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Companies obtain debt both to meet their working capital requirements and long-term investments.
Loans from banks and other financial institutions form a major part of the debt raised by companies. However, recently more and more companies, particularly companies with high-credit quality are issuing bonds.
A bilateral loan is a loan offered to a company by a single financial institution. They form a major funding source for small and medium-sized enterprises and enterprises in countries with under-developed bond markets. Access to loans depends both on the borrower’s credit quality and market conditions.
A syndicated loan is a loan advanced by a syndicate, a group of banks (joined sometimes by pension funds, insurance companies, etc.) to a single company. One bank acts as a lead (also called originator) and it manages the whole process. Even a secondary market has recently developed in the syndicated loans market in which syndicated loans are securitized and sold to investors.
Most bilateral and syndicated loans are floating-rate loans with reference rates typically LIBOR or a sovereign rate or the prime rate. The prime rate initially referred to a rate that banks offered to its most creditworthy customers but recently it is more influenced by the overnight rate at which banks lend to each other. Further, bank loans have varying structures, some are bullet, others are amortizing.
For companies with high credit quality, bank loans are expensive, hence they have an incentive to issue bonds directly to investors.
Commercial paper refers to a short-term unsecured promissory note issued in public market through private placement. It is a low-cost funding source for working capital, seasonal cash flow demand and bridge financing.
Even though the largest issuers of commercial paper are financial institutions, some non-financial institutions including governments, supranational organizations, etc. also issue them. The maturity of commercial paper may range from overnight to 1 year, with 3 months being most common.
While issuers of most commercial paper have very high credit quality, some commercial papers have a higher risk and hence higher yield. Credit rating agencies issue credit ratings for commercial paper on a scale different than the bond credit rating scale.
The key to a good commercial paper credit rating is to have backup lines of credit. It is because many commercial papers are rolled over, investors face rollover risk, the risk that an issuer might not be able to issue new commercial paper to pay off the existing commercial paper. Many issuers maintain 100% back lines of credit (also called liquidity enhancement or backup liquidity lines).
Default rates on commercial paper are low because of the short maturity. When an issuer’s credit quality deteriorates, investors can opt not to invest in the rolled over the commercial paper. This is why funding can dry up quickly in the commercial paper market. Due to short maturity, most institutional investors hold the commercial paper to maturity, hence there is little secondary market trading.
The yield on commercial paper is higher than the yield on short-term sovereign debt because (a) commercial paper has credit risk, and (b) commercial paper market is less liquid. Yield is typically higher than municipal bonds because municipal bonds have tax advantages.
The US commercial paper market is the largest market in the world and a more liquid market. Eurocommercial paper is the international commercial paper market just like the Eurobonds. It differs from US commercial paper in that in the US market, commercial paper is traded on discount-basis while in the Eurocommercial market it can be either interest-bearing or discount.
Companies are one of the major participants in capital markets. They issue bonds with varying features both through private placements and public issues.
The typical maturity of corporate bonds is 1 to 30 years. Bonds with a maturity of up to 5 years are considered short-term, those in 5-12 years range as intermediate-term and those more than 12 years as long-term. Bonds with an original maturity of up to 12 years are sometimes referred to as notes, and 12+ years as bonds.
Medium-term notes are bonds issued continuously by an agent of the issuer. Its major issuers are typically financial institutions and its major buyers are institutional investors such as pension funds, etc. They have three segments: (a) short-term securities carrying fixed/floating rate, (b) medium-term securities carrying fixed rate, and (c) structured notes. They are less liquid than typical bonds and thus offer a slightly higher yield and their cost of registration and underwriting are low.
Corporate bonds have a diverse range of coupon structures: some pay fixed coupons and other pay coupons which vary with change in interest rate, issuer’s credit quality, consumer prices, etc.
Principal repayment structure of a corporate bond is either (a) serial maturity structure, in which different chunks of a bond are structured such that they retire on different maturity dates spread out over the life of the bond, and (b) term maturity structure, in which the whole is retired through a one-off payment at maturity date.
The serial maturity structure has a lower credit risk.
Another approach to lower credit risk is for bonds to have sinking fund provision, which enables an issuer to retire a portion of debt each period by calling the bonds back at sinking fund price (which is often equivalent to par) or buying equivalent number of bonds in the secondary market and delivering them to the trustee. Sinking fund provision differs from serial maturity in that in sinking fund the retirement is random while in serial maturity structure, bondholders already know when their bonds are being retired.
Because corporate bonds have credit risk, collateral-backing and seniority ranking of a bond are important. Some bonds are secured while others are unsecured and even within each there are further finer gradations. Type of secured bonds included collateral trust bonds, asset-backed securities, etc.
Corporate bonds sometimes also contingency provisions such as a call, put and conversion options:
A callable bond entitles the issuer to retire the debt before maturity. This feature enables a company to refinance a debt when interest rates decline or to eliminate restrictive covenants. They must pay a relatively higher yield than a plain-vanilla bond.
A putable bond entitles the bondholder to sell the bond to the issuer if its price falls. This feature is valuable when interest rates increase. Since the put option is value for bondholders, these bonds pay a lower yield.
A convertible bond contains a straight-bond and conversion option which entitles the bondholder to convert the debt to equity. Common issuers are early-stage companies who do not have established presence in capital markets. Established issuers may also issue convertible bonds to take advantage of lower coupon rates. However, they may result in equity dilution.
Standardized issuance, trading, and settlement processes have been developed in the international bond market. Most bond prices are quoted in basis points in the over-the-counter (OTC) market.
by Obaidullah Jan, ACA, CFA on Mon Feb 17 2020
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