Money and Capital Markets 21 C h a p t e r Eighth Edition Financial Institutions and Instruments in a Global Marketplace Peter S. Rose McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu Business Borrowing

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin  Learning Objectives   To look at how business firms issue debt securities and negotiate loans in order to raise funds in the money and capital markets.  To learn about the key factors affecting the volume of funds that businesses seek to raise in the financial system.  To see the often powerful impact that business borrowing has upon market interest rates and credit conditions.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Introduction  Business firms draw on a wide variety of fund sources to finance their daily operations and to carry out long-term investment.  In 2000, nonfinancial business firms in the U.S. raised about $1,250 billion, of which approximately $860 billion was supplied from the financial markets through issues of bonds, stocks, notes, and other financial instruments.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Factors Affecting Business Activity in the Money and Capital Markets  Many factors affect the extent to which business firms draw on the money and capital markets for external funds:  Total funding demands of business firms  Level and expected growth of internally generated funds  Condition of the economy  Credit availability and interest rates

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Characteristics of Corporate Notes and Bonds  A note has an original maturity of five years or less, while a bond carries an original maturity of more than five years.  Both securities promise the investor an amount equal to the security’s par value at maturity plus interest payments at specified intervals.  They are generally issued in units of $1,000, and accompanied by indentures.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Characteristics of Corporate Notes and Bonds  Corporate bonds tend to be issued with longer maturities when both interest rates and inflation are low.  Some corporate bonds are backed by sinking funds.  A considerable proportion of corporate bonds that are outstanding today carry call privileges.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Characteristics of Corporate Notes and Bonds  During periods of rapid economic expansion, when the supply of credit is relatively scarce, the cost of borrowing rises.  Yields on the highest-grade bonds tend to move closely with government bond yields.  Yields carried by lower-grade corporate bonds are more closely tied to conditions in the economy and to factors specifically affecting the risk position of each borrowing firm.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Characteristics of Corporate Notes and Bonds The Signals that Corporate Bond Issues Send  A bond issue that appears to be driven by an unanticipated cash-flow shortage tends to lower the bond and equity prices of the issuer.  On the other hand, a new bond sold to expand the firm’s capitalization tends to send a positive signal to the market.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Characteristics of Corporate Notes and Bonds  Common types of corporate bonds include:  Debentures – bonds that are not secured by any specific asset  Subordinated debentures – junior securities  Mortgage bonds – may be closed end or open end  Income bonds – interest is paid only when income is actually earned  Equipment trust certificates – resemble leases  Industrial development bonds (IDBs) – issued by a local government borrowing authority

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Characteristics of Corporate Notes and Bonds  New types of corporate notes and bonds include:  Discount bonds – include zero coupon bonds  Floating-rate bonds  Commodity-backed bonds – the face value is tied to the market price of an internationally traded commodity  Medium-term notes (MTNs) – carry maturities of one to ten years

Investors in Corporate Bonds Data Source: Board of Governors of the Federal Reserve System

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin The Secondary Market for Corporate Bonds  The secondary market for corporate bonds is relatively limited compared to the markets for other long-term securities like common stock and municipal bonds.  The number of active individual investors is small and institutional investors tend to follow a buy and hold strategy.  Recently however, many institutions are looking at total performance and have become more aggressive.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin The Marketing of Corporate Notes and Bonds  New corporate bonds may be offered publicly in the open market to all interested buyers through a public sale, or sold privately to a limited number of investors via a private or direct placement.  The majority of corporate bond sales are public sales. Private placements are, however, popular among smaller companies and firms with unique financing requirements.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin The Marketing of Corporate Notes and Bonds  In a public sale, an investment banking firm or a syndicate of underwriters may either purchase the securities directly from the issuing company through a bidding process or guarantee the issuer a specific price for the securities.  In both approaches, the underwriter carries the risk of losses (or gains) when the securities are marked for sale in the open market.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin The Marketing of Corporate Notes and Bonds  In recent years, private placements have accounted for about 20% of market sales of corporate bonds.  Usually, periods of rising interest rates and reduced credit availability bring more borrowing companies into the public market, while falling interest rates often bring about a rise in private placements.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin The Volume of Borrowing In the Corporate Bond Market Volume of Outstanding Corporate and Foreign Bonds $ billions Data Source: Board of Governors of the Federal Reserve System

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin The Volume of Borrowing In the Corporate Bond Market  The growth in corporate borrowing is due to:  inflation  the increased use of financial leverage to boost returns to corporate stockholders  the development of international capital markets  recent relatively-low interest rates  the rash of corporate takeovers (leveraged buyouts) and mergers

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Bank Loans to Business Firms  Commercial banks are direct competitors with the corporate bond markets in making both short-term and long-term loans to businesses.  Although growing numbers of corporations that once relied on banks for funds have turned to selling bonds in the open market, the volume of bank credit made available to business firms remains enormous.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Bank Loans to Business Firms  The prime bank rate, or base rate, is the annual percentage rate that banks quote to their most creditworthy customers.  Traditionally, the prime rate was set by one or more of the nation’s leading banks, and the other banks followed the leader.  Nowadays however, prime rates are often pegged to the prevailing yields on Treasury bills and other money market instruments.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Commercial Mortgages  The construction of office buildings, shopping centers, and other commercial structures is generally financed with an instrument known as the commercial mortgage.  Faced with inflation and a volatile economy, new forms have been developed:  equity kicker  indexing  securitized commercial mortgages

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Money and Capital Markets in Cyberspace  More information about business borrowing can be found at:     

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Chapter Review  Introduction  Factors Affecting Business Activity in the Money and Capital Markets

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Chapter Review  Characteristics of Corporate Notes and Bonds  Principal Features  Original Maturities  Call Privileges  Sinking Fund Provisions  Yields and Costs  The Signals that Corporate Bond Issues Send  The Most Common Types of Corporate Bonds  New Types of Corporate Notes and Bonds

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Chapter Review  Investors in Corporate Bonds  The Secondary Market for Corporate Bonds  The Marketing of Corporate Notes and Bonds  The Public Sale of Bonds  Private Placements of Corporate Bonds  The Volume of Borrowing in the Corporate Bond Market

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Chapter Review  Bank Loans to Business Firms  The Prime, or Base, Interest Rate  Commercial Mortgages