DEBT FINANCING


Chapter 13 discussed raising funds through equity financing; here we discuss raising funds through debt financing. There are different ways debt can be used to raise capital. The process of issuing debt and the types of debt available are discussed in this chapter.

Corporate Debt

Corporate debt can be either private or public debt. These two types are discussed next.

Private debt

This is the first type of debt financing many young firms undertake, usually in the form or a bank loan. Private debt is debt that is not publicly traded. This market is larger than the public debt market. Private debt avoids the cost and delay of registration with the SEC. However, as a trade off, it is illiquid and therefore hard for the holder to sell it in a timely manner. Two segments of private debt are discussed next.

Bank loans

A term loan is a bank loan that lasts for a specific term. If a single loan is funded by a group of bankers it is a syndicated bank loan. A revolving line of credit is something a company can use as needed and is a credit commitment for a specific time period up to some limit. This last aspect of bank loans is asset-backed lines of credit. An asset-backed line of credit is when a company secures credit by pledging an asset as collateral. Doing this usually gets the company a larger credit amount or lowers the interest rate.

Private placements

A private placement is a bond issue that does not trade on the public market but is instead sold to a small group of investors. These also do not need to be registered with the SEC, so it is less costly to issue and often a simple promissory note is sufficient. Because it does not need to confirm to the strict rules of the SEC, it can be tailored to the particular situation. In an attempt to increase the access of foreign corporations to U.S. debt markets, the SEC issued Rule 144A. This rule significantly increased the liquidity of certain privately placed debt, but is still not as liquid as public debt. Under this rule, large amounts of private debt can be traded by large financial institutions among themselves. Many companies issue debt under this rule with an attached promise to register the debt at a later time. This way the company can raise the capital quickly and spend the time complying with SEC regulations at a later time.

Public debt

Public debt is similar to a stock offering. The prospectus is something that must be produced by the firm that describes the details of the offering. The firm must also include an indenture. An indenture is a formal contract that specifies the firm’s obligations to the bondholders. This type of contract is usually written by the issuer and a company that represents the bondholders. We talked about the different types of bonds in previous chapters. The only new one here is an original issue discount bond (OID). An OID bond is a coupon bond issued at a discount.

Secured and unsecured debt

Unsecured debt is the type that in the event of bankruptcy, the bondholders only has a claim to the assets of the firm that are not already pledged as collateral on other debt. A couple of examples are notes and debentures. A note is debt with maturities less than 10 years. Debentures are bet with maturities of 10 years or longer. On the other side, secured debt has specific assets that are pledged as collateral that bondholders have direct claim to in the event of bankruptcy. Mortgage bonds and asset-backed bonds are secured debt used in business. Mortgage bonds are secured by real property. Asset-backed bonds can be secured by any type of asset.

Seniority

Seniority is the bondholder’s priority in claiming assets in the event of company default. Because of seniority, most debenture issues contain clauses restricting the company from issuing new debt with equal or higher priority than existing debt. Debt issued that has lower priority than the already outstanding debt is called subordinated debenture. These holders have claims to the assets only after those that have seniority.

International bonds

There are four broadly defined categories of international bonds: domestic, foreign, Eurobonds, and global. Domestic bonds are issued by a local entity, denominated in the local currency, and traded in a local market, BUT purchased by foreigners. Foreign bonds are issued by a foreign company, in a local market and are intended for local investors denominate in the local currency. Eurobonds are not denominated in the local currency of the country in which they are issued. Finally, global bonds are offered for sale in several different markets simultaneously. These bonds have a foreign exchange risk, which will be discussed in a later chapter.

Bond Covenants

Covenants are restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds. This is meant to protect debt holders. A manager works to increase the value for equity holders, hence the need for covenants. Some covenants restrict payment of dividends and others may put a minimum amount of working capital that must be maintained. Covenants also help the equity holders. Stronger covenants in the bond contract make it less likely that the firm will default on the bond, and this lowers the interest rate investors will require to buy the bond. In simpler terms, strong covenants can reduce a firms cost of borrowing.

Repayment Provisions

As specified by the bond contract, bonds are repaid by making coupon and principal payments. This is not the only way that bonds can be repaid, but is a common one. There are also aspects of the bond that can affect the repayment: call provisions, sink funds, and convertible provisions.

Call provisions

This is a way firms can repay the bonds. A callable bond allows the issuer to repurchase the bonds at a predetermined price. This gives the issuer the right to retire all outstanding bonds on a specific date: the call date. This retirement is done at the call price that is specified at the issuance of the bond. This call price is a percentage of the bond’s face value and is usually above face value. The firm will exercise the call option if it is cheaper than repurchasing the bonds on the open market. So, when the market price of the bond exceeds the call price, the firm will call the bond. Although call provisions are appealing to the firm, the same is not true for the investors. The investors will pay less for a callable bond because there is a risk the firm will call the bond and the investor will receive less than what they could have gotten.

To be successful, a manager must understand how investors are evaluating callable bonds. The yield to call (YTC) is the annual yield of a callable bond calculated under the assumption that he bond is called on the earliest call date. This is not the same as the yield to maturity. When the bond’s coupon rate is above the yield for similar securities, the yield to call is less than the yield to maturity. On the other hand, is the bond’s coupon rate is below the yield for similar securities; the bond is unlikely to be called. In this second case, the firm calling the bond would actually be good for the bondholder’s. To keep things a bit easier, the bonds are usually quoted at the yield to worst: the lower of the yield to call or yield to maturity.

Sinking funds

A sinking fund is a provision that allows the company to make regular payments into a fund administered by a trustee over the life of the bond instead of repaying the entire principal on the maturity date. These payments are then used to repurchase the bonds. There are usually rules that specify a minimum rate at which the issuer must contribute to the fund. There are many ways that a firm can go about using sinking funds. They may pay them so that they can repurchase on the maturity date, they may accelerate the payments, or it may not have enough to repurchase. In this last example, the firm may be required to make a balloon payment. A balloon payment is a large payment on the maturity date that gives the fund enough money to repurchase the bonds.

Convertible Provisions

Convertible bonds have the provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock at the ratio called the conversion ratio. This way the firm retires the bonds by converting them into equity. The conversion price is the implied price per share received. This price is equal to the face value of the bond divided by the number of shares received at conversion. Often, convertible bonds have a call provision in them. This gives the bondholder the option to either let the bonds be called or convert them. Unlike the callable option, this provision adds value for the bondholder. Thus, prior to the bond maturity date a convertible bond is worth more than an otherwise identical straight bond (a non-callable, non-convertible bond).

Leverage Buyout (LBO)

A leverage buyout is basically the reverence of a company going public. In a LBO, a group of private investors purchases all the equity of a public corporation and finances the purchase primarily with debt. Doing this does not mean that the company is stuck; it can also go public again.

Conclusions

This chapter lays the ground work for other chapters. We examined the differences between private and public debt, how debt holders are protected, and the different ways the firm may choose to repay the bondholders.