Chapter 19 Business Borrowing: Corporate Bonds, Asset-Backed Securities, Bank Loans, and Other Forms of Business Debt

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.  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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction to Business Borrowing Business firms draw on a wide variety of fund sources to finance their daily operations and to carry out long-term investment. In 2003, nonfinancial business firms in the U.S. raised over $1.6 trillion, of which approximately $300 billion was supplied from the financial markets through issues of bonds, stocks, notes, and other financial instruments.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Characteristics of Corporate Notes and Bonds For a bond that matures in 10 years: Interest charges on debt are tax deductible, so k’ = k (1 – t).

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Characteristics of Corporate Notes and Bonds Signals that Corporate Bond Issues May 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Characteristics of Corporate Notes and Bonds Innovations in corporate debt include: -Discount bonds – including zero coupon bonds -Floating-rate bonds -Commodity-backed bonds – the face value is tied to the market price of an internationally traded commodity -Inflation-linked corporate notes -Medium-term notes (MTNs) – carry maturities of one to ten years

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Asset-Backed Securities Issued by Corporations The process that gives rise to the creation of asset-backed securities (ABS) is known as securitization. It involves: -Packaging groups of home mortgage loans, usually with guarantees issued by federal agencies, removing them from the lenders’ balance sheets, and placing them in a separate trust account. -Selling the new securities backed by the packaged loans in the open market with the help of an investment bank or other securities firm.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Asset-Backed Securities Issued by Corporations

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Asset-Backed Securities Issued by Corporations Securitization may: -Reduce the cost of raising funds -Grant companies greater control over their balance sheets -Help a company avoid the issuance of additional balance-sheet debt -Improve the apparent financial strength of an issuing firm -Permit greater asset diversification -Provide a new source of company earnings

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Asset-Backed Securities Issued by Corporations

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Investors in Corporate Debt Principal Investors in Corporate and Foreign Bonds, 2004* Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts: Financial Assets and Liabilities, First Quarter 2004.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Secondary Market for Corporate Debt The secondary market for corporate debt 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Marketing of Corporate Debt 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Marketing of Corporate Debt 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Marketing of Corporate Debt In recent years, private placements have accounted for about 10% 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Volume of Borrowing by Corporations

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Volume of Borrowing by Corporations 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

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Bank Loans to Business Firms Commercial banks are direct competitors with the corporate debt 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 securities in the open market, the volume of bank credit made available to business firms remains enormous.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 -asset-backed securitization

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Markets on the Net Bond Market Association at Bond Market Association – European Issues at CBS Marketwatch at CNN/Financial at

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Markets on the Net Financial Pipeline at Mortgage 101 at REBUZ – Commercial Mortgages at

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Introduction to Business Borrowing Factors Affecting Business Activity in the Money and Capital Markets

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Characteristics of Corporate Notes and Bonds -Principal Features -Recent Trends in Original Maturities -Call Privileges -Sinking Fund Provisions -Yields and Costs -Signals Corporate Bond Issues May Send -The Most Common Types of Corporate Bonds -Innovations in Corporate Debt

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Asset-Backed Securities Issued by Corporations Investors in Corporate Debt The Secondary Market for Corporate Debt The Marketing of Corporate Debt -Public Sales -Private Placements The Volume of Borrowing by Corporations

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Bank Loans to Business Firms -The Volume of Bank Credit Supplied to Businesses -The Prime, or Base, Interest Rate on Business Loans -Other Examples of Base Rates for Business Loans Commercial Mortgages