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CTP > Chapter 6 - Capital Markets > Flashcards

Chapter 6 - Capital Markets Flashcards

1
Q

Structure of Financial Markets

A

financial markets are divided into two markets

(1) money markets - issues with maturities of one year or less

(2) capital markets - issues with maturities of more than one year and is comprised of two markets
(a) debt market - fixed income capital (e.g. bonds, term loans, etc.)
(b) equity market - shares of common and preferred stock

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2
Q

Capital Market Debt Instruments

A

represent a lending arrangement in which the issuer borrows funds from the investor
- capital market debt typically has an original maturity ranging from over 1 year to 30 years or longer
- liquidity of debt instruments is inversely related to maturity

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3
Q

Equity Instruments

A

issuing firm exchanges an ownership interest in the firm for capital

  • ownership interest may result in investor earning dividends and capital gains
  • equity security does not have a fixed maturity date
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4
Q

Captial Market Participants

A

(1) Issuers: respresent the supply side of capital markets

(2) Investors: represent the demand side of capital markets

(3) Intermediaries: play a number of key roles to facilitate the purchase and sale of capital market securities

(4) Regulators: role is to ensure consistent / transparent disclosure of financial info and ensure fair and level playing field for all market participants

(5) Other Participants: include credit rating agencies, transaction processors, central securities depositories (CSDs), custodians, external auditors, etc.

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5
Q

Capital Market Participants - Issuers

A

represent the supply side of capital markets

  • issuers of debt securities are borrowers
  • issuers of equity securities are selling ownership of their company
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6
Q

Types of Capital Markets Issuers (5)

A

(1) Governments and Central Banks: issue debt securities
- issue debt securities with varying maturities
- backed by the full faith and credit of the issuing govt
- used to finance fiscal deficits
- issued through the ministry of finance or treasury dept

(2) Corporations: issue debt and equity securities
- corporates and FIs raise capital through the sale of corporate equity and issuance of debt
- most corporate debt is in the form of 3-15 year bond issues
- corporates issue both preferred and common equity and some issues can be in the form of hybrid securities (e.g. convertible bonds - combine both debt and equity features into a single instrument)

(3) State-Owned Enterprises: issue debt securities
- SOE may issue debt securities that range from short term money market securities to bonds with terms of over 20 years

(4) Sub-Sovereign Entities: issue debt securities
- govt units e.g. states / munis
- borrow extensively in the debt capital markets in many but not all countries
- interest paid to investors on such instruments is generally exempt from federal income taxation

(5) Mutual Fund Companies: issue debt and equity securities
- mutual fund is a collective investment vehicle where investors place cash and the mutual fund company / asset manager will use the cash to acquire a range of assets in the name of the fund
- mutual funds do not represent direct issuance of bons / stocks but rather shares of the funds itself, and the fund holds aggregated securities
- allow smaller investors to easily diversify their investments

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7
Q

State-Owned Enterprises

A

is a firm that is created by a national government for the purpose of participating in / supporting various commerical activities on the govt’s behalf

  • can be either wholly or partially owned by a govt
  • aka crown corporations in Canada or GSE’s in the US
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8
Q

Capital Market Participants - Investors (3)

A

investors represent the demand side of capital markets, types of investors include:

(1) retail investors: individuals buying small amounts for their own portfolios
- issuers have more stringent disclosure requirements in order to market to retail investors

(2) institutional investors: large scale investors e.g. mutual fund companies, insurance companies, money managers, pension funds, corporate treasury depts, banks
- purchase large blocks of securities for their own portfolio and / or on behalf of others

(3) central banks: purchase longer term corporate debt instruments to inject funds into the economy - a form of monetary policy known as quantitative easing

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9
Q

Capital Market Participants - Regulators

A

role of capital markets regulator is to
(1) require issuers to provide consistent and transparent disclosure of financial info
(2) ensure a fair and level playing field for all market participants

Key US Capital Markets Regulators:
(1) Securities and Exchange Commission (SEC)
(2) Financial Industry Regulatory Authority (FINRA)
(3) Commodity Futures Trading Commission (CFTC)
(4) Municipal Securities Ruulemaking Board (MSRB)

Key EU Capital Market Regulators
(1) European Securities and Markets Authority (ESMA)
(2) each member state also has its own capital market regulator

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10
Q

Capital Market Participants - Intermediaries

A

play a number of key roles to help facilitate the purchase and sale of capital market securities

(1) investment bankers: help issuers design and place new securities issues, services typically include underwriting the initial offering and providing advisory services

(2) originators: trading professionals that evaluate, price, and manage the placement of new issues

(3) securities traders: maintain active, orderly secondary markets for equity and debt instruments”

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11
Q

Regulation FD

A

provides that when an issuer discloses MNPI to certain individuals / entities e.g. stock analysts, or holders of issuer’s securities who may trade on the basis of the info, the issuer must disclose that same info publicly

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12
Q

Capital Market Participants - Other Participants

A

(1) credit rating agencies: provide info to investors that help determine credit risk and return of securities

(2) transaction processors: involved in the flow of payments from issuers to investors (e.g. dividend, interest, principa) and also provide record keeping

(3) central securities depositories (CSDs): provide settlement services for cross-border and domestic securities transactions

(4) custodians: take possesion of securities, receive delivery or book entry of P+I payments, perform record keeping and provide investment portfolio maintenace services

(5) external auditors: aduti financial statements and check mark-to-market valuations to increase reliability of financial info used by investors and creditors

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13
Q

Investment Banking Process

A

(1) investment bank / syndicate underwrites a securities issue

(2) issuing firm receives funds from investment bank on issue date and may used proceeds for their intended purpose

(3) investment bank markets the issue to the investing public through a network of brokerage firms aka selling group / syndicate

(4) issue is divided among brokerage firms based on initial syndication agreement

(5) brokerage firms in turn allocate securities to individual offices

There are 3 phases to the investment bank process:
(1) Origination
(2) Underwriting
(3) Distribution

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14
Q

IB - Origination

A

during origination phase, the investment bank will:

(1) consult with issuer on the characteristics / structure of the issue depending on factors such as volume, term, and interest structure

(2) advise on structure to meet the issuer’s requirements

(3) monitors market conditions to advise issuer on best time to bring the issue to market in order to maximize issue price and funds raised

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15
Q

IB - Underwriting

A

act of purchasing all or part of a block of securities issued by a company
- in many cases lead IB (lead left) will invite other Ibs to join the underwriting process to reduce its risk
- two wasys to underwrite a securities issue:

(1) full underwrite: IB / syndicate owns the entire issue
- issuer receives funds net of issuance costs and fees
- IB / syndicate assumes the price and marketability risks associated with the issue

(2) best efforts: issuer pays a fee directly to the IB as comp for advising and marketing the issue
- IB does NOT underwrite the issue and simply places shares through a group of brokerage firms
- if an issue is oversubscribed, possible actions include raising the issue price or issuing additional securities

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16
Q

IB - Distribution

A

involves the sale of the securities

  • once the underwriting syndicate owns the new securities, each member of the syndicate will its distribution system to sell the issue
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17
Q

IB Issue - Price Risk

A

risk that the entire issue is not able to be sold at the anticipated market price

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18
Q

IB Issue - Marketability Risk

A

risk / probability that not all of the shares will be sold

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19
Q

IB Conflict of Interest / Wall

A

(1) underwriting / distribution function - sell side

(2) advisory / management - buy side

  • research / recommendation provide by buy side should be independent from sell side to prevent each party from acquiring MNPI and acting upon it
  • research analyst may be brought “over the wall” to add knowledgable opinion to the underwriting process but that employee is not allowed to comment on any info learned from the underwriting process until it has become public knowledge
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20
Q

Major Channels of the Capital Markets

A

(1) Primary Markets: offer newly issued debt and equity securities to investors

(2) Secondary Markets: securities can be bought and sold on the secondary market and since this happens among investors, issuing firm does NOT experience change in cash flow or change in # of shares outstanding

(3) Private: private equity firms can purchase ownership of privately held companies, help public company go private; debt can also be issued privately via private placement

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21
Q

Equity Issues

A

new issues increases the issuer’s level of outstanding stock

(1) Seasoned Equity Offering (follow on issue): new equity shares issued by a firm that already has shares trading on an exchange or OTC market; market price of existing shares guides price for new shares

(2) initial public offering: when a firm issues equity shares to the public for the first time; no market guidance to value of stock shares, IB will consult to select a price that represents the highest price per share that can be obtained while selling all the shares in the issue

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22
Q

IPO for SPAC (special purpose acquisition company)

A

IPO may be used to raise capital to form a SPAC

  • SPAC will initially have no commerical activity and funds raised are placed in traust to be used to buy stock of an existing company
  • regulatory activity required for going public happens when the SPAC is launched
  • therefore, a company can go public via acquisition by a SPAC which allows it to go public without the cost of arranging its own IPO (company becomes publicly listed due to tis ownership by the publicly listed SPAC)
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23
Q

Organized Stock Exchanges

A

facilitate in buying and selling of equity securities

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24
Q

4 Benefits of Organized Stock Exchanges

A

(1) competitive marketplace where supply / demand determines price

(2) frequent trading minimizes price volatility between individual trades

(3) depth of capital markets allow issuers to raise large amounts of capital through securities offerings

(4) fair market for echange participants

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25
Q

Over the Counter (OTC) Markets

A

members of OTC markets include securities firms

  • firms may choose to maintain an inventory of equity / debt securities
  • firms stand ready to buy same securitites from investors or other dealers wishing to buy/sell
  • rely on electronic communication to conduct trading activity in an auction-style market between brokers and dealers
  • more decentralized than formal exchanges
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26
Q

Private Placement (direct placement)

A

securities are not underwritten but sold to a limited hgroup of institutional investors

  • regulation require the private placement securities be sold to a limited number of high-net-worth investors or to qualified institutional investors (QIIs)
  • IB acting as broker, meets with prospective buyers and confirms the details of the offering
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27
Q

Benefits of a Private Issue

A

(1) private issues do not require preparation of a prospectus, and may be exempt from registration with various local authorities; can be completed faster than a public issue

(2) lower issuance costs, since exempt from regulatory registration

(3) limited disclosure of proprietary info

(4) less restrictive covenants

(5) higher interest rate for the investors (to offset the lower liqudity of private placement)

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28
Q

Qualified Institutional Investors (QII) Regulation in EU

A

MiFID II regulations in the EU define 3 categories of clients:

(1) eligible counterparties: investment firms, asset managers, insurance companies, banks, and other regulated FIs

(2) professional client: to be considered professional, company must have two of the following criteria
(i) balance of EUR 20mm
(ii) net turnover of EUR 40mm
(iii) own funds of EUR 2 mm
- or other investors can request to be considered professional if they fulfill two of the following criteria:
(i) perform an avg. of 10 significant transactions per quarter for the last year
(ii) investment portfolio of at elast EUR 500k
(iii) worked in a relevant financial services role for at least a year

(3) retail client: not instituitional clients - any investors that don’t meet the criteria to be designated as either an eligible counterparty or professional client

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29
Q

US Guidelines re: Qualified Institutional Buyers (QIB)

A

US guidelines re: QIBs are established by the SEC as set forth in Rule 144A of the 1933 Securities Act:
- QIB is an institution that manages at least $100mm in securities and can be a bank, pension fund, insurance company, employee benefit plan, an entity owned entirely by qualified investors
- QIB can also be a registered broker-dealer that owns and invests at least $10mm in securities of issuers not affiliated with the broker-dealer
- private placement will often require that an investor attest to its status as a QIB as private placements may not be marketed to non-QIBs

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30
Q

Jumpstart Our Business Startups (JOBS) Act of 2012

A

relaxed Rule 144A so that securities can be sold to non-QIBs including general solicitation as long as the issuer reasonably believes the purchasers to be QIBs

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31
Q

Debt Market

A

organization and govt entities can raise debt capital in both the short term money market and long term capital market

  • debt capital imposes a payment requirement on the issuer, the interest portion of these payments is usually tax deductible for the issuing firm
  • due to fixed nature and deductibility of interest payments, debt can be an advantageous source of financing
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32
Q

Seniority

A

determines different classes of debt and their priority of claims in the event of bankruptcy

  • subordinated debt: is paid after other creditors have been paid
  • unsecured debt: the indenture agreement and covenants related to each debt issue will determine the priority of claims
  • seniority affects the risk of a given debt issue, which impacts the interest rate and covenants related to that debt issue
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33
Q

Term Loans

A
  • has a fixed maturity (usually longer than one year)
  • can be repaid either in installments or in a single payment
  • typically issued with amortized payment structure aka periodic payments that represent both interest and principal
  • can also be structured so that periodic payments only represent interest with terminal / balloon payment of principal at maturity
  • typically negotiated with a financial institution
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34
Q

Medium / Intermediate Term Notes

A
  • companies and govts can issue medium or intermediate term notes ranging from 2-10 years
  • pays interest at periodic intervals, similar to long term bonds except for the shorter maturity
  • these securities can be traded actively and dealers may stand ready to be market makers, therefore medium / intermediate term notes are deemed marketable, liquid securities
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35
Q

Long-Term Bonds

A
  • represents a contract between issuing entity and bondholders
  • typically issued with original maturities of 10 to 30 years
  • issued similar to stock and are bought and sold on the secondary market
  • bonds are typically unsecured debt
  • most long-term bonds pay coupons aka semiannual interest payments at a fixed coupon rate over the life of the bond
  • principal is repaid in full to the bondholder on the bond maturity date
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36
Q

Bond Indenture

A
  • the contract between bond issuer and bond holders
  • indenture includes:
    (1) description of the bond issue
    (2) lists collateral
    (3) representations and warranties
    (4) covenants
    (5) states the terms by which the company will provide funds for redemption
    (6) sets forth the interest payment dates / amounts, the scheduled maturity date, and any early redemption / call provisions

(7) restrictions included in the indenture can

(a) place limits on the use and disposition of
assets
(b) limits on the level and type of working capital
(c) payment of dividends and
(d) the ability to acquire additional financing

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37
Q

Bond Call Provisions

A

call provision allows the issuer to retire or “call” the bonds prior to maturity

  • normally retire bonds at a call premium
  • exercised when opportunity arises to raise new debt at a lower interest rate or following a corporate event e.g. change in ownership
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38
Q

Bond Put Provisions

A

allows the buyer to redeem the bond prior to maturity by forcing the issuer to buy the bonds back at a discount

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39
Q

Mortgage Bonds

A
  • used to finance specific assets e.g. real estate or manufacturing equipment
  • pledged assets serve as security against the issue
  • usually include substantial financial covenants or indenture agreements
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40
Q

Debentures

A
  • debentures are unsecured bonds that represent general claims against the issuer’s assets and / or cash flows
  • offer a higher interest rate than secured bonds
  • large financially secure organizations issue debentures based on their credit rating in the marketplace
  • organizations that don’t have easily securitized assets must use unsecured borrowing through debentures
  • may be issued on a subordinated basis
  • unsecured bonds may include sovereign, corporate, and muni bonds
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41
Q

Convertible Bonds

A
  • corporate debt securities that can be converted by the holder (sometimes by issuer) into shares of common or preferred stock at a fixed ratio of shares per bond
  • provide investors with potential for capital growth
  • investors may accept a lower interest rate compared to bonds that are NOT convertible
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42
Q

Sovereign Bonds

A
  • bonds issued by a national govt, typically denominated in the currency of the issuing govt
  • both credit risk and political risk associated with sovereign bonds
  • sovereign bonds have increased political risk as the decision to meet interest and debt repayment obligations can be used as a diplomatic bargaining tool in certain circumstances
  • can sometimes be issued in a currency other than the home currency of the issuer - these bonds would carry additional risks:
    (1) FX risk and
    (2) higher default risk as govt cannot print more money to meet repayment obligations
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43
Q

Sub-sovereign (Muni) Bonds

A
  • bonds issued by govt entities are usually in the form of general obligation or revenue bonds

(1) general obligation bonds: are paid from proceeds of general tax revenue

(2) revenue bonds: are repaid from the revenues generated from specific public projects or services

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44
Q

Eurobonds (external bond)

A
  • international bond that is denominated in a currency other than that of the country in which it is issued
  • typically sold simultaneously in many countries ouside the country of the borrower
  • can be an effective financing tool that gives issuer flexibility to choose currency and country in which to offer their bond based on (1) country regulatory constraints (2) foreign exchange needs (3) preferred currency
  • also provides MNC’s the ability to create natural hedge
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45
Q

Zero-Coupon Bonds

A
  • do not pay interest and issued at a discount below par value
  • sole cash outflow for the issuer is the repayment of par value at maturity
    Advantages for the Corporate Isssuer:
    (1) no cash outflow until maturity
    (2) issuing company receives an annual tax deduction until maturity
    Disadvantage for Investors:
    (1) not callable or refundable
    (2) investors are required to pay taxes on imputed interest earnings each year but no paymnet is received until maturity
  • if held in a portfolio that is not tax-exempt, there is negative cash flow for the life of the bond
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46
Q

Floating or Adjustable Rate Debt

A
  • carry interest payments that reset periodically based on movement in a representative interest rate index
  • rate is stated as a spread above the base index rate
  • interest rate may be reset daily, weekly, monthly, quarterly, semi-annually, or annuallly
  • reset frequency is based on the index that is used
  • attractive to investors during periods of rising rates as floating rate debt provides stable market value and matches current interest rates
  • borrowers may prefer floating rate debt when interest rates are believes to drop in the future
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47
Q

High-Yield Bonds

A
  • aka junk bonds , not investment grade
  • high yield bonds are issued by less creditworthy entities
  • these bonds offer a higher yield to compensate for increased default risk
  • may corporates and institutional investors have investment policies that prohibit investment in non-investment grade securities
  • therefore if a bond’s credit rating falls below investment grade, there can be an impact on its price in the secondary market if those investors seek to sell their holdings of that bond
48
Q

Income Bonds

A

pays interest only if company has profits

49
Q

Collateral Trust Bonds

A

backed by securities of companies that are owned by the issuing firm

50
Q

Equipment Trust Certificates

A

secured by movable equipment (e.g. aircraft, fleet of trucks), backed by specific group of assets (no blanket lien)

51
Q

Index Bonds

A

rates that are tied to an economic index and are often used when high level of price inflation is present or expected

52
Q

Economic Development Bonds

A

issued by developing countries to foster development of infrastructure and related projects

53
Q

Tax Increment Financing (TIF) Bonds

A

used for local financing where municipality can use all or portion of funds to finance a project

54
Q

Tender Option Bonds (Put Bonds)

A

investor can redeem the bond once during its life or on specified dates, bonds are redeemed at par value

55
Q

Foreign Bonds

A

sold by a foreign borrower, usually denominated in the currency of teh country in which it is issued

56
Q

Multicurrency Bonds

A

allow investors to choose among several predetermined currencies or currency cocktail bonds that are denominated in standard basket of currencies

57
Q

Environmental, Social, and Governance (ESG) Bonds

A

raise funds for general use, or to funds specific enironmental / social projects; issuers have to meet certain principles or KPIs, failure to do so will require the issuer to pay a higher coupon rate

58
Q

Green Bonds

A

a class of ESG bonds, used by federally qualified organizaions to raise funds to promote sustainability by developing underutilized or abandoned properties; corporate bonds that designate proceeds for environmental projects are also known as green bonds

59
Q

Project Financing

A

typically used for large projects, often in the energy space and is commonly used for private infrastructure projects e.g. stadiums, shopping centers, etc.

  • financing arrangement is complex, usually involving several companies / sponsors forming a separate legal entity to operate the project
  • lenders are paid from project’s cash flows, and do not have recourse to project’s owners or sponsors
60
Q

Securitization

A

debt instruments are securitized to increase liquidity and to lower yield paid by issuer

  • common corporate assets include A/R and inventory
  • assets can be bundled to collateralize securities and securities are then sold in tranches based on the credit rating / maturity
  • makes the investments more liquid and more attractive to investors
  • resulting securities in the securitized structure is called asset backed securities
61
Q

Asset Backed Securities (ABS)

A

e.g. FI that has outstanding credit card receivables can use them as collateral for ABS that it sells to investors

  • resulting cash can be used for additional lending
  • arrangement provides significant liquidity to the card issuers, and benefits both borrowers and lenders
62
Q

Off Balance Sheet Financing

A

designed to provide financing that does not appear on the borrowing company’s balance sheet

  • used by firms with high debt levels or restrictive covenants that limit the use of additional debt
  • e.g. joint ventures, R&D partnerships, sales of receivables (factoring) and operating leases
63
Q

Debt Indentures

A
  • indenture is a legal document that outlines the rights and obligations of the borrower and the creditor
  • contract can include restrictive covenants - either negative and affirmative
  • purpose of indenture is to protect lenders from actions by management that would heighten the risk to lenders or increase the value to shareholders at the lenders’ expense
  • violation of an indenture agreement is usually grounds for lenders to make the debt immediately due and payable, which may force a company into bankruptcy
  • in the US, the SEC must approve indenture agreements in any public offerings to ensure all indenture provisions are met before allowing a company to sell new securities to the general public
64
Q

Debt Covenants

A
  • covenants can be negative (company must not…) or affirmative (company must…)
  • e.g. company must not double pledge collateral; company must provide regular financial statements
  • typical covenants outline:
    (1) assets involved
    (2) right of the firm to issue additional debt
    (3) use of second or junior mortgages
    (4) sinking fund requirements (arrangements for orderly repayment of debt principal)
    (5) reporting requirements
    (6) restrictions on the use of funds
    (7) restrictions involving key financial ratios and liquidity
    (8) prepayment terms
    (9) restrictions on dividend policy
65
Q

Representation and Warranties

A

are existing conditions attested to by the borrower at the time when the loan agreement is executed

  • conditions generally include:
    (1) affirmation of valid legal existence of the borrowing company
    (2) resolution by the board authorizing the borrowing
    (3) authority of corporate officers signing the document
    (4) confirmation of compliance with applicable regulations
    (5) indemnity protecting the lender from environmental liabilities
    (6) confirmation that the execution fo the loan agreement does not violate charter/bylaws of the borrower or violate any other loan agreements to whic the borrower is party to
    (7) commitment by the borrower not to breach any economic sanctions
66
Q

Events of Default

A
  • may occur when borrower breaches or violates any term or condition under a debt agreement e.g.
  • nonpayment of interest / principal
  • triggering a material adverse change (MAC) clause; allows lender to refuse funding / declare a borrower to be in default even if all agreements are in compliance
  • violation of a specified covenant
  • incorrect or misrepresented representations or warranties
  • cross-default provision; puts the borrower in default if the borrower defaults on another debt agreement
67
Q

Cure Periods

A

provide a period of time in which an event of default may be corrected before lender may pursue default remedies

68
Q

Remedies

A

remedies available to a lender in an event of default includes:

  • acceleration of all principal and interest on debt
69
Q

Waivers of Default

A

may be granted at a lender’ discretion, typicallly for a fee or change in terms

70
Q

Call Provisions

A
  • gives the issuer the right to call a bond or other security for redemption prior to the original maturity
  • a call premium is generally paid when a bond is called to compensate investors for early redemption
  • call premium is larger the earlier an issue is called

BENEFIT TO ISSUER:
- allows redemption of a bond if
(1) interest rates fall and refinancing becomes an attractive option or if
(2) issuer wants to retire the debt before maturity

PRO FOR INVESTORS:
- typically require a higher coupon rate in order to attract investors

CON FOR INVESTORS:
- if rates fall and bond is called, investor is forced to reinvest the call proceeds at a lower rate

71
Q

Put Provisions

A
  • allows the investor to force the issuer to repurchase the debt at specified dateds
  • put provision generally provides that debt will be redeemed at par, creating a floor price for the debt and greater security for the holder
  • bonds with put provisions typically trade at a higher price on the secondary market
72
Q

Sinking Fund

A
  • sinking fund provisions require issuers to call, or repurchase on the open market a portion of outstanding bond issues each year so that the bond is repaid over its life
  • there is no smaller final repayment of principal
  • other provisions require a company to make payments into a trust accoutn which can either be used to repurchase cnds on the open market or to amass a lump sum of cahs for the retirement of the bonds at maturity
73
Q

Refinancing

A
  • refinancing of bonds is often done for a variety of opportunistic reasons including:

(1) raise funds for corporate transactions e.g. M&A

(2) restructuring of capital structure

(3) as part of periodic maintenance of capital structure to align repayment with anticipated cash flows to match their assets and liabilities more closely

(4) refinancing often occurs following periods of high interest rates; issuers take advantage of falling rates by issuing new bonds at a lower interest rate and use the proceeds to retire the older, higher-interest bonds

74
Q

“Make Whole” Provisions

A

provision requires the borrower to make an additional payment based on the NPV of future debt payments that will not be paid to protect the lender’s anticipated profit on the original debt

75
Q

Defeasance of Debt

A

-removes debt from the borrower’s balance sheet without retiring the debt

  • the borrower places sufficient funds in escrow that will be used to pay for interest and principal on the debt issue
  • since control of both the debt and the escrow funds is relinquished, payment and retirement of the debt issue is guaranteed
  • therefore, the borrower can remove these debt securities from its balance sheet, which can be used by the issuer to meet debt covenants
76
Q

Promissory Notes

A
  • the promissory note is the legal portion of the debt contract
  • it is an unconditional promise to pay a specified amount plus interest at a defined rate either on demand or on a certain date
  • master note is a type of promissory note, which can be used to simplify the paperwork used for loans with multiple advance features e.g. lines of credit / RLOC - borrower signs one comprehensie promissory note that covers all borrowings and repayments under the line
77
Q

Collateral

A
  • collateral are assets used as security for a loan or bond issue
  • can include (1) physical assets or (2) financial assets e.g. AR and inventory
  • condition of assets must be monitored, value appraised, and insured for physical assets
  • a “haircut” is applied to the collateral’s current market value to deteremine lending availability
  • size of haircut is determined by the quality of the assets
78
Q

Liens

A
  • lien is a legal claim on assets used as collateral in the event the lender cannot take physical possession of the assets
  • e.g. mortgage for larger assets, blanket lien against AR and inventory
  • if borrower defaults, lender can sieze the assets in lieu of repayment
79
Q

Lien Filing / Lien Search

A
  • lender must follow a legal process to establish the claim by filing notice with the appropriate govt agency
  • US UCC covers secured transactions i.e. when lender requires some type of security or collateral for money it lends
  • under this article, any business that requires a security interest must file a UCC-1 financing statement with its state’s office of assessments and taxation
  • the UCC-1 financing statment will list the collateral that has been specifically assigned to secure the loan
  • it is a legal document signed by both the borrower and lender and determines who has a right to the assets in the event of a default
  • lenders often performa lien search on potential borrowers to see if the assets offered have already been pledged to another creditor
80
Q

Credit Enhancement

A
  • provides the lender with reassurance that the borrower will honor the obligation, through additional collateral, insurance, third party guarantee
  • credit enhancements reduces the credit / default risk of debt which increases credit rating and lowers interest rates
  • most common form of credit enhancement is a guarantee but could also be in the form of SBLC or backup line of credit, or a surety bond (issued by insurance company)
81
Q

Guarantees

A
  • lenders may require another party to guarantee the loan for the borrowing entity, this provides the lender recourse to the guranteeing entity to obtain payment in the event the sub is in default

several levels of guarantees
(1) full guarantee

(2) specific project guarantee

(3) guarantee of payment or collection

(4) performance guarantee

(5) personal guarantee

(6) comfort letter

82
Q

Full Guarantee

A

guaranteeing party fully guarantees any borrowing arrangement by the sub and agrees to ttake over the loan if the sub fails to make timely payment

83
Q

Specific Project Guarantee

A

only guarantees loans related to specific projects of the sub rather than all loans

84
Q

Guarantee of Payment or Collection

A

guarantees to make paymenton the loan or collect payment form the sub BUT only if the sub formally defaults on the loan which usually requires the lender to initiate default proceedings before the guaranteeing party becomes involved

85
Q

Performance Guarantee

A

specific performance guarantees relative to the assets being financed
- under full guarantee, parent fully guarantees performance by the sub
- under best efforts guarantee, parent uses best efforts to persuade the sub to perform but does not guarantee performance

86
Q

Personal Guarantee

A

lender may require a personal guarantee by the owner or principals before granting the loan

87
Q

Comfort Letter

A

not technically a guarantee, it’s a letter stating actions the party will or will not take on behalf of the borrower

  • not legally enforceable but party preparing the comfort letter is signaling how it expects to act in the future, letter places a moral obligation on the entity to take stated actions should the need arise
88
Q

Bond/Credit Ratings

A
  • quality rating is assigned that reflects the default probability associated with the issuer
  • each issue is rated independently by one or more accredited rating agencies
89
Q

Three aspects of ratings that should be considered by issuers

A

(1) agency’s rating criteria: ratings are based on both qualitative and quantitative factors, which may vary by industry but include measures such as diversification of product lines, market share, profitavility, leverage, and financial policy

(2) importance of ratings to both firm investors and management: many investment policies restrict institutional invesotrs to only buying investment-grade bondsand these investors makeup the bulk of the bond market
- bond rating is considered a direct measure of the risk fo the related securiteis and impacts the overal cost of capital for the issuer

(3) changes in ratings: rating agencies may upgrade or downgrade an issue based on changes in either the issuer or general economic environment

  • enitities with downgraded ratings may have more difficult time raising additional captial and would be expected to pay a wider spread and consequently higher interst rate on future bonds issued
90
Q

Maturity Matching

A
  • matching the life of a debt issue to the life of the specific assets financed
  • matching the maturities of the debt issues and assets helps reduce overall firm risk
  • primary risk from a maturity mismatch results from long term assets being financed with short term sources
  • short term debt must continually be rolled over to provide an ongoing funding source
  • leads to adverse exposure to higher interest rates and inability to raise short term debt in the future
  • issuers will often stagger maturity dates to avoid having to repay / refinance too much debt at one time
91
Q

Effects of Interest Rate Levels and Forecasts

A
  • forecast of interest rates impacts both the type of capital raised and the provisions that may be attached
  • debt issuers must consider the “flight to quality” concept when financial market conditions delcine, investors move toward safe or quality investments causing the yield spread between high and low risk investments to increase significantly
92
Q

Availability of Collateral

A
  • firms with large unencumbered asset bases can typically borrow at lower rates
  • firms with low operating and financial risk will have a greater ability to borrow on an unsecured bais and obtain funds at lower rates than otherwise comparable firms
93
Q

Three Key Accounting Terms Related to Common Stock

A

(1) par value
(2) additional paid in capital
(3) retained earnings

  • the sum of these three line items = total amount of stockholder’s equity
  • but these accounts only represent the historical accounting value of equity and not the current market value
94
Q

Par (Face) Value

A
  • an arbitrary amount that is usually stated in the corporate charter
  • indicates the minimum amount stockholders have to put up
  • for most publicly traded firms, par is $1 or $0 (no par)
95
Q

Additional Paid In Capital

A
  • represents the difference between the par value and the issuance price (less underwriting fees) at the time of issuance
  • e.g. par value of $1 and firm nets $25 per share then APIC will reflect $24 per share
96
Q

Retained Earnings

A
  • accumuluated earnings since firm’s inception less dividends paid to shareholders
  • represents money reinvested in the company in lieu of dividends paid out
  • recorded in equity section of the B/S to reflect profits that have been reinvested in the firm but does not represent an actual pool of funds
97
Q

Book Value Per Share

A

total book value of common equity divided by the number of common shares outstanding

98
Q

Market Value Per Share

A

current price at which a share of stock is traded

99
Q

Treasury Stock

A
  • shares of common equity that has been acquired by the issuer
  • may be held in the firm’s treasury, reissued to the public, or retired
  • treasury stock has no dividends or voting power while held by the company
  • it is considered issued but not outstanding and therefore is deducted from capital calculations
  • some jurisdictions do not allow issuers to hold treasury stock and require any stock reacquired by the issuer to be immediately retired
100
Q

Tracking Stock

A
  • a separate stock created by the parent company to track the financial performance of a particular line of business
  • tracking stock trade under a unique ticker symbol
  • allows investors to invest in a fast growing business unit without investing into the whole firm
  • tracking stock do not provide stockholders with ownership in the parent company nor does it include voting rights
101
Q

Exchange Traded Funds (ETFs)

A
  • a collection of securities that trades on an exchange similar to stock but are designed to track a specific index
  • e.g. SPDR or SPY - it’s an ETF that mirrors the return of the S&P 500 index
102
Q

Types of Common Stock

A

(1) classified stock
(2) tracking stock
(3) exchange traded funds (ETFs)

103
Q

Classsified Stock

A
  • common stock that is divided into different classes (e.g. class A or class B)
  • each class has its own unique privileges e.g. voting rights, dividends, etc.
104
Q

Preferred Stock

A
  • differs from common stock in terms of voting rights and dividends
  • preferred stock does not have voting rights, which allows company to raise capital without ceding control
  • preferred dividends occur at fixed rates for the life of the security or into perpetuity, so cash flows for preferred stock are more similiar to debt than equity
  • firm does not risk bankruptcy if they miss a preferred dividend payment unlike missing a debt payment
  • preferred dividends are not tax-deductible unlike interest payments on debt, making cost of servicing preferred stock generally much higher than servicing debt
105
Q

Provisions of Preferred Stock Issues

A
  • preferred stockholders have a priority claim over common stockholders but after debt holders
  • preferred dividends must be paid in full before any dividends can be paid to common shareholders
  • preferred dividend is calculated as a fixed percentage of par value of a preferred share and must be paid if a company has sufficient earnings
  • preferred stock accumulates dividends in arrears meaning any missed dividends must be paid in full before any dividends can be paid to common shareholders
  • many preferred stock issues include provisions that grant voting rights to elect a rep to the BoD if a certain sequence of preferred dividends is missed
  • some preferred stock my be convertible to common shares or debt under certain circumstances
  • provisions that help make preferred stock more attractive to investors include:
    (1) voting rights under certain circumstances
    (2) participations in earnings if they exceed a certain level
    (3) sinking funds to redeem preferred stock
    (4) maturity dates
    (5) exchange / call provisions
106
Q

Benefits of Preferred Stock

A

PROS TO THE ISSUER:
- can lock in financing costs without increasing default risk with the use of preferred stock due to fixed nature of preferred dividends

  • large portions of preferred stock are issued privately to institutional investors which has substantially lower issuance costs and less stringent disclosure requirements
  • also allows issuers to raise capital without increasing leverage ratios
  • additionally rating agencies view preferred stock more favorably than debt issuance

PROS TO THE INVESTOR:

  • preferred stock provides a more predictable revenue stream compared to common stock
  • but pricing of preferred stock is still sensitive to interest rate movements due to fixed income associated with the dividend
  • for most US corporate holders of preferred stock, 50% of dividend income may be excluded from federal income tax, which makes preferred stock attractive to institutional investors
107
Q

Uses of Preferred Stock

A
  • often used by FIs or young / high growth companies or companies in financial distress
  • for FIs, most regulatory authorities view preferred stock as regulatory capital
  • for these types of companies, the tax advantages of debt financing are minimal or nonexistent making the cost differential between debt financing vs preferred stock very small
  • plus the equity nature of preferred stock, makes this form of financing very attractive to these types of issuers
108
Q

Hybrid Securities

A
  • combine elements of different types of securities, these securities typically have both debt and equity characteristics
  • most common are convertibles and warrants
109
Q

Convertibles

A
  • bond or preferred stock that may be exchangeable for common stock at the holder’s or issuer’s option under certain terms and conditions at a pre-stated price
  • the conversion does not provide additional capital for the issuer, it simply converts existing bonds or preferred stock into shares of common equity
  • conversion ratio: states the number of commone shares of equity one bond may be converted into
  • conversion price: determined by the maturity value of the bond and the conversion ratio
  • e.g. one bond with a $1000 par value with a conversion ratio of 20 shares = $1000/20 = $50 conversion price
110
Q

Dilution of Convertibles

A
  • convertibles contain clauses that protect against the dilution of value due to stock splits, stock dividends, or reduced stock prices
  • new stock is issued at a lower price, then either (1) the conversion ratio of the convertible must be raised or (2) the conversion price must be lowered to equal the new stock issue price in order to keep the value of the holdings equal
  • e.g. one bond with a $1000 par value with a conversion ratio of 20 shares = $1000/20 = $50 conversion price
  • if the stock goes through a 2-1 split, then the conversion ration must be raised to 40 shares since every 1 outstanding share of common stock will become 2, this will keep the value of the convertible equal pre and post stock split
  • the new conversion price will become $25 ($1000/40 = $25)
111
Q

Advantages / Disadvantages of Convertibles to the Issuer

A

ADVANTAGES:
offers the issuer the ability to sell debt with lower interest rates and with fewer restrictive covenants by providing investors the opportunity to participate in potential capital gains if the firms value increases

DISADVANTAGES:

(1) if stock price increases significantly during the life of the convertible, issuer may have been better off with issuing regular debt rather than funding the debt with a new stock issue

(2) if convertible has a low coupon rate, that will be lost when the bonds are converted to stock

(3) if share price does not increase, then holders may not convert bonds to stock and the issuer may be locked into the debt issue, although the coupon rate will be lower than that of a regular debt issue

112
Q

Warrants

A
  • warrants are bonds with an equity purchase option that gives warrant holder the right to buy a stated number of shares of stock at a specified price for a specific period of time (i.e. bond with an equity kicker)
  • warrants are listed on major exchanges and trade like options
  • warrants are detachable and can be traded separately from the bond
  • warrants issued with bonds represent potential for additional equity capital for the issuing company

– when a warrant is exercised, the low coupon bond issue remains outstanding, thus bringing additional funds into a company while keeping debt costs low

  • warrants are used extensively by small rapidly growing companies as a “sweetener” when selling debt or preferred equity
113
Q

Impact of Convertibles and Warrants on Equity

A
  • convertibles and warrants may dilute the value of current stockholder’s equity and the earnings per share (EPS)
  • some companies report a fully diluted EPS which assumes all outstanding convertibles and warrants are exercised
  • the SEC requires disclosures of EPS to include:
    (1) capital structure info
    (2) explanation of EPS computation
    (3) identification of common-stock equivalents (e.g. warrants, convertibles, rights)
    (4) # of shares converted
    (5) assumptions made”
114
Q

Depositary Receipts

A
  • negotiable financial instruments that trade on a local exchange but represent stock ownership in a foreign, publicly listed company, typically equity securities
  • outside the US these are known as global depositary receipts (GDRs)
  • regardless of location of issuing company, it must meet all requirements of the exchange / regulatory authorities in the country where the depositary receipt is traded
115
Q

Benefits of Depositary Receipts Market

A

offer benefits especially for issuers located in countries with limited financial markets

(1) increase global trade in local and foreign markets

(2) greater exposure and opportunity to raise capital on a global basis for companies in smaller countries

(3) help reduce market inefficiencies especially in emerging markets by allowing easier global investment into emerging markets

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