Chapter 24 Debt Financing

Chapter 24

Debt Financing

24.1 Corporate Debt

• Leveraged Buyout (LBO)

– When a group of private investors purchase all the equity of a public corporation and finances the purchase primarily with debt

• For example, Hertz was taken private through an LBO.

Table 24.1 New Debt Issued as Part of the Hertz LBO

Public Debt

• The Prospectus

– A public bond issue is similar to a stock issue.

– Indenture• Included in a prospectus, it is a formal contract

between a bond issuer and a trust company.– The trust company represents the bondholders and

makes sure that the terms of the indenture are enforced.

– In the case of default, the trust company represents the interests of the bond holders.

Public Debt (cont'd)

• Corporate bonds almost always pay coupons semiannually, although a few corporations have issued zero-coupon bonds.

• Most corporate bonds have maturities of 30 years or less.

• The face value or principal amount of a bond is denominated in standard increments, most often $1000.

• Bearer Bonds– Similar to currency in that whoever physically

holds the bond certificate owns the bond

– To receive a coupon payment, clipping a coupon off the bond certificate

• Registered Bonds– The issuer of this type of bond maintains a list of

all holders of its bonds.

– Coupon and principal payments are made only to people on this list.

Types of Corporate Debt

• Unsecured Debt– in the event of bankruptcy, gives bondholders a

claim to only the assets of the firm that are not already pledged as collateral on other debt

– Notes• A type of unsecured corporate debt

• Notes typically are coupon bonds with maturities shorter than 10 years.

– Debentures• A type of unsecured corporate debt

• Debentures typically have longer maturities than notes.

Types of Corporate Debt

• Secured Debt– A type of corporate debt in which specific assets

are pledged as collateral.

– Mortgage Bonds• Real property is pledged as collateral that bondholders

have a direct claim to in the event of bankruptcy.

– Asset-Backed Bonds• Specific assets are pledged as collateral that

bondholders have a direct claim to in the event of bankruptcy.

• Can be secured by any kind of asset

Public Debt

• Seniority

– Seniority• A bondholder’s priority in claiming assets not already

securing other debt

• Most debenture issues contain clauses restricting the company from issuing new debt with equal or higher priority than existing debt.

– Subordinated Debentures• Debt that, in the event of a default, has a lower priority

claim to the firm’s assets than other outstanding debt

Public Debt

• Bond Markets

– International Bonds

• Domestic Bonds– Bonds issued by a local entity and traded in a local

market, but purchased by foreigners

– They are denominated in the local currency.

• Foreign Bonds– Bonds issued by a foreign company in a local market and

intended for local investors

– They are denominated in the local currency.

• Bond Markets

– International Bonds

• Foreign Bonds

– Yankee Bonds

» Foreign bonds in the United States

– Samurai Bonds

» Foreign bonds in Japan

– Bulldogs

» Foreign bonds in the United Kingdom

• Bond Markets

– International Bonds• Eurobonds

– International bonds that are not denominated in the local currency of the country in which they are issued

• Global Bonds– Bonds that are offered for sale in several different

markets simultaneously

– Global bonds can be offered for sale in the same currency as the country of issuance (unlike Eurobonds).

Private Debt

• Private Debt

– Debt that is not publicly traded• Has the advantage that it avoids the cost of

registration but has the disadvantage of being illiquid

Private Debt (cont'd)

• Term Loans

– Term Loan• A bank loan that lasts for a specific term

– Syndicated Bank Loan• A single loan that is funded by a group of banks rather

than just a single bank

– Revolving Line of Credit• A credit commitment for a specific time period,

typically two to three years, which a company can use as needed

Private Debt (cont'd)

• Private Placements

– Private Placement

• A bond issue that is sold to a small group of investors rather than the general public

– Because a private placement does not need to be registered, it is less costly to issue than public debt.

» In 1990, the SEC issued Rule 144A, which allows private debt issued under this rule to be traded by large financial institutions among themselves.

» Because this debt is tradeable between financial institutions, it is only slightly less liquid than public debt.

24.2 Other Types of Debt

• Sovereign Debt

– Sovereign Debt• Debt issued by national governments

– U.S. Treasury securities represents the single largest sector of the U.S. bond market.

Sovereign Debt

• The U.S. Treasury issues:

– Treasury Bills• Pure discount bonds with maturities up to 26 weeks

– Treasury Notes• Semi-annual coupon bonds with maturities of 2 to 10

– Treasury Bonds• Semi-annual coupon bonds with maturities longer than

10 years

• Long Bonds– Bonds issued by the U.S. Treasury with the longest

outstanding maturities (currently 30 years)

Sovereign Debt (cont'd)

• TIPS (Treasury-Inflation-Protected Securities)

– An inflation-indexed bond issued by the U.S. Treasury with maturities of 5, 10, and 20 years

– They are standard fixed-rate coupon bonds with one difference: The outstanding principal is adjusted for inflation.

• Treasury securities are sold by auction.

– Two types of bids are allowed.• Competitive

– Competitive bidders submit sealed bids in terms of yields and the amount of bonds they are willing to purchase. The Treasury then accepts the lowest-yield (highest-price) competitive bids up to the amount required to fund the deal.

• Non-Competitive– Noncompetitive bidders (usually individuals) just submit

the amount of bonds they wish to purchase and are guaranteed to have their orders filled at the auction.

• STRIPS (Separate Trading of Registered Interest and Principal Securities)

– Zero-coupon Treasury securities with maturities longer than one year that trade in the bond market

• The Treasury itself does not issue STRIPS. Instead, investment banks purchase Treasury notes and bonds and then resell each coupon and principal payment separately as a zero-coupon bond.

Municipal Bonds

• Municipal Bonds (Munis)

– Bonds issued by state and local governments

– They are not taxable at the federal level (and sometimes at the state and local level as well).

• Sometimes referred to as tax-exempt bonds

– Most pay semi-annual interest• Fixed Rate

• Floating Rate

Municipal Bonds (cont'd)

• Serial Bonds– A single issue of municipal bonds that are

scheduled to mature serially over a period of years

• General Obligation Bonds– Bonds backed by the full faith and credit of the

local government

Municipal Bonds (cont'd)

• Revenue Bonds– Municipal bonds for which the local or state

government can pledge as repayment revenues generated by specific projects

• Double-Barreled– Describes municipal bonds for which the issuing

local or state government has strengthened its promise to pay by committing itself to using general revenue to pay off the bonds

Asset-Backed Securities

• Securities made up of other financial securities

– Security’s cash flows come from the cash flows of the underlying financial securities that “back” it.

• Asset securitization

– The process of creating an asset-backed security

Asset-Backed Securities (cont'd)

• Mortgage-backed security

– Largest sector of the asset-backed security market

– Backed by home mortgages

– Largest issuers are U.S. government agencies and sponsored enterprises, such as the Government National Mortgage Association (GNMA).

• GNMA-issued mortgage-backed securities are explicitly guaranteed against default risk by the U.S. government.

• Investors still have pre-payment risk– The risk that the bond will be partially (or wholly)

repaid earlier than expected.

• Other government sponsored enterprises issuing mortgage backed securities:– Federal National Mortgage Association (FNMA)– Federal Home Loan Mortgage Corporation

(FHLMC or “Freddie Mac”)

• Student Loan Marketing Association (“Sallie Mae”)– Asset-backed securities backed by student loans

• The entities on the previous slide are not explicitly backed by the full faith and credit of the U.S. government, but many believe there is an implicit guarantee.

• Private organizations, such as banks, also issue asset-backed securities.– Backed by home mortgages, auto loans, credit

card receivables, and other consumer loans.

• Collateralized debt obligation (CDO)– A re-securitization of other asset-backed

securities.– Often divided into tranches that are assigned

different repayment priority.

24.3 Bond Covenants

• Covenants

– Restrictive clauses in a bond contract that limit the issuers from undercutting their ability to repay the bonds

• For example, covenants may

– Restrict the ability of management to pay dividends

– Restrict the level of further indebtedness

– Specify that the issuer must maintain a minimum amount of working capital

Chapter 24 Debt Financing

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