Chapter 19 Business Borrowing: Corporate Bonds, Asset-Backed Securities, Bank Loans, and Other Forms of Business Debt

 Learning Objectives   To look at how business firms issue debt securities and negotiate loans in order to raise funds in the money and capital markets.  To learn about the key factors affecting the volume of funds that businesses seek to raise in the financial system.  To see the often powerful impact that business borrowing has upon market interest rates and credit conditions. 19-2

Introduction  Business firms draw on a wide variety of fund sources to finance their daily operations and to carry out long-term investment.  In 2006, nonfinancial business firms in the U.S. raised nearly $1.9 trillion, of which approximately $516 billion was supplied from the financial markets through issues of bonds, stocks, notes, and other financial instruments. 19-3

Factors Affecting Business Activity in the Money and Capital Markets  Many factors affect the extent to which business firms draw on the money and capital markets for external funds:  Total funding demands of business firms  Level and expected growth of internally generated funds  Condition of the economy  Credit availability and interest rates 19-4

Characteristics of Corporate Notes and Bonds  Maturity definition  A note has an original maturity of five years or less  A bond carries an original maturity of more than five years  General characteristics  An amount equal to the par value at maturity  Interest payments at specified intervals  Generally issued in units of $1,000  Accompanied by indentures 19-5

Characteristics of Corporate Notes and Bonds  Corporate bonds tend to be issued with longer maturities when both interest rates and inflation are low  Some corporate bonds are backed by sinking funds  A considerable proportion of corporate bonds that are outstanding today carry call privileges 19-6

Characteristics of Corporate Notes and Bonds  During rapid economic expansion  The supply of credit is relatively scarce  The cost of borrowing rises  Yield movements  Yields on the highest-grade bonds tend to move closely with government bond yields  Yields carried by lower-grade corporate bonds  More tied to conditions in the economy  Also tied more to factors specifically affecting the risk position of the borrower 19-7

Characteristics of Corporate Notes and Bonds For a bond that matures in 10 years:  Interest charges on debt are tax deductible, so k’ = k (1 – t) 19-8

Characteristics of Corporate Notes and Bonds Signals Corporate Bond Issues May Send  A bond issue that appears to be driven by an unanticipated cash-flow shortage  Tends to lower bond prices of the issuer  Tends to lower equity prices of the issuer  A new bond sold to expand the firm’s capitalization tends to send a positive signal to the market 19-9

Characteristics of Corporate Notes and Bonds  Common types of corporate bonds  Debentures – Unsecured by a specific asset  Subordinated debentures – junior securities  Mortgage bonds – closed end or open end  Income bonds – interest is paid only when income is actually earned  Equipment trust certificates – resemble leases  Industrial development bonds (IDBs) – issued by a local government borrowing authority 19-10

Characteristics of Corporate Notes and Bonds  Innovations in corporate debt include:  Discount bonds – including zero coupon bonds  Floating-rate bonds  Commodity-backed bonds – face value is tied to the market price of an internationally traded commodity  Inflation-linked corporate notes  Medium-term notes (MTNs) – carry maturities of one to ten years 19-11

Asset-Backed Securities Issued by Corporations  Securitization  The process that gives rise to the creation of asset-backed securities (ABS)  Example: Packaging group of home mortgages  Usually with federal agency guarantees  Removed from the lenders’ balance sheets  Placing them in a separate trust account  Selling securities backed by mortgages  With the help of an investment bank 19-12

Asset-Backed Securities Issued by Corporations

Asset-Backed Securities Issued by Corporations  Securitization may:  Reduce the cost of raising funds  Grant companies greater control over their balance sheets  Help a company avoid the issuance of additional balance-sheet debt  Improve the apparent financial strength of an issuing firm  Permit greater asset diversification  Provide a new source of company earnings 19-14

Asset-Backed Securities Issued by Corporations

Investors in Corporate Debt  The market is institution dominated  Pension funds prefer public corporate debt  Insurance companies frequently prefer private placement  Foreign institutions are a very dynamic sector of the market  Many dealers are international  Many of the debt instruments are for foreign takeovers of U.S. companies  Many more are ways to access dollars 19-16

Investors in Corporate Debt  Rapid growth in debt instruments in the U.S.  Not matched by rise of U.S. resident bond holdings  Differential filled by foreign investors  Bonds by U.S. companies between 1995 and 2006  Tripled from $2.5 trillion to $8.2 trillion  Foreign investment went from $461 billion to $2.7 trillion 19-17

Investors in Corporate Debt Principal Investors in Corporate and Foreign Bonds, 2006 Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts: Financial Assets and Liabilities, Fourth Quarter

The Secondary Market for Corporate Debt  The secondary market for corporate debt  Relatively limited compared to the markets for other long-term securities  The number of active individual investors is small  Institutional investors tend to follow a buy and hold strategy  Some changes in strategies more recently  Many institutions are looking at total performance  Have become more aggressive 19-19

The Marketing of Corporate Debt  Corporate bonds may be offered publicly  Through a public sale  Sold privately to a limited number of investors via a private or direct placement  The majority of offerings are public sales  Popular with firms having unique financing requirements  Private placements are common among smaller companies 19-20

The Marketing of Corporate Debt  The decision of small firms is often a function of the nature of the market  Economies of scale in public issuance of debt  So relatively cheaper for firms with large debt issuances  For smaller firms with less debt the public market is relatively more expensive  The flexibility of private issues  More easily address potential agency costs  Allow smaller debt issues 19-21

The Marketing of Corporate Debt  A public sale uses an underwriter  An investment banking firm or a syndicate of underwriters may do one of two things  Purchase the securities directly from the issuing company through a bidding process  Guarantee the issuer a specific price  The underwriter carries the risk of losses (or gains) when the securities are marked for sale in the open market 19-22

The Marketing of Corporate Debt  Private placements have accounted for about 10% of market sales of corporate bonds  Interest rates influence the private versus public decision  Rising interest rates bring more borrowing companies into the public market  Falling interest rates often bring about a rise in private placements 19-23

The Volume of Borrowing by Corporations 19-24

The Volume of Borrowing by Corporations  Growth in corporate borrowing is due to:  Inflation  The increased use of financial leverage to boost returns to corporate stockholders  The development of international capital markets  Recent relatively-low interest rates  The rash of corporate takeovers (leveraged buyouts) and mergers 19-25

The Volume of Borrowing by Corporations  Also more borrowing due to corporate stock retirements  A significant growth in popularity  Among larger corporations  Stock retirements exceeded $400 billion for the year ending in June 2006  Was only $130 billion in 2001  Various factors for the expansion  More M&A activity  More companies tapping the debt market 19-26

Bank Loans to Business Firms  Commercial banks are direct competitors with the corporate debt markets  Making both short-term and long-term loans to businesses  Growing numbers of corporations have turned to selling securities in the open market  The volume of bank credit for business firms remains enormous 19-27

Bank Loans to Business Firms  The Fed has been carrying out surveys  Examine business lending practices  Look at banks across the U.S.  Surveys indicate bank lending tends to be short-term  Average maturity of commercial and industrial loans (value-weighted) was 524 days in February 2007  Longer term loans averaged 54 months 19-28

Bank Loans to Business Firms  The prime bank rate, or base rate  The annual percentage rate that banks quote to their most creditworthy customers  Tend to be unsecured  Often require compensating balances  These tend to be short-term loans  Traditionally, the prime rate was set by one or more of the nation’s leading banks  Now, prime rates are often pegged to the prevailing yields on Treasury bills 19-29

Commercial Mortgages  Commercial mortgage  The construction of commercial structure  Office buildings  Shopping centers  Other commercial structures  Faced with inflation and a volatile economy, new forms have been developed:  equity kicker  indexing  asset-backed securitization 19-30

Markets on the Net  American Capital Advance at americancapitaladvance.com americancapitaladvance.com  Amerimerchant at amerimerchant.com amerimerchant.com  Asset Securitization Report at asreport.com asreport.com  Bankrate.com at bankrate.com bankrate.com  Bond Market Association at  Bond Market Association – European Issues at

Markets on the Net  British Bankers’ Association at  Business.com at  CBS Marketwatch at  CNN/Financial at  Financial Pipeline at  Mortgage 101 at

Markets on the Net  National Association of Small Business Investment Companies at nasbic.org nasbic.org  REBUZ – Commercial Mortgages at  Small Business Notes at smallbusinessnotes.com smallbusinessnotes.com  St. Louis Federal Reserve Bank research at research.stlouisfed.org/fred2 research.stlouisfed.org/fred2  Wikipedia at en.wikipedia.org en.wikipedia.org 19-33

Chapter Review  Introduction to business borrowing  Factors affecting business activity in the money and capital markets 19-34

Chapter Review  Characteristics of corporate notes and bonds  Principal features  Recent trends in original maturities  Call privileges  Sinking fund provisions  Yields and costs  Signals corporate bond Issues may send  The most common types of corporate bonds  Innovations in corporate debt 19-35

Chapter Review  Asset-backed securities Issued by corporations  Investors in corporate debt  The secondary market for corporate debt  The marketing of corporate debt  Public sales  Private placements  The volume of borrowing by corporations 19-36

Chapter Review  Bank loans to business firms  The volume of bank credit supplied to businesses  The prime, or base, Interest rate on business loans  Other examples of base rates for business loans  Commercial mortgages 19-37