#16814 - Debt Securities - Banking Law Notes

Terminology:

• Debt securities:

  • Tradable instruments.

  • Loans embodied in tradable instruments.

• Bonds:

  • Longer-term debt securities, usually in the range of 10 to 30 years or even longer.

  • May be secured or unsecured.

• Notes:

  • Shorter maturity, usually in the range of 1 to 10 years.

  • Floating interest rate.

  • Usually issued as part of a (securitisation) programme.

• Commercial papers:

  • 1 year or less.

Issuers and investors:

• Issuers:

  • Large public non-financial companies (that are often rated by Credit Rating Agencies). This is because the process of issuing debt securities is pretty costly.

  • Financial institutions.

  • Governments (e.g. US Treasury bonds, UK gilts, German bunds, etc.).

  • Municipal entities.

• Investors:

  • Institutional investors (such as pension funds, insurance companies, etc.).

  • Bank and non-bank financial institutions (such as hedge funds).

  • Retail investors.

Wide Variety:

• Covenants and warranties tend to be less restrictive with debt securities than with loans.

  • Why is this so?

  • This is because debt securities are transferable and there is an active secondary market for them. It is much easier for investors to “exit” their investment.

  • Because of the sheer number of investors in, and the fundamentally liquid nature of, debt securities, the associated covenants and warranties must be standardised or it will otherwise be too cumbersome for these securities to be traded.

• Interest and payment structure:

  • Plain vanilla bonds.

    • Bearer’s securities in the past: the cash flow rights to interest and principal passes together with the property in the paper itself.

    • There are small coupons that are detachable from the paper that each represent interest payments, and the paper itself represent payment of the principal.

    • C.f. the registered securities of today.

  • Zero coupon bonds.

    • I.e. no coupon payments; only a lump sum payment of the principal amount at the end.

    • E.g. Treasury bonds issued by the US government.

  • Coupon bonds.

  • Fixed or floating interest rate.

  • High-yield (junk) bonds.

    • They are usually contractually or structurally subordinated. They are riskier, and therefore carry a higher rate of return (and therefore the label of “high-yield”).

    • Some of them are rated so poorly by rating agencies that they are considered “junk”.

  • Loan notes.

  • Payment-in-kind notes.

    • Helps private equity companies to avoid capital gain tax hikes.

  • Perpetuities (i.e. consoles).

    • They never pay back the principal, but pay back the coupon rate indefinitely into the future.

    • They most closely resemble equity, and are oftentimes considered hybrid instruments.

• Redemption:

  • “Call option” for the issuer.

    • The issuer may use early redemption when interest rates go down, and he can obtain the same capital more cheaply from other sources in the market.

  • “Put option” for the holder.

    • The bond holder is thereby entitled to force early redemption by the issuer.

    • They may use early redemption when interest rates go up, and they can obtain greater returns by lending to other sources.

• Security and subordination:

  • Asset-backed securities.

  • Securitisation.

  • Deep subordination.

• Hybrids:

  • Option to convert to, or to exchange into, equity.

  • Equity warrants.

  • Contingent convertible securities (CoCos).

    • They convert automatically into equity thereby recapitalise the financial institution in question. They are therefore regarded as additional Tier 1 capital.

    • That conversion is pegged to certain benchmarks, such that, if triggered, CoCos will automatically convert from debt into equity so as to (i) reduce the financial institution’s debts and (ii) increase its equity cushion.

    • This helps the financial institution to meet the requirements regarding regulatory capital.

Bond prices and interest rates

• A bond specifies the fixed amounts to be paid and the exact dates of payment.

• E.g. 100 face value, 5% annual coupon bond with 5 year maturity.

  • 5% = Coupon yield.

  • Yield to maturity = The rate of return that the bondholder receives by holding the bond to maturity.

• What is the bond price if the discount rate is 4%, 5%, or 6%?

  • Discount rate is what we figure out through the CAPM formula.

  • It is the opportunity cost of incurred by us in investing our money in the bond.

  • P = 100/(1 + r)⁵ + ⁵_j=15/(1 + r)^j

    • P(4%) = 104.45

    • P(5%) = 100

    • P(6%) = 95.79

    • This means the, as the interest rate goes up, the opportunity cost goes up, and bond price goes down.

  • Some conclusions:

    • Rising bond prices means falling yields.

    • Falling bond prices means rising yields.

    • Bond price = face value; Coupon rate = yield to maturity.

• E.g. 100 face value, 5% annual coupon bond with 5 year maturity.

  • Coupon rate = yield to maturity.

  • Yield to maturity (interest rate) decreases/increases to 4%/6%.

  • Sell after one year.

• For what price can the bond be sold after 1 year?

  • After one year holding period, selling a 4-year bond:
    P = 100/(1 + r)⁴ + ⁴_j=15/(1 + r)^j

  • P(4%) = 103.63

  • P(6%) = 96.53

• What is the 1-year holding period rate of return?

  • P(4%) = 5/100 + (103.63 - 100)/100 = 8.63%

    • If I sell the bond after have held it for a year, I will get 5 (the annual coupon payment) + 103.63 (the amount that I will sell the bond for).

    • Assuming that I paid 100 to buy the bond, my 1-year holding period rate of return is therefore (5 + 103.63 - 100)/100 = 8.63%

  • P(6%) = 5/100 + (96.53 - 100)/100 = 1.53%

Supply, demand, and equilibrium:

• Supply increases with bond price, whilst demand decreases.

• Equilibrium is reached at the bond price where supply precisely equals demand.

• Shifting supply:

  • Government borrowing:

    • Increase in supply.

    • Decrease in prices.

  • General business conditions (are good):

    • More borrowing.

    • Increase in supply.

    • Decrease in prices.

  • Expected inflation:

    • Higher expected inflation.

    • Cost of borrowing falls. This is because, with high inflation, the same amount of money is worth very little (in real terms), but they can use the same amount of paper money to pay back the debt.

    • Increases bond supply, because it is much cheaper for issuers to borrow money through the issuance of bonds.

• Shifting demand:

  • Wealth:

    • Increase in wealth.

    • Increase in demand, increase in prices.

  • Expected inflation:

    • Fall in expected inflation.

    • “Inflation erodes the purchasing power of a bond’s future cash flows”; fall in expected inflation therefore = increase in the future purchasing power of a bond’s future cash flows.

    • Increased demand.

  • Expected returns and expected interest rates:

    • When stock market drops, increased demand for bonds.

  • Risk relative to alternatives:

    • Less risk, increased demand.

  • Liquidity relative to alternatives:

    • More liquid, increased demand.

Bond ratings:

Issue Process: Eurobonds

• This is the most commonly used process for bond issuance (by both the number of issuances and monetary value of bonds issued).

• An investment bank acts as manager for the issuer. The manager may then approach other investments banks to act as co-managers.

  • The manager (and co-managers) will underwrite the issuance and thereafter market the bonds to their clients.

• The process:

  • The lead manager advises the issuer on:

    • The terms of the issue; and

    • Questions regarding whether the bonds should be listed or not.

  • The managers will underwrite the issue.

    • They are jointly and severally liable for underwriting the issue.

    • This means that the managers are effectively taking up the risks associated with the marketability (or, more precisely, the lack thereof) of the bonds.

  • The managers will market and sell the bonds to investors. This can occur through:

    • A public offer (which requires a fully-fledged prospectus, and is a rather expensive process that is really only available to substantial public companies and not SMEs);

    • A private placement; or

    • A sale to individual investors.

    • The latter two do not require a fully-fledged prospectus, but still require an information circular.

  • The investors will pay through a paying agent (who is acting on behalf of the issuer).

• Dematerialisation and Immobilisation:
  

  • I.e. The securities are no longer issued in material form and are held at an immobile depository

    • C.f. the coupon bonds of the past, which are issued in paper form, and are passed around from one party to another as they are bought and sold on the secondary market.

  • Securities are placed with international central securities depositories (such as Euroclear and Clearstream).

    • For registered securities, a nominee for the ICSD will appear on the register.

    • For bearer securities, the global note will be stored with the ICSD or its nominee. I.e. The securities still come in paper form, but are stored in a fixed location.

    • The securities will always be stored in the form of fungible pools of securities.

  • The system participants each maintain an account with the ICSD.

    • The system participants, in turn, maintains accounts with their clients and brokers. The securities are allocated through these accounts to the clients and brokers.

    • The investors, in turn, maintain accounts with their banks or brokers. The securities are further allocated through these accounts to the actual investors.

    • The...