Capital Markets - Debt & Leveraged Finance

Question 1

What is the difference between a bond and a leveraged loan?

Answer 1

While some features of leveraged loans and bonds can overlap, the key difference is that that a loan is a private
transaction between a borrower and a lender. The lender is a single bank or a small syndicate of banks or
institutional investors. The interest cost is often LIBOR plus a spread, and the loan is often secured by collateral
with strict covenants, while the repayment of principal can happen over time or as a bullet payment at the end.
Given the collateral, earlier principal repayments, and covenants, loans are less risky and carry lower interest
rates than bonds.
Corporate bonds, in contrast, must be registered with the SEC and are public transactions. Bonds are issued to
institutional investors and traded freely on the secondary bond market, leading to a broader investor base.
Bonds are usually priced at a fixed rate with semi-annual payments, have longer terms than loans, and have a
balloon payment at maturity. Since bonds come with less restrictive covenants and are usually unsecured,
they’re riskier for investors and therefore command higher interest rates than loans.

See pg. 112 for the full chart.

Question 2

What is the difference between investment-grade and speculative-grade debt?

Answer 2

Investment-Grade Debt: Investment-grade debt (often called high-grade debt) has a credit rating above
BBB/Baa. This category of debt is issued by companies with a strong credit profile. Investment-grade debt
is considered safe, given the low risk of default.
Speculative-Grade Debt: Speculative-grade debt has a credit rating below BB/Ba. These types of debt are
issued by more leveraged companies with a riskier credit profile. Given this increased risk of default and
bankruptcy, the interest rates on these riskier debts will be significantly higher to compensate investors
for taking on the additional risk.

Question 3

What does it mean when a debt tranche is denoted as 1st lien or 2nd lien?

Answer 3

Lien is defined as the seniority and the priority of payment to a debt holder relative to the other tranches. A
lien is a legal claim against the assets of a borrowing company (i.e., used as collateral) and the right to seize
those assets first in forced liquidation/bankruptcy scenarios.
1st Lien Debt: The highest seniority, 1st lien, is fully secured by the company’s assets and has the first
claim to collateral in a liquidation/bankruptcy scenario (e.g., revolver, term loans).
2nd Lien Debt: Right below 1st lien loans sits 2nd lien where compensation is provided only if there’s
collateral value remaining once 1st lien lenders are repaid in full. These debt types are riskier and more
expensive for borrowers (e.g., high-yield bonds, mezzanine financing).

Question 4

Tell me about the different classifications of term loans.

Answer 4

Term Loan “A”: TLAs refer to secured loans syndicated to banks and are typically
packaged alongside a revolving credit facility. TLAs have shorter terms (~5 years),
carry higher amortization levels than other term loans, and are amortized evenly
over their tenor (i.e., “straight-lined”).
Term Loan “B,” “C,” or “D”: An institutional term loan (B/C/D) is a loan facility
syndicated to institutional, non-bank investors such as hedge funds, CLOs, mutual
funds, and insurance companies. These term loans differ from TLAs in having
longer terms while requiring no principal amortization before maturity – instead, they involve nominal
amortization with a bullet payment due at maturity. TL B/C/Ds are more prevalent in LBOs than TLAs, as
B/C/Ds have less strict covenants, longer terms, and require less principal amortization each year. The “B,”
“C,” or “D” designation is more indicative of the investor base than the priority rank.

Question 5

What is the difference between a secured and unsecured loan?

Answer 5

Secured Loans: If a debt instrument is secured, that means the debt is backed by collateral. The assets of
the borrower were pledged as collateral to get favorable financing terms. If the company were to go
bankrupt, the lenders have a legal claim on the pledged collateral. Leveraged loans are secured by
collateral and are the safest security class for a lender. Most term loans and revolvers in the leveraged loan
market are syndicated to institutional investors such as hedge funds, CLOs, and mutual funds.
Unsecured Loans: For unsecured loans, pension funds, mutual funds, insurance companies, hedge funds,
and some banks are typically willing to invest in this relatively riskier type of debt for the higher yield.

Question 6

What does LIBOR stand for?

Answer 6

LIBOR stands for “London Interbank Offered Rate,” representing the global standard benchmark used to set
lending rates. LIBOR is the rate at which banks lend amongst each other. For lenders of debt instruments with
floating rates, the debt pricing will be based on LIBOR, the standard interest rate. However, LIBOR is expected
to fade away in use as UK regulators have voiced a desire for LIBOR to be phased out by the end of 2021.

Question 7

How are leveraged loans usually priced?

Answer 7

Leveraged loans are usually priced off LIBOR plus a spread. In addition, loans often include a LIBOR floor, so an
example would be a pricing of “LIBOR + 3%” (300 basis points) with a LIBOR floor of 2%, so the interest rate
can never dip below 5%.

Question 8

What has replaced LIBOR in the United States? (Note my own question.)

Answer 8

…

Question 9

What is SOFR, the expected replacement of LIBOR?

Answer 9

Coming up on the horizon and expected to replace LIBOR eventually, the Secured Overnight Funding Rate
(SOFR) is a measure of the borrowing costs of cash collateralized by Treasury securities. Said another way, the
SOFR is a Repo-based funding rate of the observed transactions overnight.

Question 10

In terms of debt terminology, what does the coupon rate mean?

Answer 10

The coupon rate simply refers to the annual interest rate (“pricing”) paid on a debt obligation. The interest
expense is based on the outstanding principal amount and is modeled as a percentage of the beginning and
ending balance of the relevant debt tranche. In terms of payment dates, senior bank debt pays interest each
quarter, whereas most bonds pay interest on a semi-annual basis.

Question 11

How does the coupon on a bond differ from the yield?

Answer 11

The coupon represents the annual interest rate paid based on the notional principal of the bond, while the
yield is the annual return on the bond, including the coupon payment adjusted for the premium or discount of
the purchase price when held to maturity. One difference is coupons are fixed for the bond’s term, whereas
yields move with the markets.

Question 12

What does it mean when a bond is trading at a discount, par, or premium?

Answer 12

Discount: Price < 100, Yield is Greater than Coupon
Par: Price = 100, Yield is Equal to Coupon
Premium: Price > 100, Yield Less Than Coupon

Question 13

What is the difference between a fixed and floating interest rate?

Answer 13

Fixed Interest Rate: A fixed interest rate means the interest expense to be paid is the same regardless of
changes to the lending environment. A fixed interest rate is more common for riskier types of debt, such as
high-yield bonds and mezzanine financing.
Floating Interest Rate: A floating interest rate is tied to LIBOR plus a specified spread (i.e., LIBOR + 2-
4%). This pricing type is seen more often for senior debt tranches (e.g., term loans, revolvers).

Question 14

When would an investor prefer fixed rates over floating rates (and vice versa)?

Answer 14

If interest rates are expected to fall in the near-term future, investors would prefer fixed rates. However, if
interest rates are expected to increase, investors would prefer floating rates.

Question 15

What are some different debt amortization schedules?

Answer 15

The debt amortization schedule refers to the amount of principal the borrower must repay annually.
Compliance with this payment schedule is mandatory and not optional for the borrower.

Types of Debt Amortization Schedules:
Bullet Maturity: The entire loan payment is due at the end of the loan’s lifespan.
Straight-Line Amortization: Principal payments must be repaid in equal installments until maturity.
Minimum Amortization: Entails lesser amounts of annual payments (e.g., ~5-10% per year) – therefore,
the entire principal will not have been paid off at maturity.

Question 16

What is a callable bond and how does it benefit the issuer or borrower?

Answer 16

A callable bond can be redeemed by the issuer prior to its maturity, with the decision being at the issuer’s
discretion. A callable bond enables the issuing company to pay off the debt earlier if they have more free cash
flow remaining in the period and can refinance at lower interest rates.
From the investor’s perspective, a callable bond gives more optionality to the issuer, so the debt holders are
compensated with higher interest rates (compared to non-callable bonds).

Question 17

When would the prepayment optionality of certain debt tranches be unattractive to lenders?

Answer 17

Some debt instruments include provisions that enable the borrower to repay some principal ahead of the
payment schedule without the incurrence of any financial penalties. However, other lenders may include a call
protection feature that prohibits borrowers from prepayment until a pre-specified duration has passed. The
reason being that certain lenders prefer to disallow prepayment as it implies the receipt of more interest
payments in the future.
For instance, if the borrower pays more principal off early, the annual interest payments (inflows to the lender)
in the future are reduced since interest is based on the beginning and ending balance of the debt outstanding.

Question 18

A bond has a call protection clause of NC/2. What does this mean?

Answer 18

Many HYBs will have call protection clauses that last two or three years (denoted as NC/2 and NC/3,
respectively). Some are often NC/L, which means the bond is not callable for the term’s entire duration. Once a
bond becomes callable, the borrower may repay some (or all) of the debt balance and pay less interest. The
caveat is that the prepayment penalties could offset those savings on interest – thus, HYB’s classification as an
expensive financing source.
Therefore, NC/2 means the bond has call protection for two years. Once this two-year period has passed, the
borrower can repay the debt along with the prepayment penalty fee.

Question 19

What is a revolving credit facility and what purpose does it serve to the borrower?

Answer 19

The revolver refers to a company’s revolving line of credit drawn down when the
free cash flow being generated is insufficient. The revolver acts as a “corporate
credit card” for urgent situations. The borrower typically draws from the revolver
to meet its short-term working capital requirements after an unexpected,
temporary shortage in liquidity. Ideally, the lender doesn’t want the revolver fully
drawn frequently as it signals a deterioration in cash flows.

Question 20

What is the undrawn commitment fee associated with revolvers?

Answer 20

A revolver typically comes with a small < 1% fee, which is an annual fee paid out to the lender. The borrower is
charged an annual fee on the unused amounts, called the undrawn commitment fee.

Question 21

What is the difference between an asset-based loan and a cash flow revolver?

Answer 21

The maximum amount that can be drawn from an ABL revolver is based on the company’s liquid assets. Thus,
the amount is tied to borrowing-base lending formulas to limit borrowing to a certain percentage of the
collateral – most often inventory and accounts receivable (e.g., 80% of A/R + 65% of Inventory)
The maximum amount that can be borrowed for cash flow revolvers is tied to the borrower’s historical and
projected cash flow generation. Therefore, covenants are more restrictive due to the uncertainty around future
cash flows. Unlike physical assets such as inventory, a company’s future cash flows cannot be pledged as
collateral or seized in bankruptcy, hence its less favorable terms.

Question 22

Why do revolvers normally not have a leverage test?

Answer 22

In most cases, revolvers will only have an interest coverage ratio test (e.g., > 2.0x EBITDA/Cash Interest) and
have the simplest covenant structure relative to other tranches of debt. This is because the revolver has the
highest priority in the capital structure and has a priority claim to the borrower’s assets.
Therefore, the lender that provided the revolving credit line is unconcerned if the borrower raises additional
debt, since this means the company has more cash available (on which the revolver has the first claim). In the
scenario that the borrower undergoes bankruptcy, the revolver will almost certainly be made whole.

Question 23

What is unitranche debt and its benefits?

Answer 23

Unitranche debt financing is a blended hybrid of senior debt and subordinated debt. The distinct
characteristics of unitranche debt are that it’s just one tranche of debt instead of two (as the name suggests),
and the debt is priced at a blended interest rate. Traditionally, there would be 1st and 2nd lien debt, and the
borrower would have to get financing from two (or more) different lenders, which could make securing
financing packages a time-consuming process. But in recent years, non-bank institutional lenders began to
provide the entire package and customize it based on negotiations.
The main advantage to borrowers over traditional credit facilities is that it enables borrowers to have “one-
stop-shop” financing (i.e., the convenience factor). The borrowers would have only one set of loan documents,
one set of covenants, and a much simpler and faster process to close.

Question 24

What is the difference between a bond’s coupon rate and the bond’s current yield?

Answer 24

The coupon rate (“nominal yield”) represents a bond’s annual coupon divided by its face (par) value. The
current yield on a bond equals the bond’s coupon payment divided by the bond’s price.
For example, a bond trading at 90 with a $100 face value and a $6 coupon has a 6% coupon rate and a current
yield of 6.7% ($6/90). While the coupon rate is always the same, the current yield fluctuates based on the
market price of a bond.

Question 25

What is the difference between current yield and yield to maturity?

Answer 25

The current yield on a bond equals the bond’s coupon payment divided by the bond’s price. The current yield is
a way to discuss coupon rates when the bond price deviates from par. For example, a bond trading at 90 with a
$100 face value and a $6 coupon has a 6% coupon rate and a current yield of 6.7% ($6/90).
Unlike YTM, the current yield is not the true yield of a bond as it doesn’t capture any yield associated with
principal recovery, nor does it assume the reinvestment of coupon payments. The YTM is the internal rate of
return of a bond. YTM considers coupon payments, principal recovery, assumes reinvestment at the same rate
(an iterative process), and time to maturity.

Question 26

Could you define fixed income and name a few examples?

Answer 26

Fixed-income securities provide their investors with a stream of fixed periodic interest payments and then the
return of principal at the end of its term. The fixed amount of interest is paid in the form of coupon payments,
usually semi-annually. While all bonds technically fall under fixed income, fixed income usually refers to low-
return, low-risk bonds (as opposed to mezzanine financing and HYBs). Examples include treasury notes,
treasury bonds, treasury bills, municipal bonds, money markets, and certificates of deposits (CDs).

Question 27

What does the money market refer to and what is the typical maturity range?

Answer 27

The money market refers to the purchase and sale of large quantities of short-term bonds and other debt
instruments overnight. The maximum maturity of these short-term bonds is 397 days (~13 months), and the
investors are usually risk-averse with limited risk appetite.

Question 28

What are the two main classifications of money market accounts?

Answer 28

1. Government Money Market Funds: T-Bills, Discos (Agency Discount Notes, Reverse Repo)
2. Prime Money Market Funds: Short-Term Bonds, Commercial Paper, Certificates of Deposits

Question 29

What is a municipal bond and what is the one distinct benefit it has for investors?

Answer 29

A municipal bond is a debt instrument issued by a state, municipality, or county to finance its capital
expenditures needs, including construction needs, road developments, parks, highways, and other public
projects. “Munis” could be viewed as loans that investors make to local governments – and for doing so, these
bonds are exempt from federal taxes and most state/local taxes.

Question 30

What is the difference between coupon bonds and discount bonds?

Answer 30

Unlike coupon bonds, zero-coupon bonds (discount bonds) make no payments between issuance and maturity
and are priced at a discount to their face value.

Question 31

What is the difference between Macaulay duration and modified duration?

Answer 31

Macaulay duration is the weighted average timing of the present value of all the cash flows, typically denoted in
years. The modified duration, on the other hand, indicates the percentage change in a fixed income
instrument’s price given a 1% interest rate change – by making a slight adjustment to Macaulay’s duration to
reflect the price movement given a change in yield.
Asset managers and fixed income investors typically focus on modified duration, as it shows price sensitivity to
interest rates. For example, a 10-year bond with a modified duration of 8 would lose 8% in price (say from par
or $100 to $92) if the yield increased from 1% to 2%.

Question 32

What is the relationship between duration and the coupon?

Answer 32

The duration of any coupon-bearing bond will be less than its years to maturity, as there are coupon payments
between now and maturity.
Lower Coupon -> Longer Duration: The lower the coupon, the longer the duration is and closer the
duration is to maturity. The impact of each coupon payment to shorten the payment is reduced.
Higher Coupon -> Shorter Duration: The higher the coupon, the shorter the duration. Each coupon
payment has a higher cash flow, which shortens the duration.

Question 33

What is convexity used to measure?

Answer 33

Convexity is a measure of the relationship between the price of a bond and its yield. Often, convexity is used to
track the overall exposure risk on a portfolio of bond holdings. In general, a bond with higher convexity would
have a higher price, and its addition to a portfolio should increase the systematic risk of the entire portfolio of
bonds. Therefore, a high convexity portfolio would be more sensitive to interest rate fluctuations.

Question 34

What are the three types of covenants found in lending agreements?

Answer 34

Affirmative Covenants: These covenants require that the obligor (borrower) of the debt to perform
certain specific tasks. Examples of affirmative covenants are meeting financial reporting requirements,
paying taxes, being insured, maintaining licenses/permits, and legal compliance.
Negative Covenants: These covenants restrict the obligor of the debt to refrain from certain specific tasks
such as issuing dividends, raising debt, acquiring another company, or pledging assets as collateral.
Financial Covenants: For financial covenants, there are two types: 1) maintenance and 2) incurrence
covenants. Maintenance covenants are usually included in credit agreements (bank loans), while
incurrence covenants are included in indentures (bonds).

Question 35

What is the purpose of covenants in debt financing?

Answer 35

Covenants are contractual agreements between lenders and borrowers meant to
protect the interests of the lending parties. Failure to comply with these covenants or
breaching a covenant can cause the borrower to be placed into default, allowing
lenders to seize the borrower’s assets. Debt-holders desire assurance of the full receipt
of their due payments with a high level of certainty and restricting the borrower into
making only risk-averse decisions and maintaining healthy credit statistics decreases
the risk of not being paid back.

Question 36

What are maintenance covenants and provide some examples?

Answer 36

The objective of maintenance covenants is to ensure the borrower maintains sufficient profitability and cash
flows to service debt payments. Compliance with maintenance covenants is tested each quarter.
Examples of Maintenance Covenants
Total Debt/EBITDA must remain below 5.0x
Debt/Equity must never exceed 2.5x
Interest Coverage Ratio cannot fall below 3.0x
These parameters will change depending on the prevailing market conditions and be industry specific.

Question 37

What are incurrence covenants and give some examples?

Answer 37

The purpose of incurrence covenants is to prevent the borrower from taking specific actions that could put the
lender’s payback at risk. Compliance with incurrence covenants is tested when taking a specific action (e.g.,
new debt issuance, dividends, acquisition).
Examples of Incurrence Covenants
Restricted from making acquisitions or divesting one of its business segments (or major assets)
Prevented from raising additional debt, especially if it has higher seniority than the covenant holder
Cannot distribute dividends to equity shareholders without the approval of the lenders

Question 38

What is one key difference between maintenance and incurrence covenants?

Answer 38

Maintenance covenants differ from incurrence covenants in that they’re subject to periodic tests, typically
completed at the end of each quarter. The borrower must routinely prove its compliance with its maintenance
covenants to avoid default. Incurrence covenants are tested only once a certain action or event “triggers” it.

Question 39

Leveraged loans have become increasingly “covenant-lite,” what does this entail?

Answer 39

Secured 1st lien loans have shifted towards becoming “covenant-lite” in recent times, meaning they’re
packaged with less restrictive incurrence covenants than traditional maintenance covenants. Compliance tests
of covenant-lite loans are thus only required if the borrower takes a certain action (e.g., raises more debt,
dividend issuance), rather than being tested periodically as they traditionally were.
This trend is due to large banks needing to make their financing packages more attractive to borrowers to
compete with newer types of institutional lenders that offer more flexibility (e.g., private credit funds,
increased usage of unitranche debt).

Question 40

What are subordinated notes?

Answer 40

Subordinated notes are characterized by longer tenors and higher-interest rates that compensate investors for
undertaking more risk. This layer of debt enables the borrower to increase leverage beyond what risk-averse
institutional banks will provide. While subordinate notes have a higher cost of capital relative to bank debt and
don’t allow prepayments, these notes come with less restrictive covenants.

Question 41

What are the characteristics of mezzanine financing?

Answer 41

Mezzanine financing refers to the layer of financing that lies in between traditional debt and common equity.
This category is the lowest form of debt in the capital structure and includes preferred stock, convertible debt,
bonds coupled with warrants. All mezzanine debt is unsecured and will be of smaller magnitude relative to the
other parts of the capital structure.
The debt terms involved in mezzanine financing are highly negotiated, flexible, and tailored to meet the specific
needs of both parties. The interest rates are the highest compared to other less risky tranches and debt, with
the option for interest to be paid-in-cash or payment-in-kind (PIK). Also, the conversion feature that some of
these securities carry provides the holder with the optionality to partake in the upside potential of the equity
(and create dilution for common shareholders).

Question 42

What are bridge loans?

Answer 42

Bridge loans provide interim financing should the required debt commitments not be available by the closing
of the deal (i.e., the borrower could not secure a firm commitment letter from lenders). Investment banks that
can do so will provide this type of bridge loan commitment to prevent a transaction from stalling and give
assurance that sufficient funding will be available to close the deal.

Question 43

What is staple financing and which type of lender provides it?

Answer 43

Staple financing is when the sell-side investment bank can provide some initial debt, but rather than holding
onto the debt, they usually sell it to debt-oriented hedge funds or institutional investors.
Staple financing is an option available when the sell-side advisor is a large, more institutionalized investment
bank that has a balance sheet such as J.P. Morgan, Goldman Sachs, and Morgan Stanley. For clarification, the
phrase “has a balance sheet” means the investment bank is diversified in terms of its sources of revenue and
has a lending division, as opposed to purely offering M&A advisory services. This is an advantage that bulge
bracket banks have over elite boutiques such as Evercore and Qatalyst Partners, where most of their revenue
comes from M&A advisory – but this creates the potential for a conflict of interest since the firm serves both
sides of the transaction (the seller and the buyer).

Question 44

What is a firm commitment letter?

Answer 44

Once a financial sponsor or a strategic buyer has met with the target’s management team and has proceeded
with submitting an LOI, the next step is to get a firm commitment letter from its lender(s). This is done to gain
credibility as a buyer, as the most credible bids are the ones with financing commitments prepared with the
initial debt terms outlined.

Question 45

How does a highly confident letter differ from a firm commitment lender?

Answer 45

From both the buyer and seller perspective, committed financing is preferred as the lending bank is practically
guaranteed to fund it upon closing. Alternatively, highly confident letters mean the lender believes it can raise
the amount of capital required, but they’ll not commit to it (and not backstop it with their balance sheet).

Question 46

Other than covenants, what provisions can be included to protect lender interests?

Answer 46

Besides the traditional covenants found in lender agreements, there’ll often be conditions listed that enable the
lender to renege on its initial commitment without facing monetary consequences. These provisions are
included in the case an unexpected event occurs. The lender doesn’t want to be committed to lending in a
situation when everything appears to be headed downhill and the risk of default has significantly increased.
In these commitment letters, you would usually see a provision within the agreement to lend as long as certain
conditions are met. In nearly all cases, the letter includes phrasing along the lines of how there cannot be a
“significantly material adverse effect” that places repayment into question.

Question 47

What is commercial paper and which types of companies issue them?

Answer 47

Commercial paper is issued by large corporations with high credit ratings as short-term borrowing to finance
their working capital needs. The typical commercial paper term is ~270 days, and the debt is issued at a
discount (i.e., zero-coupon bond) as an unsecured promissory note. The minor concern associated with
commercial paper is that they’re unsecured, meaning they’re not backed by any collateral. Therefore, only large
corporations issue this type of debt as they have strong credit ratings.

Question 48

Besides market risk, name some other risks that bond investors face?

Answer 48

Default Risk: Default risk means the borrower’s creditworthiness has decreased from deteriorating
financial performance, and most often, it coincides with a downgrade from a credit agency. The higher the
credit rating, the lower the probability of default.
Liquidity Risk: Next, liquidity risk refers to when the ability of the bond to be exchanged has unexpectedly
decreased. This means that the number of potential buyers in the market has diminished (e.g., changing
lending conditions, unexpected company-specific circumstances).
Event Risk: Finally, event risk pertains to specific events such as M&A or legal investigations that could
change the risk of holding a particular bond. For example, if the SEC announces they have started an
investigation into a company for fraud, this would have an immediate negative effect on all stakeholders.

Question 49

Tell me about the debt lender and equity investor “story disconnect.”

Answer 49

This disconnect between debt lenders and equity investors is due to lenders being
“backward-looking” and focused on how the company has performed historically.
Particular attention is paid to signs of cyclicality in the borrower’s performance and
how it was affected by the latest recession. This is because debt lenders are more
concerned with the downside case. After all, even if the company performs well, the
lenders don’t get to participate in the upside alongside the equity investors.
Thus, the continued generation of the borrower’s cash flows to satisfy debt
obligations is of the utmost highest importance to debt investors.

Question 50

When a company is raising capital, why is the lender’s case usually less
optimistic than the projections shown to raise interest from equity investors?

Answer 50

A distinction when dealing with lenders is that there’s little incentive to show aggressive assumptions. Thus,
lender case forecasts are lower than the base case for the debt covenants to be set off a lower base.
While they must show that the company can meet the debt obligations to be approved for financing, there’s no
rational reason for a sponsor to stretch its assumptions beyond this.
Debt covenants are usually based on this metric of EBITDA – thus, the EBITDA provided to lenders is the
starting point. A higher EBITDA as the starting point means a higher EBITDA level is required to abide by the
covenants. Then, future covenants will be based on quarterly projections of this initial EBITDA.
Therefore, the borrower should desire a sufficient “cushion” to operate where, even if its EBITDA were to drop
in an economic downturn, the covenant would still not be breached.

Question 51

What does refinancing risk involve?

Answer 51

Refinancing risk is the concern that a borrower cannot refinance its debt obligations at the same (or similar)
rate as before. For example, the credit rating of the company may have been demoted, and lenders are no
longer willing to refinance at the same rates.

Question 52

From the perspective of an investor, what is the interest rate risk in reference to?

Answer 52

Interest rate risk becomes a consideration for bonds with longer maturities. For instance, the market rates
constantly change, and the lending environment could turn more favorable (interest rates could decrease).
If an investor is locked into a long-term bond, they’ll face more interest rate risk due to the longer maturities.
Therefore, the investor would demand a higher yield to compensate for the additional risk taken on by
agreeing to a long-term arrangement.

Question 53

What is prepayment risk?

Answer 53

Prepayment risk (often called reinvestment risk) is the risk that a lender takes on when allowing the borrower
to pre-maturely paydown a particular debt. For example, if a borrower has pre-paid their loan and the lender
has received the initial principal back – the lender must search for a new borrower.
However, there’s the risk that the credit market has become less favorable to lenders, and the lender may not
achieve the same yield as before. For this reason, many lenders will not allow the optionality for prepayment,
or if they do, they’ll attach prepayment penalties as compensation for taking on the risk of having to reinvest at
the current market rates (which could be significantly lower).

Question 54

In mezzanine financing, what is an “equity kicker”?

Answer 54

An equity kicker is often issued as a “deal sweetener” for new debt issuances. Through the inclusion of an
equity kicker, mezzanine investors can often increase returns by an extra 100-200 basis points. In return, the
cost of financing can be brought down to allow the borrowing company to secure better terms.
“Equity Kicker” Types
Warrants: Warrants function similar to employee stock options such that the mezzanine investors have
the option to exercise their options and turn them into common stock if profitable. This usually amounts to
1-2% of the total equity of the borrower.
Co-invest: Mezzanine investors may seek the right to co-invest equity alongside the controlling
shareholder, such as the financial sponsor in the case of funding an LBO.
Conversion Feature: If the debt or preferred stock is structured as convertible, the investor has the option
to 1) participate in the common equity’s upside or 2) continue to receive interest or dividends.