Debt Market

- Senior Debt → usually provided by banks or financial institutions pursuant a Credit Agreement,
characterized by low cost, variable interest rate, collateral, yearly ammortization of principal

- Subordinated Debt → usually high yield bonds, with higher cost, fixed interest rate, unsecured.

Loan Agreement:

- Note → specifies princial, interest rate and maturity

- Collateral → specifies the assets covering the contract.

- Borrower Guarantees → promise to assume the debt obbligation of the borrower in case of default.

- Events of Default → conditions in which the loan is considered in a default state.

Leveraged Loans:

Arranged by syndicates and granted to firms that already have an high leverage ratio and a low rating.
Unlike high yield bonds, they are not traded on the market, and they tend to be protected by covenants.

Lenders consider leveraged loans to carry a higher risk of default, and as a result, a leveraged
loan is more costly to the borrower. This operation is liked by financial institutions which struggle
to find high interest rates, in an era characterized by low ones (after 2008 crisis and regulation).

A leveraged loan is structured, arranged, and administered by commercial or investment bank.

These institutions are called arrangers and subsequently may sell the loan, in a process called
syndication, to other banks or investors to lower the risk to lending institutions (by bundling).

Hence, to be sold, levereged loans nedd to be securitized into CDOs through trenching…

Collateralized Loan Obligations:

Leveredge loans can be bundled in securities in order to be traded in financial markets as CLOs.
To do so they are divided into senior, mezzanine and junior tranches (in order of payment and risk).

This kind of operation is “abused” by banks, which on average retain less than 30% of their original
loans, while distributing more than 70% of them through CLOs (banks do not want to keep on
their own balances these very risky loans). These kind of operations obviously brings higher
systematic risk into the banking system, as info gets lost through many securitizations.
CLOs are in fact very sensible to economic downgrades, as they cause downgrading of bad loans…

This systematic risk is aggravated by the Fire-sales risk in the leveraged loan market: constrained CLOs
are forced to sell loans downgraded to CCC or below, which experience a temporary price depreciacion.
As CLO market grows, each CLO effort to diversify its portfolio leads to similarity in loan holdings in CLOs
creating overlapping in loans downgrading, hence, higher systematic risk and fire-sales spillovers.
Debt Market:

Firms looking for financing opportunities can use:

- Corporate bonds → direct issueing of bonds by firms, traded in opena market.

- Istitutional investors → loans granted by financial instutions.

- Bank Credit lines → loans granted by banks.

- Private Debt (PD) fund lending → funds granted by non-banks, not traded in opena market.

Private vs Public Debt:

The firms’ choice between public and private debt depends on the following factors:

- Interest rates→ private debt loans grant higher interest rates rather than banks’ loans.

- Regulation → after 2008 crisis, banks are very strict on whom they can grant loans to.

- Information Costs → when asking financing to a bank, you need to give them a lot of info.

There is no clean definition for PD non bank loans, but essentially it refers to rarely or never-traded
investments far beyond mainstream stocks and bonds, like farmland, real estate, infrastructure, venture
capital, direct lending and private equity. To the present day, PD market is larger than US’ HY market.

Those loans are granted by special porpouse veichles (SPVs), managed by private or public companies.
PD firms aise funds from institutional investors, which are limited partners (LP) who only provide capital.
On the other hand, General Partners (GP) are the ones with full liability, actually managing the firm.

Debt Covenants

Debt covenants are agreements between a company and its creditors that the company should operate
within “certain limits”: A company may agree to limit other borrowing or to maintain a certain level of
gearing. Other common limits include levels of interest cover, working capital and debt service cover

Debt covenants are agreed as a condition of borrowing, and their purpose is to

mitigate the agency problem between creditors and borrowers (conflict of interest).

In theory, breach of a debt covenant usually allows creditors to demand immediate repayment.
This rarely happens in practice. The debtor is not usually in a position to make an immediate repayment

Ambreach to the debt covenant can have different outcomes based on the contract that has been made.

In theory in case of breach, the creditor has the right to ask to the borrower the full loan immediately.
In reality the loan is negotiated again in terms which are more favourable to the lender.

- Negative Covenants → they specify what the borrower cannot do (don’t sell certain assets).

- Positive Covenants → they specify what the borrower must do (maintain financial ratios).
Covenants Violations

- Small firms are more likely to violate covenants.

- Unrated or Low ratings are more likely to violate covenants.

- After violation firms invest less, issue less debt (less credit) and same equity (leverage D/ E ↓).

- This goes on in the short term, but also in the medium-long period (up to 1 and a half year).

→ Companies violating or having violated covenants have progressive lower leverage ratio for 1,5 yrs.

Violations of debt covenants help to explain a particular family of capital structure theories:

The presence of covenants in debt agreements is motivated by their ability to mitigate incentive
conflicts between managers and creditors, and in particular bankruptcies costs. In fact, covenant
violations give creditors the right to demand immediate repayment and withhold further credit, hence,
providing a potential channel through which the misalignment of incentives can impact financial policy.

Violations Deeterminants:

What factors determine the speed of adjustment of financial policies after covenant violations?

∆ Net Debt Issuance=α + β firm characteristics+…+ui

The smaller (or negative) is the delta, the faster the firm adjusts its policies to covenants violations.

- Leverage Ratio → companies with high LR (Debt) correpsonds to speedier compliance (riskier).

- MB ratio → high ratio tend to adjust more slowly (creditors give more time as these are growth
stocks).

- Credit Rating → high rating tend to adjust more slowly (creditors trust more those companies).

Creditors Reaction to Violations:

What is Creditors’ Response to covenant violations in reality?

- In 65% of the cases creditors do almost nothing.

- In 35% of the cases creditors take actions: reduce credit, increase interest rate, add collateral…

The characteristics of a company for which lenders usually take no actions are high cash (pay debt).
Characteristics of a company to take on actions are high leverage ratio, usual violator, no cash or sales.