Chapter 6 - Capital Markets Flashcards
Euroxxxx
Outside the country where that currency is prevalent
Two Types of Financial Markets
Money Markets
Capital Markets
Liquidity of debt instruments is inversely related to what?
Maturity
3 Key Concepts of Government Debt
Backed by the full faith and credit of the issuing government
Used to finance fiscal deficits
Issued through the ministry of finance or treasury department
Central banks in many countries issue their own securities for what purpose?
Finance the acquisition of assets
What types of securities do governments and not-for-profits issue?
Debt securities
What do non-profits have instead of equity?
Net assets
Typical corporate debt tenor
3 to 15 years
Crown Corporations
GSEs in Canada
Sub-sovereign entities
Governmental units within a country
States, cities, etc.
Are Mutual Fund Companies considered issuers in capital markets?
Yes
Purchase shares of the fund and diversify holdings
Quantitative Easing
Central banks purchase longer-term corporate debt in order to inject funds into the economy
Are regulatory requirements for selling to retail investors more or less restrictive than selling to institutional investors?
More stringent
Capital Market Intermediaries
Investment Bankers - Design and placement of securities issues, including underwriting and advisory
Originators - Evaluating, pricing, and managing the placement of new security issues
Securities Traders - Maintain active, orderly secondary markets
What is the role of financial regulators in capital markets?
Ensure transparent disclosure to allow for a fair and level playing field for all market participants
Proceeds from the issuance of securities will come from which entity?
The investment bank
Syndicate or Selling Group
Network of brokerage firms
Syndication Agreement
Determines breakout of who gets to act as broker for the issuance of new securities
Three Stages of Issuing New Stocks or Bonds
Origination
Underwriting
Distribution
Origination (Capital Markets)
Process of determining the structure of the new issuance
Underwriting
Purchasing all or part of a block of securities issued by a company
Lead Underwriter or Lead-Left Bank
Lead investment banker on new issuance deal
Full-Underwriting vs. Syndicated Underwriting
Syndicated underwriting allows other investment banks to share in the risk
Price Risk (Securities Issuance)
Pricing goal for new securities will not be achieved
Marketability Risk (Securities Issuance)
All of the new securities will not be sold
Best Efforts Basis as Underwriting Alternative
Investment bank will assist on best-efforts basis instead of completing underwriting phase
Issuer pays a fee directly to the investment bank as compensation
Helps place shares through a group of brokerage firms
Sell Side of the House
Investment banks offering underwriting /distribution function
Buy Side of the House
Investment advisory or management function
What European legislation requires financial intuitions to take the appropriate steps to identify, prevent, and manage conflicts of interest?
MiFID II
Brought Over the Wall
Research analyst joins underwriting department to assist and cannot comment afterwards
Seasoned Equity Offering (SEO) / Follow-On Issue
New equity shares with shares already trading on the exchange
SPAC
Special Purpose Acquisition Company
Funds from IPO are put into a trust to be used to purchase stock in other companies
May be cheaper for a private company to be acquired and become public through the corporate ownership
Organized Stock Exchanges Benefits
Competitive market
Frequent trading to reduce price volatility
Depth of capital markets to allow for larger raises of capital
Fair market
Government, municipal, and corporate debt along with some equities not traded on exchanges are sometimes traded in the _____ markets.
OTC
Private Placements require that investors are what type of investor?
Qualified Institutional Buyers (QIB)
Qualified Institutional Investors (QII)
MiFID II Three Categories of Clients
Eligible Counterparties: investment firms, banks, asset managers
Professional Client: high net worth, turnover, or ownership of lots of funds
Retail Client: Not institutional investors
Who establishes guidelines regarding QIBs in the US?
SEC
Rule 144A of the 1933 Securities Act
$100M in securities managed
Broker-Dealer - $10M of non-affiliated securities
What did the JOBS Act in 2012 do to Rule 144A?
Relaxed the rule so that securities can be sold to non-QIBs so long as issuers reasonably believe the purchasers to be QIBs
Overview of Private Placements
No need to file detailed prospectus or other filing requirements
Lower issuance costs (due to less regulation)
Limited disclosure of proprietary information
Less restrictive covenants
Higher interest rate due to less liquidity
Two Advantages of Debt
Fixed schedule
Tax savings from interest expense payments
Term Loans
Typically not bought and sold in the secondary market
Issued by a financial institution
Balloon payment or amortized payment
Medium or Intermediate Term Notes
Tenors of 2 to 10 years
Usually have semiannual interest payments
Long-Term Bonds
Tenors of 10 to 30 years
In many countries, which market is the major component of capital markets?
Bond market
Bond Indenture
Contract that defines the rights and obligations of the borrowers and issuer
Describes the bond issue
Lists collateral
Makes representations and warranties
Specifies covenants
States the terms by which the company will provide funds for redemption
Sets for the schedule of payments, as well as any early redemption or call provisions
If there is a risk that the bond’s indenture requirements will be violated, what typically happens to the bond’s price?
It decreases
Mortgage Bonds
Used to finance specific assets
Substantial financial covenants or indenture agreements
Debentures
Unsecured bonds that represent general claims against the issuer’s assets and /or cash flows
Higher interest rate than secured bonds
Large institutions will issue debentures based on their credit rating
Convertible Bonds
Ability to convert to equity and potential for capital growth results in a lower rate
Issuing sovereign debt in a currency other than the local currency increases which risks?
Foreign exchange risk
Higher default risk (government can’t print the non-local currency)
Sub-sovereign Debt is also known as…
Municipal Bonds
General Obligation Municipal Bond
Paid from the proceeds of general tax revenue
Revenue Municipal Bond
Paid from the revenues of specific public projects or services
Historically, where has the market for municipal bonds primarily existed?
United States
Eurobond / External Bond
International bond issued outside the country of the borrower in a currency other than the currency of the country where it is issued
Typically sold simultaneously in many countries
Usually issued by international syndicate
Eurobonds can help companies put in place what types of hedges?
Natural hedges
Zero-Coupon Bonds – Advantages for Issuer
No cash outflow until maturity
Issuing company receives an annual tax deduction until maturity
Zero-Coupon Bonds – Disadvantages for Investor
Pay taxes on imputed interest earnings without actual cash inflows
Not callable or refundable
The reset frequency for floating rate debt is typically determined by what?
The index that is used for the security
High Yield Bonds are also known as…
Junk bonds
Non-investment grade bonds
Income Bonds
Only pay interest if company has profits
Collateral Trust Bonds
Backed by securities of other companies owned by the issuer
Equipment Trust Certificates
Bonds secured by movable equipment
Index Bonds
Interest rates tied to an economic index
Often used when high level of price inflation is present or expected
Economic Development Bonds
Issued by developing countries
Tax Increment Financing (TIF) Bonds
Local financing where municipality will use all new tax revenues from a specific district
Tender Option Bonds or Put Bonds
Allow the investor to redeem the bond either once during its life or on specified dates
Typically redeemed for par value
Foreign Bonds
Borrower is foreign to country of issuance, but usually issued in local currency where issued
Multicurrency Bonds
Currency Options Bonds – choose among predetermined currencies
Currency Cocktail Bonds – standard basket of several currencies (SDRs)
SDRs
Special drawing rights
Artificial currency based on basket of currencies
Created by the International Monetary Fund (IMF)
ESG Bonds
Used to pay for ESG initiatives
Have to meet criteria or rate increases
Green Bonds
Federally qualified organizations to raise funds for brownfield sites
Corporations that designate proceeds for environmental projects, renewable energy projects, etc.
Project Financing
Large projects like energy or stadiums, toll roads, etc.
Complex, involving several companies or sponsors forming a separate legal entity
Do not have recourse on individual sponsors or owners
Paid from the project’s cash flows
Why are debt instruments commonly securitized?
To lower the yield paid by issuers
Increase liquidity
What are common corporate assets used in securitization of debt instruments?
Accounts receivable
Inventory
Asset-Backed Securities
Securitized structure for debt issuances
Off-Balance Sheet Financing & Examples
Helpful to comply with covenants
Joint ventures
R&D partnerships
Receivables factoring
Operating leases
Negative vs. Affirmative Covenants
Negative = Things the issuer may not do
Affirmative = Things the issuer must do
Change of Control Covenant
May be triggered when there is a material change in the company’s ownership or executive leadership
Most-Favored-Nation Covenant
Can’t offer new buyers better terms without first offering it to the first buyer
What is the purpose of an indenture agreement from the perspective of the investor?
Protects the investor from actions by management that would heighten the risk to lenders
Reduces risk that equity investors would receive favorable outcomes at the expense of the debt holders
What happens if the indenture agreement is violated?
Debt becomes immediately due and payable
In the US, who must approve indenture agreements for public offerings?
SEC
Typical covenants will outline:
Assets involved
Right of an organization to issue additional debt
Use of second or junior mortgages
Sinking fund requirements
Reporting requirements
Restrictions on the use of funds
Restrictions involving key financial ratios and liquidity
Prepayment terms
Restrictions on dividend policy
Representations and Warranties (Indenture Agreement)
Existing conditions attested to by the borrower at the time when the loan agreement is executed
Attestation also occurs on drawdown and with each quarterly reporting requirement
A commitment by the borrower not to breach economic sanctions would be an example of a convent or representation/warranty?
Representation/warranty
Material Adverse Change (MAC) Clause
Allows lender to refuse funding or declare a borrower to be in default even when all agreements are in full compliance
Could be triggered by new laws, regulations, or loss of borrower’s primary customer
Cure Periods
Provide a period of time in which an event of default may be corrected before remedies are pursued
Remedies
Available to lender and typically involves acceleration of principal and interest when default occurs
Waivers of Default
May be given at the lender’s discretion, typically for a fee or change in terms
When a security is called, it typically will be called for a ___________?
Call premium
Larger premiums are paid when the call date is earlier
Will callable bonds usually have a higher or lower interest rate?
Higher because of the risk of the call
Do bonds with put provisions typically trade with a higher price or lower price on the secondary market?
Higher price
Provides greater security for the holder, so it is more attractive and drives up the price
Sinking Funds
Requires issuers to call or repurchase on the open market, a portion of the outstanding bond issue each year
Reduces a large final repayment at the end
May also use a trust account where they will hold funds or repurchase
Will sinking fund provisions result in a lower or higher interest rate?
Lower interest rate because amortized payments are made, thus reducing risk
Make Whole Provision
Requires the borrower to make an additional payment based on the net present value of the future debt payments that will not be paid in a debt refinancing
Used as part of an early redemption
Defeasance
Removes the debt from the balance sheet without retiring the debt issue
Borrower places sufficient funds in escrow, usually in government securities
Promissory Note
Legal portion of the debt contract
Unconditional promise to pay a specified amount plus interest either on demand or at a certain date
Master Promissory Note
Helps to facilitate administrative burden by consolidating legal paperwork when multiple advance features are present (e.g. revolving lines of credit)
Haircut for Collateral
Lender will deduct a percentage of the current market value of any assets used as security
Liens
Legal claim on assets used as collateral in the event it cannot take physical possession of the assets
Liens are covered by which article in the UCC?
Article 9
In order to ensure proper registration of a security interest, what must be filed in accordance with UCC Article 9?
UCC-1 Financing Statement with state’s office of assessments and taxation
Process is known as perfecting
The UCC-1 Form is also known as a __________?
Financing Statement
Full Guarantee
Guaranteeing party fully guarantees any borrowing arrangement
Specific-Project Guarantee
Only loans relating to specific projects
Guarantee of Payment or Collection
Guaranteeing party guarantees to make payment on the loan or collect payment from the subsidiary, but only if the subsidiary formally defaults
Performance Guarantee (3 Types)
Full Performance
Best-Efforts = does not provide guarantee
Third-Party = Company is reselling a third party’s products or services
Personal Guarantee
Require guarantee from owner or other principals in the business
Comfort Letter
Not a guarantee
Letter from one party stating actions it will or will not take on behalf on another party
Primary Risk from Maturity Mismatch
Long-term assets are funded by oftentimes more expensive short-term debt
Maturity Matching for Debt
Matching the life of a debt issue to the life of the specific asset financed
“Flight to Quality”
Investors seek higher quality in times of economic uncertainty
Increase the spread between high quality and low quality ratings
Technological developments have allowed stock exchange to do what?
Consolidate and integrate
Clearing and custody has become increasingly concentrated
What types of investors own the majority of all common stock?
Institutional investors
Is Treasury stock deducted from capital calculations?
Yes
Tracking Stock
Separate stock created by a parent company to track the financial progress of a particular line of business
Allows investors to buy into a fast-growing unit without buying into the whole company
Revenues and expenses of unit are extracted from the financial statements
No ownership in the parent
No voting rights
ETF
Exchange traded fund for equity investment
SPDR
Key Differences between Preferred Stock and Common Stock
Preferred stock has no voting rights, though this may be allowed when a sequence of dividends are missed
Preferred dividends often occur at fixed rates for the life of the security or in perpetuity, usually a percentage of the par value
Dividends in arrears must first be paid to preferred shareholders
Major Advantage and Disadvantage of Preferred Stock vs. Debt
Advantage: Missing a payment does not cause default
Disadvantage: No tax savings from interest payments
Features that make preferred stock attractive to investors
Voting rights in certain situations
Participation in earnings above a certain level
Sinking funds to redeem preferred stock
Maturity dates
Exchange or call provisions
What can preferred stock be converted into?
Common stock or debt
A large portion of preferred stock is issued to which type of investors, which in turn does what to issuance costs?
Institutional investors
Reduces costs
Tax Incentive for Preferred Stock as Investor in the US
US allows 50% of the dividend to be excluded
Once all factors are considered, preferred stock can be ___________ in terms of pricing when compared to debt issuances
Very similar
Why have financial institutions been heavy issuers of preferred stock?
It counts as regulatory capital despite having many qualities of debt
Convertibles
Debt or preferred stock that may be exchangeable for common stock at the holder’s or issuer’s option under certain terms and conditions
Do convertibles result in new capital for the issuer?
No
What determines the conversion price on a convertible bond?
Par / maturity value divided by the conversion ratio
e.g. $1000 par value with conversion rate of 20 = $50 conversion price
Convertibles will contain clauses that protect against dilution of value by doing what?
Adjusting conversion ratio or conversion price to the issue price of new stock when new stock is below the conversion price
If the stock price increases significantly during the convertible’s life, what disadvantage does this cause for the issuer?
Company may have been better off issuing regular debt than refunding the debt with a new stock issue
Most owners of the convertible securities will want to convert, further diluting ownership
If the convertible issue has a low coupon rate, what disadvantage does this cause for the issuer?
If it is converted, they’ve lost the low-rate financing
If the stock price does not rise, what disadvantage does this cause for the issuer?
Company is locked into the debt issue, though it will be at a lower rate
Warrants
Company-issued options that give the warrant’s owner the right to buy a stated number of stock at a specified price for a specified period of time
What do warrants trade like?
Options
Listed on many exchanges
Do warrants and/or convertibles result in new capital for the issuer?
Warrants result in new capital for the issuer
What types of companies like to use warrants?
Small rapidly growing companies
Known as “sweeteners”
Gives the company the ability to expand its mix of securities
What does it mean that warrants are detachable?
They can be traded separately from the bond
Common-Stock Equivalents
Full disclosure of EPS is required by the SEC, which requires the disclosure of the impact of securities like warrants and convertibles on the EPS calculation
Depository Receipts
Typically equity securities, these are negotiable financial instruments that trade on local exchanges, but actually represent stock ownership in a foreign, publicly listed company
ADR
American Depository Receipt
Most common depository receipts in US
GDR
Global Depository Receipt
Name for ADR equivalents outside the US
Regardless of where the issuing company is located, the issuance of depository receipts must conform with the laws of where the depository receipts are
Traded
Can you do an IPO via depository receipts?
Yes
Benefits of Depository Receipts for issuers in countries with limited financial markets
Increase global trade in local and foreign markets
Greater exposure to raise capital on a global basis
Reduce market inefficiencies in developing markets
Allow for easier global investment
APIC Calculation
Calculations for APIC include the issuance price LESS UNDERWRITING COSTS
Foreign Bond vs. Eurobond
Foreign Bond: Issued outside of the country, but issued in the country of issuance’s currency
Eurobond: Issued outside of the country, but also issued in a currency different than the country of issuance
Pledge
Binding promise in which a borrower offers collateral to a lender as security, usually in return for a loan
Political Risk
A variety of actions that a government may take that negatively impact a company’s operations and/or value
Put Provision
A condition that allows a bondholder to resell a bond back to the issuer at a pre-established price on certain stipulated dates prior to maturity
Securitization
The process by which financial assets are transformed into securities
The practice of pooling various debt contracts, such as consumer loans, credit card debt, and mortgages, and using them as a basis for issuing securities
What types of bonds typically have substantial financial covenants or indenture agreements?
Mortgage bonds
Are debentures secured or unsecured?
Unsecured
Do convertible bonds typically have higher or lower pricing compared to other bonds?
Lower pricing due to the potential for benefit of converting to equity
Receivables factoring is an example of what type of financing?
Off-balance sheet financing
Which security best allows an issuing company to obtain additional funding while keeping debt costs low?
A. Depositary Receipts
B. Preferred Stock
C. Convertibles
D. Warrants
D.
Key phrases here include:
**additional funding
**keeping debt costs low
Issuing preferred stock is similar to issuing debt, so it’s not the best answer
Warrants have the ability to bring additional funds into a company while keeping debt costs low
MNPI & the Buy/Sell Side in Capital Markets
Each side should have separate internal controls and procedures to prevent each party from acquiring material nonpublic information from the other side and transacting / acting on it
Instead of underwriting a new securities issuance, an investment bank may do what instead for the issuer?
Act on a best efforts basis to help place shares through a group of brokerage firms
Key Capital Market Regulators in the US
SEC
FINRA
CFTC
MSRB (Municipal Securities Rulemaking Board)
Which document related to a debt issuance will outline any early redemption / make-whole provisions?
Indenture
