1.4 Asset Classes- Corporate Debt

Question 0

Secured Debt

Answer 0

Investors in corporate debt face the risk that the issuer will not be able to pay the interest and/or the principal amount. When this happens, it is known as default.

One way for the corporate borrower to lessen the risk of default is to issue secured debt, when the debt offers the company’s assets as a guarantee. There are two ways of doing this:

• fixed charge – the debt carries a fixed charge over a particular company asset, eg, a building;
• floating charge – the debt is secured against a group of the company’s assets; in the event of default, a floating charge crystallises over the available assets.

Bonds issued with a fixed charge are generally referred to as debentures.

Question 1

Corporate Debt

Answer 1

Corporate debt is simply money that is borrowed by a company that has to be repaid. Generally, corporate debt also requires servicing by making regular interest payments. Corporate debt can be subdivided into money borrowed from banks via loans and overdrafts, and money borrowed directly from investors in the form of IOU instruments, typically bonds.

Debt finance is less expensive than equity finance because investing in debt finance is less risky than investing in the equity of the same company. The interest on debt has to be paid before dividends, so there is more certainty. Additionally, if the firm were to go into liquidation, the holders of debt finance would be paid back before the shareholders received anything.

For investors in bonds, firms like Standard & Poor’s capture the comparative riskiness of the issuer and the bond in their credit ratings.
However, raising money via debt finance does present dangers to the issuing company. The lenders are often able to claim some or all of the assets of the firm in the event of non-compliance with the terms of the loan – in the same way that a bank providing mortgage finance would be able to claim the property as security against the loan.

Question 2

Asset-Backed Securities (ABSs)

Answer 2

Asset-backed securities (ABSs) are bonds that are backed by a particular pool of assets. These assets can take several forms, such as mortgage loans, credit card receivables and car loans. Major banks, such as Citigroup, Bank of America and JP Morgan Chase, commonly securitise the amounts owed by their customers on their credit cards.

The assets provide the bondholders’ security, since the cash generated from them is used to service the bonds (pay the interest), and to repay the principal sum at maturity. Such arrangements are often referred to as the securitisation of assets. The name ‘securitisation’ reflects the fact that the resulting financial instruments used to obtain funds from the investors are considered, from a legal and trading point of view, as securities.

Question 3

Mortgage-backed securities (MBSs)

Answer 3

Mortgage-backed securities (MBSs) are one example of ABSs. They are created from mortgage loans made by financial institutions like banks and building societies. MBSs are bonds that are created when a group of mortgage loans are packaged (or pooled) for sale to investors. As the underlying mortgage loans are paid off by the homeowners, the investors receive payments of interest and principal.
The MBS market began in the US, where the majority of issues are made (or guaranteed) by an agency of the US government. The Government National Mortgage Association (commonly referred to as Ginnie Mae), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are the major issuers. These agencies buy qualifying mortgage loans, or guarantee pools of such loans originated by financial institutions, then they securitise the loans and issue bonds. Some private institutions, such as financial institutions and house builders, issue their own mortgage-backed securities.

As with other ABSs, MBS issues are often subdivided into a variety of classes (or tranches), each tranche having a specific priority in relation to interest and principal payments. Typically, as the underlying payments on the mortgage loans are collected, the interest on all tranches of the bonds is paid first. As loans are repaid, the principal is first paid back to the first tranche of bondholders, then the second tranche, third tranche, and so on. Such arrangements will create different risk profiles and repayment schedules for each tranche, enabling the appropriate securities to be held according to the needs of the investor. Traditionally, the investors in such securities have been institutional investors, like insurance companies and pension funds, although some are attracting the more sophisticated individual investor.

Question 4

Special Purpose Vehicle (SPV)

Answer 4

The investors in ABSs have recourse to the pool of assets, although there may be an order of priority between investors in different tranches of the issue.

The precise payment dates for interest and principal are dependent on the anticipated and actual payment stream generated by the underlying assets and the needs of investors. ABSs based on a pool of mortgage loans are likely to be longer-dated than those based on a pool of credit card receivables. Within these constraints, the issuers of asset-backed securities do create a variety of tranches to appeal to the differing maturity and risk appetites of investors.

ABSs often utilise a special purpose vehicle (SPV) in order to lessen the default risk that investors face when investing in the securities. This SPV is often a trust, and the originator of the assets, such as the bank granting the mortgage loans, sells the loans to the SPV and the SPV issues the asset-backed bonds. This serves two purposes:

1. The SPV is a separate entity from the originator of the assets, so the assets leave the originator’s financial statements to be replaced by the cash from the SPV. This is often described as an off- balance-sheet arrangement because the assets have left the originator’s balance sheet.
2. The SPV is a stand-alone entity, so, if the originator of the assets suffers bankruptcy, the SPV still remains intact with the pool of assets available to service the bonds. This is often described as bankruptcy remote and enhances the creditworthiness of asset-backed securities, potentially giving them a higher rating than the originator of the assets.

In instances when no SPV is created, the asset-backed bonds are simply referred to as ‘covered bonds’, referring to the pool of assets that provide the ‘cover’ to the bondholder. So, with covered bonds, the assets are retained on the balance sheet of the issuing entity, such as a bank, rather than transferred to an SPV. Indeed, when an SPV is used and the assets become distressed, or if there is no market for determining the value of the assets held in the SPV, as was the case during the sub-prime crisis of 2007– 08, the originator of the securitisation instruments may decide to transfer the troubled assets fully on to its primary balance sheet to become covered bonds.

Question 5

Trustee for Secured Debt Issues

Answer 5

In the UK a secured debt transaction is called a debenture, whereas the term is not so widely used in the US; the term ABS is more commonly used.

When a corporation either in the UK or US issues a secured debt, it is invariably the case that a trustee will be appointed when debenture stock is issued to a large number of persons.

The mechanics of the process are that, under the terms of the trust deed, the property of the company is mortgaged to the debenture holders to secure payment of the money owing under the debenture(s). However, there is a contract or deed of trust put in place between the company and the trustees. The trustee holds the benefit of the covenant by the company to repay the monies on trust for the holders of the debenture stock.

Question 6

Main trustee roles for a UK debenture trustee (4)

Answer 6

Under English law, the trustee has wide discretionary powers, whereas under US law its responsibilities are usually clearly defined. The main trustee roles for a UK debenture trustee are:

• Note Trustee – is appointed to represent the interests of holders of issues of securities, while providing guidance to the issuer.
• Security Trustee – for issues secured by a pledge of securities or other properties, the security is charged in favour of the trustee for the benefit of the various secured parties. The governing documents dictate the order of priority of payments among the entitled parties.
• Share Trustee – holds the shares in an issuing SPV in order to ensure off-balance-sheet treatment for the originator of the transaction. Sometimes these SPVs are domiciled in offshore jurisdictions.
• Successor Trustee – this role played by a trustee is provided for banks which need to resign because of conflicts of interest (especially in connection with defaulted or bankrupt issues) or when work requirements exceed the bank’s capacity.

Question 7

Benefits of a Trust Deed

Answer 7

The security and all enforcement powers in respect of the trust deed are vested in the trustee as a single entity acting on behalf of all the debenture holders. This enables a coherent enforcement procedure, rather than a series of disparate actions by different debenture holders. This is an advantage to the individual holders as it ensures organised action and parity of treatment. The trust deed would usually provide that all holders are paid proportionately, and a single action by the trustee prevents some holders recovering and not others. It is also an advantage to the company as it means it does not have to defend a series of actions for what might be a trifling breach of any one provision.

Costs
Administration and enforcement by the trustee will be less costly than numerous parties dealing with the company.

Question 8

Representation of the Interests of the Bondholders

Answer 8

To make bonds a marketable security, a trustee is assigned to represent the interests of the bondholders. The corporate trustee is usually a bank or a trust company, and, although the trustee is paid by the issuing corporation, it represents the interests of the bondholders.
Before marketing a debenture the issuer, often using the corporate trustee as its agent, will engage the services of a credit rating agency to assess the creditworthiness of the issuer and the likelihood that all of the terms of the debenture offering are likely to be fulfilled. This engagement is to represent the interest of the bondholders as just stated above, but in this instance there is more cause for a potential conflict of interest, as the credit rating agency will be paid by the issuer, while its ratings are provided to advise the bondholders of the security risk of the offering. Credit ratings agencies will never specifically recommend any particular offering, but the ratings which are provided (these are discussed in Section 4.4) are relied upon by many investors.

The corporate trustee must keep track of all bonds sold, verifying that the amount issued is not greater than what is stated in the indenture and making sure that the corporation complies with all covenants – which are the terms of the indenture – while the bond issue is outstanding.

For instance, the indenture may stipulate that the corporation maintains a certain percentage of assets over liabilities, or that the corporation does not take on too much debt. Adherence to the covenants of the indenture is one of the principal roles of the trustee.
The trustee may either provide services for the payment of dividends and the cash management function, or it may appoint a separate custodian for the purpose.

Question 9

Unsecured Debt

Answer 9

Unsecured debt is not secured against any of the company’s assets, so the holder has no special protection against default. To compensate the holder for the additional risk, the coupon on an unsecured bond, or the interest on unsecured bank borrowing, will be higher than on equivalent secured borrowings.

Question 10

Types of Unsecured Debt

Answer 10

• Subordinated Debt
• Guaranteed Debt
• Convertible Bonds
• Fixed Coupon Debt
• Floating Rate Bonds

Question 11

Subordinated Debt

Answer 11

Subordinated debt is not secured and the lenders have agreed that, if the company fails, they will only be repaid once other creditors have been repaid if there is enough money left over. Unsecured debtholders, however, would still be repaid prior to shareholders, as ‘lenders’ are always repaid before ‘owners’ in an insolvency. Interest payments on subordinated borrowings will be higher than those on equivalent unsecured borrowings that are not subordinated. This is simply because of the additional default risk faced by subordinated lenders.

Question 12

Guaranteed Debt

Answer 12

Guaranteed debt is when a guarantee is provided by someone other than the issuer. The guarantor is typically the parent company, or another company in the same group of companies as the issuer.

Question 13

Fixed-Coupon Bonds

Answer 13

Fixed-coupon bonds are issued with a fixed rate of coupon. If interest rates rise, the fixed coupon becomes less attractive and the price of the bond falls. The opposite is true of an interest rate fall. As for government bonds, the interest is always calculated by reference to the nominal value of the bond, so a £1,000 nominal 5% ABC corporate bond will pay £50 per annum to the holder.

Question 14

Floating Rate Bonds/Notes

Answer 14

Floating rate bonds or notes are bonds when the coupon rate varies. The rate is adjusted in line with published, market interest rates. The published interest rates that are normally used are based on the London InterBank Offered Rate (LIBOR). There are a number of LIBORs published each day for different currencies and different periods, such as three-month US dollar LIBOR and six-month sterling LIBOR. LIBORs reflect the average rates at which banks in London offer loans to other banks. Until recently, LIBORs were published by the British Bankers’ Association (BBA), using quotes provided by a panel of banks; however, after regulatory investigations discovered that LIBORs were being manipulated by a number of those banks, the UK regulator, the Financial Conduct Authority (FCA), concluded that the administrator of LIBOR required regulatory authorisation. LIBORs are now calculated by Intercontinental Exchange Benchmark Administration ltd, an entity owned by exchange operator Intercontinental Exchange Inc, and regulated by the FCA.

Floating rate notes typically add a margin to the LIBOR rate, measured in basis points, with each basis point representing one hundredth of 1%. A corporate issuer may offer floating rate bonds to investors at three-month sterling LIBOR plus 75 basis points. If LIBOR is at 4%, the coupon paid will be 4.75%, with the additional 75 basis points compensating the investor for the higher risk of payment default.

Question 15

Debt Seniority (3 categories)

Answer 15

Debt issued by companies can come in a variety of forms including bonds and bank borrowing. When there are multiple forms of debt, the issuer will have to establish some sort of order as to which debt will be serviced and repaid first, in the event of the company’s encountering financial difficulties. In broad terms the seniority of the debt falls into three main headings:

• Senior – senior debt or bonds have a claim that is above that of the more junior forms of borrowing and the equity of the issuer in the event of liquidation.
• Subordinated – subordinated debt- or bondholders have accepted that their claim to the issuer’s assets ranks below that of the senior debt in the event of a liquidation. As a result of accepting a greater risk than the senior debt, the subordinated borrowing will be entitled to a greater rate of interest than that available on the senior debt.
• Mezzanine and payment in kind (PIK) – the mezzanine level of debt, if it exists at all, will be even more risky than the subordinated debt. It will rank below other forms of debt but above the equity in a liquidation. As the most risky debt, the mezzanine debt will offer a greater rate of interest than the subordinated and senior levels of debt. Mezzanine borrowing can be raised in a variety of ways – one example is the issue of PIK notes. PIK notes are simply ZCBs that are issued at a substantial discount to their face value. When they are repaid, the difference between the redemption value and the purchase cost provides the investor’s return.

It should be noted that each of the three main categories can themselves contain sub-categories such as senior secured, senior unsecured, senior subordinated and junior subordinated. In practice, the various rating agencies look at debt structures in these narrower terms. Seniority can be contractual as the result of the terms of the issue, or based on the corporate structure of the issuer.

Question 16

Credit Ratings

Answer 16

Bondholders face the risk that the issuer of the bond might default on their obligation to pay interest and the principal amount at redemption. This so-called credit risk or default risk – the probability of an issuer defaulting on their payment obligations and the extent of the resulting loss – can be assessed by reference to the independent credit ratings given to most bond issues.

There are a significant number of credit ratings agencies around the world, some of whom specialise in particular regions or particular types of company. However, the three most prominent agencies that provide these ratings are Standard and Poor’s (S&P), Moody’s and Fitch Ratings. Bond issues subject to credit ratings can be divided into two distinct categories: those accorded an investment grade rating and those categorised as non-investment grade or speculative. The latter are also known as high-yield or junk bonds. Investment grade issues offer the greatest liquidity. The table following provides a comprehensive survey of the credit ratings available from the three agencies.

Although the three rating agencies use similar methods to rate issuers and individual bond issues, essentially by assessing whether the cash flow likely to be generated by the borrower will comfortably service, and ultimately repay, its debts, the rating each gives sometimes differs, though not usually significantly so.

Occasionally, issues such as ABSs are credit-enhanced in some way to gain a higher credit rating. The simplest method of achieving this is through some form of insurance scheme that will pay out should the pool of assets be insufficient to service or repay the debt.

In 2007–08, a financial crisis arose from ABSs such as MBSs. The credit rating agencies were criticised for the generous ratings they had attached to some of these securities. As a result, it is likely that there will be increased regulatory oversight of the credit rating process in the future.

Question 17

Discount securities

Answer 17

Discount securities, such as ZCBs, are attractive investments for an investor looking for a fixed sum at some set date in the future. Because the investor is looking for a set, single sum, he does not want to worry about reinvesting regular interest payments.

Question 18

Commercial paper (CP)

Answer 18

Commercial paper (CP) is a money market instrument, issued by a company. The money market is the term for the market involving cash deposits and short-term instruments that are issued with less than one year to their maturity. CP is the corporate equivalent of a government’s Treasury bill (see Section 5.1). CP is issued at a discount to its nominal value and can have a maturity of up to one year in Europe and 270 days in the US; however, it is common to find in both territories that CP will be issued for three months.

Large companies issue CP to assist in the management of their liquidity. Rather than borrowing directly from banks, these large entities run CP programmes that are placed with institutional investors.
The various companies’ CP is differentiated by credit ratings – when the large credit rating agencies assess the stability of the issuer.

Question 19

Asset-backed CP

Answer 19

Asset-backed CP is a short-term investment vehicle with a maturity that is typically between 90 and 180 days. The security itself will be issued by a bank or other financial institution, and the notes are backed by physical assets such as trade receivables. Finance companies will typically provide consumers with home loans, unsecured personal loans and retail automobile loans. These receivables are then used by the finance company as collateral for raising money in the CP market. Some finance companies are specialist firms that provide financing for purchases of another firm’s products. For example, the major activity of Ally Financial Inc (formerly the General Motors Acceptance Corporation (GMAC)) is the financing of purchases and leases of General Motors’ vehicles by dealers and consumers.

It is perhaps important to mention that a missed payment by an issuer of a CP for as little as one day can lead to bankruptcy proceedings. Issuers take great care to repay the principal on the due day.

Question 20

Commercial Paper (CP) Issuance and the Role of Dealers

Answer 20

There are two methods of issuing CP. The issuer can market the securities directly to a buy-and-hold investor as with most money market funds. Alternatively, it can sell the paper to a dealer, who then sells the paper in the market. The dealer market for CP involves large investment banks and other financial services firms such as gilts dealers and other participants in the money markets.

Unlike bonds or other forms of long-term indebtedness, a CP issuance is not all brought to market at once. Instead, an issuer will maintain an ongoing CP programme. It advertises the rates at which it is willing to issue paper for various terms, so buyers can purchase the paper whenever they have funds to invest. Programmes may be promoted by dealers, in which case the paper is called dealer paper. Larger issuers, especially finance companies, have the market presence to issue their paper directly to investors. Their paper is called direct paper.

Direct issuers of CP are usually financial companies that have frequent and sizeable borrowing needs and find it more economical to sell paper without the use of an intermediary. In the US, direct issuers save a dealer fee of approximately five basis points, or 0.05% annualised, which translates to $50,000 on every $100 million outstanding. This saving compensates for the cost of maintaining a permanent sales staff to market the paper. Dealer fees tend to be lower outside the US.