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Chapter 24 Debt Financing. 24.1 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.
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24.1 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.
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.
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.
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.
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.
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
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
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.
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
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).
Private Debt • 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
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
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.
24.2 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.
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)
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.
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.
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.
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
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
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
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
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).
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.
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
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.
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.
24.3 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