Fixed-Income Markets for Corporate Issuers Flashcards
Non-financial corporations often rely on financial intermediaries for short-term financing. Common instruments include:
Uncommitted bank lines of credit
Committed bank lines of credit
Revolving credit agreements, or revolvers
What are uncommitted lines of credit?
The least reliable form of bank borrowing for a company. A bank offers uncommitted credit lines up to a certain principal amount for a pre-determined maximum maturity, charging a base or market reference rate plus an issuer-specific spread on only the principal outstanding for the period of use. Companies often find uncommitted bank credit lines to be the most flexible and least costly means of external funding. Banks usually offer these lines on an unsecured basis to clients who maintain stable cash deposits at the bank, allowing the banks to closely monitor and react to adverse borrower developments, such as declining account balances. Uncommitted credit lines require minimal capital reserves until they are drawn down and used, but banks reserve the right to refuse to honor any request for use of the line.
What are committed (regular) lines of credit?
A more reliable source of financing than uncommitted lines because they involve a formal written commitment. Committed lines require more bank capital than uncommitted lines, although commitments of less than a year minimize a bank’s capital requirement.
What are revolving credit agreements or revolvers?
The most reliable source of short-term bank funding. These are multiyear credit commitments and lenders typically seek protections, such as covenants which require or restrict certain borrower actions as in the case of a bond indenture.
What are secured loans?
Loans in which the lender requires the company to provide collateral in the form of an asset.
What is a factoring arrangement?
The company shifts the credit-granting and collection process of accounts receivable to the lender or factor.
What is commercial paper?
Large, highly rated companies can issue short-term, unsecured notes in the public market or via a private placement. Commercial paper issued by corporations typically matures in less than three months and can be used to fund working capital, seasonal demand for cash, or to provide bridge financing.
What is bridge financing?
Interim financing that provides funds until permanent financing can be arranged.
In most cases, maturing commercial paper is paid with the proceeds of newly issued commercial paper (rolled over). This practice raises the possibility that an issuer is unable to issue new paper at maturity, known as rollover risk. To minimize rollover risk, investors usually require a committed backup line of credit from banks.
The largest commercial paper issuers include financial institutions, governments, and supranational agencies. Commercial paper issued in the international market is known as Eurocommercial paper (ECP). Although similar to United States commercial paper (USCP), typical ECP transaction sizes are much smaller and less liquid than the USCP market.
Household and commercial deposits are a primary source of short-term funding for most banks. These are usually in the form of checking accounts, or deposits with no stated maturity available for transactional purposes that pay little or no interest. For larger depositors, operational deposits generated by clearing, custody, and cash management activities are also a relatively stable source of funding, while rules requiring banks to maintain liquidity reserves against other less stable demand deposits make them a less attractive funding source.
What are saving deposits and certificate of deposits?
Saving deposits are usually held for non-transactional purposes and often have a stated term. For example, a bank may accept a specific deposit with a pre-determined maturity and interest rate known as a certificate of deposit (CD).
What are negotiable and non-negotiable CDs?
Negotiable CDs allow a depositor to withdraw funds by selling the CD in the open market prior to maturity. Non-negotiable CD involves payment of principal and interest at maturity to the initial depositor, with a penalty for early withdrawal.
What is the interbank market?
The interbank market involves short-term borrowing and lending among financial institutions on a secured or unsecured basis. Unsecured loans and deposits in the interbank market typically range from overnight to a one-year term at an interest rate closely tied to a market reference rate.
In most countries, banks and other financial institutions are required to maintain reserves at the central bank. While some banks may have excess funds over the minimum reserve requirement, others may run short of required reserves. This imbalance is solved through the central bank funds market, allowing banks with a surplus of funds to lend to others at the central bank funds rate.
Special purpose entities are not recorded on the balance sheet!
An important source of secured short-term lending and borrowing is the repurchase agreement (repo)!
What is a repurchase agreement or repo?
It involves the sale of a security with a simultaneous agreement by the seller to buy the same security back from the purchaser at an agreed-on repurchase price and future date called the repurchase date.
Since lenders in the repo market are primarily interested in both the liquidity and safety of their investments, most repos are typically very short-term transactions with the highest quality securities such as sovereign bonds serving as collateral.
In addition to the high quality of underlying securities, repos include features designed to reduce the risk of a collateral shortfall over the contract life. One such feature is the provision of collateral in excess of the cash exchanged, known as initial margin = security price / purchase price
What is a repo haircut?
Security price - purchase price / security price
What are three purposes to use the repo market for financial market participants?
Finance the ownership of a security
Earn short-term income by lending funds on a secured basis
Borrow a security in order to sell it short
What are bilateral and triparty repos?
Repos executed directly between two parties are called bilateral repos; under a triparty repo, both parties agree to use a third-party agent for the transaction.
