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Ac.F302: Corporate Finance

Week 15 – Debt financing
Dr. Patricia Boyallian
[email protected]
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Lecture Outline

1. Corporate Debt

2. Bond Covenants

3. Repayment Provisions: Callable & Convertible Bonds

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1. Corporate Debt
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Overview of Different Classifications

of Corporate Debt

▪ Public ▪ Private
▪ Unsecured ▪ Secured
▪ Senior ▪ Junior
▪ Domestic ▪ Foreign
▪ Short-term vs. ▪ Long-term
▪ Fixed rate ▪ Floating rate
▪ Coupon-paying ▪ Zero-Coupon
▪ Callable ▪ Non-callable
▪ Straight ▪ Convertible
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Corporate Debt: Public vs.

Private

• Companies can raise debt using different sources. Typical

types of corporate debt include:

– Public debt: which trades in a public market

– Private debt: which is negotiated directly with a bank or a
small group of investors.

• The securities that companies issue when raising debt are

called corporate bonds.

Warning! Not to be confused with “Sovereign” debt, which is issued by governments, e.g.: treasury
bills, municipal bonds, etc.
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Public Debt

• The Prospectus
– A public bond issue is similar to a stock issue.
– A prospectus or offering memorandum must be produced
that describes the details of the offering.
– Indenture
▪ Must be included in the prospectus
▪ It is a formal contract between a bond issuer and a trust
company.
– The trust company 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.
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Public Debt

• Corporate bonds almost always pay coupons semiannually,

although a few corporations have issued zero-coupon bonds in
the past.

• 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.

– The face value does not always correspond to the actual

money raised because of underwriting fees and/or if the
bond is issued at a discount.
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Public Debt

• How do bondholders receive their coupon payments?

– Bearer bonds:
▪ Whoever physically holds the bond certificate owns the
bond.
▪ To receive a coupon payment, the holder must provide
explicit proof of ownership by literally clipping a coupon off
the bond certificate and remitting it to the paying agent.

– 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.
– Almost all bonds today are registered bonds.
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Bearer Bond
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Bearer Bond
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Types of Public Corporate

Debt: secured vs. unsercured

• Four types of public corporate debt are typically issued: notes,

debentures, mortgage bonds, and asset-backed bonds.

• Notes and debentures are types of unsecured debt:

– In the event of bankruptcy, unsecured debt gives bondholders
a claim to only the assets of the firm that are not already
pledged as collateral on other debt.

• Notes typically are coupon bonds with maturities shorter than 10

years.

• Debentures typically have longer maturities than notes.

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Types of Public Corporate

Debt: secured vs. unsercured

• Mortgage and asset-backed bonds are types of secured debt:

– In the event of bankruptcy, secured debt gives bondholders a
claim to the specific assets that are pledged as collateral.

• For mortgage bonds, real property is pledged as collateral.

• Asset-backed bonds can be secured by any kind of asset that

the issuing company owns.
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Types of Public Corporate

Debt: secured vs. unsercured

• Unsecured Debt and Seniority:

– Because more than one debenture/note might be outstanding,

the bondholder’s priority in claiming assets in the event of
default (i.e., their seniority) is important.

– Most debenture issues contain clauses restricting the

company from issuing new debt with equal or higher priority
than existing debt.

– Subordinated (junior) debentures: In the event of a default,

have a lower priority claim to the firm’s assets than other
outstanding debt.
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Public Debt: domestic vs. foreign

• Bond Markets:

▪ Domestic Bonds
– Bonds issued by a local entity and traded in a local
market (can be purchased by foreigners).
– They are denominated in the local currency.
– Example: A U.S. firm issuing a dollar-denominated
bond in the U.S.
▪ Foreign Bonds
– Bonds issued by a foreign company in a local market
and intended for local investors.
– They are denominated in the local currency.
– Example: A British firm issuing a dollar-denominated
bond in the U.S.
– Yankee (U.S.), Bulldog (UK), Samurai (Japan).
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Public Debt: domestic vs. foreign

• Bond Markets:

▪ Eurobonds
– Bonds issued outside the home country of the issuer through
an international syndicate and sold to investors residing in
various countries.
– Are usually denominated in a currency other than that of the
country where it is issued.
– Example: A US company issuing a dollar-denominated bond in
European and/or Asian countries (Eurodollar bond).

▪ Global Bonds
– Similar to Eurobonds but can also be traded and issued
simultaneously in the country whose currency is used to value
the bond.
– Example: A British or US company issuing a dollar-
denominated bond both in France and the U.S.
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Private Debt

• Debt that is not publicly traded.

• Has the advantage that it avoids the cost of public registration

but has the disadvantage of being illiquid.

• There are two segments of the private debt market: term loans
and private placements.
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Private Debt

• 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 Placements
– 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.
2.Debt Covenants

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Debt Covenants

• Restrictive clauses that lenders put in lending agreements

(contracts) to limit the borrowers from taking certain actions that
may reduce their ability to repay the bonds or loans.

• They are not used to place a burden on the borrower. Rather,

they are used to align the interests of the principal (borrower)
and agent (lender) and reduce agency costs of debt.

• By making it legally binding for the borrower to maintain a

certain limit of a financial ratio or keep a certain level of cash
flow, the lender protects itself from the risks associated with the
loan agreement.
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Debt Covenants

• The stronger the covenants in the bond (loan) contract, the lower the
interest rate required by lenders.

• For example, covenants may:

– Restrict the ability of management to pay high dividends.
– Restrict the level of further indebtedness.
– Specify that the issuer must maintain a minimum amount of
working capital.

• Specific examples:
– The company cannot pay annual cash dividends exceeding 65%
of net earnings.
– The company cannot borrow debt that is senior to this debt.
– The company must maintain an interest coverage ratio of 3.20
based on cash flow from operations.
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Importance of Debt Covenants:

Further indebtedness

• Assume a company has equity for $4 million and no debt. The leverage ration of this
company is L=D/E = 0
• Then, Lender A lends $1 million to the company. Based on the risk profile of the
company, the lender lends at an annual interest rate of 7%. After this round of
borrowing, the company has a leverage ratio of L=1/4=0.25
• If there are no covenants restricting further debt, the company can immediately borrow
an additional $2 million from another lender (Lender B). In such case the new Leverage
rate of the company would be: L = (1 + 2)/4=0.75

• If the company turns around and borrows more money from additional lenders, the
original loan will be a riskier proposition for Lender A because of the higher possibility
of the company defaulting on its loan repayment to Lender A due to the increased
leverage of the company.

• Therefore, it is in Lender A’s best interest to put a covenant in the loan contract to
restrict the company from raising more debt or to limit the company to certain debt
ratio.
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Importance of Debt Covenants:

Cashing out

• Lender A lends $1 million to a company.

• In the following days, the company declares a liquidating dividend to all
shareholders.

• Without covenants, the company is free to pay out all of its earnings or
liquidate its assets and pay a liquidating dividend to all shareholders.

• In this scenario, the lender will lose his/her money.

• Therefore, it is in Lender A’s best interest to put a covenant in the loan

contract to restrict the company to a certain dividend payout ratio.
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Violation of Debt Covenants

• When a debt covenant is violated, depending on the severity,

the lender can do several things:

– Demand penalty payment.

– Increase the predetermined interest rate.

– Increase the amount of collateral.

– Demand full immediate repayment of the loan.

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3.Repayment provisions
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Repayment Provisions

• A bond issuer typically repays its bonds by making coupon

and principal payments as specified in the bond contract
However, the issuer can:
– Repurchase a fraction of the outstanding bonds in the
market
– Make a tender offer for the entire issue
– Exercise a call provision
– Convertible provision
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Call Provisions

• Callable Bonds: Bonds that contain a call provision that allows

the issuer to repurchase the bonds at a predetermined price.

• A call feature allows the issuer of the bond the right (but not the
obligation) to retire all outstanding bonds on (or after) a specific
date (the call date), for the call price.

• The call price is generally set at or above, and expressed as a

percentage of, the bond’s face value.

• A firm may choose to call a bond issue if interest rates have

fallen.
– The issuer can lower its borrowing costs by exercising the
call and then immediately refinancing the issue at a lower
rate.
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Call Provisions

• Holders of callable bonds understand that the issuer will

exercise the call option only when the coupon rate of the bond
exceeds the prevailing market rate.

• If a bond is called, investors must reinvest the proceeds

when market rates are lower than the coupon rate they are
currently receiving.
– This makes callable bonds relatively less attractive to
bondholders than identical non-callable bonds.
– A callable bond will trade at a lower price (and therefore a
higher yield) than an otherwise equivalent non-callable
bond.
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Call Provisions: on the call

date

• Consider what happens to a bond that is callable at par on only one

specific date. On the call date:
– If the yield of the callable bond is less than the coupon, the callable
bond will be called, so its price is its par value.
– If this yield is greater than the coupon, then the callable bond will not
be called, so it has the same price as the non-callable bond.
▪ Note: The callable bond price is capped at par: The price can be
low when yields are high but does not rise above the par value
when the yield is low.
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Figure 24.2 Prices of Callable

and Non-Callable Bonds on the
Call Date
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Call Provisions: prior to the

call date
• Prior to the Call Date
– When market yields are high relative to the bond coupon, investors
anticipate that the likelihood of exercising the call is low and the
bond price is similar to an otherwise identical non-callable bond.

– When market yields are low relative to the bond coupon, investors
anticipate that the bond will likely be called, so its price is close to
the price of a non-callable bond that matures on the call date.
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Figure 24.3 Prices of Callable and

Non-Callable Bonds Prior to the
Call Date
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Call Provisions

• Yield to Call ( YTC )

– The yield of a callable bond calculated under the
assumption that the bond will be called on the earliest
call date
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Convertible Provisions

• Convertible Bond
– A corporate bond with a provision that gives the bondholder
an option to convert the bond owned into a fixed number of
shares of common stock at any time up to the maturity of the
bond.

• Conversion Ratio
– The number of shares into which each bond can be
converted.

• Conversion Price
– The face value of a convertible bond divided by the number
of shares received if the bond is converted.
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Convertible Provisions

• A convertible bond can be thought of as a regular bond plus a

special type of call option called a warrant.

– Warrant: A call option written by the company itself on new

stock (whereas a regular call option is written on existing
stock).

• When a holder of a warrant exercises it and thereby purchases

stock, the company delivers this stock by issuing new stock.

• Convertible debt carries a lower interest rate because it has an

embedded warrant.
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Convertible Provisions

• Assume you have a convertible bond with a $1000 face value and
a conversion ratio of 15.

– If you convert the bond into stock, you will receive 15 shares.

– If you do not convert, you will receive $1000 at maturity.

– By converting you essentially “pay” $1000 for 15 shares,

implying a price per share of $66.67 (the strike price of the
warrant).

– If the price of the stock in the market exceeds $66.67, you will
choose to convert; otherwise, you will take the cash.
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Convertible Provisions

Prior to maturity, If the

stock price is low so that
the embedded warrant is
deep out-of-the-money,
the conversion provision
is not worth much and the
bond’s value is close to
the value of a straight
bond.

When the stock price is

high and the embedded
warrant is deep in-the-
money, then the
convertible bond trades
close to but higher than
the value of the bond if
converted (to reflect the
time value of the option).