Chapter 24 Debt Financing

Copyright ©2014 Pearson Education, Inc. All rights reserved 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.24-3 Table 24.1 New Debt Issued as Part of the Hertz LBO

Copyright ©2014 Pearson Education, Inc. All rights reserved.24-4 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.24-5 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.24-6 Public Debt (cont'd) 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.24-7 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.24-8 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.24-9 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

Copyright ©2014 Pearson Education, Inc. All rights reserved 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved Public Debt (cont'd) 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

Copyright ©2014 Pearson Education, Inc. All rights reserved Public Debt (cont'd) 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).

Copyright ©2014 Pearson Education, Inc. All rights reserved 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

Copyright ©2014 Pearson Education, Inc. All rights reserved 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

Copyright ©2014 Pearson Education, Inc. All rights reserved 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved 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 years –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)

Copyright ©2014 Pearson Education, Inc. All rights reserved 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved Sovereign Debt (cont'd) 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved Sovereign Debt (cont'd) 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved 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

Copyright ©2014 Pearson Education, Inc. All rights reserved 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

Copyright ©2014 Pearson Education, Inc. All rights reserved 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

Copyright ©2014 Pearson Education, Inc. All rights reserved 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

Copyright ©2014 Pearson Education, Inc. All rights reserved 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).

Copyright ©2014 Pearson Education, Inc. All rights reserved Asset-Backed Securities (cont'd) 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved Asset-Backed Securities (cont'd) 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

Copyright ©2014 Pearson Education, Inc. All rights reserved Asset-Backed Securities (cont'd) 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved Asset-Backed Securities (cont'd) 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.

Copyright ©2014 Pearson Education, Inc. All rights reserved 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