Lecture 5: Structured products and financing Flashcards
What are the two basic types of convertibles?
The two basic types of convertibles are;
- Mandatory converting convertibles
- Optionally converting convertibles
How do credit rating agencies rate mandatory and optionally converting convertibles
Mandatory converting convertibles: treated having equity like characteristics: pose greatest risk to investors therefore have the highest yield
Optionally converting convertibles: Treated as having bond like charachteristcs: least risky for investors and therefore have the lowest yield
What is the formula for determining the number of shares in a mandatory converting convertible?
Total proceeds of the offering/ conversion price
What is the conversion price. Is a higher or lower conversion price better
A premium to the current market price (usually around 25%). A lower conversion price is better (more shares issued to investors)
When issuing convertible bonds, why can the issuer offer the coupon to the lower than that of straight bonds? A
Investors have the option to convert the bond into shares - this is the price paid by investors for the option, and there is less risk involved from the perspective of the investor
What are the basic role of credit rating agencies?
Primary role is to assign credit ratings to:
- Debt issuers and their debt instruments (convertibles, bonds and loans)
- Structured finance securities (ABS, MBS, CDOs )
What is the relationship between IB and credit rating agencies? What is the potential conflict?
IB work closely with credit rating agencies to suggest potential credit rating outcomes to clients.
- Credit rating agencies pay far less than big brokerage firms - people in credit rating agencies looked to befriend, accommodate and impress wall street clients to get hired
What is the relationship between issuers and credit rating agencies:
Issuers will engage credit rating agencies to facilitate investor purchases of securities at lowest possible yield
- Credit rating agencies work closely with issuers building financial models that reflect well on the company’s strength
- There is an adversarial relationship: when credit rating agencies decide to downgrade the credit rating issued by companies
What are the two types of risk in the credit rating process?
Business risk: Competitive position within industry, diversity of product line, profitability
Financial risk: Accounting, cash flow financial flexibility and capital structure
What do credit ratings represent?
The issuers credit worthiness (ability to repay obligation)
What are the advantages of using structure products?
- Provides off balance sheet financing
- Aid with the asset and liability mismatch
- Provides liquidity for products that were historically non-liquid
What is CDS? What is the relationship between CDS premium and the credit risk of the underlying asset?
CDS: A type of insurance between two parties, where one party will make periodic payments in return for a payoff in a credit event.
What are the basic criticisms of credit rating agencies/ issuers during the GFC?
Issuers: Were skewing their incentives of originators in favour of loan volume vs quantity
Credit rating agencies: were subject to undue influence from wall street banks: since they were the clients: vulnerable to being misled (paid less, and ended up working for wall street firms): also relied heavily on diversification
Rank the following in terms of most to least EPS dilution: coupon-paying convertible, mandatory convertible, zero coupon convertible
Zero coupon convertible, coupon-paying convertible, and mandatory
convertible.
What does it mean for a company to be investment grade?
Strong credit, low risk of default, strong liquidity
