Topic 7 - Medium And Long Term Debt (Debt Markets)

This article is a topic within the subject Capital Markets and Institutions.

Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 332-365.

Term Loans And Fully Drawn Advances

A common form of intermediated finance is the term loan &/or fully drawn advance. A Term Loan is a loan advanced for a specific period (typically 3-15 years), usually for a known purpose (buying equipment), it is secured over the assets purchased or other assets of the firm. A Fully Drawn Advance is where the full amount of the term loan is provided at the start of the loan. Providers tend to be commercial banks & finance companies (IB’s, credit unions etc. to a lesser degree). There are different term loan structures:

1. Interest – interest only during the term of the loan, principal repaid at maturity (bond)
2. Amortised / Credit Foncier Loan – periodic repayments consist of interest due & reductions of principal
3. Deferred Repayment Loan – loan instalments commence after a specified period related to project cash flows & the debt is amortised over the remaining term of the loan

Interest Rates

The interest rate may be fixed or variable & is determined by an indicator rate (BBSW – bank bill swap rate or banks prime lending rate- reflects borrowing costs & overhead but can spike) plus a margin influenced by:

• Credit Risk – risk that a borrower will default on a loan commitment (require risk premium) D/E & Performance metrics
• Term of the Loan – longer term attracts higher interest (more uncertain/risky)
• Repayment Schedule – frequency of repayments (higher frequency = lower risk)

Loan Covenants

Loan Covenants restrict the business & financial activities of the borrowing firm. Covenant breaches result in default on the loan contract, entitling the lender to act. It helps reduce the lenders financial risk exposure.

• Positive Covenant - requires borrowers to take prescribed actions e.g. maintain a minimum level of working capital
• Negative Covenant - restricts the activities & financial structure of a borrower e.g. maximum D/E ratio, restrict dividends

Long Term Debt Calculations - Annuities

Mortgage Finance

A Mortgage is a form of security for a loan whereby a lender registers an interest over the title of the property; it is discharged when the loan is repaid. The borrower (mortgagor) conveys an interest in the land & property to the lender (mortgagee). If the mortgagor defaults on the loan, the mortgagee can foreclose the property (take possession & realise any amount owing).

Interest Rates

Interest Rates are fixed (reset every 5 years or less) or variable. For interest only loans the interest only period is usually 5 years or less. The mortgagee can reduce risk exposure to borrower default by requiring the mortgagor to take out mortgage insurance up to 100% of the mortgage value (a 80% loan to value ratio protects mortgagee, insurer is exposed to sale value – amount owing). It is typically used for retail home loans (up to 30 years) & commercial loans at times (10 years). Providers include commercial banks, building societies, life insurance offices, superannuation funds, finance companies & mortgage originators

Securitisation

Mortgage originators, commercial banks & other institutions use securitisation to manage their mortgage loan portfolios. It involves the conversion of non liquid assets into new asset backed securities that are serviced with cash flows from the original asset. The original lender sells bundled mortgage loans to a special purpose vehicle. It is a Trust set up to hold securitised assets & issue asset backed securities like bonds - providing investors with security & payments of interest & principal.

Debentures, Unsecured Notes And Subordinated Debt

• Corporate Bonds - pays a specified periodic interest rate (coupon) for the term of the bond & principal repaid at maturity
  • No intermediary margin (cheaper costs &/or greater returns for investors), allow for funding diversification
• Debentures - secured by a charge over the issuer’s unpledged assets, listed/traded on SX, higher asset claim in liquidation
  • Fixed Charge – borrowers asset can’t be sold until bondholders repaid, Floating– saleable assets, crystallises (fixed)
• Unsecured Notes - bonds with no underlying security attached, lower claim on assets

There are 3 principal issue methods:

1. Public Issue – issued to the public at large, by prospectus (information about business)
2. Family Issue – issued to existing shareholders & investors (bondholders), by prospectus
3. Private Placement – issued to institutional investors, by information memorandum

These securities are usually issued at face value but may be at a discount (or premium) with normal, deferred or zero interest intermediate cash flows.

Subordinated Debt

Subordinated Debt is often regarded as more like equity than debt (quasi-equity) improving credit ratings & D/E ratio. Claims of debt holders are subordinated to all other company liabilities.

Bond Calculations

There are 2 types of bond calculations. Once occurs at the coupon date (the second after the coupon has been paid) or between coupon dates.

Here are 2 examples from the prescribed textbook / lecture notes.

Leasing

A lease is a contract where the owner of an asset (lessor) grants the lessee the right to use an asset for an agreed period of time in return for periodic rental payments. It is the borrowing (renting) of an asset instead of borrowing the funds to purchase the asset. Providers are commercial banks, finance companies, IB’s, leasing companies, & capital equipment manufacturers.

Advantages for Lessee Compared to “Borrow & Purchase”

• Conserves Capital & doesn't Use up Unused Lines of Credit (financial arrangement to provide source of funds in future)
• Provides 100% Financing (no equity financing needed)
• Structure to Match Project Cash Flows (flexibility – deferred payments)
• Bypass Existing Loan Covenants
• Don’t Have to Dispose Assets (e.g. only require asset for a short period)
• Rental Payments are Tax Deductible

Advantages for Lessor over “Straight Loans”

• Less Risk (asset can easily/quickly be repossessed if default – retain ownership of asset)
• Administratively Cheaper (particularly for small amounts)
• Attractive Alternative Source of Finance to Both Business & Government

Types Of Leases

• Operating – a short term lease; the asset maybe leased any times; asset maintained by lessor
  • Short Term – may lease asset to successive lessees (short term use of equipment)
• Full Service – maintenance & insurance provided by lessor
  • Obsolescence Risk – remains with lessor
  • Minor cancellation penalties
• Finance – long term lease; on final payment of a residual amount (or shortfall from sale) ownership passes to lessee
• Net Lease – lessee pays for maintenance repairs, insurance, stamp duties/tax

Finance Lease Structures

• Direct Finance Lease – lessor purchases asset with own funds & leases asset directly to a lessee
  • Retains legal ownership & repossesses on default, specified residual value
  • Security – leasing agreement & leasing guarantee (3rd party agreement)
• Leveraged Finance Lease – lessor contributes limited equity & uses borrowed funds to purchase asset
  • Gains tax advantages from depreciation & interest payments
  • Lease manager brings parties together & structures/negotiates complex lease & manages it for its life

End

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References

Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.