Chapter 24 : Notes on Different kinds of debt

 Nature of needs for funds

- Temporary need
- Long Term need

 Short term Debt

- From Banks – Revolving line of credit
- Commercial paper
- Medium-term notes
 Long-Term Debt
- Bonds (Convertible, Zero-coupon, Bonds with warrants, Floating-rate
notes, Registered vs Bearer bonds, Collateral trust bond, Privately
placed bonds, public issue of bonds, callable/puttable bonds etc.)
- Syndicated loans

Different Types of Bonds:

Convertible Bonds: Bonds which are initially run as a debt instrument and
eventually converted into common stock
Bonds with warrants: Company sometimes issues a package of straight bonds
and warrants. Warrants are simply long-term call option that give investor right to
buy firm’s common stock. In case of convertible bond, the bond-holder simply
exchanges the bond for common stock, whereas in case of warrants, the bond-
holder choosing to exercise warrant puts in extra cash for acquiring common
stock.
Registered & Bearer Bonds: Company’s registrar records the ownership of each
bond and it pays interest and principal amount directly to the owner whose name
appears in the records of the company as bond-holder. In case of bearer bonds,
certificate constitute the primary evidence of ownership so the bond-holder must
return the certificate to the company to claim the final repayment of the
principal.
Zero-coupon Bonds: A bond that is issued at deep discount to its face value but
pays no interest. A zero-coupon bond is a debt security that does not pay interest
but instead trades at a deep discount, rendering a profit at maturity, when the
bond is redeemed for its full face value.
Callable/Puttable Bonds: Company, at times, issues bonds with a call option with
early repayment. In this case, company is at liberty to call the bonds for repayment.
In case of Puttable bonds give investors right to demand early repayment.
Euro Bonds: Bond issues that are denominated in one currency but marketed
internationally outside that country are known as Eurobonds. Eurobonds are
usually made in one of the major currencies such as U.S. Dollars, the Euro or the
Yen,
(Please also refer Table 24.3 of the Chapter 24 (Page 637) for some examples of
innovative bonds.)
 Security and Seniority
- Usually secured bonds are issued by private companies
- First mortgage or charge on fixed assets on a pari-passu basis with other
fixed charge holders
- Charge created on behalf of all debenture-holders by a trustee appointed
by the issuing company
- Also called mortgage-bonds
- Sometimes charge against specific fixed assets of the issuing company –
say building or assets of a particular division/plant of the company
- Sometimes securities (common stock or other investments) may also be
used as collateral e.g. Holding company having common-stock of
subsidiaries
- Seniority – in case of default, senior bonds come first in pecking order –
hierarchy of status
- Subordinated lender gets in line behind the general creditors but ahead
of the preferred stock-holders

 What is ‘charge’ on assets?

Assets of the company which are offered as security for repayment of the
debt underlying the bonds/loans is called charge. It is the right of a lender
to be paid from a borrower's assets if the debt is not paid on time. Charge is
created by way of mortgage of immovable properties of the issuing
company and hypothecation of movable assets of the company including
inventory, receivables etc.

 What is pari passu charge?

Meaning of pari passu charge – Pari-passu is a Latin phrase, which means

“equal footing”. ... “Pari Passu” charge means that when borrower company
goes into liquidation, the assets over which the charge has been created
will be distributed in proportion to the lenders respective outstanding dues.
Asset-Backed Securities

 Bundling a group of assets and then selling the cash flows from these
assets is known as asset-backed security or ABS
 Example: A large no. of mortgage loans to buyers of homes or commercial
real estate are bundled together and packages as securities or bonds.
Other examples are automobile loans, student loans and credit card
receivables are also often bundled and marketed as an asset-backed
security
 Intention is not to wait till until the loans are paid off and the issuer wants
to get his hand on the money now.
 Process of bundling a no. of future cash flows into a single security is
called securitization
 Also called collateralized debt obligations or CDO
 Securitization distributes the risk of the loans widely and because the
package (CDOs) can be traded, investors are not obliged to hold it to
maturity. Risk of CDO is less than that of any of the parts or individual
mortgage.
 Subprime mortgage: A type of loan granted to individuals with poor credit
scores, who as a result of their deficient credit histories, would not be able
to qualify for conventional mortgages.
 CDOs have disappeared after 2007 due to economy-wide slump in the
housing sector and exposure of CDOs subprime mortgages
Sinking Fund:

 A method to repay the principal on regular basis before maturity

 Option – I In cash of cash deposit in sinking fund, trustees select bond
by lottery to redeem them at face value. This will be resorted to if the
price of the bond is high.
 Option – II the company can choose to buy bonds in the market place
and pay this into the fund. If the bond price is low, the firm will buy the
bonds in the mrket and hand them to the sinking fund
Bond Covenants:
 Negative-pledge :A negative pledge clause is a type of negative
covenant that prevents a borrower from pledging any assets if doing so
would jeopardise the lenders’ security.
 Limitation on leasing
 Borrowing covenants
 Dividend or other payment restrictions
 Change in control/Merger restrictions
 Default-related events