Laurence Booth Sean Cleary. LEARNING OBJECTIVES Debt Instruments 18 18.1 Define “debt” and...

Laurence Booth

Sean Cleary

LEARNING OBJECTIVESLEARNING OBJECTIVES

Debt Instruments18

18.1 Define “debt” and identify the basic features that distinguish debt from equity financing.

18.2 Identify and describe the different types of short-term debt issued in the money market.

18.3 Describe the types of debt financing provided by banks.18.4 Identify the requirements that must typically be satisfied for public

debt issues.18.5 Explain how debt ratings are determined, what they mean, and how

useful they are in predicting default and recovery rates associated with public debt issues.

18.1 WHAT IS DEBT?• Debt creates fixed contractual commitments which include:

– Repayment of the principal borrowed– Payment of interest for the use of the amount borrowed– Adherence to other agreed terms such as limiting the amount of

additional debt taken on, maintaining financial ratios, regular financial reporting, etc.

• Short-term debt has a maturity of one year or less– Interest rates are often lower than those on long-term borrowing– Interest rates are typically variable (floating) which exposes the borrower

to interest rate risk• Long-term debt has a maturity that exceeds one year

– Interest rates are typically greater than those on short-term debt– Often borrowing occurs at a fixed rate, which immunizes the borrower

from interest rate risk by locking in a coupon rate in the case of bonds and debentures

3© John Wiley & Sons Canada, Ltd.Booth • Cleary – 3rd Edition

• Interest on debt is a tax-deductible expense for a firm, so there is a tax shield benefit for firms that use this type of financing

• The after-tax cost of debt is found using Equation 18-1:

The tax shield benefit depends on the corporate tax rate.• The higher the tax rate, the greater the benefit a firm has from financing

profit-making activities with debt.• Small businesses in Canada pay about 20% in corporate tax, but are

riskier than larger businesses and so borrow at higher rates• Example: If a small business borrows at 200 basis points above prime

and prime is 5%, the cost of debt is 7%. The after-tax cost of debt, with a 20% tax rate, is:

4© John Wiley & Sons Canada, Ltd.

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Booth • Cleary – 3rd Edition

18.1 WHAT IS DEBT?

• Large corporations in Canada pay about 34% in corporate tax.• Example: If a corporation borrows at 25 basis points above prime

and prime is 5%, the cost of debt is 5.25%. The after-tax cost of debt, with a 34% tax rate, is:

CRA Tests to Determine if Interest is Tax-Deductible• Interest is compensation for the use or retention of money owed

to another• Interest must be referable to a principal sum• Interest accrues from day to day


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18.1 WHAT IS DEBT?

18.2 SHORT-TERM DEBT AND THE MONEY MARKET

• Short-term debt is traded in the money market and is any debt instrument sold with a life that is 365 days or shorter– Examples: Treasury bills, commercial paper, bankers’

acceptances• Usually there is no stated rate of interest and instead money

market instruments are sold at a discount from face value• The difference between the purchase price and the par value is

treated as interest by Canada Revenue Agency (CRA)


Government Treasury Bills• Government of Canada treasury Bills (T-bills) are short-term

unsecured promissory notes of the Government of Canada• T-Bills are sold at weekly auctions through the Canadian

Government’s fiscal agent, the Bank of Canada, to primary dealers called Government Securities Dealers (GSDs)

• There is a strong secondary market in outstanding T-bills• T-Bills are sold with maturities of 365 days or less. Generally, T-

bills are sold with three different maturities:– 3 month T-bills (91 days)– 6 month T-bills (182 days)– 1 year T-bills



Government Treasury Bills• Government of Canada treasury bills are sold at a discount to face

value, so the difference between the price paid and face value is treated as interest.

• Price are quoted on the basis of a $100 par value to four digits• Bills are normally purchased in denominations of at least $100,000• Example: A 91-day Government of Canada treasury bill is sold for a

price of $99.0909 with a par value of $100. What is the T-bill yield?


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91

365

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0909.99$100$

maturity todays ofnumber

365Yield Bill-T

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01

P

PP



Commercial Paper• Commercial paper (CP) are short-term debt instruments that are

usually unsecured and issued by corporations• It is usually sold at a discount from face value with maturities of

30 to 60 days• Commercial paper involves more credit risk than government

treasury bills because the financial condition of a corporation can deteriorate and thereby risk the repayment of the amount borrowed

• Since there is additional credit risk, there is usually only a market for commercial paper issued by the most creditworthy corporate issuers



Commercial Paper• Since there is a non-negligible probability of default, the forecast

annualized return on commercial paper is known as the promised yield

• Payoff expectations must always take into account the possibility of default as demonstrated in Figure 18-1



Commercial Paper• Since commercial paper is riskier than treasury bills, the promised yield

on commercial paper is higher than the treasury-bill yield• The value of the 30-day commercial paper issue can be found from

Equation 18-2:

where the par value PAR is $1,000R is the promised yieldP is the probability of not defaulting(1 – P) is the probability of defaultingRECOVER is the recovery rate if the company defaultsK is the investor’s required return


K1

)P1(RECOVERP)R1(PARV



Commercial Paper• If we assume the recovery rate is zero and the investor’s

required return is equal to the T-bill yield, then Equation 18-2 becomes Equation 18-3:

• In the absence of default risk (where P = 1), the promised yield on commercial paper is the same as the treasury bill yield


1P

K1R TB



Commercial Paper• The difference between commercial paper yields and

equivalent maturity Treasury bill yields is called the yield spread, and it depends on the default risk of the commercial paper issuer and on market conditions.

• Yield spreads increase when the market becomes pessimistic about the future of the economy (i.e., expects a recession)

• Yields spreads decrease when the market becomes optimistic about the future of the economy (i.e., expects improvement)



Commercial PaperRatings• The Dominion Bond Rating Service (DBRS), Moody’s and Standard &

Poor’s (S&P) rate Canadian commercial paper issues.• DBRS has three ratings: R1 (prime quality), R2 (adequate quality) and

R3 (speculative)• Commercial paper ratings help reduce uncertainty in the market and

can make different issuers of paper interchangeable if they have the same rating.

Liquidity Support• In addition to ratings, commercial paper issuers try to reduce investor

uncertainty by arranging liquidity support, often in the form of a dedicated line of credit from a bank that ensures that the company will have access to money to pay off the commercial paper at maturity if the firm finds it cannot refinance the issue



Bankers’ Acceptances (BAs) • Bankers’ acceptances (BAs) are short-term paper sold by an issuer to a

bank which guarantees (or “accepts”) it, obligating the bank to pay the debt instrument at maturity if the issuer defaults

• Therefore, bankers’ acceptances are a type of bank-guaranteed commercial paper

• The yield on bankers’ acceptances reflect the credit risk of the guaranteeing bank rather than that of the corporate issuer

• Corporate issuers pay a stamping fee to the bank for its guarantee, usually between 0.5% and 0.75% of the amount guaranteed

• Commercial paper tends to be a lower cost alternative to bankers’ acceptances for the most creditworthy corporations that do not require 100% backup from a line of credit



Bankers’ Acceptances (BAs) • Creditworthy governments and corporations gain access to large sums

of low-cost short-term financing in the Canadian money market• Investors, banks, corporations and governments also use the money

market to invest in very high quality short-term investments



18.3 BANK FINANCING• Chartered Banks are an important source of two major types of

short-term financing for Canadian companies: lines of credit and term loans

• Lines of credit in support of working capital needs– Two types: operating (demand) and term (revolving)– Useful for working capital financing, e.g., receivables– A “cleanup” period in which a firm maintains a zero-balance

on its line of credit to ensure that the bank is not providing permanent financing maybe required


Lines of Credit (LCs)• Made for operating purposes, and not to back up a commercial paper

program• Technically, operating lines of credit can be cancelled at any time• Establishes a maximum dollar amount the firm can drawn down

electronically• Usually the balance must be returned to zero for a period of time in the

operating year, usually following the seasonal buildup of inventory and receivables around the major sales season

• The cost is usually set at the prime lending rate although it is not uncommon for the most creditworthy corporate customers to borrow at rates lower than prime

• Less creditworthy customers pay prime plus a risk premium (e.g., 0.5%, 1.0%, etc.)


18.3 BANK FINANCING

Lines of Credit (LCs)• Term is between 364 days and five years, renewable every six

months• “Revolving” means that the line of credit may be drawn upon,

partially retired, and then drawn upon again without the full retirement of the balance during the operating year

• Revolving lines of credit are for liquidity purposes and not credit enhancement. The bank reserves the right to withdraw the line of credit if there is a material adverse change in the customer’s business


18.3 BANK FINANCING

Lines of Credit (LCs)• Borrowers have to meet a variety of restrictions and conditions

(covenants), such as:– Minimum current ratio of 1.4 or net working capital of $100

million– Net worth in excess of $250 million– Minimum interest coverage ratio– Asset coverage ratio in excess of 2 and a debt ratio less than

0.75• In addition to interest costs, banks normally change a

commitment fee of about 0.5% for setting up the line of credit


18.3 BANK FINANCING

18.3 BANK FINANCINGTerm Loans• Term loans in support of longer term investment requirements,

such as equipment purchases– Have fixed maturity and require repayment to be made on a

fixed schedule– Floating interest rates based on the prime rate, which places

interest rate risk on the borrower– Various payment structures, including: blended, bullet and

balloon payments


18.4 LONG-TERM DEBT AND THE MONEY MARKET

• Long-term financing is any debt issue with a term longer than one year, and is also known as funded debt– Examples: mortgage bonds, secured and unsecured

debentures, subordinated debt• Private Placements are debt financing commonly available

through insurance companies and other specialized financial institutions through an offering memorandum

• Public Debt Offerings require a prospectus approved by the provincial securities regulator


Types of Public Debt Offerings• Mortgage bonds where the lender has a registered claim on the

underlying real property• First mortgage bonds where the lender has first claim on the

assets• Second mortgage bonds where the lender ranks behind the first

mortgage bonds• Unsubordinated debt which is unsecured and ranks first among

unsecured debt



Public Debt Offerings: The Bond Indenture• The bond indenture is the legal document that specifies the rights

and responsibilities of the parties to the contract• Bond indentures include:

– Actions that could trigger default– Covenants (promises), including limits on additional borrowing,

prohibitions on subsequent issues of more senior debt, requirements to maintain certain financial ratios, etc.

• Bond investors realize they have a fixed financial claim on the firm over a long period of time, so when financial contracting occurs they negotiate covenants that will protect their long-term financial exposure to the issuing firm



18.5 BOND RATINGSInterpreting Debt Ratings• Bond ratings vary from AAA (highest quality) to CCC (lowest

quality)• Bond ratings are changed by the bond-rating service over time in

response to changes in the financial condition of the issuer• Ratings reflect the downside risk faced if economic conditions

deteriorate• The most common rating is A, which is describe as:

Long-term debt rated “A” is of satisfactory credit quality. Protection of interest and principal is still substantial, but the degree of strength is less than that of AA rated entities. While “A” is a respectable rating, entities in this category are considered to be more susceptible to adverse economic conditions and have greater cyclical tendencies than higher-rated securities.



18.5 BOND RATINGS

Bonds rated below BBB are commonly referred to as junk bonds

Determining Bond Ratings• Companies pay to have their bonds rated because this reduces market

uncertainty regarding their credit risk• Rating agencies conduct extensive analysis of a company, including on-

site visits and historical reviews of its financial performance• Ratings are on the bonds, not on the issuer, so different bond issues

from the same issuer could have different ratings• Six factors are considered in the rating process

1. Core profitability2. Asset quality3. Strategy and management strength4. Balance sheet strength5. Business strength6. Miscellaneous issues


18.5 BOND RATINGS

Empirical Evidence Regarding Debt Ratings• The quality of DBRS ratings can be assessed by examining their

correlation with future default rates to examine their predictive power• DBRS ratings are good indicators of credit risk• Default rates are very low for investment grade bonds• Default risk increases exponentially as credit quality deteriorates• DBRS modifies ratings over time as the financial condition of the issuer

changes, although this is not reflected in Table 18-6

28Booth • Cleary – 3rd Edition © John Wiley & Sons Canada, Ltd.

18.5 BOND RATINGS

• The priority of the debt claim on the firm in the case of insolvency has a direct relationship to the degree of discount from face value

• High risk bonds have both a higher probability of default as well as a lower recovery rate


18.5 BOND RATINGS

• Yield spreads are greater with lower-rated debt, as well as more variable

• During economic slowdowns there is a flight to quality as investors abandon lower quality bonds and increasing yield spreads

• Economic slowdowns can limit or even eliminate access to long-term market-traded debt capital by low quality bond issuers


18.5 BOND RATINGS

© John Wiley & Sons Canada, Ltd. 31

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COPYRIGHTCopyright © 2013 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.

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Laurence Booth Sean Cleary. LEARNING OBJECTIVES Debt Instruments 18 18.1 Define “debt” and...

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