Raising Capital: Debt Flashcards
(23 cards)
Some fundamental features of debt finance
What is debt?
Why is debt finance generally ____ ____________ than equity? (4)
Do lenders share in the value created by a successful business?
Does debt finance provide voting power?
How do interest payments impact taxable profit?
What happens if a company fails to meet loan terms?
What is debt?
- Debt is something that has to be repaid.
Why is debt finance generally less expensive than equity?
- The costs of raising the funds are lower.
- The annual return required to attract investors is less.
- Interest payments are tax deductible.
- New UK tax rules (April 2017) limit interest deductions for large businesses with over £2M in finance costs per annum.
Do lenders share in the value created by a successful business?
- No, lenders do not benefit from the business’s success beyond the interest payments received.
Does debt finance provide voting power?
- No, debt holders do not gain voting rights in the company.
How do interest payments impact taxable profit?
- Interest payments are considered a cost of doing business and reduce taxable profit.
What happens if a company fails to meet loan terms?
- Creditors can claim some or all of the firm’s assets in case of non-compliance with loan agreements.
Bank loans: An under-recognised role in finance
Borrowing from banks is attractive to companies for the following reasons (4)
Borrowing from banks is attractive to companies for the following reasons:
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Administrative and legal costs are low:
- Compared to issuing shares or bonds, bank loans require less paperwork and regulatory compliance.
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Quick:
- Bank loans can be processed quickly, allowing businesses to access funds without lengthy approval processes.
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Flexibility:
- Banks offer various loan structures, including short-term and long-term financing, tailored to business needs.
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Available to small firms:
- Unlike capital markets, which favor larger corporations, banks provide financing options for small and medium-sized enterprises (SMEs).
Challenges & Government Incentives for Small Business Lending
What are the main factors behind banks finding it hard to offer loans to small businesses at “reasonable” interest rates? (6)
What incentives can governments provide in free-market economies to encourage banks to lend to small businesses? (4)
What are the main factors behind banks finding it hard to offer loans to small businesses at “reasonable” interest rates?
- Higher default risk
- Lack of collateral
- High administrative costs
- Limited credit history & financial transparency
- Economic uncertainty & market conditions
- Regulatory & risk management constraints
What incentives can governments provide in free-market economies to encourage banks to lend to small businesses?
- Government loan guarantees & risk-sharing programs
- Tax incentives for lenders
- Interest rate subsidies
- Regulatory flexibility & capital relief
Factors for a firm to consider when borrowing from a bank
What are the costs to consider when borrowing from a bank? (3,3,2)
What is a revolving credit facility?
What is SONIA (Sterling Overnight Index Average)?
What are the costs to consider when borrowing from a bank?
- Arrangement fee
- Interest rate (fixed or floating)
- Floating-rate borrowings: the rate will generally be certain percentage points above the banks’ base rate
Advantages:
- If interest rates fall, loan cost decreases - Fixed rates are usually higher than floating rates - Returns on firm’s assets may increase during higher interest rates
Disadvantages:
- Interest rates may rise, increasing loan costs - Cash outflow uncertainty
What is a revolving credit facility?
- Allows a borrower to access credit repeatedly up to a set limit, repaying and borrowing again without needing to reapply.
What is SONIA (Sterling Overnight Index Average)?
- A benchmark interest rate based on actual transactions, making it transparent and robust.
What is LIBOR? (2)
Which currencies and maturities were covered by LIBOR? (2)
How was LIBOR determined?
Why was LIBOR phased out? (2)
What is SONIA? (2)
What is LIBOR?
- LIBOR (London Interbank Offered Rate) was the benchmark interest rate used globally for interbank lending.
- It determined borrowing costs for financial products such as loans, derivatives, and mortgages.
Which currencies and maturities were covered by LIBOR?
- Available for multiple currencies: USD, GBP, EUR, JPY, etc.
- Covered various maturities: Overnight, 1-week, 1-month, 3-month, etc.
How was LIBOR determined?
- Based on estimates provided by a panel of banks.
Why was LIBOR phased out?
- Concerns about rate manipulation.
- Decline in actual interbank lending activity, making it less reliable.
What is SONIA?
- Sterling Overnight Index Average (SONIA) is the UK’s benchmark rate that replaces LIBOR.
- It reflects actual overnight borrowing costs between financial institutions rather than estimated rates.
How can banks/lenders protect themselves?
Why are banks concerned about borrowers?
How can companies reduce bank uncertainty?
What is asymmetric information? (1+2)
How does ____________ help banks protect themselves?
What are ______ ______________? (1+2)
What are ______________ _______________?
Why are banks concerned about borrowers?
- Banks worry about the borrower’s competence and honesty.
How can companies reduce bank uncertainty?
- By providing as much information as possible.
What is asymmetric information?
When one party in a transaction has more or better information than the other
- Adverse selection – Risk of lending to high-risk borrowers.
- Moral hazard – Borrowers taking risky actions after receiving funds.
How does collateral help banks protect themselves?
- Collateral consists of assets pledged to secure the loan, reducing risk for lenders.
What are loan covenants?
Restrictions on managerial action.
Positive covenants – Require maintaining a minimum working capital and providing financial statements.
Negative covenants – Restrict dividends, asset pledging, mergers, asset sales or leases, and new debt issuance.
What are personal guarantees?
- A director personally guarantees the loan, making them liable if the company fails to repay.
Corporate Bonds
What is a bond?
What does the company promise to do?
What happens at maturity?
What are the different forms of negotiable instruments? (5)
What are these instruments linked to?
What is a bond?
- A bond is a long-term contract in which bondholders lend money to a company.
What does the company promise to do?
- The company typically promises to pay the bond owners predetermined payments, usually a series of coupons, until the bond matures.
What happens at maturity?
- At maturity, the bondholder receives a specified principal sum called the par (face or nominal) value of the bond.
What are the different forms of negotiable instruments?
- Secured bonds
- Unsecured bonds
- Straight, plain vanilla, or bullet bonds
- Zero-coupon bonds
- Floating-rate or variable-rate bonds
What are these instruments linked to?
- Linked to a wide variety of economic events or investment interests, including moral money and green investing.
Corporate Bonds: Green Bond & “Sustainability-Linked” Bonds
What is the current regulatory framework around calling a bond a “green bond”?
What are the most well-known and recognized principles for green bonds?
What is the Green Bond Principles set of principles managed by?
What are the four major components of the Green Bond Principles?
What has the period of voluntary practice been under?
What did the UK Financial Conduct Authority publish in July 2022?
What is the current value of the green bond market?
What is the implication of the green bond market’s value?
What is the current regulatory framework around calling a bond a “green bond”?
- There is currently no regulatory or definitive required framework around calling a bond a “green bond,” only voluntary best practice principles exist.
What are the most well-known and recognized principles for green bonds?
- The most well-known and recognized principles are the Green Bond Principles, though the World Bank and IFC also have their own separate principles.
What is the Green Bond Principles set of principles managed by?
- The Green Bond Principles are managed by the International Capital Market Association (ICMA).
What are the four major components of the Green Bond Principles?
- Use of Proceeds
- Process for Project Evaluation and Selection
- Management of Proceeds
- Reporting
What has the period of voluntary practice been under?
- The period of voluntary practice has been under sustained regulatory scrutiny of late and probably will not last due to a series of “greenwashing” scandals.
What did the UK Financial Conduct Authority publish in July 2022?
- In July 2022, the UK Financial Conduct Authority published a report which effectively called for ESG claims to be brought directly under their remit.
What is the current value of the green bond market?
- The green bond market has a value of $1tn a year issuance.
What is the implication of the green bond market’s value?
- The market is simply too large to ignore and leave unregulated any longer.
Secured Bonds, Debentures, Loan Stocks and Notes
What are secured bonds? (2)
What are unsecured bonds (_______________)? (2)
What is loan stock? (2)
What are medium-term notes? (2)
What are secured bonds?
- Secured bonds are backed by specific assets used as collateral.
- If the issuer defaults, bondholders gain title to the asset.
What are unsecured bonds (debentures)?
- Unsecured bonds are not backed by collateral but rely on the issuer’s reputation.
- They may carry a general fixed or floating charge on company assets.
What is loan stock?
- Loan stock refers to shares issued by a company in exchange for a fixed-interest loan.
- The issued shares act as collateral for the loan.
What are medium-term notes?
- Medium-term notes (MTNs) are debt instruments similar to bonds.
- Typically have maturities ranging from nine months to under 10 years, though some extend up to 30 years.
Trust deeds and Covenants
What is a trust deed, and what do trustees ensure? (2)
What are affirmative covenants?
What are negative (restrictive) covenants? (4)
What happened between 2012-2020 regarding bonds and covenants? (2)
What is an example of “doc-lite” bonds compared to traditional debt?
What is a trust deed, and what do trustees ensure?
- A trust deed is a legal document governing a bond issue.
- Trustees ensure compliance with the contract.
What are affirmative covenants?
- Obligations placed on the borrower to take specific actions.
What are negative (restrictive) covenants?
- Limits on further debt issuance.
- Restrictions on dividend levels.
- Limits on the disposal of assets.
- Requirements to maintain certain financial ratios.
What happened between 2012-2020 regarding bonds and covenants?
- Emergence of increasingly “doc-lite” bonds.
- Steady decrease in covenant quality and investor protections.
What is an example of “doc-lite” bonds compared to traditional debt?
- Unlike traditional debt, where the borrower must maintain a certain level of EBITDA or leverage ratio, “doc-lite” bonds might not require these safeguards, leaving lenders with fewer protections.
Repayments
How are bond repayments usually handled?
What is a call provision? (4)
What is a sinking fund? (3)
What is tranching?
How can firms buy back outstanding bonds?
What are perpetual bonds? (3)
How are bond repayments usually handled?
- Paid entirely at maturity, often by re-financing the loan.
What is a call provision?
- Allows early repayment before the final redemption date.
- Firm can repurchase bonds at a predetermined price.
- Call price is higher than face value.
- Call premium = Call price - Face value.
What is a sinking fund?
- A fund set up by a company to gradually buy back bonds before maturity.
- Reduces total outstanding debt.
- Improves creditworthiness and lowers default risk.
What is tranching?
- Bonds may have multiple redemption dates instead of a single maturity date.
How can firms buy back outstanding bonds?
- Issuing firm can repurchase outstanding bonds on the open market.
What are perpetual bonds?
- Bonds with no maturity date.
- Have a fixed interest rate.
- Considered risky investments.
Negative yield
What does a negative yield mean for a bondholder?
What is an example of investing in a bond with a negative yield?
Why might some investors speculate that yields can fall further?
Why do negative yields seem counterintuitive, and what factors drive market behavior?
What does a negative yield mean for a bondholder?
- A negative yield means the bondholder will lose money in nominal terms over the life of the bond.
What is an example of investing in a bond with a negative yield?
- If you invest £100,000 in a bond with a negative yield, you might only get back £95,000 when the bond matures, even though you are receiving interest payments.
Why might some investors speculate that yields can fall further?
- Some investors may speculate that yields can fall even further, which will push up the prices of corporate bonds—allowing them to sell the bonds at a higher price.
Why do negative yields seem counterintuitive, and what factors drive market behavior?
- While negative yields seem counterintuitive, the demand for safe assets and specific economic circumstances can still drive market behavior. The decision to buy or sell these bonds often comes down to broader economic conditions, central bank policies, and individual investment strategies.
Credit rating
How do credit rating agencies (CRAs) function?
What determines a debt rating? (2)
What is meant by ‘Investment grade’?
What exactly is rated in credit assessments?
How do credit rating agencies (CRAs) function?
- They assess the creditworthiness of entities and financial instruments.
What determines a debt rating?
- Probability of default (failure to pay interest or capital).
- Level of protection available to the lender in case of default.
What is meant by ‘Investment grade’?
- Bonds rated highly enough for many institutional investors to invest in them.
What exactly is rated in credit assessments?
- The specific loan itself, rather than the borrower.
Syndicated Loans
What is the availability of syndicated loans? (2)
Who manages syndicated loans? (3)
What are the characteristics of syndicated loans? (3)
What fees are associated with syndicated loans? (4)
What covenants do syndicated loans carry?
What is the availability of syndicated loans?
- Syndicated loans are typically available for amounts exceeding £50m.
- Multiple banks contribute portions to form the overall loan.
Who manages syndicated loans?
- Lead manager and arranging bank(s).
- A syndicate group consisting of co-managing banks.
- The managing bank underwrites much of the loan.
What are the characteristics of syndicated loans?
- Loans can be arranged quickly and discreetly.
- Interest rates are generally floating, with rollovers every three or six months.
- Typically offer lower returns than bonds.
What fees are associated with syndicated loans?
- Management fees (around 1% of the total loan).
- Loan commitment fees (e.g., 0.5% of undrawn funds).
- Underwriting fees for guaranteeing fund availability.
- Agent’s fee.
What covenants do syndicated loans carry?
- Similar covenants to bond agreements, including draw-down schedules and grace periods.
High Risk Debt: Mezzanine Financing
What is Mezzanine Financing of debt?
What are other names for Mezzanine Financing?
What type of finance is Mezzanine Financing? (2)
How does Mezzanine Financing rank in terms of payment?
What are the interest rates for Mezzanine Financing?
When is Mezzanine Financing used?
What does Mezzanine Financing permit the firm to do?
What is Mezzanine Financing of debt?
- A high-risk debt option that offers high returns.
What are other names for Mezzanine Financing?
- Also known as subordinated, intermediate, or low-grade debt.
What type of finance is Mezzanine Financing?
- A hybrid finance option bridging debt and equity.
- Allows lenders to convert to equity in case of default.
How does Mezzanine Financing rank in terms of payment?
- Can be unsecured or secured but ranks below senior loans for interest and capital repayment.
What are the interest rates for Mezzanine Financing?
- Typically 2-9% higher than senior debt rates.
When is Mezzanine Financing used?
- Used when bank borrowing limits are reached and issuing more equity is not an option.
What does Mezzanine Financing permit the firm to do?
- Allows firms to exceed conventional debt-to-equity ratios.
High Risk Debt: High-Yield (Junk) Bonds
What are high-yield (junk) bonds?
How does the European high-yield bond market compare to the United States?
What was the demand trend for high-yield bonds between 2018-2020?
What is the typical lifespan of high-yield bonds compared to investment grade bonds?
What are high-yield (junk) bonds?
- Bonds with high-risk and high-return characteristics (ratings of Bs and Cs).
- ‘Fallen angels’ or bonds issued specifically to provide higher-risk finance instruments for investors.
How does the European high-yield bond market compare to the United States?
- European high-yield bond market is less developed than in the United States.
What was the demand trend for high-yield bonds between 2018-2020?
- In 2018-2020, these markets were strongly in demand due to yield-seeking, particularly from Japanese investors.
What is the typical lifespan of high-yield bonds compared to investment grade bonds?
- Typically have a life of 5-7 years as opposed to the more usual 10 years+ of investment grade bonds.
High Risk Debt: Leveraged Loan Market
What are leveraged loans? (2)
How has the leveraged loan market grown since 2010? (2)
What constitutes a substantial part of the leveraged loan market? (2)
What are leveraged loans?
- High-risk loans provided to companies with poor credit histories and ratings.
- Carry a significant risk of default.
How has the leveraged loan market grown since 2010?
- Increased due to investor appetite for yield.
- Valued at $1.2 trillion in the US and an estimated $2.2 trillion worldwide.
What constitutes a substantial part of the leveraged loan market?
- 50% of the market consists of repackaged debt sold as Collateralised Debt Obligations (CDOs).
- CDOs are purchased and resold in financial markets.
Project Finance
What is project finance? (4)
What is the spectrum of risk sharing in project finance deals? (3)
Why are interest rates higher in project finance?
What are examples of capital-intensive infrastructure projects?
What is project finance?
- Equity capital for a separate legal entity.
- Project debt finance is provided as bank loans or bond issues direct to a separate entity (special purpose vehicle, SPV).
- Loan returns are tied to potential cash flows and revenue of a specific project.
- The project must be identifiable and separable from the rest of the company’s activities.
What is the spectrum of risk sharing in project finance deals?
- Recourse finance: Lender can claim the borrower’s personal assets beyond the collateral if the loan isn’t repaid.
- No right of recourse: Lender can only claim the pledged collateral, not other borrower assets.
- Various arrangements exist between these extremes.
Why are interest rates higher in project finance?
- Due to additional risks to lenders, interest rates tend to be higher.
What are examples of capital-intensive infrastructure projects?
- Transportation infrastructure, energy, mining, oil, and gas projects.
Sale and leaseback
What is sale and leaseback? (2)
What are the benefits of sale and leaseback? (3)
What are the drawbacks of sale and leaseback? (4)
What is sale and leaseback?
- A firm that owns buildings, land, or equipment sells to another firm.
- Simultaneously agrees to lease the property back for a stated period under specific terms.
What are the benefits of sale and leaseback?
- Immediate cash received, which can be reinvested, used for debt repayment, or business expansion.
- In some countries, tax rules favor sale and leaseback as lease payments are tax-deductible as business expenses.
- Encourages efficiency by making managers more aware of asset value in operations.
What are the drawbacks of sale and leaseback?
- Creates a regular cash flow liability for the seller.
- Rental payments increase periodically.
- Involves complex documentation and large legal fees.
- The property can no longer be used as security for loans.
What do retail chains do to free up capital while maintaining operations?
How do airlines reduce capital expenditure?
What do companies in the real estate sector do for continued use of their buildings?
What do retail chains do to free up capital while maintaining operations?
- Retail chains (e.g., Walmart, Tesco, McDonald’s) sell stores and lease them back to free up capital while maintaining operations.
How do airlines reduce capital expenditure?
- Airlines (e.g., British Airways, Delta) sell aircraft to leasing companies and lease them back to reduce capital expenditure.
What do companies in the real estate sector do for continued use of their buildings?
- Real estate companies (e.g., Banks, Hotels, Manufacturing Plants) sell office buildings, factories, or hotels to real estate investors and lease them for continued use.
Securitisation
What is the market in repackaged debt?
What is the replacement of long-term assets with cash?
What is selling asset-backed securities, ABS (asset securitisation)?
What does asset-backed securitisation involve?
What are the types of securitisation?
What is a special purpose vehicle (SPV) or special purpose entity (SPE)?
What does securitisation permit financial institutions to do?
What is the market in repackaged debt?
- Market in repackaged debt.
What is the replacement of long-term assets with cash?
- Replacement of long-term assets with cash.
What is selling asset-backed securities, ABS (asset securitisation)?
- Selling asset-backed securities, ABS (asset securitisation).
What does asset-backed securitisation involve?
- Pooling and repackaging of relatively small, homogeneous, and illiquid financial assets into liquid securities.
What are the types of securitisation?
- Can be either ‘non-recourse’ or with ‘recourse’.
What is a special purpose vehicle (SPV) or special purpose entity (SPE)?
- Special purpose vehicle (SPV) or ‘special purpose entity’ (SPE).
What does securitisation permit financial institutions to do?
- Focus on aspects of the lending process where they have a competitive edge.
Structured Finance and Debt Instruments: Key Concepts Explained
What are the underlying assets for CLOs and CDOs? (2)
What is the risk profile of CLOs compared to CDOs? (2)
Who are the typical investors for CLOs and CDOs? (2)
How are CLOs and CDOs structured in terms of tranches? (2)
What is the association of CLOs and CDOs with the 2008 financial crisis? (2)
What are the underlying assets for CLOs and CDOs?
- CLOs: Primarily corporate leveraged loans (loans to highly indebted companies).
- CDOs: Can be backed by various debt instruments, including corporate bonds, mortgage-backed securities (MBS), credit card debt, auto loans, or other fixed-income assets.
What is the risk profile of CLOs compared to CDOs?
- CLOs: Generally lower risk than CDOs, as loans are backed by operating businesses.
- CDOs: More complex and riskier, especially CDOs backed by subprime mortgages (e.g., the 2008 crisis).
Who are the typical investors for CLOs and CDOs?
- CLOs: Institutional investors (hedge funds, pension funds, banks) seeking high-yield, structured debt exposure.
- CDOs: Broad range of investors, but CDOs became infamous for hiding bad assets before the financial crisis.
How are CLOs and CDOs structured in terms of tranches?
- CLOs: Structured into senior (AAA), mezzanine, and equity tranches.
- CDOs: Similar tranche structure, but risk depends on asset quality.
What is the association of CLOs and CDOs with the 2008 financial crisis?
- CLOs: Less associated with the crisis, as corporate loans performed better.
- CDOs: Played a major role in the 2008 financial crisis, especially subprime mortgage-backed CDOs.
Negative Yield Bonds: Understanding Their Implications and Investment Strategies
What does a negative yield mean for bondholders?
What is an example of a negative yield scenario?
Why might some investors still buy bonds with negative yields?
What factors influence the decision to buy or sell bonds with negative yields?
What does a negative yield mean for bondholders?
- A negative yield means the bondholder will lose money in nominal terms over the life of the bond.
What is an example of a negative yield scenario?
- If you invest £100,000 in a bond with a negative yield, you might only get back £95,000 when the bond matures, even though you are receiving interest payments.
Why might some investors still buy bonds with negative yields?
- Some investors speculate that yields could fall further, which would increase corporate bond prices, allowing them to sell at a higher price.
What factors influence the decision to buy or sell bonds with negative yields?
- The decision is driven by broader economic conditions, central bank policies, and individual investment strategies.
