The Many Different Kinds of Debt

In Chapters 17 and 18, we discussed how much a company should borrow. But companies also need to think about what type of debt to issue. They can choose to issue short-or long-term debt, straight or convertible bonds; they can issue in the United States or in the international debt market; and they can either sell the debt publicly or place it privately with a few large investors.

As a financial manager, you need to choose the type of debt that makes sense for your company. For example, if a firm has only a temporary need for funds, it will generally issue short-term debt. Firms with a substantial overseas business may prefer to issue foreign currency debt. Sometimes competition between lenders opens a window of opportunity in a particular sector of the debt market. The effect may be only a few basis points reduction in yield, but on a large issue, that can translate into savings of several million dollars. Remember the saying, “A million dollars here and a million there—pretty soon it begins to add up to real money.”¹

Figure 24.1 provides a road map through this chapter. Our initial focus is on the long-term bond market. We start with the more standard bonds. We examine the differences between senior and junior bonds and between secured and unsecured bonds, including a special kind of secured bond called an asset-backed bond. We describe how bonds may be repaid by means of a sinking fund and how the borrower or the lender may have an option for early repayment. As we review these different features of corporate debt, we try to explain why sinking funds, repayment options, and the like exist. They are not simply matters of custom or neutral mutations; there are generally good reasons for their use.

Our next task is to look at some less common bonds, starting with convertible bonds and their close relative, the package of bonds and warrants. We also illustrate the enormous variety of bond designs by looking at a few unusual bonds and at some of the motives for innovation in the bond market.

The rest of the chapter is concerned with shorter-term debt, much of which is supplied by banks. Often, companies arrange a revolving line of credit with a bank that allows them to borrow up to an agreed amount whenever they need financing. This is often intended to tide the firm over when it has a temporary shortage of cash and is therefore repaid in only a few months. However, banks also make term loans that sometimes extend for five years or more. Some loans are too large to be made by a single bank. We describe how such loans are syndicated among a group of banks. We also look at how banks protect their loans by imposing restrictions on the borrower and by requiring security.

Rather than borrowing from a bank, large blue-chip companies sometimes bypass the banking system and regularly issue their own short-term debt to investors. This is called commercial paper. Somewhat longer-term loans that are marketed on a regular basis are known as medium-term notes. We discuss both in turn.

In the Appendix to the chapter, we look at another form of private placement known as project finance. This is the glamorous part of the debt market. The words project finance conjure up images of multibillion-dollar loans to finance huge ventures in exotic parts of the world. You’ll find there’s something to the popular image, but it’s not the whole story.

FIGURE 24.1 The principal species of corporate debt and the sections of this chapter in which they are discussed

We should point out that many debts are not shown on the company’s balance sheet. For example, companies have occasionally disguised the debt by establishing special-purpose entities (SPEs), which raise cash by a mixture of equity and debt and then use that cash to help fund the parent company. By making use of SPEs, Enron kept a large amount of its debt off-balance-sheet, but that did not stop the company from going bankrupt. Since the Enron scandal, accountants have moved to tighten up the rules on disclosing SPE debt.

Companies have other important long-term liabilities that we do not discuss in this chapter. For instance, long-term leases are very similar to debt. The user of the equipment agrees to make a series of lease payments and, if it defaults, it may be forced into bankruptcy. We discuss leases in Chapter 25.

Postretirement health benefits and pension promises can also be huge liabilities. For example, in 2003 General Motors had a pension deficit of $19 billion. To reduce this deficit, GM made a large issue of bonds and invested the majority of the proceeds in its pension fund. You could say that the effect was to increase the company’s debt, but the economic reality was that it substituted one long-term obligation (the new debt) for another (its pension obligation). Management of pension plans is outside the scope of this book, but financial managers spend a good deal of time worrying about the pension “debt.”

24-1Long-Term Bonds

Bond Terms

Applied Materials (AMAT) supplies equipment and software for the manufacture of semiconductors. In 2011, AMAT issued 30-year bonds to help finance an acquisition. The bond was a plain-vanilla issue; in other words, it was pretty well standard in every way. To give you some feel for the bond contract (and for some of the language in which it is couched), we have summarized in Table 24.1 the terms of the issue. We will look in turn at its principal features.

Issue date	June 8, 2011
Amount issued	$600 million
Maturity	June 15, 2041
Denomination, face value, or principal	$1,000
Interest	5.85% per annum payable June 15 and December 15. First payment due December 2011.
Offered	Issued at a price of 99.592% plus accrued interest (proceeds to company 98.717%)
Joint book-running managers	Citi, JPMorgan
Registered	Issued in fully registered form only
Trustee	U.S. Bank National Association
Security	Not secured. Company will not permit to have any lien on its property or assets without equally and ratably securing the debt securities.
Seniority	Senior notes ranking pari passu with other unsecured unsubordinated debt.
Change of control event	If a change of control occurs and the notes are simultaneously downrated to below investment grade the company will offer to repurchase the notes.
Sinking fund	None.
Callable	At whole or in part at the option of the Company with at least 30 days, but not more than 60 days, notice at the greater of (i) 100% of the principal amount or (ii) the sum of the scheduled remaining payments discounted at 30 basis points above the Treasury rate.
Moody’s rating at issue date	A3

TABLE 24.1 Summary of terms of bond issue by Applied Materials (AMAT)

The AMAT bond was issued in 2011 and is due to mature 30 years later in 2041. It was issued in denominations of $1,000. So, at maturity, the company will repay the principal amount of $1,000 to the holder of each bond.

The annual interest or coupon payment on the bond is 5.85% of $1,000, or $58.50. This interest is payable semiannually, so every six months the bondholder receives interest of 58.50/2 = $29.25. Most U.S. bonds pay interest semiannually, but in many other countries it is common to pay interest annually.²

The regular interest payment on a bond is a hurdle that the company must keep jumping. If AMAT ever fails to make the payment, lenders can demand their money back instead of waiting until matters deteriorate further.³ Thus, regular interest payments provide added protection for lenders.

Sometimes bonds are sold with a lower coupon payment but at a significant discount on their face value, so investors receive much of their return in the form of capital appreciation.⁴ The ultimate is the zero-coupon bond, which pays no interest at all; in this case, the entire return consists of capital appreciation.⁵

The AMAT interest payment is fixed for the life of the bond, but in some issues the payment varies with the general level of interest rates. For example, the payment may be set at 1% over the U.S. Treasury bill rate or (more commonly) over the London interbank offered rate (LIBOR), which is the rate at which international banks borrow from one another. Sometimes these floating-rate notes specify a minimum (or floor) interest rate, or they may specify a maximum (or cap) on the rate.⁶ You may also come across “collars,” which stipulate both a maximum and a minimum payment.

The AMAT bonds have a face value of $1,000 and were sold to investors at 99.592% of face value. In addition, buyers had to pay any accrued interest. This is the amount of any future interest that has accumulated by the time of the purchase. For example, investors who bought bonds for delivery on (say) October 15, would have only two months to wait before receiving their first interest payment. Therefore, the four months of accrued interest would be (120/360) × 5.85 = 1.95%, and the investor would need to pay the purchase price of the bond plus 1.95%.⁷

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Accrued interest calculations

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Although the AMAT bonds were offered to the public at a price of 99.592%, the company received only 98.717%. The difference represents the underwriters’ spread. Of the $597.6 million raised, $592.3 million went to the company and $5.3 million (or about .9%) went to the underwriters.

Moving down Table 24.1, you see that the AMAT’s bonds are registered. This means that the company’s registrar records the ownership of each bond and the company pays the interest and final principal amount directly to each owner. Almost all bonds in the United States are issued in registered form, but in many countries, companies may issue bearer bonds. In this case, the bond certificate constitutes the primary evidence of ownership, so the bondholder must return the certificate to the company to claim the final repayment of principal.

The AMAT bonds were sold publicly to investors. Before it could sell the bonds, it needed to file a registration statement for approval of the SEC and to prepare a prospectus. The bond was issued under an indenture, or trust deed, between the company and a trustee. U.S. Bank National Association, which is the trust company for the issue, represents the bondholders. It must see that the terms of the indenture are observed and look after the bondholders in the event of default. The bond indenture is a turgid legal document that is bedtime reading only for insomniacs.⁸ However, the main provisions are described in the prospectus to the issue.

Security and Seniority

Sometimes a company sets aside particular assets for the protection of the bondholder. For example, utility company bonds are often secured. In this case, if the company defaults on its debt, the trustee or lender may take possession of the relevant assets. If these are insufficient to satisfy the claim, the remaining debt will have a general claim, alongside any unsecured debt, on the other assets of the firm.

Unsecured bonds maturing in 10 years or fewer are usually called notes, while longer-term issues may be called bonds (as in the case of the AMAT bond) or debentures.⁹ Like most bond issues by industrial and financial companies, the AMAT bonds are unsecured. In that case, it is common for the issue to include a so-called negative pledge clause that promises that the company will not issue any secured bonds without offering the same security to its unsecured bonds.

The majority of secured bonds are mortgage bonds. These sometimes provide a claim against a specific building, but they are more often secured on all of the firm’s property.¹⁰ Of course, the value of any mortgage depends on the extent to which the property has alternative uses. A custom-built machine for producing buggy whips will not be worth much when the market for buggy whips dries up.

Companies that own securities may use them as collateral for a loan. For example, holding companies are firms whose main assets consist of common stock in a number of subsidiaries. So, when holding companies wish to borrow, they generally use these investments as collateral. In such cases, the problem for the lender is that the stock is junior to all other claims on the assets of the subsidiaries, and so these collateral trust bonds usually include detailed restrictions on the freedom of the subsidiaries to issue debt or preferred stock.

A third form of secured debt is the equipment trust certificate. This is most frequently used to finance new railroad rolling stock but may also be used to finance trucks, aircraft, and ships. Under this arrangement, a trustee obtains formal ownership of the equipment. The company makes a down payment on the cost of the equipment, and the balance is provided by a package of equipment trust certificates with different maturities that might typically run from 1 to 15 years. Only when all these debts have finally been paid off does the company become the formal owner of the equipment. Bond rating agencies such as Moody’s or Standard & Poor’s usually rate equipment trust certificates one grade higher than the company’s regular debt.

Bonds may be senior claims or they may be subordinated to the senior bonds or to all other creditors.¹¹ If the firm defaults, the senior bonds come first in the pecking order. The subordinated lender gets in line behind the general creditors but ahead of the preferred stockholders and the common stockholders.

As you can see from Figure 24.2, if default does occur, it pays to hold senior secured bonds. On average, investors in these bonds can expect to recover over 50% of the amount of the loan. At the other extreme, recovery rates for junior unsecured bondholders are only 14% of the face value of the debt.

FIGURE 24.2 Percentage recovery rates on defaulting debt by seniority and security, 1983–2017

Source: Moody’s “Annual Default Study: Corporate Default and Recovery Rates, 1920–2017,” February 2018.

Asset-Backed Securities

Instead of borrowing money directly, companies sometimes bundle up a group of assets and then sell the cash flows from these assets. This issue is known as an asset-backed security, or ABS. The debt is secured, or backed, by the underlying assets.

Suppose your company has made a large number of mortgage loans to buyers of homes or commercial real estate. However, you don’t want to wait until the loans are paid off; you would like to get your hands on the money now. Here is what you do. You establish a separate, special-purpose company that buys a package of the mortgage loans. To finance this purchase, the company sells mortgage-backed securities. The holders of these bonds simply receive a share of the mortgage payments. For example, if interest rates fall and the mortgages are repaid early, holders of the bonds are also repaid early. That is not generally popular with these holders because they get their money back just when they don’t want it—when interest rates are low.

Instead of issuing one class of bonds, a pool of mortgages can be bundled and then split into different slices (or tranches), known as collateralized debt obligations, or CDOs. For example, mortgage payments might be used first to pay off one class of security holders and only then will other classes start to be repaid. The senior tranches have first claim on the cash flows and therefore may be attractive to conservative investors such as insurance companies or pension funds. The riskiest (or equity) tranche can then be sold to hedge funds or mutual funds that specialize in low-quality debt.

Real estate lenders are not unique in wanting to turn future cash receipts into up-front cash. Automobile loans, student loans, and credit card receivables are also often bundled and remarketed as an asset-backed security. Indeed, investment bankers seem able to repackage any set of cash flows into a loan. In 1997, David Bowie, the British rock star, established a company that then purchased the royalties from his current albums. The company financed the purchase by selling $55 million of 10-year notes. The royalty receipts were used to make the principal and interest payments on the notes. When asked about the singer’s reaction to the idea, his manager replied, “He kind of looked at me cross-eyed and said ‘What?’”¹²

The process of bundling a number of future cash flows into a single security is called securitization. You can see the arguments for securitization. As long as the risks of the individual loans are not perfectly correlated, the risk of the package is less than that of any of the parts. In addition, securitization distributes the risk of the loans widely and, because the package can be traded, investors are not obliged to hold it to maturity.

In the years leading up to the financial crisis, the proportion of new mortgages that were securitized expanded sharply, while the quality of the mortgages declined. By 2007, more than half of the new issues of CDOs involved exposure to subprime mortgages. Because the mortgages were packaged together, investors in these CDOs were protected against the risk of default on an individual mortgage. However, even the senior tranches were exposed to the risk of an economywide slump in the housing market. For this reason, the debt has been termed “economic catastrophe debt.”¹³

Economic catastrophe struck in the summer of 2007, when the investment bank Bear Stearns revealed that two of its hedge funds had invested heavily in nearly worthless CDOs. Bear Stearns was rescued with help from the Federal Reserve, but it signaled the start of the credit crunch and the collapse of the CDO market. By 2009, issues of CDOs had effectively disappeared.¹⁴

Did this collapse reflect a fundamental flaw in the practice of securitization? A bank that packages and resells its mortgage loans spreads the risk of those loans. However, the danger is that when a bank can earn juicy fees from securitization, it might not worry so much if the loans in the package are junk.¹⁵

Call Provisions

Back to our AMAT bond. The bond includes a call option that allows the company to repay the debt early. This can be a valuable option if AMAT wishes to reduce its leverage or tidy up its outstanding debt. The price at which companies could call their bonds used to be set at a fixed number. In this case, issuers had an incentive to call the bonds whenever they were worth more than the call price. This was not popular with investors. These days, it is more common to link the call price to an estimate of the bond’s value. Thus, if interest rates fall and the bond increases in value, AMAT must pay more than face value to buy back its bonds. The formula for determining this price seeks to ensure that AMAT can never buy back the bond for less than it is worth.

Very occasionally you come across bonds that give investors the repayment option. Extendible bonds give them the option to extend the bond’s life, while retractable (or puttable) bonds give investors the right to demand early repayment. Puttable bonds exist largely because bond indentures cannot anticipate every action the company may take that could harm the bondholder. If the value of the bonds is reduced, the put option allows the bondholders to demand repayment.

Puttable loans can sometimes get their issuers into BIG trouble. During the 1990s, many loans to Asian companies gave their lenders a repayment option. Consequently, when the Asian crisis struck in 1997, these companies were faced by a flood of lenders demanding their money back.

Sinking Funds

The AMAT bond must be repaid in its entirety in 2041. But in many cases, a bond issue is repaid on a regular basis before maturity. To do this, the company makes a series of payments into a sinking fund. If the payment is in the form of cash, the trustee selects bonds by lottery and uses the cash to redeem them at their face value.¹⁶ Alternatively, the company can choose to buy bonds in the marketplace and pay these into the fund. This is a valuable option for the company. If the bond price is low, the firm will buy the bonds in the market and hand them to the sinking fund; if the price is high, it will call the bonds by lottery.

Generally, there is a mandatory fund that must be satisfied and an optional fund that can be satisfied if the borrower chooses. We saw earlier that interest payments provide a regular test of solvency. A sinking fund provides an additional hurdle that the firm must keep jumping. If it cannot pay the cash into the sinking fund, the lenders can demand their money back. That is why long-dated, lower-quality issues involve larger sinking funds. Higher-quality bonds generally have a lighter sinking fund requirement if they have one at all.

Unfortunately, a sinking fund is a weak test of solvency if the firm is allowed to repurchase bonds in the market. Since the market value of the debt declines as the firm approaches financial distress, the sinking fund becomes a hurdle that gets progressively lower as the hurdler gets weaker.

Bond Covenants

Investors in corporate bonds know that there is a risk of default. But they still want to make sure that the company plays fair. They don’t want it to gamble with their money. Therefore, the loan agreement usually includes a number of debt covenants that prevent the company from purposely increasing the value of its default option.¹⁷ These covenants may be relatively light for blue-chip companies but more restrictive for smaller, riskier borrowers.

Lenders worry that after they have made the loan, the company may pile up more debt and so increase the chance of default. They protect themselves against this risk by prohibiting the company from making further debt issues unless the ratio of debt to equity is below a specified limit.

Not all debts are created equal. If the firm defaults, the senior debt comes first in the pecking order and must be paid off in full before the junior debtholders get a cent. Therefore, when a company issues senior debt, the lenders will place limits on further issues of senior debt. But they won’t restrict the amount of junior debt that the company can issue. Because the senior lenders are at the front of the queue, they view the junior debt in the same way that they view equity: They would be happy to see an issue of either. Of course, the converse is not true. Holders of the junior debt do care both about the total amount of debt and the proportion that is senior to their claim. As a result, an issue of junior debt generally includes a restriction on both total debt and senior debt.

All bondholders worry that the company may issue more secured debt. An issue of mortgage bonds often imposes a limit on the amount of secured debt. This is not necessary when you are issuing unsecured debentures. As long as the debenture holders are given an equal claim, they don’t care how much you mortgage your assets. Therefore, unsecured bonds usually include a so-called negative-pledge clause, in which the unsecured holders simply say, “Me too.”¹⁸ We saw earlier that the AMAT bonds include a negative pledge clause.

Instead of borrowing money to buy an asset, companies may enter into a long-term agreement to rent or lease it. For the debtholder, this is very similar to secured borrowing. Therefore, debt agreements also include limitations on leasing.

We have talked about how an unscrupulous borrower can try to increase the value of the default option by issuing more debt. But this is not the only way that such a company can exploit its existing bondholders. For example, the value of the default option is increased when the company pays out some of its assets to stockholders. In the extreme case a company could sell all its assets and distribute the proceeds to shareholders as a bumper dividend. That would leave nothing for the lenders. To guard against such dangers, debt issues may restrict the amount that the company may pay out in the form of dividends or repurchases of stock.¹⁹

Take a look at Table 24.2, which summarizes the principal covenants in a large sample of senior bond issues. These covenants prevent the company from taking certain actions that would reduce the value of their bonds. Notice that investment-grade bonds tend to have fewer restrictions than high-yield bonds. For example, restrictions on the amount of any dividends or repurchases are less common in the case of investment-grade bonds.

	Percentage of Bonds with Covenants
Type of Covenant	Investment-Grade Bonds	Other Bonds
Merger restrictions	92%	93%
Dividends or other payment restrictions	6	44
Borrowing covenants	74	67
Default-related eventsa	52	71
Change in control	24	74

TABLE 24.2 Percentage of a sample of bonds with covenant restrictions. Sample consists of 4,478 senior bonds issued between 1993 and 2007.

^aFor example, default on other loans, rating changes, or declining net worth.

Source: S. Chava, P. Kumar, and A. Warga, “Managerial Agency and Bond Covenants,” Review of Financial Studies 23 (2010), pp. 1120–1148.

These debt covenants do matter. Asquith and Wizman, who studied the effect of leveraged buyouts on the value of the company’s debt, found that when there were no restrictions on further debt issues, dividend payments, or mergers, the buyout led to a 5.2% fall in the value of existing bonds.²⁰ Those bonds that were protected by strong covenants against excessive borrowing increased in price by 2.6%.

Unfortunately, it is not easy to cover all loopholes, as the bondholders of Marriott Corporation discovered in 1992. They hit the roof when the company announced plans to divide its operations into two separate businesses. One business, Marriott International, would manage Marriott’s hotel chain and receive most of the revenues, while the other, Host Marriott, would own all the company’s real estate and be responsible for servicing essentially all of the old company’s $3 billion of debt. As a result, the price of Marriott’s bonds plunged nearly 30%, and investors began to think about how they could protect themselves against such event risks. It is now more common for bondholders to insist on clauses that oblige the borrower to repay the debt if there is a change of control and the bonds are downrated. You can see that the AMAT bond included such a clause.

Privately Placed Bonds

The AMAT notes were registered with the SEC and sold publicly. However, bonds may also be placed privately with a few financial institutions, though the market for privately placed bonds is much smaller than the public market.²¹

As we saw in Section 15-5, it costs less to arrange a private placement than to make a public debt issue. But there are other differences between a privately placed bond and its public counterpart.

First, if you place an issue privately with one or two financial institutions, it may be necessary to sign only a simple promissory note. This is just an IOU that lays down certain conditions that the borrower must observe. However, when you make a public issue of debt, you must worry about who is supposed to represent the bondholders in any subsequent negotiations and what procedures are needed for paying interest and principal. Therefore, the contract has to be more complicated.

The second characteristic of publicly issued bonds is that they are somewhat standardized products. They have to be—investors are constantly buying and selling without checking the fine print in the agreement. This is not so necessary in private placements, so the debt can be custom-tailored for firms with special problems or opportunities. The relationship between borrower and lender is much more intimate. Imagine a $200 million debt issue placed privately with an insurance company, and compare it with an equivalent public issue held by 200 anonymous investors. The insurance company can justify a more thorough investigation of the company’s prospects and, therefore, may be more willing to accept unusual terms or conditions.²²

These features of private placements give them a particular niche in the corporate debt market—namely, relatively low-grade loans to small- and medium-sized firms.²³ These are the firms that face the highest costs in public issues, that require the most detailed investigation, and that may require specialized, flexible loan arrangements.

Of course, the advantages of private placements are not free, for the lenders demand a higher rate of interest to compensate them for holding an illiquid asset. It is difficult to generalize about the difference in interest rates between private placements and public issues, but a typical differential is 50 basis points, or .50 percentage point.

Foreign Bonds and Eurobonds

AMAT’s bonds were registered with the SEC, denominated in dollars, and were marketed to investors in the United States and overseas. If the company had needed the cash for a project in another country, it might have preferred to issue debt in that country’s currency. For example, it could have sold sterling bonds in the U.K. or Swiss franc bonds in Switzerland. Foreign currency bonds that are sold to local investors in another country are known as foreign bonds. Many foreign companies issue their bonds in the United States, making it by far the largest market for foreign bonds. Japan and Switzerland are also substantial markets. Foreign bonds have a variety of nicknames. For example, a bond sold by a foreign company in the United States is known as a yankee bond, a bond sold by a foreign firm in Japan is a samurai, and one sold in Switzerland is an alpine.

Of course, any firm that raises money from local investors in a foreign country is subject to the rules of that country and oversight by its financial regulator. For example, when a foreign company issues publicly traded bonds in the United States, it must first register the issue with the SEC. However, as long as the bonds are not publicly traded, foreign firms borrowing in the United States can avoid registration by complying with the SEC’s Rule 144A. Rule 144A bonds can be bought and sold only by large financial institutions.²⁴

Instead of issuing a bond in a particular country’s market, a company may market a bond issue internationally. Issues that are denominated in one country’s currency but marketed internationally outside that country are known as eurobonds and are usually made in one of the major currencies, such as the U.S. dollar, the euro, or the yen. For example, AMAT could have issued a dollar bond just to overseas investors. As long as the issue is not marketed to U.S. investors, it does not need to be registered with the SEC.²⁵ Euro-bond issues are marketed by international syndicates of underwriters, such as the London branches of large U.S., European, and Japanese banks and security dealers. Be careful not to confuse a eurobond (which is outside the oversight of any domestic regulator and may be in any currency) with a bond that is marketed in a European country and denominated in euros.²⁶

The eurobond market arose during the 1960s because the U.S. government imposed a tax on the purchase of foreign securities and discouraged American corporations from exporting capital. Consequently, both European and American multinationals were forced to tap an international market for capital. The tax was removed in 1974. Since firms can now choose whether to borrow in New York or London, the interest rates in the two markets are usually similar. However, the eurobond market is not directly subject to regulation by the U.S. authorities, and therefore, the financial manager needs to be alert to small differences in the cost of borrowing in one market rather than another.

24-2Convertible Securities and Some Unusual Bonds

Unlike the common or garden bond, a convertible security can change its spots. It starts life as a bond (or preferred stock) but subsequently may turn into common stock. For example, in March 2017, Tesla issued $850 million of 2.375% convertible senior notes due in 2022. Each bond can be converted at any time into 3.0534 shares of common stock. Thus the owner has a five-year option to return the bond to the company and receive 3.0534 shares of common stock in exchange. The number of shares into which each bond can be converted is called the bond’s conversion ratio. The conversion ratio of the Tesla bond is 3.0534.

To receive these shares, the owner of the convertible must surrender bonds with a face value of $1,000. This means that to receive one share, the owner needs to surrender a face amount of $1,000/3.0534 = $327.75. This is the bond’s conversion price. Anybody who bought the bond at $1,000 to convert it into stock paid the equivalent of $327.75 a share, 25% above the stock price at the time of the convertible issue.

You can think of a convertible bond as equivalent to a straight bond plus an option to acquire common stock. When convertible bondholders exercise this option, they do not pay cash; instead they give up their bonds in exchange for shares. If Tesla’s bonds had not been convertible, they would probably have been worth about $870 at the time of issue. The difference between the price of a convertible bond and the price of an equivalent straight bond represents the value that investors place on the conversion option. For example, an investor who paid $1,000 in 2017 for the Tesla convertible would have paid about $1,000 − $870 = $130 for the five-year option to acquire 3.0534 shares.

The Value of a Convertible at Maturity

By the time that the Tesla convertible matures, investors need to choose whether to stay with the bond or convert to common stock. Figure 24.3a shows the possible bond values at maturity.²⁷ Notice that the bond value is simply the face value as long as Tesla does not default. However, if the value of the company’s assets is sufficiently low, the bondholders will receive less than the face value and, in the extreme case that the assets are worthless, they will receive nothing. You can think of the bond value as a lower bound, or “floor,” to the price of the convertible. But that floor has a nasty slope and, when the company falls on hard times, the bond may not be worth much.

FIGURE 24.3 (a) The bond value when Tesla’s convertible bond matures. If firm value is at least equal to the face value of Tesla’s debt, the bond is paid off at face value. (b) The conversion value at maturity. If converted, the value of the convertible rises in proportion to firm value. (c) At maturity the convertible bondholder can choose to receive the payment on the bond or convert to common stock. The value of the convertible bond is therefore the higher of its bond value and its conversion value.

Figure 24.3b shows the value of the shares that investors receive if they choose to convert. If Tesla’s assets at that point are worthless, the shares into which the convertible can be exchanged are also worthless. But, as the value of the assets rises, so does the conversion value.

Tesla’s convertible cannot sell for less than its conversion value. If it did, investors would buy the convertible, exchange it rapidly for stock, and sell the stock. Their profit would be equal to the difference between the conversion value and the price of the convertible. Therefore, there are two lower bounds to the price of the convertible: its bond value and its conversion value. Investors will not convert if the convertible is worth more as a bond; they will do so if the conversion value at maturity exceeds the bond value. In other words, the price of the convertible at maturity is represented by the higher of the two lines in Figures 24.3a and b. This is shown in Figure 24.3c.

Forcing Conversion

Many issuers of convertible bonds have an option to buy (or call) the bonds back at their face value whenever its stock price is 30% or so above the bond’s conversion price.²⁸ If the company does announce that it will call the bonds, it makes sense for investors to convert immediately. Thus, a call can force conversion.

Why Do Companies Issue Convertibles?

You are approached by an investment banker who is anxious to persuade your company to issue a convertible bond with a conversion price set somewhat above the current stock price. She points out that investors would be prepared to accept a lower yield on the convertible, so that it is “cheaper” debt than a straight bond.²⁹ You observe that if your company’s stock performs as well as you expect, investors will convert the bond. “Great,” she replies, “in that case, you will have sold shares at a much better price than you could sell them for today. It’s a win-win opportunity.”

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Why companies issue convertibles

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Is the investment banker right? Are convertibles “cheap debt”? Of course not. They are a package of a straight bond and an option. The higher price that investors are prepared to pay for the convertible represents the value that they place on the option. The convertible is “cheap” only if this price overvalues the option.

What then of the other argument, that the issue represents a deferred sale of common stock at an attractive price? The convertible gives investors the right to buy stock by giving up a bond.³⁰ Bondholders may decide to do this, but then again they may not. Thus, issue of a convertible bond may amount to a deferred stock issue. But if the firm needs equity capital, a convertible issue is an unreliable way of getting it.

John Graham and Campbell Harvey surveyed companies that had seriously considered issuing convertibles. In 58% of the cases, management considered convertibles an inexpensive way to issue “delayed” common stock. Forty-two percent of the firms viewed convertibles as less expensive than straight debt.³¹ Taken at their face value, these arguments don’t make sense. But we suspect that these phrases encapsulate some more complex and rational motives.

Notice that convertibles tend to be issued by smaller and more speculative firms. These issues are almost invariably unsecured and generally subordinated. Now put yourself in the position of a potential investor. You are approached by a firm with an untried product line that wants to issue some junior unsecured debt. You know that if things go well, you will get your money back, but if they do not, you could easily be left with nothing. Since the firm is in a new line of business, it is difficult to assess the chances of trouble. Therefore, you don’t know what the fair rate of interest is. Also, you may be worried that once you have made the loan, management will be tempted to run extra risks. It may take on additional senior debt, or it may decide to expand its operations and go for broke on your money. In fact, if you charge a very high rate of interest, you could be encouraging this to happen.

What can management do to protect you against a wrong estimate of the risk and to assure you that its intentions are honorable? In crude terms, it can give you a piece of the action. You don’t mind the company running unanticipated risks as long as you share in the gains as well as the losses.³² Convertible securities make sense whenever it is unusually costly to assess the risk of debt or whenever investors are worried that management may not act in the bondholders’ interest.³³

The relatively low coupon rate on convertible bonds may also be a convenience for rapidly growing firms facing heavy capital expenditures.³⁴ They may be willing to provide the conversion option to reduce immediate cash requirements for debt service. Without that option, lenders might demand extremely high (promised) interest rates to compensate for the probability of default. This would not only force the firm to raise still more capital for debt service but also increase the risk of financial distress. Paradoxically, lenders’ attempts to protect themselves against default may actually increase the probability of financial distress by increasing the burden of debt service on the firm.

Valuing Convertible Bonds

We have seen that a convertible bond is equivalent to a package of a bond and an option to buy stock. This means that the option-valuation models that we described in Chapter 21 can also be used to value the option to convert. We don’t want to repeat that material here, but we should note three wrinkles that you need to look out for when valuing a convertible:

1. Dividends. If you hold the common stock, you may receive dividends. The investor who holds an option to convert into common stock misses out on these dividends. In fact, the convertible holder loses out every time a cash dividend is paid because the dividend reduces the stock price and thus reduces the value of the conversion option. If the dividends are high enough, it may even pay to convert before maturity to capture the extra income. We showed how dividend payments affect option value in Section 21-5.

2. Dilution. The second complication arises because conversion increases the number of outstanding shares. Therefore, exercise means that each shareholder is entitled to a smaller proportion of the firm’s assets and profits.³⁵ This problem of dilution never arises with traded options. If you buy an option through an option exchange and subsequently exercise it, you have no effect on the number of shares outstanding.

3. Changing bond value. When investors convert to shares, they give up their bond. The exercise price of the option is therefore the value of the bond that they are relinquishing. But this bond value is not constant. If the bond value at issue is less than the face value (and it usually is less), it is likely to change as maturity approaches. Also, the bond value varies as interest rates change and as the company’s credit standing changes. If there is some possibility of default, investors cannot even be certain of what the bond will be worth at maturity. In Chapter 21, we did not get into the complication of uncertain exercise prices.

A Variation on Convertible Bonds: The Bond–Warrant Package

Instead of issuing a convertible bond, companies sometimes sell a package of straight bonds and warrants. Warrants are simply long-term call options that give the investor the right to buy the firm’s common stock. For example, in 2017 the German chemical giant, BASF, placed a $600 million package of bonds and warrants maturing in 2023. The exercise price of the warrants was set at 112.45 euros, 25% above the price of the stock at the time of issue.

Convertible bonds consist of a package of a straight bond and an option. An issue of bonds and warrants also contains a straight bond and an option. But there are some differences:

1. Warrants are usually issued privately. Packages of bonds with warrants tend to be more common in private placements. By contrast, most convertible bonds are issued publicly.

2. Warrants can be detached. When you buy a convertible, the bond and the option are bundled together. You cannot sell them separately. This may be inconvenient. If your tax position or attitude to risk inclines you to bonds, you may not want to hold options as well. Warrants are sometimes also “nondetachable,” but usually you can keep the bond and sell the warrant.

3. Warrants are exercised for cash. When you convert a bond, you simply exchange your bond for common stock. When you exercise warrants, you generally put up extra cash, though occasionally you have to surrender the bond or can choose to do so. This means that the bond–warrant package and the convertible bond have different effects on the company’s cash flow and on its capital structure.

4. A package of bonds and warrants may be taxed differently. There are some tax differences between warrants and convertibles. Suppose that you are wondering whether to issue a convertible bond at 100. You can think of this convertible as a package of a straight bond worth, say, 90 and an option worth 10. If you issue the bond and option separately, the IRS will note that the bond is issued at a discount and that its price will rise by 10 points over its life. The IRS will allow you, the issuer, to spread this prospective price appreciation over the life of the bond and deduct it from your taxable profits. The IRS will also allocate the prospective price appreciation to the taxable income of the bondholder. Thus, by issuing a package of bonds and warrants rather than a convertible, you may reduce the tax paid by the issuing company and increase the tax paid by the investor.

5. Warrants may be issued on their own. Warrants do not have to be issued in conjunction with other securities. Often they are used to compensate investment bankers for underwriting services. Many companies also give their executives long-term options to buy stock. These executive stock options are not usually called warrants, but that is exactly what they are. Companies can also sell warrants on their own directly to investors, though they rarely do so.

Innovation in the Bond Market

Domestic bonds and eurobonds, fixed- and floating-rate bonds, coupon bonds and zeros, callable and puttable bonds, straight bonds and convertible bonds—you might think that this would give you as much choice as you need. Yet almost every day some new type of bond seems to be issued. Table 24.3 lists some of the more interesting bonds that have been invented in recent years.³⁶ Earlier in the chapter, we described asset-backed securities, and in Chapter 26, we discuss catastrophe bonds whose payoffs are linked to the occurrence of natural disasters.

Asset-backed securities	Many small loans are packaged together and resold as a bond.
Catastrophe (CAT) bonds	Payments are reduced in the event of a specified natural disaster.
Contingent convertibles (cocos)	Bonds that convert automatically into equity as the value of the company falls.
Equity-linked bonds	Payments are linked to the performance of a stock market index.
Liquid yield option notes (LYONs)	Puttable, callable, convertible, zero-coupon debt.
Longevity bonds	Bonds whose payments are reduced or eliminated if there is a fall in mortality rates.
Mortality bonds	Bonds whose payments are reduced or eliminated if there is a jump in mortality rates.
Pay-in-kind bonds (PIKs)	Issuer can choose to make interest payments either in cash or in more bonds with an equivalent face value.
Credit-linked bonds	Coupon rate changes as company’s credit rating changes.
Reverse floaters (yield-curve notes)	Floating-rate bonds that pay a higher rate of interest when other interest rates fall and a lower rate when other rates rise.
Step-up bonds	Bonds whose coupon payments are increased over time.

TABLE 24.3 Some examples of innovation in bond design

Some financial innovations appear to serve little or no economic purpose; they may flower briefly but then wither. For example, toward the end of the 1990s in the United States, there was a bout of new issues of floating-price convertibles, or, as they were more commonly called, death-spiral, or toxic, convertibles. When death-spiral convertibles are issued, the conversion price is set below the current stock price. Moreover, each bond is convertible not into a fixed number of shares but into shares with a fixed value. Therefore, the more the share price falls, the more shares that the convertible bondholder is entitled to. With a normal convertible, the value of the conversion option falls whenever the value of the firm’s assets falls; so the convertible holder shares some of the pain with the stockholders. With a death-spiral convertible, the holder is entitled to shares with a fixed value, so the entire effect of the decrease in the asset price falls on the common stockholders. Death-spiral convertibles were issued largely by companies that were already in desperate straits, and, when the issuers failed to recover, the toxic chicken came home to roost. After the initial flurry of issues in the United States, death-spiral convertibles seem now to have been consigned to the garbage heap of unsuccessful innovations.

Many other innovations seem to have a more obvious purpose. Here are some important motives for creating new securities:

1. Investor choice. Sometimes new financial instruments are created to widen investor choice. Economists refer to such securities as helping to “complete the market.” This was the idea behind the 2013 issue of nearly $180 million of mortality, or death bonds by the French insurance company SCOR. One of the big risks for a life insurance company is a pandemic or other disaster that results in a sharp increase in the death rate. SCOR’s bond, therefore, offers investors a higher interest rate for taking on some of that risk. Holders of the bonds will lose their entire investment if U.S. death rates for two consecutive years are unusually high. Mortality bonds widen investor choice. They allow insurance companies to protect themselves against adverse changes in mortality and they spread the risk widely around the market.

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Longevity swaps

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2. Government regulation and tax. Merton Miller has described new government regulations and taxes as the sand in the oyster that stimulates the design of new types of security. For example, we have already seen how the eurobond market was a response to the U.S. government’s imposition of a tax on purchases of foreign securities.

Asset-backed securities provide another instance of a market that was encouraged by regulation. To reduce the likelihood of failure, banks are obliged to finance part of their loan portfolio with equity capital. Many banks were able to reduce the amount of capital that they needed to hold by packaging up their loans or credit card receivables and selling them off as bonds. Bank regulators have worried about this. They think that banks may be tempted to sell off their riskiest loans and to keep their safest ones. They have therefore introduced new regulations that will link the capital requirement to the riskiness of the loans.

3. Reducing agency costs. We have already seen how convertible bonds may reduce agency cost. Here is another example. At the turn of the century, investors were worried by the huge spending plans of telecom companies. So when Deutsche Telecom, the German telecom giant, decided to sell $15 billion of bonds in 2000, it agreed to increase the coupon rate on the bonds by 50 basis points if ever its bonds were downgraded to below investment grade by Moody’s or Standard & Poor’s. Deutsche Telecom’s credit-linked bonds protected investors against possible future attempts by the company to exploit existing bondholders by loading on more debt.

Here is yet another example where bond design can help to solve agency problems. Bankers love to borrow rather than issue equity. The problem is that when banks encounter heavy weather, the shareholders may refuse to come to the rescue with more capital. One suggested remedy is for the banks to issue contingent convertible bonds (or cocos). These are bonds that convert automatically into equity if the bank hits trouble. For example, in 2016 the Spanish bank, BBVA, issued €500 million of perpetual cocos. If BBVA’s capital falls below a specified level, the cocos reduce the bank’s leverage by changing into equity.

Dreaming up these new financial instruments is only half the battle. The other problem is to produce them efficiently. Think, for example, of the problems of packaging together several hundred million dollars’ worth of credit card receivables and allocating the cash flows to a diverse group of investors. That requires good computer systems. The deal also needs to be structured so that, if the issuer goes bankrupt, the receivables will not be part of the bankruptcy estate. That depends on the development of legal structures that will stand up in the event of a dispute.

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Contingent convertibles

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24-3Bank Loans

Bonds are generally long-term loans and more often than not are issued publicly by the borrowing company. It is now time to look at shorter-term debt. This is not usually issued publicly and is largely supplied by banks. Whereas the typical bond issue has a maturity of 10 years, the bank loan is generally repaid in about 3 years.³⁷ Of course, there is plenty of variation around these figures.

In the United States, bank loans are a less important source of finance than the bond market, but for many smaller firms, they are the only source of borrowing. Bank loans come in a variety of flavors. Here are a few of the ways that they differ.

Commitment

Companies sometimes wait until they need the money before they apply for a bank loan, but about 90% of commercial loans by U.S. banks are made under commitment. In this case, the company establishes a line of credit that allows it to borrow up to an established limit from the bank. This line of credit may be an evergreen credit with no fixed maturity, but more commonly, it is a revolving credit (revolver) with a fixed maturity. One other common arrangement is a 364-day facility that allows the company, over the next year, to borrow, repay, and re-borrow as its need for cash varies.³⁸

Credit lines are relatively expensive; in addition to paying interest on any borrowings, the company must pay a commitment fee on the unused amount. In exchange for this extra cost, the firm receives a valuable option: It has guaranteed access to the bank’s money at a fixed spread over the general level of interest rates.

The growth in the use of credit lines has changed the role of banks. They are no longer simply lenders; they are also in the business of providing companies with liquidity insurance.

Maturity

Many bank loans are for only a few months. For example, a company may need a short-term bridge loan to finance the purchase of new equipment or the acquisition of another firm. In this case, the loan serves as interim financing until the purchase is completed and long-term financing arranged. Often, a short-term loan is needed to finance a temporary increase in inventory. Such a loan is described as self-liquidating; in other words, the sale of goods provides the cash to repay the loan.

Banks also provide longer-maturity loans, known as term loans. A term loan typically has a maturity of four to five years. Usually it is repaid in level amounts over this period, though there is sometimes a large final balloon payment or just a single bullet payment at maturity. Banks can accommodate the precise repayment pattern to the anticipated cash flows of the borrower. For example, the first repayment might be delayed a year until the new factory is completed. Term loans are often renegotiated before maturity. Banks are willing to do this if the borrower is an established customer, remains creditworthy, and has a sound business reason for making the change.³⁹

FINANCE IN PRACTICE

LIBOR

Each day at around 11 a.m. in London, a panel of major banks provide estimates of the interest rate at which they could borrow funds from another bank in reasonable market size. They produce these estimates for seven maturities that range from overnight to one year. In each case, the top and bottom quarter of the estimates are dropped, and the remainder are averaged to provide the set of rates known as LIBOR. The rates most commonly quoted as LIBOR are for borrowing U.S. dollars, but similar sets of LIBOR are also produced for four other currencies—the euro, the Japanese yen, the pound sterling, and the Swiss Franc. LIBOR rates are published by the ICE Benchmark Administration (ICE).^*

Figure 24.4 plots the difference between the interest rate on three-month Treasury bills and LIBOR. This spread is known as the TED spread. For many years the TED spread was typically less than 50 basis points (.5%), but in 2008, it widened dramatically, at one point reaching 360 basis points (3.6%). Suddenly, the choice of benchmark for bank loans began to be very important.

FIGURE 24.4 Month-end values for the spread between the interest rate on three-month Treasury bills and LIBOR (the TED spread), August 2004 to February 2018

Source: Federal Reserve Bank of St. Louis.

*In the case of euro deposits, the European Banking Federation calculates an alternative measure, known as Euribor. You can find historical values for LIBOR at http://research.stlouisfed.org/fred2/series/TEDRATE and for Euribor at www.euribor.org.

Rate of Interest

Most short-term bank loans are made at a fixed rate of interest, which is often quoted as a discount. For example, if the interest rate on a one-year loan is stated as a discount of 5%, the borrower receives $100 − $5 = $95 and undertakes to pay $100 at the end of the year. The return on such a loan is not 5%, but 5/95 = .0526, or 5.26%.

For longer-term bank loans the interest rate is usually linked to the general level of interest rates. The most common benchmarks are LIBOR, the federal funds rate,⁴⁰ or the bank’s prime rate. Thus, if the rate is set at “1% over LIBOR,” the borrower may pay 5% in the first three months when LIBOR is 4%, 6% in the next three months when LIBOR is 5%, and so on. The nearby box describes how LIBOR is set and its relationship to the Treasury bill rate.

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The LIBOR scandal

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Syndicated Loans

Some bank loans and credit lines are too large for a single lender. In these cases, the borrower may pay an arrangement fee to one or more lead banks, which then parcel out the loan or credit line among a syndicate of banks.⁴¹ For example, in 2017 JPMorgan, Citigroup, Mizuho Bank, and Goldman Sachs arranged a syndicated loan facility for Sprint Communications. The package consisted of a $4.0 billion term loan and a $2.0 billion revolving credit facility. The term loan had a seven-year maturity and was priced at 2.5% over LIBOR. The interest rate on the revolving credit facility was 1.75% to 2.75% over LIBOR.⁴² In addition, Sprint was required to pay a commitment fee of .25% to .45% on any unused portion of the revolving credit.

The syndicate arrangers serve as underwriters to the loan. They price the loan, market it to other banks, and may also guarantee to take on any unsold portion. The arrangers’, first step is to prepare an information memo that provides potential lenders with information on the loan. The syndicate desk will then try to sound out the level of interest in the deal before the loan is finally priced and marketed to interested buyers. If the borrower has good credit or if the arranging bank has a particularly good reputation, the majority of the loan is likely to be syndicated. In other cases the arranging bank may need to demonstrate its faith in the deal by keeping a high proportion of the loan on its own books.⁴³

Bank loans used to be illiquid; once the bank had made a loan, it was stuck with it. This is no longer the case so that banks with an excess demand for loans may solve the problem by selling a portion of their existing loans to other institutions. For example, about 20% of syndicated loans are subsequently resold, and these sales are reported weekly in The Wall Street Journal.⁴⁴

Security

If a bank is concerned about a firm’s credit risk, it will ask the firm to provide security for the loan. This is most common for longer-term bank loans, more than half of which are secured.⁴⁵ Sometimes the bank will take a floating lien. This gives it a general claim if the firm defaults. However, it does not specify the assets in detail, and it sets few restrictions on what the company can do with the assets.

More commonly, banks require specific collateral. For example, suppose that there is a significant delay between the time that you ship your goods and when your customers pay you. If you need the money up front, you can borrow by using these receivables as collateral. First, you must send the bank a copy of each invoice and provide it with a claim against the money that you receive from your customers. The bank may then lend up to 80% of the value of the receivables. Each day, as you make more sales, your collateral increases and you can borrow more money. Each day, some customers also pay their bills. This money is placed in a special collateral account under the bank’s control and is periodically used to reduce the amount of the loan. Therefore, as the firm’s business fluctuates, so does the amount of the collateral and the size of the loan.

You can also use inventories as security for a loan. For example, if your goods are stored in a warehouse, you need to arrange for an independent warehouse company to provide the bank with a receipt showing that the goods are held on the bank’s behalf. The bank will generally be prepared to lend up to 50% of the value of the inventories. When the loan is repaid, the bank returns the warehouse receipt, and you are free to remove the goods.⁴⁶

Banks are naturally choosey about the security that they will accept. They want to make sure that they can identify and sell the collateral if you default. They may be happy to lend against a warehouse full of a standard nonperishable commodity, but they would turn up their nose at a warehouse of ripe Camembert.

Banks also need to ensure that the collateral is safe and that the borrower doesn’t sell the assets and run off with the money. This is what happened in the great salad oil swindle. Fifty-one banks and companies made loans of nearly $200 million to the Allied Crude Vegetable Oil Refining Corporation. In return, the company agreed to provide security in the form of storage tanks full of valuable salad oil. Unfortunately, cursory inspections failed to notice that the tanks contained seawater and sludge. When the fraud was discovered, the president of Allied went to jail and the 51 lenders were left out in the cold, looking for their $200 million.

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Hazards of secured bank lending

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Loan Covenants

We saw earlier that bond issues may contain covenants, which restrict companies from taking actions that would increase the risk of their debt. For publicly issued bonds, these restrictions are often mild and are generally incurrence covenants. In other words, they might say that the company may not issue more debt unless the interest cover is greater than five times. In the case of privately placed debt, such as the Sprint syndicated loan, the covenants are generally more severe, and include maintenance covenants. For example, these may say that the company is in violation if interest cover falls below five times regardless of whether that is a result of taking on more debt or is simply caused by declining earnings.

Since privately placed debt keeps the borrower on a fairly short leash, it is quite common for a covenant to be breached. This is not as calamitous as it may sound. As long as the borrower is in good financial health, the lender may simply adjust the terms of the covenant. Only if covenants continue to be violated will the lender choose to take more drastic action.

Covenants on bank loans and privately placed bonds are principally of three kinds.⁴⁷ The first and most common covenant sets a maximum fraction of net income that can be paid out as dividends. A second set of covenants, called sweeps, state that all or part of the loan must be repaid if the borrower makes a large sale of assets or a substantial issue of debt. The third group places conditions on key financial ratios, such as the borrower’s debt ratio, and interest coverage ratio, or current ratio. For example, the Sprint loan requires the company to maintain a specified debt ratio and interest cover.

24-4Commercial Paper and Medium-Term Notes

Commercial Paper

Banks borrow money from one group of firms or individuals and relend the money to another group. They make their profit by charging the borrowers a higher rate of interest than they offer the lender.

Sometimes it is convenient to have a bank in the middle. It saves the lenders the trouble of looking for borrowers and assessing their creditworthiness, and it saves the borrowers the trouble of looking for lenders. Depositors do not care about the identity of the borrowers: They need only satisfy themselves that the bank as a whole is safe.

There are also occasions on which it is not worth paying an intermediary to perform these functions. Large well-known companies can bypass the banking system by issuing their own short-term unsecured notes. These notes are known as commercial paper (CP). Both foreign and domestic financial institutions, such as bank holding companies and finance companies,⁴⁸ also issue commercial paper, sometimes in very large quantities. The major issuers of commercial paper have set up their own marketing departments and sell their paper directly to investors, often using the web to do so. Smaller companies sell through dealers who receive a fee for marketing the issue.

Commercial paper in the United States has a maximum maturity of nine months, though most paper is for less than 60 days. Buyers generally hold it to maturity, but the company or dealer that sells the paper is usually prepared to repurchase it earlier.

Commercial paper is not risk-free. When California was mired in the energy crisis of 2001, Southern California Edison and Pacific Gas and Electric defaulted on $1.4 billion of commercial paper. And in 2008, Lehman Brothers filed for bankruptcy with $3 billion of paper outstanding. But such defaults are rare. The majority of commercial paper is issued by high-grade, nationally known companies,⁴⁹ and the issuers generally support their borrowing by arranging a backup line of credit with a bank, which guarantees that they can find the money to repay the paper.⁵⁰

Because investors are reluctant to buy commercial paper that does not have the highest credit rating, companies cannot rely on the commercial paper market to always provide them with the short-term capital that they need. For example, when the rating services downgraded the commercial paper of Ford and General Motors, both companies were forced to sharply reduce their sales of paper.

When Lehman Brothers filed for bankruptcy in September 2008, the commercial paper market nosedived. The spread between the interest rates on commercial paper and Treasury bills doubled, while the market closed entirely for low-grade issuers. Many firms that found themselves shut out of the commercial paper market rushed to borrow on their bank lines of credit. Firms that had no such alternative source of borrowing were forced to cut back on their investment plans.⁵¹ Only after the Fed announced plans to buy large quantities of high-grade paper did the market begin to return to normal.

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Commercial paper and the financial crisis

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In addition to unsecured commercial paper, there is also a market for asset-backed commercial paper. In this case, the company sells its assets to a special-purpose vehicle that then issues the paper. For example, as the auto companies reduced their sales of unsecured commercial paper, they increasingly relied on asset-backed paper secured by the firm’s receivables. As the customers paid their bills, the cash was passed through to the holders of this paper.

By 2007, asset-backed paper accounted for almost half the commercial paper market, but weaknesses surfaced after a number of banks set up structured investment vehicles (SIVs) that invested in mortgage-backed securities financed by asset-backed paper. Because the buyers of the commercial paper bore the credit risk, the banks had less incentive to worry about the quality of the underlying mortgages. Once it became clear to investors that this quality was very low, many of the SIVs found it impossible to refinance the maturing paper and went into default.

Medium-Term Notes

New issues of securities do not need to be registered with the SEC as long as they mature within 270 days. So by limiting the maturity of commercial paper issues, companies can avoid the delays and expense of registration. However, large blue-chip companies also make regular issues of unsecured medium-term notes (MTNs).

You can think of MTNs as a hybrid between corporate bonds and commercial paper. Like bonds, they are relatively long-term instruments; their maturity is never less than 270 days, though it is typically less than 10 years.⁵² On the other hand, like commercial paper, MTNs are not underwritten but are sold on a regular basis either through dealers or, occasionally, directly to investors. Dealers support a secondary market in these MTNs and are prepared to buy the notes back before maturity.⁵³

Borrowers such as finance companies, which always need cash, welcome the flexibility of MTNs. For example, a company may tell its dealers the amount of money that it needs to raise that week, the range of maturities that it can offer, and the maximum interest that it is prepared to pay. It is then up to the dealers to find the buyers. Investors may also suggest their own terms to one of the dealers, and, if these terms are acceptable, the deal is done.

SUMMARY

You should now have a fair idea of what you are letting yourself in for when you make an issue of bonds. The detailed bond agreement is set out in the indenture between your company and a trustee, but the main provisions are summarized in the prospectus to the issue. The indenture states whether the bonds are senior or subordinated, and whether they are secured or unsecured. Most bonds are unsecured debentures or notes. This means that they are general claims on the corporation. The principal exceptions are utility mortgage bonds, collateral trust bonds, and equipment trust certificates. In the event of default, the trustee to these issues can repossess the company’s assets to pay off the debt. Sometimes firms raise money using asset-backed securities, which involve bundling assets together and selling the cash flows from them.

Some long-term bond issues have a sinking fund. This means that the company must set aside enough money each year to retire a specified number of bonds. A sinking fund reduces the average life of the bond, and it provides a yearly test of the company’s ability to service its debt. It therefore helps to protect the bondholders against the risk of default.

Long-dated bonds may be callable before maturity. This option to call the bond may be valuable to a company that wishes to reduce its leverage or tidy up its outstanding debt.

Lenders usually seek to prevent the borrower from taking actions that would damage the value of their loans. Here are some examples of debt covenants:

1. The loan agreement may limit the amount of additional borrowing by the company.

2. Unsecured loans may incorporate a negative pledge clause, which prohibits the company from securing additional debt without giving equal treatment to the existing unsecured bonds.

3. Lenders may place a limit on the company’s dividend payments or repurchases of stock.

Bonds can be issued in the public markets in the United States, in which case they must be registered with the SEC. Alternatively, if they are issued to a limited number of buyers, they can be privately placed. They can also be issued in a foreign bond market or in the Eurobond market. Eurobonds are marketed simultaneously in a number of foreign countries by the London branches of international banks and security dealers.

Most bonds start and finish their lives as bonds, but convertible bonds give their owner the option to exchange the bond for common stock. The conversion ratio measures the number of shares into which each bond can be exchanged. You can think of a convertible bond as equivalent to a straight bond plus a call option on the stock. Sometimes, instead of issuing a convertible, companies may decide to issue a package of bonds and options (or warrants) to buy the stock. If the stock price rises above the exercise price, the investor may then keep the bond and exercise the warrants for cash.

There is an enormous variety of bond issues and new forms of bonds are spawned almost daily. By a process of natural selection, some of these new instruments become popular and may even replace existing species. Others are ephemeral curiosities. Some innovations succeed because they widen investor choice or reduce agency costs. Others owe their origin to tax rules and government regulation.

Many corporations, particularly smaller ones, obtain finance from banks. Bank loans usually have shorter maturities than bonds. Most result from commitments. Firms pay a commitment fee to keep a credit line open that they can draw upon when they need the cash.

Many bank loans are short term at a fixed rate of interest. The interest rate on longer-term bank loans is usually linked to LIBOR or some other index of interest rates. Often bank loans are provided by a syndicate of banks if the amount needed is too large to be provided by a single bank. Loans are frequently secured by collateral such as receivables, inventories, or securities. Covenants are usually more restrictive than with bonds.

Commercial paper and medium-term notes are a cheaper alternative to bank loans for many large firms. They can be sold directly to lenders or through dealers. Commercial paper can be unsecured or asset-backed. Medium-term notes are a hybrid between bonds and commercial paper. They are longer term than commercial paper but are sold in a similar way.

FURTHER READING

A useful general work on debt securities is:

F. J. Fabozzi (ed.), The Handbook of Fixed Income Securities, 8th ed. (New York: McGraw-Hill, 2011).

For an excellent guide to syndicated lending see:

Standard & Poor’s, A Guide to the Loan Market, September 2011.

For nontechnical discussions of the pricing of convertible bonds and the reasons for their use, see:

M. J. Brennan and E. S. Schwartz, “The Case for Convertibles,” Journal of Applied Corporate Finance 1 (Summer 1988), pp. 55–64.

C. M. Lewis, R. J. Rogalski, and J. K. Seward, “Understanding the Design of Convertible Debt,” Journal of Applied Corporate Finance 11 (Spring 1998), pp. 45–53.

For a useful description of the commercial paper market and its difficulties in the crash of 2007–2009, see:

M. Kacperczyk and P. Schnabl, “When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007–2009,” Journal of Economic Perspectives 24 (Winter 2010), pp. 29–50.

The readings listed at the end of Chapter 17 include several articles on financial innovation.

PROBLEM SETS

 Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.

1. Bond terms Use Table 24.1 (but not the text) to answer the following questions:

a. Who are the principal underwriters for the AMAT bond issue?

b. What is the percentage underwriting spread?

c. How many dollars does the company receive for each bond after deduction of the underwriters’ spread?

d. Is the bond “bearer” or “registered”?

e. Who is the trustee for the issue?

2. Bond terms Look at Table 24.1:

a. The AMAT bond was issued on June 8, 2011, at 99.592%. How much would you have to pay to buy one bond delivered on June 15? Don’t forget to include accrued interest.

b. When is the first interest payment on the bond, and what is the total dollar amount of the payment?

c. On what date do the bonds finally mature, and what is the amount to be paid on each bond at maturity?

3. Bond terms Find the terms and conditions of a recent bond issue and compare them with those of the AMAT issue.

4. Bond terms* Select the most appropriate term from within the parentheses:

a. (High-grade bonds/Low-grade bonds) generally have only light sinking-fund requirements.

b. Equipment trust certificates are usually issued by (railroads/bank holding companies).

c. Mortgage pass-through certificates are an example of (an asset-backed security/a convertible bond).

5. Bond terms Suppose that the AMAT bond was issued at face value and that investors continue to demand a yield of 5.85%. Sketch what you think would happen to the bond price as the first interest payment date approaches and then passes. What about the price of the bond plus accrued interest (sometimes known as the dirty price)?

6. Bond terms Bond prices can fall either because of a change in the general level of interest rates or because of an increased risk of default. To what extent do floating-rate bonds protect the investor against each of these risks?

7. Security and seniority

a. As a senior bondholder, would you like the company to issue more junior debt to finance its investment program, would you prefer it not to do so, or would you not care?

b. You hold debt secured on the company’s existing property. Would you like the company to issue more unsecured debt to finance its investments, would you prefer it not to do so, or would you not care?

8. Security and seniority* Proctor Power has fixed assets worth $200 million and net working capital worth $100 million. It is financed partly by equity and partly by three issues of debt. These consist of $250 million of First Mortgage Bonds secured only on the company’s fixed assets, $100 million of senior debentures, and $120 million of subordinated debentures. If the debt were due today, how much would each debtholder be entitled to receive?

9. Security and seniority Elixir Corporation has just filed for bankruptcy. Elixir is a holding company whose assets consist of real estate worth $80 million and 100% of the equity of its two operating subsidiaries. It is financed partly by equity and partly by an issue of $400 million of senior collateral trust bonds that are just about to mature. Subsidiary A has issued directly $320 million of debentures and $15 million of preferred stock. Subsidiary B has issued $180 million of senior debentures and $60 million of subordinated debentures. A’s assets have a market value of $500 million, and B’s have a value of $220 million. How much will each security holder receive if the assets are sold and distributed strictly according to precedence?

10. Security and seniority

a. Residential mortgages may stipulate either a fixed rate or a variable rate. As a borrower, what considerations might cause you to prefer one rather than the other?

b. Why might holders of mortgage pass-through certificates wish the mortgages to have a floating rate?

11. Sinking funds For each of the following sinking funds, state whether the fund increases or decreases the value of the bond at the time of issue (or whether it is impossible to say):

a. An optional sinking fund operating by drawings at par.

b. A mandatory sinking fund operating by drawings at par or by purchases in the market.

c. A mandatory sinking fund operating by drawings at par.

12. Call provisions

a. Look at Table 24.1. Suppose that AMAT decides to call the bond one year before it is due to expire. The interest rate on one-year Treasury bonds is 2%. What price must AMAT pay to call the bonds?

b. Now suppose that the interest rate on Treasury bonds is 10%. What price must AMAT pay to call its bonds?

13. Covenants Alpha Corp. is prohibited from issuing more senior debt unless net tangible assets exceed 200% of senior debt. Currently, the company has outstanding $100 million of senior debt and has net tangible assets of $250 million. How much more senior debt can Alpha Corp. issue?

14. Covenants Explain carefully why bond indentures may place limitations on the following actions:

a. Sale of the company’s assets.

b. Payment of dividends to shareholders.

c. Issue of additional senior debt.

15. Private placements Explain the three principal ways in which the terms of private placement bonds commonly differ from those of public issues.

16. Convertible bonds True or false?

a. Convertible bonds are usually senior claims on the firm.

b. The higher the conversion ratio, the more valuable the convertible.

c. The higher the conversion price, the more valuable the convertible.

d. Convertible bonds do not share fully in the price of the common stock, but they provide some protection against a decline.

17. Convertible bonds* Maple Aircraft has issued a 4¾% convertible subordinated debenture due 2023. The conversion price is $47.00 and the debenture is callable at 102.75% of face value. The market price of the convertible is 91% of face value, and the price of the common is $41.50. Assume that the value of the bond in the absence of a conversion feature is about 65% of face value.

a. What is the conversion ratio of the debenture?

b. If the conversion ratio were 50, what would be the conversion price?

c. What is the conversion value?

d. At what stock price is the conversion value equal to the bond value?

e. Can the market price be less than the conversion value?

f. How much is the convertible holder paying for the option to buy one share of common stock?

g. By how much does the common have to rise by 2023 to justify conversion?

18. Convertible bonds The Surplus Value Company had $10 million (face value) of convertible bonds outstanding in 2015. Each bond has the following features.

Face value	$1,000
Conversion price	$25
Current call price	105 (percent of face value)
Current trading price	130 (percent of face value)
Maturity	2022
Current stock price	$30 (per share)
Interest rate	10% (coupon as percent of face value)

a. What is the bond’s conversion value?

b. Can you explain why the bond is selling above conversion value?

c. Should Surplus call? What will happen if it does so?

19. Convertible bonds Sweeney Pies has issued a zero-coupon 10-year bond that can be converted into 10 Sweeney shares. Comparable straight bonds are yielding 8%. Sweeney stock is priced at $50 a share.

a. Suppose that you had to make a now-or-never decision on whether to convert or to stay with the bond. Which would you do?

b. If the convertible bond is priced at $550, how much are investors paying for the option to buy Sweeney shares?

c. If, after one year, the value of the conversion option is unchanged, what is the value of the convertible bond?

20. Convertible bonds Iota Microsystems’ 10% convertible is about to mature. The conversion ratio is 27.

a. What is the conversion price?

b. The stock price is $47. What is the conversion value?

c. Should you convert?

21. Convertible bonds Zenco Inc. is financed by 3 million shares of common stock and by $5 million face value of 8% convertible debt maturing in 2029. Each bond has a face value of $1,000 and a conversion ratio of 200. What is the value of each convertible bond at maturity if Zenco’s net assets are worth:

a. $30 million?

b. $4 million?

c. $20 million?

d. $5 million?

Draw a figure similar to Figure 24.4c showing how the value of each convertible bond at maturity varies with the value of Zenco’s net assets.

22. Bank loans* Match each of the following terms with one of the definitions below

A. Revolving credit

B. Bridge loan

C. Term loan

D. Syndicated loan

E. Commitment fee

F. Maintenance covenant

a. Requirement that borrower keeps in the future to a certain condition—for example, a minimum debt ratio.

b. Rather like a corporate credit card, it allows the company to choose to borrow up to a certain limit and to repay.

c. Loan that is parceled out among a group of banks.

d. Longer term bank loan with a fixed maturity.

e. Fee paid on unused portion of a revolving credit.

f. Short-term bank loan taken out until more permanent funding can be arranged.

23. Bank loans Suppose that you are a banker responsible for approving corporate loans. Nine firms are seeking secured loans. They offer the following assets as collateral:

a. Firm A, a heating oil distributor, offers a tanker load of fuel oil in transit from the Middle East.

b. Firm B, a wine wholesaler, offers 1,000 cases of Beaujolais Nouveau located in a field warehouse.

c. Firm C, a stationer, offers an account receivable for office supplies sold to the City of New York.

d. Firm D, a bookstore, offers its entire inventory of 15,000 used books.

e. Firm E, a wholesale grocer, offers a boxcar full of bananas.

f. Firm F offers 100 ounces of gold.

g. Firm G, a government securities dealer, offers its portfolio of Treasury bills.

h. Firm H, a boat builder, offers a half-completed luxury yacht. The yacht will take four more months to complete.

Which of these assets are most likely to be good collateral? Which are likely to be poor collateral? Explain.

24. Bank loans, commercial paper, and medium-term notes* Complete the passage below by selecting the most appropriate terms from the following list: floating lien, revolving credit, medium-term note, warehouse receipt, unsecured, commitment fee, commercial paper.

Companies with fluctuating needs for cash often arrange a _____ with their bank that allows them to borrow up to a specified amount. In addition to paying interest on any borrowings, the company must pay a ____ on any unused amount.

Secured short-term loans are sometimes covered by a _____, which gives it a general claim on the firm’s assets. Generally, however, the borrower pledges specific assets. For example, a loan may be secured by inventory. In this case, an independent warehouse company provides the bank with a _____, showing that the goods are held on the bank’s behalf and releases those goods only on instructions.

Banks are not the only source of short-term debt. Many large companies issue their own _____ debt directly to investors, often on a regular basis. If the maturity is less than 270 days, the debt does not need to be registered with the SEC and is known as _____. A company may also have a program to sell longer-maturity debt to investors on a continuing basis. This is called a _____ program.

25. Bank loans, commercial paper, and medium-term notes Term loans usually require firms to pay a fluctuating interest rate. For example, the interest rate may be set at 1% over LIBOR. LIBOR can sometimes vary by several percentage points within a single year. Suppose that your firm has decided to borrow $40 million for five years and that it has three alternatives:

a. Borrow from a bank at 1.5% over LIBOR, currently 6.5%. The proposed loan agreement requires no principal payments until the loan matures in year 5.

b. Issue 26-week commercial paper, currently yielding 7%. Since funds are required for five years, the commercial paper will need to be rolled over semiannually; that is, financing the $40 million will require 10 successive commercial paper sales.

c. Issue a five-year medium-term note at a fixed rate of 7.5%. As in the case of the bank loan, no principal has to be repaid until the end of year 5.

What factors would you consider in analyzing these alternatives? In what circumstances would you prefer each of these possible loans?

CHALLENGE

26. Tax benefits Dorlcote Milling has outstanding a $1 million 3% mortgage bond maturing in 10 years. The coupon on any new debt issued by the company is 10%. The finance director, Mr. Tulliver, cannot decide whether there is a tax benefit to repurchasing the existing bonds in the marketplace and replacing them with new 10% bonds. What do you think? Does it matter whether bond investors are taxed?

27. Convertible bonds This question illustrates that when there is scope for the firm to vary its risk, lenders may be more prepared to lend if they are offered a piece of the action through the issue of a convertible bond. Ms. Blavatsky is proposing to form a new start-up firm with initial assets of $10 million. She can invest this money in one of two projects. Each has the same expected payoff, but one has more risk than the other. The relatively safe project offers a 40% chance of a $12.5 million payoff and a 60% chance of an $8 million payoff. The risky project offers a 40% chance of a $20 million payoff and a 60% chance of a $5 million payoff.

Ms. Blavatsky initially proposes to finance the firm by an issue of straight debt with a promised payoff of $7 million. Ms. Blavatsky will receive any remaining payoff. Show the possible payoffs to the lender and to Ms. Blavatsky if (a) she chooses the safe project and (b) she chooses the risky project. Which project is Ms. Blavatsky likely to choose? Which will the lender want her to choose?

Suppose now that Ms. Blavatsky offers to make the debt convertible into 50% of the value of the firm. Show that in this case the lender receives the same expected payoff from the two projects.

28. Convertible bonds Occasionally, it is said that issuing convertible bonds is better than issuing stock when the firm’s shares are undervalued. Suppose that the financial manager of the Butternut Furniture Company does have inside information indicating that the Butternut stock price is too low. Butternut’s future earnings will in fact be higher than investors expect. Suppose further that the inside information cannot be released without giving away a valuable competitive secret. Clearly, selling shares at the present low price would harm Butternut’s existing shareholders. Will they also lose if convertible bonds are issued? If they do lose in this case, is the loss more or less than it would be if common stock were issued?

Now suppose that investors forecast earnings accurately but still undervalue the stock because they overestimate Butternut’s actual business risk. Does this change your answers to the questions posed in the preceding paragraph? Explain.

MINI-CASE

The Shocking Demise of Mr. Thorndike

It was one of Morse’s most puzzling cases. That morning, Rupert Thorndike, the autocratic CEO of Thorndike Oil, was found dead in a pool of blood on his bedroom floor. He had been shot through the head, but the door and windows were bolted on the inside, and there was no sign of the murder weapon.

Morse looked in vain for clues in Thorndike’s bedroom and office. He had to take another tack. He decided to investigate the financial circumstances surrounding Thorndike’s demise. The company’s capital structure was as follows:

· 5% debentures: $250 million face value. The bonds mature in 10 years and offer a yield of 12%.

· Stock: 30 million shares, which closed at $9 a share the day before the murder.

· 10% subordinated convertible notes: The notes mature in one year and are convertible at any time at a conversion ratio of 110. The day before the murder these notes were priced at 5% more than their conversion value.

Yesterday, Thorndike had flatly rejected an offer by T. Spoone Dickens to buy all of the common stock for $10 a share. With Thorndike out of the way, it appeared that Dickens’s offer would be accepted, much to the profit of Thorndike Oil’s other shareholders.⁵⁴

Thorndike’s two nieces, Doris and Patsy, and his nephew, John, all had substantial investments in Thorndike Oil and had bitterly disagreed with Thorndike’s dismissal of Dickens’s offer. Their stakes are shown in the following table:

	5% Debentures (Face Value)	Shares of Stock	10% Convertible Notes (Face Value)
Doris	$4 million	1.2 million	$0 million
John	0	0.5	5
Patsy	0	1.5	3

All debt issued by Thorndike Oil would be paid off at face value if Dickens’s offer went through. Holders of the convertible notes could choose to convert and tender their shares to Dickens.

Morse kept coming back to the problem of motive. Which niece or nephew, he wondered, stood to gain most by eliminating Thorndike and allowing Dickens’s offer to succeed?

QUESTION

1. Help Morse solve the case. Which of Thorndike’s relatives stood to gain most from his death?

APPENDIX

Project Finance

Project finance loans are loans that are tied as closely as possible to the fortunes of a particular project and that minimize the exposure of the parent. These loans are usually referred to simply as project finance and are a specialty of large international banks.

Project finance means debt supported by the project, not by the project’s sponsoring companies. Debt ratios are nevertheless very high for most project financings. They can be high because the debt is protected not just by the project’s assets, but also by a variety of contracts and guarantees provided by customers, suppliers, and local governments as well as by the project’s owners.

Some Common Features

No two project financings are alike, but they have some common features. Typically, the parent will set up a special-purpose company to own and manage the project. This company will then enter into a package of contracts that ensures the project will generate the cash flows needed to service the debt. Three components of this package are particularly important.

First, the lenders need to be confident that the project will be built on time and to specifications. This is the role of the engineering, procurement, and construction (EPC) contract between the project company and the plant’s constructors.

Second, the lenders need to know that the project will be able to generate sufficient revenues to enable it to service the loans. Therefore, the project company will generally enter into a long-term, off-take contract with the business that is buying the product (the offtaker).

A third set of contracts involve the government of the host country. The lenders require assurance that the government will not impose new taxes or limit its ability to access the currency markets. If possible, it can be helpful to have the involvement of the World Bank or an international development bank to ensure that the government plays fair.

BEYOND THE PAGE

Revenue guarantees for project finance

mhhe.com/brealey13e

The effect of this web of contracts is to shift much of the project’s risk away from the special-purpose company. As a result, the project company commonly has very little equity, and about 70% of the capital for the project is typically provided in the form of bank debt or other privately placed borrowing. This debt is supported by the project cash flows; if these flows are insufficient, the lenders do not have any recourse against the parent companies.

The Role of Project Finance

Project finance is widely used in developing countries to fund power, telecommunications, mining, and transportation projects, but it is also used in the major industrialized countries. In the United States, project finance has been most commonly used to fund power plants. For example, an electric utility company may get together with an industrial company to construct a cogeneration plant that provides electricity to the utility and waste heat to a nearby industrial plant. The utility stands behind the cogeneration project and guarantees its revenue stream. Banks are happy to lend a high proportion of the cost of the project because they know that once the project is up and running, the cash flow is insulated from most of the risks facing normal businesses.⁵⁵

Project financing is costly to arrange,⁵⁶ and the project debt usually carries a relatively high interest rate. So why don’t companies simply finance the projects by borrowing against their existing assets? Notice that most of the projects have limited lives and employ established technologies. They generate substantial free cash flow, and there are few options to make profitable follow-on investments. If such investments are funded with project finance, management has little discretion over how the cash flows are used. Instead, the debt-service requirements ensure that the cash must be returned to investors rather than frittered away on unprofitable future ventures.⁵⁷

EXAMPLE 24A.1 Project Finance for a Power Station

In 2005, the Indonesian government designated a new ultra-supercritical coal-fired power plant in Central Java as a top priority. The $4.2 billion investment was planned to be the first public-private partnership infrastructure project in Indonesia, and a model for future projects.

Electricity generation and distribution in Indonesia is the responsibility of the government-owned company, PLN. To get the Central Java project off the ground, PLN engaged International Finance Corporation (IFC), which is the project-finance arm of the World Bank, to provide advice on structuring the development. IFC worked with key stakeholders, including the PLN, the Ministry of Finance, the newly established Indonesia Infrastructure Guarantee Fund (IIGF), and potential investors to structure a bankable transaction. IFC recommended that the project be set up as a public-private partnership and that a private-sector investor should be appointed to build, own, and operate the plant for its first 25 years. At the end of that period, the operator would transfer the plant to PLN, which would then run it for the remainder of its useful life (a minimum of 40 years).

The first step was to appoint a private-sector investor that was both technically competent and prepared to sell the output of the plant to PLN at a competitive price. Four consortia from Japan and China submitted bids to build and run the project. In 2011, the project was awarded to a special-purpose company, BPI, which was owned in roughly equal proportions by J-Power (a Japanese electric utility company), Itochu Corporation (a Japanese conglomerate with major coal interests), and Adaro Power (part of an Indonesian energy group). Before going ahead with the project, BPI needed to enter into a series of contracts that would protect it against risks that were beyond its control. Foremost among these was a long-term Power Purchase Agreement with PLN. If PLN was unable to meet its obligations, any losses to BPI would be made good by the Indonesia Infrastructure Guarantee Fund, which was backed by the World Bank. These guarantees were buttressed by force majeure clauses that protected BPI from political or natural risks.

BPI needed to hire a consortium of companies to be the engineering, procurement, and construction contractors for the project, and it needed to arrange financing. The security provided by the power purchase agreement and guarantees meant that BPI’s equity in the project could be highly levered. Eighty percent of the $3.4 billion cost of the project was in the form of bank loans. Most of this was provided by the Japan Bank for International Cooperation (JBIC), and the remainder came from seven Japanese and two Singaporean banks. JBIC provided a political risk guarantee for the portion financed by these private institutions.

The original plan called for all the agreements to be signed in 2013 and for the plant to be in operation by 2016, but large project financings are rarely plain sailing. The project encountered opposition from landowners and environmental groups. It was not until June 2016 that the project was finally signed off and construction could begin.

QUESTIONS

1. Explain when it makes sense to use project finance rather than a direct debt issue by the parent company.

2. Look back at the Central Java project. There were many other ways that the project could have been financed. For example, PLN could have invested in the power plant and hired a consortium to run it. Alternatively, the consortium could have owned the power plant directly and funded its cost by a mixture of new borrowing and the sale of shares. What do you think were the advantages of setting up a separately financed company to undertake the project?

APPENDIX FURTHER READING

Discussions of project finance include:

B. C. Esty, Modern Project Finance: A Casebook (New York: John Wiley, 2003).

B. C. Esty, “Returns on Project-Financed Investments: Evolution and Managerial Implications,” Journal of Applied Corporate Finance 15 (Spring 2002), pp. 71–86.

R. A. Brealey, I. A. Cooper, and M. Habib, “Using Project Finance to Fund Infrastructure Investments,” Journal of Applied Corporate Finance 9 (Fall 1996), pp. 25–38.

¹The remark was made by the late Senator Everett Dirksen. However, he was talking billions.

²If a bond pays interest semiannually, investors usually calculate a semiannually compounded yield to maturity on the bond. In other words, the yield is quoted as twice the six-month yield. When bonds pay interest annually, it is conventional to quote their yields to maturity on an annually compounded basis. For more on this, see Section 3-1.

³There is one type of bond on which the borrower is obliged to pay interest only if it is covered by the year’s earnings. These so-called income bonds are rare and have largely been issued as part of railroad reorganizations.

⁴Any bond that is issued at a discount is known as an original issue discount bond. A zero-coupon bond is often called a “pure discount bond.” The capital appreciation on a discount bond is not taxed as income as long as it amounts to less than .25% a year (IRS Code Section 1272).

⁵The ultimate of ultimates was an issue of a perpetual zero-coupon bond on behalf of a charity.

⁶Instead of issuing a capped floating-rate loan, a company sometimes issues an uncapped loan and at the same time buys a cap from a bank. The bank pays the interest in excess of the specified level.

⁷In the U.S. corporate bond market, accrued interest is calculated on the assumption that a year is composed of twelve 30-day months; in some other markets (such as the U.S. Treasury bond market) calculations recognize the actual number of days in each calendar month.

⁸For example, the indenture for the AMAT bond states, “Unless and until it is exchanged in whole or in part for securities in definitive form, this security may not be transferred except as a whole by the depositary to a nominee of the depositary or by a nominee of the depositary to the depositary or to another nominee of the depositary or by the depositary or any such nominee to a successor depositary or a nominee of such successor depositary. Unless this global security is presented by an authorized representative of the depositary to the company or its agent for registration of transfer, exchange or payment, and any security issued is registered in the name of any entity as may be requested by an authorized representative of the depositary (and any payment is made to such entity as may be requested by an authorized representative of the depositary), any transfer, pledge or other use hereof for value or otherwise by or to any person is wrongful inasmuch as the registered owner hereof has an interest herein.” Try saying that three times very fast.

⁹In some countries, such as the U.K. and Australia, “debenture” means a secured bond.

¹⁰If a mortgage is closed, no more bonds may be issued against the mortgage. However, usually there is no specific limit to the amount of bonds that may be secured (in which case the mortgage is said to be open). Many mortgages are secured not only by existing property but also by “after-acquired” property. However, if the company buys only property that is already mortgaged, the bondholder would have only a junior claim on the new property. Therefore, mortgage bonds with after-acquired property clauses also limit the extent to which the company can purchase additional mortgaged property.

¹¹If a bond does not specifically state that it is junior, you can assume that it is senior.

¹²See J. Matthews, “David Bowie Reinvents Himself, This Time as a Bond Issue,” Washington Post, February 7, 1997.

¹³J. D. Coval, J. Jurek, and E. Stafford, “Economic Catastrophe Bonds,” American Economic Review 99 (June 2009), pp. 628–666.

¹⁴Data on issuance are available on www.sifma.org.

¹⁵CDO fees for the originating bank were in the region of 1.5% to 1.75%, more than three times the amount that the bank could earn from underwriting an investment-grade bond. However, many banks during the crisis seem to have persuaded themselves that the underlying mortgages were not junk and kept a large portion of the loans on their own books. See, for example, V. Acharya and M. Richardson (eds.), Restoring Financial Stability (Hoboken, NJ: Wiley, 2009).

¹⁶Every investor dreams of buying up the entire supply of a sinking-fund bond that is selling way below face value and then forcing the company to buy the bonds back at face value. Cornering the market in this way is fun to dream about but difficult to do.

¹⁷We described in Section 18-3 some of the games that managers can play at the expense of bondholders.

¹⁸“Me too” is not acceptable legal jargon. Instead the bond agreement may state that the company “will not consent to any lien on its assets without securing the existing bonds equally and ratably.”

¹⁹A dividend restriction might typically prohibit the company from paying dividends if their cumulative amount would exceed the sum of (1) cumulative net income, (2) the proceeds from the sale of stock or conversion of debt, and (3) a dollar amount equal to one year’s dividend.

²⁰P. Asquith and T. Wizman, “Event Risk, Covenants, and Bondholder Returns in Leveraged Buyouts,” Journal of Financial Economics 27 (September 1990), pp. 195–213. Leveraged buyouts (LBOs) are company acquisitions that are financed by large issues of (usually unsecured) debt. We describe LBOs in Chapter 32.

²¹D. J. Denis and V. T. Mihov estimated that the value of privately placed bond issues is less than 20% that of total bond issues. See D. J. Denis and V. T. Mihov, “The Choice among Bank Debt, Non-Bank Private Debt and Public Debt: Evidence from New Corporate Borrowings,” Journal of Financial Economics 70 (2003), pp. 3–28.

²²Of course, debt with the same terms could be offered publicly, but then 200 separate investigations would be required—a much more expensive proposition.

²³See D. J. Denis and V. T. Mihov, “The Choice among Bank Debt, Non-Bank Private Debt, and Public Debt: Evidence from New Corporate Borrowings,” op.cit.

²⁴We described Rule 144A in Section 15-5.

²⁵You should not, however, get the impression that the eurobond market is some lawless wilderness. Eurobond contracts typically state that the issue is subject to either British or New York law.

²⁶To make matters more confusing, the term “eurobond” has also been used to refer to bonds that in the future might be issued jointly by eurozone governments.

²⁷You may recognize this as the position diagram for a default-free bond minus a put option on the assets with an exercise price equal to the face value of the bonds. See Section 23-2.

²⁸The Tesla convertible is not callable.

²⁹She might even point out to you that several Japanese companies have issued convertible bonds at a negative yield. Investors actually paid the companies to hold their debt.

³⁰That is much the same as already having the stock together with the right to sell it for the convertible’s bond value. In other words, instead of thinking of a convertible as a bond plus a call option, you could think of it as the stock plus a put option. Now you can see why it is wrong to think of a convertible as equivalent to the sale of stock; it is equivalent to the sale of both stock and a put option. If there is any possibility that investors will want to hold on to their bond, this put option has value.

³¹See J. R. Graham and C. R. Harvey, “The Theory and Practice of Finance: Evidence from the Field,” Journal of Financial Economics 60 (2001), pp. 187–243.

³²In the survey referred to above, a further 44% of the respondents reported that an important factor in their decision was the fact that convertibles were attractive to investors who were unsure about the riskiness of the company.

³³Changes in risk are more likely when the firm is small and its debt is low-grade. Therefore, we should find that convertible bonds of such firms offer their holders a larger potential ownership share. This is indeed the case. See C. M. Lewis, R. J. Rogalski, and J. K. Seward, “Understanding the Design of Convertible Debt,” Journal of Applied Corporate Finance 11 (Spring 1998), pp. 45–53.

³⁴Of course, the firm could also make an equity issue rather than an issue of straight debt or convertibles. However, a convertible issue sends a better signal to investors than an issue of common stock. As we explained in Chapter 15, announcement of a stock issue prompts worries of overvaluation and usually depresses the stock price. Convertibles are hybrids of debt and equity and send a less negative signal. If the company is likely to need equity, its willingness to issue a convertible and take the chance that the stock price will rise enough to lead to conversion also signals management’s confidence in the future. See J. Stein, “Convertible Bonds as, ‘Backdoor’, Equity Financing,” Journal of Financial Economics 32 (1992), pp. 3–21.

³⁵In their financial statements, companies recognize the possibility of dilution by showing how earnings would be affected by the issue of the extra shares.

³⁶For a more comprehensive list of innovations, see K. A. Carow, G.R. Erwin, and J. J. McConnell, “A Survey of U.S. Corporate Financing Innovations: 1970–1997,” Journal of Applied Corporate Finance 12 (Spring 1999), pp. 55–69.

³⁷See D. J. Denis and V. T. Mihov, “The Choice among Bank Debt, Non-Bank Private Debt, and Public Debt: Evidence from New Corporate Borrowings,” Journal of Financial Economics 70 (2003), pp. 3–28.

³⁸Banks originally promoted 364-day facilities because they did not need to set aside capital for commitments of less than a year.

³⁹One study of private debt agreements found that over 90% are renegotiated before maturity. In most cases, this is not because of financial distress. See M. R. Roberts and A. Sufi, “Renegotiation of Financial Contracts: Evidence from Private Credit Agreements,” Journal of Financial Economics 93 (2009), pp. 159–184.

⁴⁰The federal funds rate is the rate at which banks lend excess reserves to each other.

⁴¹For a standard loan to a blue-chip company, the fee for arranging a syndicated loan may be as low as 10 basis points, while a complex deal with a highly leveraged firm may carry a fee of up to 250 basis points. For good reviews of the syndicated loan market, see S. C. Miller, “A Guide to the Loan Market,” Standard & Poor’s, September 2011 (www.standardandpoors.com); and B. Gadanecz, “The Syndicated Loan Market: Structure, Development and Implications,” BIS Quarterly Review, December 2004, pp. 75–89 (www.bis.org).

⁴²In the case of both facilities, Sprint had the option to link the interest rate to an alternative measure of the short-term interest rate.

⁴³See A. Sufi, “Information Asymmetry and Financing Arrangements: Evidence from Syndicated Loans,” Journal of Finance 62 (April 2007), pp. 629–668.

⁴⁴Loan sales generally take one of two forms: assignments or participations. In the former case, a portion of the loan is transferred with the agreement of the borrower. In the second case, the lead bank maintains its relationship with the borrower but agrees to pay over to the buyer a portion of the cash flows that it receives.

⁴⁵The results of a survey of the terms of business lending by banks in the United States are published quarterly in the Federal Reserve Bulletin (see www.federalreserve.gov/releases/E2).

⁴⁶It is not always practicable to keep inventory in a warehouse. For example, automobile dealers need to display their cars in a showroom. One solution is to enter into a floor-planning arrangement in which the finance company or bank holds title to the cars until they are sold. When the cars are sold, the proceeds are used to repay the loan. The interest or “flooring charge” depends on how long the cars have been in the showroom.

⁴⁷For an analysis of loan covenants in privately placed debt see M. Bradley and M. R. Roberts, “The Structure and Pricing of Corporate Debt Covenants,” Quarterly Journal of Finance 5 (June 2015), pp. 1–37.

⁴⁸A bank holding company is a firm that owns both a bank and nonbanking subsidiaries.

⁴⁹Moody’s, Standard & Poor’s, and Fitch publish quality ratings for commercial paper. For example, Moody’s provides three ratings, from P-1 (i.e., Prime 1, the highest-grade paper) to P-3. Most investors are reluctant to buy low-rated paper. For example, money-market funds are largely limited to holding P-1 paper.

⁵⁰For top-tier issuers, the credit line is generally 75% of the amount of paper; for lower-grade issuers, it is 100%. The company may not be able to draw on this line of credit if it does not satisfy bank covenants. Therefore, lower-rated companies may need to back their paper with an irrevocable line of credit.

⁵¹For an analysis of firm reaction to the collapse of the commercial paper market, see P. Gao and H. Yun, “Commercial Paper, Lines of Credit, and the Real Effects of the Financial Crisis of 2008: Firm-Level Evidence from the Manufacturing Industry,” working paper, University of Notre Dame, 2010.

⁵²Occasionally, an MTN registration may be used to issue much longer term bonds. For example, Disney has even used its MTN program to issue a 100-year bond.

⁵³In Chapter 15, we encountered SEC Rule 415, which allows companies to file a single registration statement covering financing plans for up to three years in the future (shelf registration). Since the interest rates on MTN issues are adjusted frequently, an active MTN market was feasible only after the passage of Rule 415 in 2005.

⁵⁴Rupert Thorndike’s shares would go to a charitable foundation formed to advance the study of financial engineering and its crucial role in world peace and progress. The managers of the foundation’s endowment were not expected to oppose the takeover.

⁵⁵There are some interesting regulatory implications to this arrangement. When a utility builds a power plant, it is entitled to a fair return on its investment: Regulators are supposed to set customer charges that will allow the utility to earn its cost of capital. Unfortunately, the cost of capital is not easily measured and is a natural focus for argument in regulatory hearings. But when a utility buys electric power, the cost of capital is rolled into the contract price and treated as an operating cost. In this case, the pass-through to the customer may be less controversial.

⁵⁶Total transaction costs for infrastructure projects average 3% to 5% of the amount invested. See M. Klein, J. So, and B. Shin, “Transaction Costs in Private Infrastructure Projects—Are They Too High?” The World Bank Group, October 1996.

⁵⁷Because the project is an independent company, it cannot drag down the parent company if something does go badly wrong with the project.