Chapter 5: Long-term Debt Financing

Tunis Business School-Senior Major : Finance and Accounting -Fall 2021-

Dr: Manara Abdelaziz Toukabri

Prerequisite:
One of the basic distinction of the modern theory and practice of corporate finance classify
securities issued by a corporation roughly as equity or debt.

Equity Debt

securities

At its crudest level, debt represents something that must be repaid, it is a result of borrowing
money.

When corporation borrow, they contract to make regularly scheduled interest payments and to
repay the original amount borrowed (that is the principal).

The person making the loan is called a creditor or lender.

Interest versus dividend.

▪ The corporation borrowing the money is called a debtor or borrower.

▪ The amount owed the creditor is a liability of a corporation, however it is a liability of
limited value.
▪ From a financial point of view, the main difference between a debt and an equity are
the following:
✓ Debt is not an ownership interest in the firm. Creditors do not usually
have voting power. The device used by creditors to protect themselves
is the loan contract: the indenture.
✓ The corporation’s payment of interest on debt is considered a cost of
doing business and is fully tax deductible. Thus, interest expense is
paid out to creditors before the corporation tax liability is computed. /
Dividend on common and preferred stock are paid to shareholders after

1
 tax liability has been determined. Dividend are considered a return to
shareholders on their contributed capital.
✓ Unpaid debt is a liability of the firm. If is not paid, the creditors can
legally claim the assets of the firm. This action may result in liquidation
and bankruptcy.

Introduction:
Chapter 1 introduced the mechanics of new long-term financing with an emphasis on equity. This
chapter takes a closer look at long term debt instruments.

Debt

other types of Debt corporate Debt

Quasi- Government Supranational

sovreign Bond Non sovreing Bond Public Private
Bonds Bonds

Term Loan
Corporate notes and
Secured Debt unsecured Debt (bilateral/syndicated Private placement
bonds.
)

Mortage Bonds asset backed bonds notes Depentures*

1. Corporate Debt:
Companies differ from governments and government- related entities in that their primary
goal is profit; they must be profitable to stay in existence.

Thus, profitability is an important consideration when companies make decisions, including

financing decisions. Companies routinely raise debt as part of their overall capital structure,
both to fund short- term spending needs (e.g., working capital) as well as long- term capital
investments.

We can focus on publicly issued debt, but loans from banks and other financial institutions are
a significant part of the debt raised by companies. For example, it is estimated that European

2
companies meet 75% of their borrowing needs from banks and only 25% from financial
markets. In Japan, these percentages are 80% and 20%, respectively. However, in the US
debt capital is much more significant: 80% is from financial markets and just 20% from
bank lending. (2018)

1.1. Private debt

Bank loans are an example of private debt, debt that is not publicly traded.
The private debt market is larger than the public debt market.
Private debt has the advantage that it avoids the cost of registration but has the
disadvantage of being illiquid.
There are segments of the private debt market:

➢ Loans (bilateral and syndicated),

➢ Private placements
➢ Corporate notes and bonds.

A) Bank Loans and Syndicated Loans

➢ A bilateral loan:
A bilateral loan is a loan from a single lender to a single borrower.

Companies routinely use bilateral loans from their banks, and these bank loans are governed
by the bank loan documents.

Bank loans are the primary source of debt financing for small and medium- size companies as
well as for large companies in countries where bond markets are either under- developed or
where most bond issuances are from government, government- related entities, and financial
institutions.

Access to bank loans depends not only on the characteristics and financial health of the
company, but also on market conditions and bank capital availability

➢ A syndicated loan:
A syndicated loan is a loan from a group of lenders, called the “syndicate,” to a single
borrower.

A syndicated loan is a hybrid between relational lending and publicly traded debt.

Syndicated loans are primarily originated by banks, and the loans are extended to companies
but also to governments and government- related entities.
3
The coordinator, or lead bank, originates the loan, forms the syndicate, and processes the
payments.

In other words; the concept of syndication:

▪ Very large banks have a larger demand for loans than they can supply, and
small regional banks have frequently more funds on hand than they can
profitably lend to existing customers.
▪ Basically, they cannot generate enough good loans with funds they have
available.
▪ As a result, a very large bank may arrange a loan with a firm or country and
then sell portions of it to a syndicate of others banks.

B) Private Placements:
A private placement is a bond issue that does not trade on a public market but rather is sold
to a small group of investors.
Because a private placement does not need to be registered, it is less costly to issue.
Instead of an indenture, often a simple promissory note is sufficient.
Privately placed debt also need not conform to the same standards as public debt; as a
consequence, it can be tailored to the particular situation.
Private placements sometimes represent a step in the company’s financing evolution
between syndicated loans and public offerings.

C) Corporate notes and bonds:

Companies are active participants in global capital markets and regularly issue corporate
notes and bonds. These securities can be placed directly with specific investors via private
placements or sold in public securities markets.

1.2. Public debt:

Global fixed- income markets represent the largest subset of financial markets in terms of
number of issuances and market capitalization. These markets bring borrowers and lenders
together to allocate capital globally to its most efficient uses. Fixed- income markets include

4
not only publicly traded securities, such as commercial paper1, notes, and bonds, but also
non- publicly traded loans.

The Institute of International Finance reports that the size of the global debt market
surpassed USD 247 trillion in the first quarter of 2018.

Understanding how fixed- income markets are structured and how they operate is important
for debt issuers and investors. Debt issuers have financing needs that must be met. For
example, a government may need to finance an infrastructure project, a new hospital, or a
new school. A company may require funds to expand its business. Financial institutions also
have funding needs, and they are among the largest issuers of fixed- income securities.

Fixed income is an important asset class for both individual and institutional investors.

1.2.1. Bonds
The general procedures followed in a public issue of bonds are the same as those for stocks.
The issue must be registered with SEC (or other). The registration statement for a public issue
of bonds is different from common stock: for bonds, the registration statement must indicate
a trust deed which is the legal contract that describes the form of the bond, the obligations of
the issuer, and the rights of the bondholders. Market participants frequently call this legal
contract the bond indenture, particularly in the United States and Canada.

The bond Indenture:

Because it would be impractical for the issuer to enter into a direct agreement with each of
many bondholders, the indenture is usually held by a trustee.

The trustee is typically a financial institution with trust powers, such as the trust
department of a bank or a trust company.

The indenture is a written agreement, can be a document hundred pages, between the
corporation (the borrower) and a trust company it generally includes:

1
Commercial paper is a short- term, unsecured promissory note issued in the public market or via a private
placement that represents a debt obligation of the issuer. Commercial paper is a valuable source of flexible,
readily available, and relatively low cost short- term financing. It is a source of funding for working capital and
seasonal demands for cash. Traditionally, only the largest, most stable companies issued commercial paper

5
 Trust
Corporation
Indenture company
A
Details of
The basic description The Sinking
the Call
terms of of property seniority of fund
protective provision
bonds used as the bonds agreement
covenants
security

A trust company:

Is appointed by the corporation to represent the bondholders (a bondholder is an investor

or owner of debt securities that are typically issued by corporations and governments.
Bondholders are essentially lending money to the bond issuers).

In the event of default, the discretionary powers of the trustee increase considerably. The
trustee is responsible for calling meetings of bondholders to discuss the actions to take.
The trustee can also bring legal action against the issuer on behalf of the bondholders

The trust company must:

➢ Be sure the terms of indenture are obeyed

➢ Manage the sinking funds
➢ Represent bondholders if the company defaults on its payments.

a) Basic terms:
Bonds usually have a face value, called also the principal value and it is stated on the bond
certificate. In addition, the par value (initial accounting value) of a bond is the same as the
face value.Transactions between bond buyers and bond sellers determine the market value of
the bond.

b) Security:
Debt securities are classified according to the collateral protecting bondholders. Collateral is a
general term for the assets that are pledged as security for payment of debt.

c) Seniority:
In general terms, seniority indicates preference in position over other lenders and debts are
sometimes labeled “senior” or “junior” to indicate seniority. Some debts are subordinated. In
the event of default, holders of subordinated debt must give preference to others special

6
creditors. Usually, this means that the subordinated lenders are paid off from cash flow and
asset sales only after the specified creditors have been compensated.

However, debt cannot be subordinated to equity.

d) Protective covenants :
Bond covenants are legally enforceable rules that borrowers and lenders agree on at the
time of a new bond issue. An indenture will frequently include affirmative (or positive)
and negative covenants.

In other words, protective covenant is that part of the indenture or loan agreement that
limits certain actions of the borrowing company.

Covenants are clauses that specify the rights of the bondholders and any actions that the
issuer is obligated to perform or prohibited from performing. Protective covenants can be
classified in two types: negative covenants and positive covenants.

Negative covenants: Positive covenants:

Limits or prohibits actions that the company may take Specifies an action that the company agrees to take or a
condition the company must. Affirmative covenants are
typically administrative in nature.

Limitations are placed on the amount of dividend a company The issuer may promise to comply with all laws and
may pay. regulations, maintain its current lines of business, insure and
maintain its assets, and pay taxes as they come due
The firm cannot pledge any of its assets to other lenders.

7
 The firm cannot merge with another firm.

The firm may not lease or sell its major assets without the
approval by the lender.

The firm cannot issue additional long term debt

e) The sinking funds (credit enhacements) :

A sinking fund arrangement is a way to reduce credit risk by making the issuer set aside funds
over time to retire the bond issue. Credit enhancements refer to a variety of provisions that
can be used to reduce the credit risk of a bond issue. Thus, they increase the issue’s credit
quality and decrease the bond’s yield.

For example, a corporate bond issue may require a specified percentage of the bond’s
outstanding principal amount to be retired each year. The issuer may satisfy this requirement
in one of two ways. The most common approach is for the issuer to make a random call for
the specified percentage of bonds that must be retired and to pay the bondholders whose
bonds are called the sinking fund price. Alternatively, the issuer can deliver bonds to the
trustee with a total amount equal to the amount that must be retired. To do so, the issuer may
purchase the bonds in the open market. The sinking fund arrangement on a term maturity
structure accomplishes the same goal as the serial maturity structure—that is, both result in a
portion of the bond issue being paid off each year.

In other words; a sinking fund; is an account managed by the bond trustee for the purpose of
repaying the bonds. Typically, the company makes yearly payments to the trustee. The trustee
can purchase bonds in the market or can select bonds randomly using a lottery and purchase
them, generally at face value. ***

Sinking funds have two opposing effects on bondholders:

1) Sinking funds provide extra protection to bondholders: a firm experiencing

financial difficulties would have trouble making sinking fund payments. Thus, sinking
fund payments provide an early warning system to bondholders.
2) Sinking fund give the firm an attractive option: if bond prices fall below the face
value, the firm will satisfy the sinking fund by buying bonds at the lower market
prices. If bond prices rise above the face value, the firm will buy the bonds back the
lower face value.
8
 f) The call provision:

A call provision lets the company repurchase or call the entire bond issue at a
predetermined price over a specified period. Historically, the call price was set above the
bond’s face value of $1, 000. The difference between the call price and the face value is
the premium.

Call provisions are not usually operative during the first years of a bond’s life. For
example, a company may be prohibited from calling its bonds for the first 10 years. This
is refereed to as deferred call.

https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-
bulletins/investor-bulletins/what-are

2. Other debts :

2.1. SOVEREIGN BONDS

National governments issue bonds primarily for fiscal reasons—to fund spending when tax
revenues are insufficient to cover expenditures. To meet their spending goals, national
governments issue bonds in various types and amounts.

Sovereign bonds denominated in local currency have different names in different countries.
For example, they are named US Treasuries in the United States, Japanese government bonds
(JGBs) in Japan, gilts in the United Kingdom, Bunds in Germany, and obligations
assimilables du Trésor (OATs) in France.

Names may also vary depending on the original maturity of the sovereign bond. For example,
US government bonds are named Treasury bills (T- bills) when the original maturity is one
year or shorter, Treasury notes (T- notes) when the original maturity is longer than one year
and up to 10 years, and Treasury bonds (T- bonds) when the original maturity is longer than
10 years.

Sovereign bonds are usually unsecured obligations of the sovereign issuer—that is, they are not
backed by collateral but by the taxing authority of the national government.

Highly rated sovereign bonds denominated in local currency are virtually free of credit risk. Credit
rating agencies assign ratings to sovereign bonds, and these ratings are called “sovereign ratings.”

9
 2.2. Non- Sovereign Bonds
Levels of government below the national level such as provinces, regions, states, and cities
issue bonds called non- sovereign government bonds or non- sovereign bonds. These bonds
are typically issued to finance public projects, such as schools, motorways, hospitals, bridges,
and airports. The sources for paying interest and repaying the principal include the taxing
authority of the local government, the cash flows of the project the bond issue is financing, or
special taxes and fees established specifically for making interest payments and principal
repayments. Non- sovereign bonds are typically not guaranteed by the national government

2.3. Quasi- Government Bonds :

National governments establish organizations that perform various functions for them. These
organizations often have both public and private sector characteristics, but they are not actual
governmental entities. They are referred to as quasi- government entities, although they take
different names in different countries. These quasi- government entities often issue bonds to
fund specific financing needs. These bonds are known as quasi- government bonds or agency
bonds. Examples of quasi- government entities include government- sponsored enterprises
(GSEs) in the United States, such as the Federal National Mortgage Association (“Fannie
Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”), and the Federal
Home Loan Bank (FHLB). Other examples of quasi- government entities that issue bonds
include Hydro Quebec in Canada.

2.4. Supranational Bonds

A form of often highly rated bonds is issued by supranational agencies, also referred to as
multilateral agencies. The most well- known supranational agencies are the International
Bank for Reconstruction and Development (the World Bank), the International Monetary
Fund (IMF), the European Investment Bank (EIB), the Asian Development Bank (ADB), and
the African Development Bank (AFDB). Bonds issued by supranational agencies are called
supranational bonds.
Highly rated supranational agencies, such as the World Bank, frequently issue large- size
bond issues that are often used as benchmarks issues when there is no liquid sovereign bond
available

10
11