Corporate Debt: Bank Loans and Commercial Paper | CFA Level I Fixed Income
As we shift from government-related debt, let’s dive into the corporate sector. In this lesson, we’ll discuss how companies raise capital through bank loans, issuing commercial paper, and corporate bonds.
Companies, unlike governments, focus on profit and usually have smaller-scale borrowings. They raise debt to fund short-term spending needs and long-term capital investments.
Bank loans play a significant role in corporate debt financing, especially for small and medium-sized companies. In countries with underdeveloped bond markets, large companies also rely on bank loans.
- Bilateral loans are loans from a single bank to a borrower. These loans are often simpler and more straightforward due to the limited number of parties involved. However, they may be more challenging for borrowers seeking large loans, as a single bank may not be willing or able to provide the entire amount needed.
- Syndicated loans involve a group of banks, known as a syndicate, lending to a borrower. Syndicated loans are typically used for larger loans, where the risk is spread among multiple lenders. They often have more complex terms and conditions due to the involvement of multiple parties, but they can provide borrowers with access to more substantial funds.
A secondary market for syndicated loans has emerged, packaging and securitizing loans to be sold to investors.
Most bank loans are floating-rate loans, with interest rates based on a reference rate (e.g., LIBOR or the prime rate) plus a spread. These loans can be customized to meet the borrower’s needs.
For larger, creditworthy corporations, issuing commercial paper can be more cost-effective than taking out bank loans. Commercial paper is a short-term, unsecured debt instrument used to fund working capital or as a temporary source of funds before issuing longer-term debt.
Key features of commercial paper:
- US commercial paper (USCP) is issued in US dollars, with maturities up to 270 days.
- Eurocommercial paper (ECP) can be denominated in any currency, with maturities up to 364 days.
- USCP is typically issued as a pure discount security, while ECP can have either a discount yield or an interest-bearing yield.
Company A issues a $1 million, 180-day US Commercial paper with a 6% annualized interest rate. The discounted price is $970,000, and the par value of $1 million is returned to investors after 180 days.
Company B issues a 1 million pound, 180-day Eurocommercial paper with a 6% annualized interest rate on an interest-bearing basis. The par value of 1 million pounds plus the 30,000 pound interest is paid to investors after 180 days.
Note: The holding period yields are different, with 3.09% for the discount basis and 3% for the interest-bearing basis.
Rollover Risk and Backup Lines of Credit
Companies often reissue or roll over commercial paper when it matures. Rollover risk occurs when a company cannot sell new commercial paper to replace maturing paper due to deteriorating financial conditions or systemic financial distress. To obtain acceptable credit ratings, corporations maintain backup lines of credit with banks, providing funds when needed, except in cases of significant financial deterioration.
Advantages of Commercial Paper
- Lower interest rates: Compared to bank loans, commercial paper generally has lower interest rates, making it more cost-effective for creditworthy corporations.
- Flexibility: Commercial paper can be issued with various maturities and denominations, allowing corporations to tailor the debt to their specific needs.
- Market access: Issuing commercial paper can help corporations build a presence in the capital markets, potentially making it easier to access additional funding in the future.
- Liquidity: Commercial paper is often considered a liquid investment due to its short-term nature and active secondary market.
Disadvantages of Commercial Paper
Despite its advantages, commercial paper also has some drawbacks:
- Rollover risk: Corporations may face difficulty rolling over commercial paper if market conditions worsen or their credit ratings decline.
- Backup lines of credit: Companies often need to maintain backup lines of credit with banks, which can add to their overall borrowing costs.
- Limited investor base: Commercial paper is typically only accessible to large, creditworthy corporations, limiting the pool of potential issuers.
Corporate bonds are an essential form of public debt for larger companies.
While there is no universally accepted classification for corporate bond maturities, for our purposes, we’ll use the following:
- Short-term: original maturities of 5 years or less
- Intermediate-term: original maturities longer than 5 years and up to 12 years
- Long-term: original maturities longer than 12 years
Medium-term notes (MTNs) are a unique form of debt securities issued by corporations, offering continuous issuance to investors with maturities ranging from 9 months to 100 years.
Coupon Payment Structure
Corporate bonds can have various coupon payment structures:
- Conventional coupon bonds: fixed coupon payments
- Floating rate bonds: adjustable coupon payments based on metrics like market interest, inflation, or issuer’s credit quality
- Payment-in-kind coupon bonds: periodic coupon payments in the form of securities
- Deferred coupon bonds: no initial coupon payments, higher coupons later
- Zero-coupon bonds: sold at a discount to par, no coupon payments
Principal Repayment Structure
Bond issuers can structure the principal repayment of bonds in various ways:
- Bullet bonds: full principal repayment at maturity
- Sinking fund provision: periodic retirement of part of the bond issue to reduce credit risk
- Serial bond issue: bonds with several maturity dates, redeemed periodically
- Term maturity structure: all bonds mature on the same date
Corporate bonds can be structured with collateral backing to improve credit quality:
- Secured bonds: backed by some form of collateral
- Equipment trust certificates: secured by physical assets, like aircraft or railroads
- Collateral trust bonds: secured by financial assets, such as stocks or other bonds
- Unsecured bonds: claims on general assets, repaid after more senior bonds
These provisions grant rights to the issuer or bondholders when specific events occur:
- Call provision: issuer can redeem bonds before maturity at a predetermined price
- Put provision: bondholder can sell bonds back to issuer before maturity at a predetermined price
- Convertibility option: bondholder can convert bonds into a specified number of the issuer’s common shares