Fund Raising with bonds

Vaibhav Jain
Associate, Credit Research
Copal Amba
• Used to finance a project. More often used in infrastructure, and oil & gas
rigs.

• Alternative source of funding for infrastructure projects.

• Longer duration of bond.

• Low cost of funding compared to bank loan.

• Basel 3 recommended strict capital requirements for capital on loans.

 Types of bonds

Issuer Priority Coupon Rate Redemption Feature

Corporate Senior/Subordinate Fixed Callable

Floating, and Inverse

Municipal Secured/Unsecured Floating Convertible

Government Zero Coupon Puttable


•Stringent Covenants.
•Typically 3-5 years
•Periodical principal
repayments are required
Bank Loan
by banks.
Equity
•Can be repaid at any time.
•Generally Senior Secured,
secured over first lien.
•Usually Floating Rate.
•Investors are banks, and
institutional funds.
•No standardization,
lender can manipulate
terms to large extent.
•Usually less onerous
covenants.
•Typically longer maturity.
Usually offered for 5-10 years.
•Usually very expensive •Usually bullet maturity,
•No repayment however they may be sinking
restriction. fund too.
•Restriction on periodical •Generally have non callable
Bonds
issue. period of some years initial
•Ownership dilution. years, giving relief to issuer.
•No. of regulatory Like PNC10, 10NC5, 8NC5,
requirements. 7NC4.
•Decline in earnings per •Can be secured, senior, or
share if additional stock subordinated
issued. •Fixed or Floating rate.
•High risk. •Investors are mutual funds,
pension funds, hedge funds,
insurance companies, and
asset managers.
•Standardized contract.
• Issuer is typically looking finance for a longer duration.

• Company is looking for a leveraged buy out.

• Typically softer covenants than a bank loan.

• Issuer has a stable, resilient business model.

• Access to debt market as it is expensive for the first time issue, however it costs low in

overall terms.

• Higher financing needs.

• Indenture: The promises of the issuer and the rights of the bondholders are set forth in
great details in a bond indenture.

• Covenants: as part of indenture, there are two types of covenants:

 Affirmative: Actions that the issuer promises to carry out.

 Negative: Impose restrictions on the issuer’s activities.

• Coupon: represents the interest payments made by issuer. Can be annual, semi annual,
and quarterly.
• Change of Control: Also called Poison Put. Sell bond back to issuer, if control changes.

• Cross Default: Bond is in default, if another security is in default.

• Equity Claw Back: Buy back bond up to 35-40% from equity offering. It takes place at predefined
price, like 100% + 1 year Coupon.

• Net Debt/EBITDA: Limitation to debt incurrence.

• Limitation on Guarantee: Limits and controls a company’s guarantee.

• Make Whole: Premium paid to debt investor above market value. Basically call at higher price.

• Negative Pledge: Guarantee by company that it will not pledge or place liens on assets, if it has
detrimental effect on current bond holders.
• Maturity:
 Also known as term to maturity.

 Tells number of years the bond will be outstanding.

 Yield: The yield offered on bond depends on the term. (Yield Curve)

 Price: The price of bond will fluctuate over its life time as interest rates in the market
change. The price volatility of a bond is a function of its maturity (directly
proportional)

 Interesting Fact: In July 1993, Walt Disney issued bonds with maturity date of
7/15/2093. (100 years bond)
• Z Spread:
 Zero Volatility spread
 Spread over Treasury yield curve required to discount bond to give its market value.
 Simply put, it is Risk premium

• OAS spread:
 Spread added to benchmark yield curve to match market price, using model which
adjusts the embedded option.
 Used to compare with non callable/puttable securities.
 Z Spread = OAS + Option cost
• Zero Coupon Bond:

 Not contracted to make coupon payments. Issued at a discount and redeem at par.

 Implied interest.

• Step up bonds:

 Coupon steps up over time.

• Floaters:
 Coupon rates are reset periodically according to some reference rate, like LIBOR,
EURIBOR
 Coupon Rate: Reference rate+ Quoted Margin. Reference Index

Quoted Margin
 Treasury Inflation Protection Security (TIPS):
Reset Frequency
 Special kind of FRN, which is linked to inflation.
Maturity date
 This type of bonds hedge the inflation risk.

 Cap: Restriction on maximum coupon.

 Floor: Restriction on minimum coupon.

 Collar: Restriction on both the ends.
• Hybrid bonds:
 Combine characteristics of both – Debt and Equity.

 Generally subordinated or Junior subordinated. Example: AT1 bonds, T2 bonds.

 At times senior also, with a convertible clause.

 Generally have a clause of conversion in equity.

 Conversion triggered by happening of an event.

 Redeemable, Perpetual.
• Mutual funds pool the assets of investors to create portfolios of bonds – HY funds,
income mutual funds, and corporate bond funds.

• Insurance companies invest their own capital in bonds.

• Pension funds invest in HY bonds to earn higher rates of return than those available
from IG bonds, or as an alternative to investing in an issuer’s stock.

• High-net-worth individual (HNI) investors purchase individual bonds, often as part of

a well-diversified investment portfolio.

• Hedge funds invest in distressed debt to maximize returns through their complicated
trading strategies.

• Investment banks invests in bonds through their proprietary desk.

Contractual

Structural

Effective
• Debt subordination arising from
indenture/contract Example of contractual subordination
• Debt subordination arising from contractual
agreement between the lenders Subordinated
Notes EUR900m

Waterfall
• Example: Operating
 Senior secured loans – EUR500m Senior secured
loans EUR500m loans
Company
 Subordinated Notes – EUR900m
 EBITDA – EUR250m
 EV/EBITDA – 7.00x
 EV – 1,750m
• Waterfall
 As both debts are issued by the operating
company, waterfall will be
 Most senior – EUR500m senior secured loans
 Subordinated debt – EUR900m
• No written contract between the parties.
• Parent Subsidiary structure is most basic form.
• Liabilities issued at HoldCo as well as OpCo level.
• Structural subordination of debt means placement of the debt away from the entity
generating income within the group’s organization structure.
• Weak credit quality of Holdco as compared to OpCo.
• Assumption: In bankruptcy, the senior debt will first be recovered from the operating
company’s assets before the structurally subordinated debt at the HoldCo receives any
pay-out, as debt is placed away from the cash flows.

A $500m Senior Notes

X Y Z
$500m Senior Notes
• Example
 Senior secured loans – EUR500m
Example of contractual subordination
 Senior Notes – EUR900m
 Senior Notes – EUR250m Senior
Notes EUR250m Holding
 EBITDA – EUR250m
Company
 EV/EBITDA – 7.00x

Waterfall
 EV – EUR1,750m Senior
Notes EUR900m
• Waterfall Operating
Senior secured
Company
 Most senior – EUR500m senior secured loans
loans EUR500m loans

 Subordinated debt – EUR900m PIK

 Least subordinated – EUR250m
Interest Rate Currency Reinvestment
Default Risk Inflation Risk
Risk Risk Risk
Rate the bonds.

Reflect the opinion of issuer’s creditworthiness.

Affect the interest rate that corporate can charge.

If they downgrade rating post issue, it may have a severe impact.

(Sometimes Poison Put)
• Three basic pillars: Institutions, Participants, and Instruments.

• Hedging instruments: Restricted use of derivatives like CDS.

• Regulatory reporting: Primary issue reporting is good, however regular reporting is very poor. No
disclosure at all.

• Liberalization: Much need of liberalization. Still dependent of bank loans, and to some extent equity.

• Lack of remedial action in default, like Chapter 11, and Chapter 7.

• Lack of proper benchmark yield curve. Mostly 10Y bonds, with very few of other maturities.

• Narrow Issuer base and limited instruments lead to illiquidity.