerings, private
placement, and bank financing
n Compare the advantages, disadvantages, and costs of each method of raising
debt capital
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ISSUING DEBT SECURITIES
Two methods for issuing debt securities are public offering and
private placement. In this section, we discuss the process for each
type of offering.
Public Offering
Issue process In a public offering, a company offers its debt securities to all
participants in the market. There are several steps in the public debt
offering process.
Select
investment
bank
1. The issuer selects an investment bank to manage the offering.
If the issue is large, or is to be placed in several markets, the
investment bank may assemble a syndicate, or group, of
investment banks. A syndicate helps to ensure that the entire
issue can be placed with investors and spreads the underwriting
risk among several underwriters. In a syndicate, one investment
bank is chosen to be the lead, or managing, underwriter.
Discuss
financing
needs
2. The issuer and the investment bank (or syndicate) meet to
discuss the financing needs of the company. In most cases, the
two parties have an ongoing relationship, so the investment bank
is familiar with the issuer and its needs.
Prepare
registration
statement
3. The issuer and the investment bank prepare a registration
statement and submit it to the appropriate government regulatory
agency. The registration statement may take three or four weeks
to complete.
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Conduct "due
diligence"
4. Because the investment bank serves both the issuer and the
investor, it must maintain certain ethical standards. The bank
must preserve confidentiality for the issuer at the same time it
supports the investor's need for disclosure. The process of
discovering for investors all relevant information about the
issuer and its operations is called "due diligence." The
investment bank managing the issue will investigate and verify
all of the company's claims about its operations and finances,
both quantitative and qualitative. One might say that the due
diligence process requires the investment bank to become the
"devil's advocate" in questioning the issuer's claims.
Generate
interest
5. To help sell the issue, the investment bank (or syndicate) begins
to generate interest in the debt securities among its investor
clients. The investment bank may hold informational meetings
with groups of clients or contact them individually through
brokers.
Price and sell
the issue
6. After receiving approval from the regulatory agency, the issuer
and the investment bank set a date for the issue to be sold. On
this date, known as the pricing day, the issuer and the investment
bank complete the final prospectus, price the securities, prepare
a "tombstone" to announce the issue, and complete the sale of
the securities to the investors.
Issuing costs The underwriting fees for a public issue of debt usually depend on
the maturity of the securities being sold. Fees range from 40 – 50
basis points, for a short-term issue, to 85 – 90 basis points for thirty-
year bonds. Underwriters charge these fees up front and often deduct
them from the proceeds of the issue. Other expenses include
registration fees, legal expenses, printing expenses, rating agency
fees, and other miscellaneous expenses. Expenses for offerings range
from $350,000 to nearly $500,000. There are some economies of
scale in these expenses because larger issues commit a relatively
smaller proportion of proceeds to expenses.
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Tenor and size Securities in public issues range in maturity from two to thirty years,
but most of them are under ten years in tenor. Issue sizes usually
range from $100 million to $500 million. Investors perceive smaller
issues to be less liquid than larger issues.
Investors /
issuers
Institutional investors dominate the market, but many individual
investors buy debt instruments. Individual investors in the public
market often seek a recognizable company name, which effectively
limits public offerings to larger, more established firms.
Small or new companies often find that their investment bank cannot
place their entire issue with investors and that the costs of the issue
are prohibitive. In addition, public debt securities require a public
credit rating, a process that many smaller companies find too
expensive.
Advantages A public issue of debt securities gives the company more flexibility in
terms of its operations. Although the issuer is required to make public
disclosure of its financial and operating conditions, it generally has to
maintain few minimum operating and financing covenants
(requirements).
Disadvantages In times of distress, it is hard to renegotiate the terms of publicly-
traded instruments without entering some type of bankruptcy
protection. Because many investors may own the securities, it is
difficult to gain a consensus on suitable terms.
Euromarket
issues
The process we have discussed in this section focuses on a domestic
issue — a company issuing in its own domestic market. Many firms
have found that the Euromarket provides an adequate pool of investors
at a lower cost to the issuer. The Euromarket has effectively eliminated
much of the government registration process — shortening the issue
process by several weeks. The public disclosure requirements for
financial and operating reporting are usually less stringent as well.
This competition has forced many domestic markets to simplify their
registration and reporting requirements.
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Private Placement
Another method companies use to issue debt securities is private
placement. In a private placement, a company places its debt directly
with private investors without a public registration of the offering.
Let's look at the process for a private offering.
Issue process 1. As with a public offering, the issuing company selects an
investment bank to manage the process.
2. The investment bank provides the following services:
n Assists the issuer in planning the financial strategy and
determining its financial needs
n Prepares a placement memorandum, which is a marketing
book and credit analysis of the company
n Circulates the placement memorandum among potential
investors to help generate interest in the issue
n Assists in preparing documents which describe the details
of the loan agreement
n Acts as a placement agent working on a "best efforts" basis
to sell the securities to investors. The investment bank
does not underwrite the issue, but it does try its best to find
sufficient investors to provide the required amount of capital.
Issuing costs The costs and fees for private placements generally are less than for
public issues. Placement fees run from 25 – 50 basis points. Legal
and other expenses usually range between $50,000 and $100,000 per
issue.
Tenor and size Private market issues, like public issues, range in maturity from less
than one year up to thirty years, with most issues being less than ten
years. The size of the issue is more flexible than in the public markets.
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Investors Investors in the private placement market tend to be large institutional
investors and very wealthy individual investors. Depending on the
type of security issued, the institutional investors may include
insurance companies, pension funds, commercial finance companies,
leveraged buyout firms, banks, trust funds, and mutual funds.
Covenants Investors often require a set of covenants for the company issuing
securities. These covenants dictate minimum and maximum levels for
key financial and operational ratios such as debt-to-equity ratio,
interest coverage ratio, and fixed payment coverage ratio. The
covenants negotiated between the investors and the issuer usually
depend on the industry in which the issuer conducts its business.
Failure to meet specified covenants often gives investors the right to
return bonds to the issuer. However, in times of distress, issuers
often are able to renegotiate the terms with the investors.
Credit rating
system
A credit rating system for private placement issues in U.S. markets,
similar to the public issues systems, has been established by the
National Association of Insurance Commissioners (NAIC).
Companies use this rating system to determine the rate they will pay
on privately-placed instruments. As with public issues, higher-rated
securities will pay lower interest rates, all other factors being equal.
A rating generally is not required because most investors in privately-
placed debt make their own determination of credit quality.
Advantages The private placement market offers issuers several advantages.
n Private issues require no public disclosure. The issuer can
maintain confidentiality because the securities are sold to a
small group of institutional investors.
n The issuer can control the marketing process, effectively
targeting particular types of investors.
n The issuer can sell securities with unusual terms or structures
because the investors are sophisticated.
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n Issuers need less lead time (4-8 weeks) to bring a private
placement issue to market than to bring a public placement
issue to market (12-16 weeks).
Disadvantages One disadvantage of the private placement market is a lack of liquidity
for the securities. The lack of a secondary market forces issuers to pay
higher interest rates than similar issues in the public market.
SEC Rule 144A The regulatory agency for the U.S. market, the Securities and
Exchange Commission (SEC), passed Rule 144A to increase liquidity
in the private placement market. Rule 144A allows for the resale of
privately-placed securities (previously restricted in the U.S. market).
However, the rule limits secondary market buying and selling to
qualified institutional buyers (QIBs) that have at least $100 million of
invested funds in their portfolio. Rule 144A issues often require
additional legal and rating agency fees, but the issues are still
competitively priced for many issuers.
Rule 144A has provided many foreign issuers the opportunity to
access U.S. capital markets without having to conform to the
relatively tough U.S. accounting and disclosure standards. Many
Latin American companies have been able to place issues with U.S.
investors through Rule 144A. The interest rates being paid on Rule
144A issues are very competitive with other issues.
BANK FINANCING
In addition to issuing securities through public offerings or private
placements, companies can raise debt capital by arranging for bank
financing.
Lead bank in
a syndicate
Many debt financings are simply loan agreements between a company
and a bank, or bank syndicate. The lead manager, or loan arranger, is
the bank that assumes primary responsibility for working out terms of
the loan and for bringing other banks (known as participating banks) to
share in the loan. Generally, banks handle a small loan request on their
own and include other banks for the larger debt needs of a company.
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Bank financing
process
Let's look at the steps in the bank financing process.
1. The borrowing company selects a bank to serve as the lead
manager. Generally, the company chooses a bank with which
they already have a relationship.
2. The lead manager and the company negotiate the amount of the
loan, the interest rate (or rates) to be paid, banking fees, and
other details concerning the arrangement — based on the
demand for the loan by prospective participating banks.
3. The bank develops a placement memorandum that describes the
borrower's financial condition and the details of the loan.
4. Prospective participating banks review the placement memo to
determine if they want to participate in the syndicate.
Underwritten
loans
The loan is fully underwritten if the lead manager guarantees the full
amount of the loan. If demand for the loan by prospective
participating banks is insufficient, the lead manager may have to
provide the additional capital for the borrower.
"Best efforts"
loans
A "best efforts" offering of a syndicated loan requires that managing
banks try their best to find enough lenders to complete the syndicate
and provide the necessary capital. If demand for the loan is low, the
amount of the loan may be renegotiated with the borrowing company.
Periodic costs The borrower incurs periodic costs and up-front costs. The periodic
costs may include:
n The interest paid on the amount of the credit being used
For example, a syndicate provides a line of credit for $100
million. If the borrower currently is using only $40 million,
the interest payment will be based on the $40 million being
used. Interest rates may be fixed or floating, depending on the
agreement. Most rates are set as a premium from a benchmark
rate (e.g., LIBOR + 50 basis points).
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n A commitment fee, ranging from 25 – 75 basis points on the
unused portion of the credit
n A small agent fee paid to the bank for its services
Up-front costs Up-front fees include a one-time fee of 50 – 250 basis points on the
total amount of the loan. The borrower pays this up-front fee to the
lead bank for organizing and managing the loan. The managing bank
generally passes along a portion of this fee to other participating
banks. The syndicate agreement specifies the allocation of the up-
front fee.
Size and tenor The size of syndicated loans is flexible, depending on the needs of the
borrowing company. The maturity of the loans is also flexible, but the
most common syndicated loans are for less than seven years.
Restrictive
covenants
Syndicated bank loans typically are more restrictive than private
placement for the borrowing company in terms of the covenants for
the agreement. However, if the company has a relationship with the
lead manager, it usually can renegotiate the terms of the agreement
when the company's prospects change.
Advantages and
disadvantages
Larger companies often arrange syndicated bank lines of credit as
collateral for issuing securities in the debt markets. Syndicated loans
are common for smaller, less established companies. Lenders
generally charge higher interest rates than companies pay for private
placements or public issues because of the perceived credit risks.
However, the process of arranging a syndicated loan takes much less
time, and has lower up-front expenses than other methods of raising
debt capital.
UNIT SUMMARY
In this unit, we have reviewed the three primary methods companies
use to raise debt capital. Key features, advantages, and disadvantages
of each method are summarized in the chart on page 2-10.
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METHOD KEY FEATURES ADVANTAGES DISADVANTAGES
Issuing Debt
Securities
1. Public Offering Large pool of investors
Issue size from $100MM to
$500MM
Issuers: Large established
companies
Large secondary market
Few minimum operating and
financing covenants
to maintain
Liquidity for investors
High costs
Difficult to renegotiate
terms
Difficult and expensive for
small companies
2. Private Placement Investment bank works on best
efforts basis
Flexible issue size
No public registration
requirements
Restricted secondary market
Accessible to foreign issuers
Small group of sophisticated
investors
Less costly than public issue
Faster than public issuing
process
No public disclosure
Control of marketing process
Easy to renegotiate terms
Marketability of securities
with unusual structures or
terms
Illiquidity forces company
to pay higher interest rates
Restrictive covenants
Bank Financing
3. Bank Loans Agreement between company
and bank or syndicate
Loans underwritten or on best
efforts basis
Common for small, new
companies
Flexible size and maturity for
loans
Easy to renegotiate terms
Faster, less expensive
process than issuing debt
securities
Most restrictive covenants
of all three methods
Requires higher interest
rate than private and public
placement
You have completed Unit Two, Raising Debt Capital. Please complete the Progress Check
to test your understanding of the concepts and check your answers with the Answer Key. If
you answer any questions incorrectly, please reread the corresponding material. Then,
continue to Unit Three, Valuing Debt.
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✔✔✔✔ PROGRESS CHECK 2
Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
Question 1: Which method for raising debt capital places the least restrictive financial
and operational covenants on the borrower?
_____a) Public offering
_____b) Private placement
_____c) Bank financing
Question 2: Which of the three methods for raising debt capital attracts large
institutional investors and wealthy individual investors?
_____a) Public offering
_____b) Private placement
_____c) Bank financing
Question 3: The purpose of conducting "due diligence" before a public offering is to:
_____a) maintain confidentiality for the issuer.
_____b) rate the borrower's creditworthiness.
_____c) investigate and verify the issuer's claims.
_____d) simplify the registration process.
Question 4: ABC Tool and Die Company is a small company with a brief history and no
track record. The business is growing and needs additional capital to
finance an expansion of operations. Management has decided to raise the
capital through debt financing. Which method will it use?
_____a) Public offering
_____b) Private placement
_____c) Bank financing
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ANSWER KEY
Question 1: Which method for raising debt capital places the least restrictive financial
and operational covenants on the borrower?
a) Public offering
Question 2: Which of the three methods for raising debt capital attracts large
institutional investors and wealthy individual investors?
b) Private placement
Question 3: The purpose of conducting "due diligence" before a public offering is to:
c) investigate and verify the issuer's claims.
Question 4: ABC Tool and Die Company is a small company with a brief history and no
track record. The business is growing and needs additional capital to
finance an expansion of operations. Management has decided to raise the
capital through debt financing. Which method will it use?
c) Bank financing
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PROGRESS CHECK 2
(Continued)
Question 5: Select the major disadvantage of bank financing.
_____a) Length of time to arrange
_____b) Difficult to renegotiate
_____c) Limitations on size and tenor
_____d) Higher interest rates
Question 6: Select one advantage that a private debt placement has over a public debt
offering.
_____a) It allows more flexibility for the issuer in its operations.
_____b) The lead time for bringing an issue to market is shorter.
_____c) It increases the liquidity for the securities.
_____d) There is a large pool of secondary market investors.
Question 7: In the U.S. debt markets, Rule 144A of the Securities and Exchange
Commission (SEC) has:
_____a) provided access to the U.S. market for many foreign issuers.
_____b) increased the liquidity for many privately-placed debt issues.
_____c) limited buying and selling of privately-placed securities to qualified
institutional buyers (QIBs).
_____d) accomplished all of the above.
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ANSWER KEY
Question 5: Select the major disadvantage of bank financing.
d) Higher interest rates
Question 6: Select one advantage that a private debt placement has over a public debt
offering.
b) The lead time for bringing an issue to market is shorter.
Question 7: In the U.S. debt markets, Rule 144A of the Securities and Exchange
Commission (SEC) has:
d) accomplished all of the above.
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PROGRESS CHECK 2
(Continued)
Question 8: Identify the activities associated with each method of raising debt capital.
Mark "O" for public offering, "P" for private placement, and "B" for bank
financing.
_____a) Prepare a marketing book and credit analysis
_____b) Prepare a registration document
_____c) Sell securities only on "best efforts" basis
_____d) Pay interest on the amount of credit being used
_____e) Prepare a tombstone and final prospectus
_____f) Make a public disclosure of financial and operating conditions
_____g) Use NAIC ratings system to determine interest rate
_____h) Select a lead manager
_____i) Payment of up-front organizational and management fee
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ANSWER KEY
Question 8: Identify the activities associated with each method of raising debt capital.
Mark "O" for public offering, "P" for private placement, and "B" for bank
financing.
P a) Prepare a marketing book and credit analysis
O b) Prepare a registration document
P c) Sell securities only on "best efforts" basis
B d) Pay interest on the amount of credit being used
O e) Prepare a tombstone and final prospectus
O f) Make a public disclosure of financial and operating conditions
P g) Use NAIC ratings system to determine interest rate
B h) Select a lead manager
B i) Payment of up-front organizational and management fee
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UNIT 3: VALUING DEBT
INTRODUCTION
In Unit Two, we described three methods for issuing debt. Now we will focus on methods for
comparing and pricing debt securities.
In this unit, you will learn how to calculate the rate of return, or yield, earned by investors as
well as how to find the price at which a bond should be selling. Investors use these
calculations to determine which debt instrument provides the highest rate of return on their
investment. Issuers use these calculations to find the lowest cost borrowing alternative.
Finally, we will show how analysts use duration to measure the sensitivity of bond prices to
changes in interest rates.
It is important that you feel comfortable using your calculator to make future value and
present value computations. You may want to review the concepts of future and present
value before trying the calculations required in this unit. Unit Three, Time Value of Money,
in the Basics of Corporate Finance workbook is a good place to begin your review.
UNIT OBJECTIVES
When you complete Unit Three, you will be able to:
n Select and calculate appropriate measures of yield
n Determine the price and discount yield of zero-coupon bonds
n Determine the price of a debt security that makes periodic coupon payments
n Calculate the duration of a bond
n Calculate the duration of a portfolio
n Use modified duration to estimate the sensitivity of a bond's price to changes
in interest rates
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CALCULATING YIELD
Income from a
debt security
Let's begin this section by emphasizing a key point about debt
securities. The owner of a debt security has three potential sources of
income:
1. Contractual interest payments (coupon payments)
2. Income generated from the reinvestment of coupon payments
3. Capital gain or loss incurred when selling the security
There are several yield measures, each with a specific definition and
calculation method based on different assumptions about income. This
section will help you to differentiate among the types of yield and
understand their uses and functions. The four types of yield we will
look at are current yield, yield-to-maturity, yield-to-call, and
realized compound yield.
Example bond Throughout this section, we will illustrate the yield calculations with a
hypothetical bond from XYZ Corporation. The bond has these
characteristics:
Years to maturity = 7
Coupon rate = 5%
Payment frequency = Semiannual
Market price = $842.60
Redemption value = $1,000.00
(Face or par value)
Selling at a
premium /
discount
This bond is said to be selling at a discount, because the market price
is less than the par value. A bond with a market price greater than the
par value is selling at a premium.
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Current Yield
Annual coupon
interest and
market price
Current yield relates the annual coupon interest to the market price of
the security. The formula for calculating current yield is:
Current yield = Annual coupon interest / Market price
For our XYZ Corporation bond, the current yield is:
Current yield = (.05 x $1,000) / $842.60
= $50 / $842.60
= 0.0593 or 5.93%
In other words, investors are earning 5.93% on their investment.
Compared to
coupon rate
The current yield is always higher than the coupon rate for bonds selling
at a discount to par value. For bonds selling at a premium, the current
yield is always less than the coupon rate. Many secondary market bond
quotations list a bond's current yield as well as its pricing information.
Weakness One weakness of the current yield calculation is that it includes only
one of the three sources of potential income: the periodic interest
payment. It does not account for the reinvestment of interest payments
or for any capital gains or losses.
For example, an investor who buys the XYZ Corporation bond for
$842.60 and holds it until maturity will realize a capital gain of
$157.40 ($1,000.00 – $842.60). The current yield does not take the
capital gain into account.
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Yield-to-maturity
Present value
of cash flows
and market
price
The yield-to-maturity is the discount rate that equates the present value
of the future cash flows generated by the bond with the current market
price of the bond. To calculate the yield-to-maturity (discount rate), we
begin with the formula for pricing a bond (see below) and solve for R.
M x T (C / M) F
P = Σ ___________ + _____________
i = 1 [1 + (R / M)]i [1 + (R / M)]M x T
Where:
P = Market price of the bond
C = Annual coupon payment
T = Number of years until maturity
M = Number of coupon-paying periods per year
R = Yield-to-maturity
F = Face value of the bond
Please note that all calculations in this unit are presented as performed
on a financial calculator. Solving this equation with a pencil may be
difficult; therefore, we recommend that you use a financial calculator.
(Before the invention of hand-held calculators, analysts worked by
trial and error until they found a close approximation of R.)
Before you begin, check the owner's manual for your financial
calculator. Most machines require that either the present value or the
coupon payments and future value of the instrument be entered as
negative numbers. The last coupon and principal payment (future
value) may have to be combined into one cash flow.
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Example Let's calculate the yield-to-maturity for the XYZ Corporation bond
(page 3-2).
1. Since the bond has seven years until maturity and is a semiannual
bond, we input 14 for the number of interest paying periods. Enter
14 and press the N key.
2. Enter the current market price of $842.60 as the present value of
the instrument. Press the PV key.
3. Enter the size of each coupon payment as $25 (0.05/2 x $1,000).
Press the PMT key.
4. Input the par value of $1,000 as the future value. Press the FV key.
5. Press the I key or I% key. You should have a solution of
R = 3.99%.
6. Multiply 3.99 by 2 to arrive at the yield-to-maturity of 7.98%.
(Because we are working with a semiannual instrument, we need
to convert this to an annual rate.)
Investors are earning a 7.98% rate of return on their investment in
the XYZ Corporation bond.
Fully-
discounted
yield
Technically, the fully-discounted yield for a security making
semiannual coupon payments is the compounded semiannual return. In
our example, the true yieldis (1.0399)2
– 1 = 8.14%.
Bond
equivalent
yield
In practice, however, analysts simply multiply the semiannual rate by
two, as we did above, to arrive at 7.98%. This is called the bond
equivalent yield(BEY). The BEY is the rate of return that investors
compare with the yield on other instruments and to the quote on zero-
coupon securities (including U.S. Treasury bills).
Comparative
advantages
The yield-to-maturity improves upon the current yield measure
because it accounts for the capital gain of $157.40. Yield-to-maturity
also considers the reinvestment of interest payments. However, this
measure assumes that interest payments are reinvested at exactly the
yield-to-maturity rate (in this case, 7.98%). If that assumption is not
valid, then yield-to-maturity comparisons may not be appropriate.
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Yield-to-call
Assumes
issuer calls
bond
Yield-to-call is conceptually similar to yield-to-maturity. The major
difference is that yield-to-call assumes the issuer will call the bond at
the first opportunity. The yield-to-call calculation is the same as the
yield-to-maturity calculation except that the number of interest
paying periods until the first opportunity to call is used instead of
the number of periods until maturity.
Yield-to-call, like yield-to-maturity, assumes that interest payments
are reinvested at the same rate as the yield-to-call rate. Another
weakness of yield-to-call is that it does not consider what happens to
the proceeds of the bond if it is called. The bond purchaser often has an
investment horizon that is longer than the period until first call. This
measure does not allow a direct comparison with investment
opportunities for such an investor.
Realized Compound Yield
Different
reinvestment
rate
The final measure, realized compound yield, adjusts for interest
payments that are reinvested at a different rate than the yield-to-
maturity.
To calculate the realized compound yield, take the following steps:
1. Compute the total dollars to be received in the future from the
investment.
To do this, find the future value of the coupon payments reinvested
at the appropriate rate. Using an annuity for the period that the
payments are to be received, enter the amount of the payment and
the number of payments. Use the reinvestment interest rate as the
discount rate to calculate the future value of
the annuity.
Add the face value of the bond to this amount to compute the total
dollars to be received.
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2. Enter this total as the future value of the investment in your
calculator.
3. Enter the amount paid for the bond as the present value of the
investment. (Your calculator may require that this number be
entered as a negative number.)
4. Enter the number of coupon-paying periods.
5. Press the I (or I%) key to find the realized compound yield. If the
coupon period is semiannual, multiply this yield by 2 to find the
annual realized compound yield.
Example We can use the XYZ Corporation bond to illustrate the calculation.
Remember that the bond has the following characteristics.
Years to maturity = 7
Coupon rate = 5%
Payment frequency = Semiannual
Market price = $842.60
Redemption value
(Face or par value) = $1,000.00
If we reinvest the coupon payments at an annual rate of 4% and we
hold the bond to maturity, what is the realized compound yield?
1. The first step is to find the future value of the coupon payments.
Holding the bond until maturity, we would receive 14 payments of
$25 and reinvest them at a 2% semiannual rate.
Find the future value as you would for any other annuity. Enter in
your calculator 14 payments of $25 with an interest rate of 2%.
Make sure that the calculator knows that the payments are
received at the end of each period. Pressing the future value key
should give you $399.35 for the value of the coupon payments
received and reinvested.
2. Enter $1,399.35 ($399.35 + $1,000) as the future value of the
investment.
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3. Enter $842.60 as the present value (the amount that we paid for
the bond).
4. Enter 14 as the number of coupon-paying periods.
5. Press the IRR key to get the semiannual rate of 3.69%. Multiply by
2 to get the annual realized compound yield of 7.38%. Assuming
you reinvest your coupon payments at a 4% rate, you will earn
7.38% on your investment in the XYZ Corporation bond.
One problem with realized compound yield is that the analyst may not
know the reinvestment rate. When comparing investments, analysts can
use the same arbitrary reinvestment rate for all investment alternatives.
Usually, they use the yield-to-maturity for comparison purposes if they
do not know the reinvestment rate.
Summary
As you can see from the calculations, it is important to select the
appropriate yield measure when calculating your rate of return. The
chart below summarizes the different yields we calculated for our
sample investment in XYZ Corporation bond.
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TYPE OF
YIELD
DESCRIPTION RATE OF
RETURN
IMPLICATIONS
Current Yield Relates annual coupon
interest to market price
Does not account for
reinvested interest
payments or capital
gains/losses
5.93% Rate of return higher than
coupon rate because
bond sells at
a discount to par value
Yield-to-
maturity
Relates present value of
future cash flows to
market price
Assumes reinvestment
rate = yield-to-maturity
7.98% Rate of return higher than
current yield because it
accounts for capital gain
of $157.40
Yield-to-call Similar to yield-to-
maturity
Assumes issuer will call
bond at first opportunity
Realized
Compound
Yield
Adjusts for interest
payments reinvested
at a different rate than
yield-to-maturity
7.38% Rate of return lower than
yield-to-maturity because
it assumes lower
reinvestment rate (4%)
Please complete Practice Exercise 3.1 to check your understanding of
calculating yield. Then, continue to the next section of Unit Three
which covers methods for pricing common bond instruments.
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PRACTICE EXERCISE 3.1
Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
Use the following data to answer Questions 1 and 2.
Years to maturity = 6
Coupon rate = 5.5%
Payment frequency = Semiannual
Market price = $955.60
Redemption (face) value = $1,000.00
Question 1: What is the current yield for the bond?
_______________________________
Question 2: Calculate the yield-to-maturity for the instrument.
_______________________________
Question 3: The yield-to-maturity calculation shows a higher rate of return than the
current yield calculation because yield-to-maturity:
____ a) compounds the semiannual payments.
____ b) assumes interest payments are reinvested at the coupon rate.
____ c) includes the income from a capital gain.
____ d) factors in the accumulated interest between coupon-paying periods.
Question 4: You expect Quickly Company to repurchase its bonds at the first opportunity.
Which measure would you use to calculate the yield of the Quickly Company
bonds?
____ a) Realized compound yield
____ b) Yield-to-call
____ c) Yield-to-maturity
____ d) Current yield
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ANSWER KEY
Question 1: What is the current yield for the bond?
Current yield = $55 / $955.60
= 5.76%
Question 2: Calculate the yield-to-maturity for the instrument.
Enter into your financial calculator:
Number of payments (12)
Present value ($955.60)
Future value ($1,000)
Coupon payments ($27.50)
Press the I% key to find the answer:
3.20% x 2 = 6.40%
Question 3: The yield-to-maturity calculation shows a higher rate of return than the
current yield calculation because yield-to-maturity:
c) includes the income from a capital gain.
The current yield calculation results in a lower rate of return because it only
accounts for one of the three sources of potential income from debt securities:
the contracted interest payments. The yield-to-maturity calculation figures in the
capital gain when the security matures and assumes that interest payments are
reinvested at a rate equaling the yield-to-maturity.
Question 4: You expect Quickly Company to repurchase its bonds at the first opportunity.
Which measure would you use to calculate the yield of the Quickly Company
bonds?
b) Yield-to-call
Rather than calculating and discounting the cash flows for the entire life of the
instrument, yield-to-call calculates the rate of return using the number of interest-
paying periods until the first opportunity to call.
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CALCULATING PRICE
Next, we will focus on the methods analysts use to price common
bond instruments. The basic idea throughout this section is to find the
present value of future cash flows generated by the security. We will
demonstrate price calculations for zero-coupon securities, which
make no interest payments, and for fixed income securities, which
make fixed income payments.
Zero-coupon Securities
Two cash flows Zero-coupon bonds are the easiest instruments to value because there
are only two cash flows: the price paid for the bond and the price
received when the bond is redeemed. We want to find the price to be
paid for the bond.
Price and yield
based on days
to maturity
U.S. Treasury bills, and other zero-coupon money market instruments
quoted at a discount from their face value, typically have short-term
maturities. Their price and yield calculations are based on the number
of days until the security matures. The formula for finding the price of a
money market security quoted on a discount basis is:
P = F [1 - ((R x DM) / DY )]
Where:
P = Current price of the security
F = Face value of the security
DM = Number of days until the security matures
DY = Number of days in quoted year that
security is priced
R = Discount yield used to price the security
Example This example will show you how to use the formula.
Suppose that we have a Treasury bill, quoted on a 360-day year, with
a face value of $1,000, priced to yield at 6.5% annually, that is held for
123 days. What is the price for this instrument?
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P = F [1 - ((R x DM ) / DY)]
P = $1,000 [ 1 - (0.065 x 123 / 360)]
P = $1,000 [ 1 - 0.0222]
P = $1,000 [ 0.9778]
P = $977.78
We expect the security to sell for $977.78 in the money market. The
financial section of the newspaper usually quotes prices on a
percentage basis. In this case, the security has a quoted price of 97.78
or 97.78% of $1,000 (face value).
Note that most money market instruments, including U.S. Treasury
bills, are quoted on a 360-day year (DY). Some short-term corporate
securities use the 365-day year. Be sure to check the details so that
your pricing computation is accurate.
Discount Yield
Rate to price
the security
Sometimes we may know the price of the security but want to find the
discount yieldused to price the instrument. The discount yield is the
rate that is used to discount the cash flows of the zero-coupon security.
To calculate the rate, we use the pricing formula and solve for R.
R = [(F - P) / F] x ( DY / DM)
The variables are the same as in the pricing formula (see page 3-13).
Example This example will help you understand the discount yield calculation.
Suppose that a $1,000 security, quoted on a 360-day year, with 45
days until maturity, is priced at $994 in the market. What was the
discount yield used to price the security?
R = [(F - P) / F] x (DY / DM )
R = [($1,000 - $994) / $1,000] x (360 / 45)
R = [0.0060] x (8.00)
R = 0.0480 or 4.80%