Chapter 5 : Debt Financing

Question 1

LBO

Answer 1

Definition: Leverage Buyout (LBO) / Rachat avec effet de levier = when a group of private investors purchase all the equity of a public corporation and finances the purchase primarily with debt

Question 2

Prospectus

Answer 2

is a legal document containing all the key information about the bond offering.

Question 3

Indenture

Answer 3

a formal contract included in the prospectus. It is signed between the bond issuer (the company), and a trust company (a third-party institution). The trust company acts on behalf of the bondholders, and its roles are:
1. To ensure the issuer complies with the terms of the indenture.
2. To protect the bondholders’ interests in case of default or violation of the contract.

Question 4

Coupons, maturity, face value, OID

Answer 4

1. Coupon Payments :
   Most corporate bonds pay interest (coupon) twice a year (semiannually).
   A few companies issue zero-coupon bonds, which don’t pay interest — instead, they’re sold at a discount and repaid at full value at maturity.
2. Maturity :
   Most corporate bonds mature in 30 years or less.
3. Face Value (Principal) :
   The standard face value of a bond is usually $1,000. But the actual money raised can be less due to:
   * Underwriting fees (fees paid to banks helping with the issuance)
   * Or if the bond is sold at a discount (i.e., below $1,000).
4. Original Issue Discount Bond (OID) :
   This is a bond that is issued at a price lower than its face value.
   Example: A bond with $1,000 face value might be issued at $950.

Question 5

Bearer Bonds

Answer 5

• These work like physical cash:
  → Whoever holds the paper certificate is considered the owner.
• To get a coupon payment, the bondholder must: Physically clip the coupon from the bond and send it to the paying agent.
• There’s no record of ownership by the issuer → total anonymity.
  Downside: If you lose it, you lose ownership. It’s not traceable.

Question 6

Registered Bonds :

Answer 6

• The issuer keeps a list of all bondholders’ names.
• Coupon and principal payments are made only to registered owners.
• This is much safer and easier to manage.
  Almost all bonds today are registered bonds, not bearer bonds.

Question 7

2 types of corporate debt :

Answer 7

Unsecured and secured

Question 8

Unsecured : notes, debenture

Answer 8

1) Unsecured : notes, debenture
* No specific asset is pledged as collateral.
* In case of bankruptcy, bondholders only get what’s left over after secured debts are paid.
* It’s riskier than secured debt, so it often comes with higher interest rates.
Notes : A type of unsecured debt, typically short-term: maturity is less than 10 years, pays regular coupon payments
Debentures : Also unsecured like notes, but usually with longer maturities, common for big, well-known companies with strong credit.

Question 9

Secured : Mortgage Bonds, Asset-Backed Bonds

Answer 9

2) Secured : Mortgage Bonds, Asset-Backed Bonds
Here, specific assets (collateral) are pledged. If the company defaults, bondholders can claim those assets directly. Less risky → often lower interest rates.
Mortgage Bonds :A type of secured debt backed specifically by real estate or buildings, bondholders have a direct claim to the property, all securities are repaid from the same source of cash flows (like rent, for example).
Asset-Backed Bonds: Also secured, but the collateral can be any kind of asset (not just property).Examples: car loans, credit card receivables, etc, Bondholders have a direct claim to those specific assets in bankruptcy.
Tranches : A single bond issue can be split into different classes (tranches). Each tranche might have different risk levels, maturities, or repayment priorities, but they’re all paid from the same cash flow source.

Question 10

Seniority

Answer 10

Seniority refers to the order of priority in which bondholders are repaid in case the company goes bankrupt.
 If the company is liquidated, senior bondholders are paid first.
 Bondholders with lower seniority get paid only if there’s money left after higher-priority debts are covered.

Question 11

Debenture clauses

Answer 11

Debenture Clauses : Most debenture contracts include protective clauses to prevent the company from issuing new debt that:
 Has equal or higher priority,
 Which could dilute the security of existing debenture holders.

Question 12

Subordinated debentures

Answer 12

Subordinated Debentures :
 These are debentures that are junior to other forms of debt.
 In case of bankruptcy, they are repaid after all senior debts.
 Higher risk → usually offer a higher yield to compensate.

Question 13

4 types of international bonds

Answer 13

Domestic bonds, foreign bonds, eurobonds, global bonds

Question 14

Domestic bonds

Answer 14

 Issued by a local company
 Traded in the local market
 Denominated in local currency
 Can be purchased by foreigners, but they’re not specifically designed for them.
Example: A French company issues bonds in euros, sold in France — even if bought by foreign investors, it’s still a domestic bond.

Question 15

Foreign bonds

Answer 15

 Issued by a foreign company
 Traded in a local market, in the local currency
 Intended for local investors
 Special names depending on the market:
Yankee Bonds Issued by foreign firms in the U.S. (USD)
Samurai Bonds Issued by foreign firms in Japan (JPY)
Bulldog Bonds Issued by foreign firms in the UK (GBP)

Question 16

Eurobonds

Answer 16

 Issued in a currency that is not the local currency of the country where it’s sold.
 Not tied to one national market.
Example: A German company issuing bonds in USD in France = a Eurobond
 Despite the name, Eurobonds have nothing to do with the euro currency.

Question 17

Global Bonds

Answer 17

 Offered simultaneously in multiple countries.
 Can be in the same currency as one of the countries of issuance (unlike Eurobonds).
Example: A U.S. company issues bonds in USD, offered at the same time in Europe, the U.S., and Asia.

Question 18

Private Debt

Answer 18

Private debt is debt that is not traded on public markets.

Question 19

Advantages and Disadvantages of Private Debt

Answer 19

Advantages: No registration costs:
→ Unlike public bonds, private debt doesn’t require SEC registration, which saves time and money for the issuer.
Disadvantages: Illiquidity:
→ Since it’s not traded, it’s harder to resell before maturity.
→ Investors might demand higher interest to compensate for this risk

Question 20

Term Loans

Answer 20

a bank loan with a fixed maturity (e.g., 3, 5, or 7 years). The company repays it over time or in a lump sum at maturity.

Question 21

Syndicated Bank Loan

Answer 21

A large term loan provided by a group of banks (a syndicate), not just one. This allows sharing the risk and funding among multiple lenders.

Question 22

Revolving Line of credit

Answer 22

A credit line the company can draw from when needed, up to a limit. Usually lasts 2–3 years. Works like a credit card for companies: borrow, repay, borrow again.

Question 23

Provate Placements (definition, advantages, rule 144A)

Answer 23

Private Placements = A bond issue sold to a small group of investors (not the general public). Often used by companies that want to raise money quietly without going through the full public process.
Advantages: No registration → Lower issuance costs and Faster to arrange
Rule 144A (SEC, 1990) : Allows these private bonds to be traded between large institutions, like banks or pension funds. This makes them somewhat liquid, even if they’re not fully public.

Question 24

Sovereign Debt

Answer 24

Sovereign debt = debt issued by national governments. In the U.S., this refers to Treasury securities, which are the largest part of the U.S. bond market.

Question 25

Type of treasury securities

Answer 25

Type of treasury securitites Coupon? Maturity Notes Treasury Bills (T-Bills) ❌ (zero-coupon) Up to 1 year (max 52 weeks) Sold at discount Treasury Notes (T-Notes) ✅ Semiannual 2 to 10 years Fixed-rate coupons Treasury Bonds (T-Bonds) ✅ Semiannual More than 10 years Often 30 years – "Long Bonds"

Question 26

TIPS

Answer 26

 TIPS – Treasury Inflation-Protected Securities  Bonds with fixed coupons, but the principal amount is adjusted for inflation.  Maturities: 5, 10, and 30 years.  Your coupon payment increases when inflation rises, since it's based on the inflation-adjusted principal. Example: If inflation rises 10%, your $1,000 principal becomes $1,100 → coupon is calculated on $1,100.

Question 27

 How Treasury Securities Are Sold ? Auctions. Two types of bids:

Answer 27

1. Competitive Bids o You specify the yield you want and how much you want to buy. o Only accepted if your bid is among the lowest yields (i.e., highest prices). 2. Noncompetitive Bids o You agree to accept whatever yield is decided at the auction. o Your entire order is guaranteed.

Question 28

Stop-Out Yield

Answer 28

* This is the highest yield accepted among the successful competitive bids. * All winning bidders, including noncompetitive ones, get this yield.

Question 29

STRIPS – Separate Trading of Registered Interest and Principal Securities

Answer 29

 Zero-coupon securities created by investment banks, not the Treasury itself.  A bank buys a regular Treasury bond, then separates each coupon and principal into individual zero-coupon bonds.  Investors can buy just the interest or just the principal.

Question 30

Municipal bonds

Answer 30

What are Municipal Bonds (Munis)? Bonds issued by state or local governments (not the federal government). They are often tax-exempt: No federal tax on the interest, Sometimes no state or local tax either, especially if you live in the issuing state. -> Because of this tax benefit, they’re very popular among wealthy investors. Interest Payments : Most Munis pay interest semiannually (every six months). They can have: Fixed rate: same interest payment every period. Or Floating rate: interest adjusts over time, based on market rates.

Question 31

Types of Munis

Answer 31

1) Serial Bonds : A single bond issue, but with different maturity dates (spread over several years). Useful for managing cash flow (gradual repayments). 2) General Obligation Bonds (GO Bonds) : Backed by the "full faith and credit" of the local government. The municipality promises to repay using any source of income (like taxes) 3) Revenue Bonds : Repaid only using revenues from a specific project (like a toll road, stadium, or airport). Riskier than GO bonds, since repayment depends on the project's success. 4) Double-Barreled Bonds : A mix between GO and Revenue bonds. The project generates revenue but the local government also guarantees repayment using general tax income if needed. Safer than regular revenue bonds.

Question 32

ABS

Answer 32

What is an Asset-Backed Security (ABS)? An ABS is a financial product where: * The payments to investors come from cash flows of other assets, like loans. * These loans are “securitized”, meaning they're packaged together and transformed into bonds that can be sold. This process is called Asset Securitization. * In good times, ABS appear diversified because defaults are rare and uncorrelated. In bad times, defaults rise together across assets — correlations increase sharply.→ Even "safe" tranches can be hit. * Lesson: Diversification in ABS can break down during crises.

Question 33

Types of ABS

Answer 33

1) Mortgage-Backed Securities (MBS) The biggest type of ABS. Backed by home mortgages (people’s housing loans). Often issued by government agencies or entities, such as: Government National Mortgage Association, Federal National Mortgage Association…  Risks to Investors : Even with government guarantees (e.g., GNMA), investors face prepayment risk: The borrower might pay off the loan early, so the bond pays back sooner than expected → the investor earns less interest. 2) Private ABS Issued by banks and private institutions. Can be backed by: Auto loans, Credit card debt, Student loans, Consumer loans… 3) Collateralized Debt Obligations (CDOs) A second-level securitization: They take different ABS (like MBS or other loan-backed bonds), re-bundle them, and issue new securities. CDOs are split into tranches: Each tranche has different levels of risk and priority in getting repaid. Senior tranches get paid first, junior tranches bear more risk.

Question 34

Bond Covenants and types of covenants

Answer 34

What are Bond Covenants? Covenants are rules written in the bond contract (called the indenture) that the issuer must follow. Their goal is to protect investors by reducing the risk that the issuer will act in a way that harms their ability to repay the bond. Types of Covenants (Restrictions) 1. Dividend Restrictions : The issuer may not be allowed to pay large dividends, so that more cash is available to repay the debt. 2. Debt Limitations : The company may be restricted from taking on too much additional debt, to avoid becoming overleveraged. 3. Working Capital Requirements : The company might have to keep a minimum level of working capital (current assets – current liabilities), to make sure it can cover short-term obligations.

Question 35

Repayment

Answer 35

Standard repayment or Alternatives (market repurchase, tender offer, call provision,...)

Question 36

Repayment alternatives

Answer 36

a) Market Repurchase : The issuer buys back a portion of its bonds on the open market, comme n’importe quel investisseur b) Tender Offer : The issuer makes an official offer to buy back all or a large part of the bonds at a specific price. Investors can choose to accept or not. c) Call Provision : The bond includes a call option, meaning the company has the right (but not the obligation) to buy back the bond early, at a pre-set price (usually above par). These are called callable bonds. Callable Bonds (repayment provision continued) : Allow the issuer to repurchase the bond early, typically: After a certain date and At a specific call price (e.g., 102% of par) Why call a bond ?If interest rates fall, the company can call the old bond (which has a high coupon) → And issue a new bond at a lower rate = save on interest.

Question 37

Call provision

Answer 37

What is a Call Provision? * It gives the issuer the right (but not the obligation) to repay the bond early (before maturity). * This can happen on or after a specific date → called the call date. * The call price is usually: o Equal to or slightly above the face value (par) o Expressed as a % of face value (e.g. 102%)

Question 38

Why call a bond ? (interest rate, investor perspective)

Answer 38

Why Call a Bond? If interest rates drop, the company wants to: 1. Call (repay) the existing bond (high coupon) 2. Issue new bonds at a lower rate → reduce interest cost If rates rise, no benefit in calling the bond → they leave it outstanding. From the Investor’s Perspective * Investors know the company will call the bond only when it's good for them (i.e. when market rates are lower than the coupon). * So: o Investors lose the high coupon early o They must reinvest at a lower rate * This makes callable bonds less attractive → so they trade at a lower price (and higher yield) than similar non-callable bonds.

Question 39

Call provision : Bond price behavior on and before the call date

Answer 39

Bond Price Behavior at the Call Date : On the call date: o If market yield < coupon → bond will be called, and price = par o If market yield > coupon → bond won’t be called, so price = like a non-callable bond Callable bond prices are capped at par value when yields are low. → The upside is limited. Before the Call Date * If market yields are high: Unlikely the bond will be called → price behaves like a non-callable bond * If market yields are low: Bond will probably be called → price stays close to par, since the issuer may call it soon. Investors are always thinking: “Will this be called?”

Question 40

YTC

Answer 40

Yield to Call (YTC) * The YTC is like Yield to Maturity (YTM), but assumes the bond is called at the first call date. * It’s useful because callable bonds are often repaid before maturity.

Question 41

Sinking fund

Answer 41

What is a Sinking Fund? It’s a mechanism for repaying bonds gradually. The company makes regular payments into a special fund, managed by a trustee. The trustee uses this money to buy back (retire) bonds over time. Objective: Avoid repaying all the debt at once at maturity → This reduces risk for both the issuer and the bondholders. How Does It Work in Practice? * If the bond is trading at a discount (below par) → the company buys back on the open market (cheaper). * If the bond is above par, the company may buy at par (face value). o In this case, which bonds are repurchased is chosen randomly (by lottery).  This protects investors from unfair treatment.

Question 42

Balloon Payment

Answer 42

What Is a Balloon Payment? * A balloon payment is a large lump-sum repayment at the end of the bond’s life. * It happens when: o The sinking fund doesn’t retire all the bonds over time. o So the issuer must pay a big final amount at maturity

Question 43

Convertible Provisions

Answer 43

What is a Convertible Bond? A convertible bond is a corporate bond that gives the bondholder the right to convert the bond into a fixed number of shares of the company’s stock. This is optional: the investor can choose between: Getting the bond’s cash value at maturity Or converting it into shares

Question 44

Conversion Ratio

Answer 44

🔹 Conversion Ratio: Number of shares you receive if you convert one bond. Usually based on a $1000 face value. Example: conversion ratio = 15 → you get 15 shares per bond.

Question 45

Conversion Price

Answer 45

🔹 Conversion Price: It’s the effective price you're paying per share if you convert: If the stock price > $66.67, it’s better to convert the bond and take the shares. Convertible or Not? If stock price is... Then investor will... Above $66.67 Convert to shares Below $66.67 Keep the bond (cash)

Question 46

Callable Convertible Bonds

Answer 46

Some convertible bonds are also callable. If the issuer calls the bond, the bondholder is forced to choose: Convert to shares, or Redeem for cash at the call price. This strategy is often used by the issuer to force conversion when the share price has risen.

Question 47

Warrant

Answer 47

* A warrant is like a call option, but issued by the company itself. * It gives the right to buy new shares at a set price. * When exercised: The company issues new shares to the investor. * Warrants are often attached to bonds (like convertible bonds) to make them more attractive, allowing the company to offer a lower coupon rate.