The Priority of Payment

In the event of the insolvency of a company, there is a priority of claims on the assets of the company. The degree to which this actually happens depends on the legal environment of the country. A typical priority structure would be:

Institutional Investors

In today’s financial world, the role of the investors is a crucial one. Banks have moved away from taking the majority of risk on their balance sheet from clients who wish to raise capital. As a result, banks need to find providers of capital who wish to take risk and invest in those companies who are raising money.

There are a wide variety of investor types and we shall examine the principal ones. 

Trading Bonds

As we have said, there is a secondary market in bonds. However, the ease with which one can trade different types of bond varies widely. Bonds that are liquid are ones which are easy to trade. Such bonds would trade in large volumes with large individual ticket sizes, a narrow spread between the bid and offer price (i.e. the buy and the sell price), many market makers being willing to make a price, and the ability to trade in large size without moving the price significantly. Government bonds are usually the most liquid bonds. Most corporate bonds become fairly illiquid after issuance, particularly if they have been purchased by “buy and hold” investors who, by their nature, trade infrequently. Complex securities, such as structured credit instruments are not very liquid. The lack of liquidity in these bonds came into sharp focus as the fallout from the sub-prime crisis in the United States spread in the second half of 2007. 

Bond Risks

Interest Rate Risk

Interest rate risk is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond’s duration, a technique used to manage interest rate risk exposure.

There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:

1.      Marking to market, calculating the net market value of the assets and liabilities.

2.      Stress testing the market value by shifting the yield curve in a specific way. Duration is a stress test where the yield curve shift is parallel.

3.      Calculating the Value at Risk (VaR) of the portfolio.

4.      Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves.

5.      Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.

Credit Risk

Credit risk is the risk of loss due to a debtor’s non-payment of a loan or other line of credit, either the principal or interest or both. The higher the perceived risk the more spread over a risk free rate will be required. A recent innovation to protect lenders and bond holders from the danger of default are credit derivatives, most commonly in the form of a credit default swap. These financial contracts allow users to buy protection against defaults from a third party, the protection seller. The protection seller receives a periodic fee (the credit spread) as compensation for the risk it takes and in return, it agrees to buy the debt at the defaulted market price, should a credit event (“default”) occur.

Liquidity Risk

Liquidity risk arises from situations in which a party interested in trading an asset cannot do so because there is no counterparty willing to purchase the asset. Liquidity risk becomes significant during times of market distress, since it affects the ability to execute trades with immediacy, depth and resilience.

This risk is very different from a significant drop in price. A fall to a price of zero is saying that the asset is worthless. Liquidity risk is usually found more often in emerging markets or low-volume markets. Liquidity is one of the most unstable and difficult to measure risk parameters.

Bonds Issued by Foreign Entities

Many non-domiciled issuers may target foreign currency markets either to access alternative global investment capital or those markets that may appear to be more stable and predictable than their domestic currency. Note that foreign issuance is subject to strict local banking regulations.

The proceeds from the issuance of these bonds can be used by companies to break into foreign markets, or can be converted into the issuing company’s local currency to be used for existing operations. Foreign issuer bonds can also be used to hedge foreign exchange rate risk. The table below lists some of the generic issuance “labels”:

Eurobond	A bond issued outside the issuer’s domestic market and jurisdiction
Eurodollar	USD bond issued by a non-US entity outside the US
Yankee	USD bond issued by a non-US entity in the local market
Maple	CAD bond issued by a non-Canadian entity in the local market
Samurai	JPY bond issued by a non-Japanese entity in the local market
Shogun	Non-JPY bond issued by a non-Japanese entity in the local market
Kangaroo	An AUD bond issued by a non-Australian entity in the local market
Panda	A Chinese renminbi bond issued by a non-Chinese entity in the Peoples Republic of China
Matrioshka	RUB bond issued by a non-Russian entity in the local market
Kimchi	Non-KWR bond issued by a non-Korean entity in the local market

Types of Bonds

Fixed rate bonds have a coupon that remains constant throughout the life of the bond. These bonds are therefore sensitive to the general interest rate environment, and as rates rise the bonds lose value. Floating Rate Notes (FRNs or floaters) pay a coupon that is linked to a money market index, such as LIBOR or EURIBOR, e.g. three-month USD LIBOR + 0.50%. Since the coupon is reset periodically, typically every three months, these bonds are generally insensitive to interest rate movements.

Zero-coupon bonds pay no interim interest. All interest is compounded at the initial internal rate of return and paid out as a lump sum at maturity. As such, they trade at a discount to par value. The main benefit for investors of zero-coupon bonds is the elimination of coupon reinvestment risk. Issuers have the advantage of delaying the interest cash outlay until maturity. However, from a credit risk viewpoint, zero-coupon bonds have more risk as investors have to wait until maturity to receive any income.

High yield bonds are bonds that are rated below investment grade by the credit rating agencies (see section on credit ratings). As these bonds are relatively risky, investors expect to earn a higher yield. These bonds are also called junk bonds or speculative grade securities. High yield bonds tend to be relatively illiquid and are also highly sensitive to the credit quality of the issuer (volatile credit spread that is priced into the bond value expressing the market implied default risk).

Subordinated bonds are those that have a lower priority (than other bonds of the same issuer) in terms of claims over the corporate assets in cases of liquidation. The order in which recovery values are allocated after a default follows what is referred to as the priority of payment, more commonly known as the “waterfall”. Since subordinated bond holders are paid after senior obligations, the risk is higher. Consequently, they have lower credit ratings than obligations higher up the capital structure.

Inflation-linked bonds, in which both the principal amount and the coupon payments are indexed to inflation, offer real rates of return. Therefore, the initial coupon is lower than comparable conventional bonds of the same maturity. However, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation-linked Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation-linked bonds issued by the US government. The largest inflation bond market in the Eurozone is in France.

Asset-Backed Securities (ABS) are bonds whose interest and principal payments are backed by cash flow receivables from a pool of underlying assets. Examples of asset-backed securities are Mortgage-Backed Securities (MBSs), Collateralised Mortgage Obligations (CMOs) and Collateralised Debt Obligations (CDOs).

Municipal bonds are securities issued by a state, city, local government, or their agencies primarily in the US. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, subject to local jurisdiction. 

Debt Securities & Bond Characteristics

Debt Securities

A bond is a debt obligation contracted by an issuer/borrower, where the issuer is obliged to make regular payments of both interest and principal. Compared with loans, there is a much more active secondary market and bonds can be sold without requiring the approval of the borrower.

Bond Characteristics

Bonds have the following attributes:

• They generally do not have flexible payment structures. The bond indenture, specifying the rights of bond holders, generally requires approval by a majority (substantial) vote before amendments can be made to the documents
• Their issuance requires some form of public disclosure (the amount of information depends on the market used for issuance)
• Bonds are much easier to sell to investors when they have a credit rating
• The maturity of bonds can be much longer than for bank loans. For example, bank loans are rarely longer than seven years (perhaps beyond ten years for property loans), whereas bonds can be issued with maturities of thirty years and beyond. There are three groups of bond maturities: short term (bills) for maturities up to one year; medium term (notes) for maturities between one and ten years, and long term (bonds) for maturities greater than ten years
• Bonds can be issued paying either fixed or floating interest. Floating rate bonds are called FRNs (Floating Rate Notes). Each year, the amounts of fixed or floating bonds issued vary according to the inclinations of issuers and investors. In the US, most bonds pay a coupon on a semi-annual basis while in Europe, most bonds are annual and pay only one coupon a year. It is also worth noting that each currency market assumes a different day count convention when calculating the accrued interest payable for each coupon (actual/360, actual/365, 30/360 or actual/actual)
• Bonds are less likely to have restrictive covenants. However, in recent years, investors have been able to achieve more protection, particularly the change of control covenant
• Some bonds may contain embedded optionality that grants either the holder or the issuer certain predefined rights. Callable bonds give the issuer the right to repay the principal before the scheduled maturity date on specified call dates at a price typically around the bond’s par value. Such structures are frequently used in the US agency and high yield markets. Puttable bonds offer holders the right to force the issuer to repay the bond before the maturity date on the specified put dates; offering investors extra protection against declining creditworthiness.

Types of Facilities

A revolving credit facility is one where the borrower has the ability to repay and redraw (rather like an overdraft).

A term loan, if repaid early, cannot be redrawn.

A bilateral loan is made by one bank to a borrower.

A club deal is where a large borrower arranges for a small group of relationship banks to lend it money. The operation is controlled by the borrower.

Most companies borrow money under a syndicated loan. Here, the arranging bank (appointed by the borrower) manages a syndicate of banks who all lend money on the same terms. The arranging bank controls the process. Upfront fees are paid according to the size of commitment made. The advantages of syndicated lending are that the loan is much more likely to be priced and structured correctly and the borrower saves valuable negotiating time.

It can be argued that large commercial banks grant loans to customers below economic fair value in order to ingratiate themselves with customers in the expectation of winning more lucrative business such as mergers and acquisitions, arranging equity or bond finance, and derivatives. This is more often the case during buoyant economic conditions. 

Covenants

A covenant is a restriction placed on a borrower designed to afford protection to lenders. If a covenant is breached, the loan may have to be repaid early. There are two basic types of covenants.

Maintenance covenants would set minimum levels on financial indicators such as profitability, cash flow, liquidity and interest cover, and maximum levels on gearing.

Incurrence covenants would restrict a company in:

•   Taking on more debt
•   Payment of dividends or other distributions subject to certain criteria
•   Sale or transfer of assets
•   Extending guarantees
•   Granting “negative pledges”
•   Permitting change of control

The change of control clause has, in recent years, proved very contentious. Most bank loans contain such a clause whereas bonds, until the last few years, did not. In the event that a company would be acquired and the acquiror was financed in a very leveraged way, the bank loans would have to be refinanced immediately, whereas the bonds could become junk and investors would suffer significant losses. Examples of even a putative takeover having such a negative effect on bond prices are Marks & Spencer and J Sainsbury. 

Loan Characteristics

Bank loans have the following attributes:

• They exhibit flexible payment structures
• They do not require public disclosure
• As banks are lending the money directly, they do not require credit ratings. However, more non-bank lenders are becoming part of lending syndicates. There is a secondary market in loans, and loans are being repackaged into structured credit instruments. These factors have led to more loans being rated
• The interest on loans is usually floating. The most common index is LIBOR, with a margin added. The magnitude of the margin depends on the credit rating and sector of the company, the length and size of the loan, and how aggressive the banks are in lending money at the current point of the business cycle
• Loans can usually be repaid early at the option of the borrower. This is generally not the case for bonds
• Loans are more likely to have restrictive covenants than bonds (although more recent bond issues have tended to give borrowers less financial freedom)

Debt & Bank Finance

Debt Finance

The two principal sources of debt finance are bank loans (in various forms) and the bond markets. We shall examine the differences between them. Historically, US corporations have made greater use of the bond markets due to the higher investor acceptance and the quest by banks for higher returns elsewhere. In Europe, the pressure on banks to increase returns for shareholders, the arrival of the euro (creating a pan-European investor base), and the growing use of credit ratings have led to an increasing use of bonds in the last few years. It is now also the case that investment banks make loans to corporates in order to cement their relationships with key clients and to show a commitment to them. Historically, loans were generally made by commercial banks whose balance sheets therefore are much larger than those of investment banks.

Bank Finance

The distinction between uncommitted and committed facilities is important to make.

An uncommitted facility is one which provides short-term (usually up to one year), temporary or seasonal financing. It is relatively cheap, but can be withdrawn by the bank very quickly. Typical uncommitted facilities would include money market lines, foreign exchange lines and overdraft facilities.

A committed facility is longer term (usually between one and five years) and where the borrower pays a fee to the bank for the facility. This fee may depend on the utilisation of the credit line (how much money has been borrowed). Most companies have committed facilities. The amount, maturity and terms of undrawn committed facilities are key indicators as to the financial health of a company. Uses of committed facilities include financing core working capital, financing fixed assets or providing funds for acquisitions (putting together a committed facility when making a takeover bid is often the first step in the M&A process).

In periods of deteriorating credit conditions, banks need to ensure that they have not committed to lend to too many companies at unfavourable rates (from their perspective) and that they have the ability to raise sufficient finance themselves in order to make the loans. 

Equity Valuation Metrics

The P/E ratio (Price-to-Earnings ratio) of a stock (also called its “earnings multiple”, or simply “multiple”) is a measure of the price paid for a share relative to the income or profit earned by the firm per share. A higher P/E ratio means that investors are paying more for each unit of income. It is a valuation ratio included in other financial ratios.

The price per share (numerator) is the market price of a single share of the stock. The earnings per share (denominator) is the net income of the company for the most recent 12-month period, divided by number of shares outstanding.

For example, if Stock A is trading at $30 and the earnings per share for the most recent 12-month period is $3, then Stock A has a P/E ratio of 30/3 or 10. Put another way, the purchaser of Stock A
is paying $10 for every dollar of earnings. Companies with losses or no profit have an undefined P/E ratio. However, a negative P/E ratio may be shown.

By comparing price and earnings per share for a company, one can analyse the market’s stock valuation of a company and its shares relative to the income the company is actually generating. Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal, it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, companies and time periods may be misleading. Hence, more complicated peer group analysis is required.

Care should be taken when analysing P/E ratios. It is also common market practice to use historic P/E ratios, or forward P/E ratios which factor in future consensus corporate growth rates. Either way, how do we interpret in a simple manner what the ratios means? If a company trades on a P/E ratio of 10, we could conclude that it takes about ten years to recoup the price paid for a stock (not including any income from the reinvestment of dividends). In principle, the P/E ratio incorporates the market’s view of future growth prospects and perceived riskiness of a company’s future earnings.

Various interpretations are possible, but the table below gives an indicative guide as to their meaning:

The dividend yield is the dividend paid in the last accounting year divided by the current share price. If a stock paid out $5 per share in cash dividends to its shareholders last year, and its price is currently $50, then it has a dividend yield of 10%.

The earnings yield is the reverse/reciprocal of the P/E ratio. The earnings yield is quoted as a percentage, and is useful in comparing a stock, sector, or the market’s valuation relative to bonds. The earnings yield is also the cost to a publicly traded company of raising capital through the issuance of stock.

Dividend Dates

Once dividends are declared/approved by a company’s Board of Directors, there are four important dates to remember regarding dividends:

Declaration date – is the day the Board of Directors announces its intention to pay a dividend. On this day, a liability is created and the company records that liability on its books; it now owes the money to the stockholders. On the declaration date, the Board will also announce a date of record and a payment date.

Ex-dividend date – is the day after which all shares bought and sold no longer come attached with the right to be paid the most recently declared dividend. Prior to this date, the stock is said to be cum dividend (with dividend): existing holders of the stock and anyone who buys it will receive the dividend, whereas any holders selling the stock lose their right to the dividend. On and after this date, the stock becomes ex-dividend: existing holders of the stock will receive the dividend even if they now sell the stock, whereas anyone who now buys the stock will not receive the dividend. It is expected that a stock’s price will fall on the ex-dividend date by an amount approximately equal to the dividend paid. This reflects the decrease in the company’s assets resulting from the declaration of the dividend. The company does not take any explicit action to adjust its stock price; in an efficient market, this will automatically occur.

Record date – shareholders who have registered their ownership on or before the date of record will receive the dividend. Registration in most countries is essentially automatic for shares purchased before the ex-dividend date.

Payment date – is the day when the dividend will actually be posted to the shareholders of a company or credited to brokerage accounts.

Preference Shares

Unlike common stock, preferred stock usually has several rights attached to it:

• Almost all preferred shares have a negotiated fixed dividend amount. The dividend is usually specified as a percentage of the par value or as a fixed amount
•  The core right is that of preference in the payment of dividends and upon liquidation of the company. Before a dividend can be declared on the common shares, any dividend obligation to the preferred shares must be satisfied
• The dividend rights are often cumulative, such that if the dividend is not paid, it accumulates from year to year
• Preference shares have a claim on liquidation proceeds of a stock corporation, equivalent to its par or liquidation value unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim
• Some preferred shares have special voting rights to approve certain extraordinary events (such as the issuance of new shares or the approval of the acquisition of the company) or to elect directors, but most preferred shares provide no voting rights. Some preferred shares only gain voting rights when the preferred dividends are in arrears for a substantial time
• Usually, preferred shares contain protective provisions which prevent the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior, pari-passu or junior relationship with other series issued by the same corporation
• Occasionally, companies use preferred shares as a mean of preventing hostile takeovers, creating preferred shares with a “poison put” or forced exchange/conversion features that are exercised upon a change in control

There are various types of preferred stocks that are common to many corporations:

• Cumulative Preferred Stock – if the dividend is not paid, it will accumulate for future payment
• Non-cumulative Preferred Stock – dividends for this type of preferred stock will not accumulate if they are unpaid. Very common in bank preferred capital, since under BIS capital adequacy requirements, preferred stock must be non-cumulative if it is to be included in Tier 1 capital
• Convertible Preferred Stock – this type of preferred stock carries the option to convert into common stock at a prescribed price
• Participating Preferred Stock – this type of preferred stock allows the possibility of an additional dividend above the stated amount under certain conditions
• Perpetual Preferred Stock – have no fixed date on which invested capital will be returned to the shareholder, although there will always be redemption privileges held by the corporation. Most preferred stock is issued without a set redemption date
• Puttable Preferred Stock – such issues have a “put” privilege whereby the holder may, upon certain conditions, force the issuer to redeem the stock

Ordinary Shares

An ordinary share forms the basic capital of a limited company. As a unit of ownership, shares convey a number of rights to the holder:

1.       Rights of Transfer – of ownership by sale (or gifting).

2.       Dividends – payments made by a company to its shareholders. When a company earns a profit, the cash can be put to two uses: either re-invested in the company (retained earnings), or paid to shareholders of the company as a dividend. Publicly traded companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from a regular one.

3.       Right To Vote – the right to vote at members’ meetings on the major strategic issues of the company. These must be usually held at least annually (in the form of an AGM – Annual General Meeting) and on any major corporate action (e.g. mergers and acquisitions). In most cases, one share carries one voting right.

4.       Rights of Inspection – under normal circumstances, the shareholder has the right to inspect the shareholder list, minutes of shareholders’ general meetings, copies of the directors’ service contracts and various registers maintained by the company.

5.       Liquidation Rights – ordinary shareholders have the right to share in proceeds in the event of the liquidation of the company. However, ordinary shares have the last claim upon liquidation after trade creditors, debt holders and preferred shareholders have been paid.

6.       Pre-emptive Rights (anti-dilution clause) – under UK company law, on the issue of any new shares, the present shareholders must be offered the new shares to allow them to maintain their proportionate ownership in the company. Note that there are many countries, such as the USA, which do not require existing shareholders to receive pre-emptive rights on any new shares.

Understanding the Different Products in the Capital Structure

What is Equity?

Equity capital, or financing, is money raised by a business in return for a share of ownership in the company. It is permanent capital (it does not need to be repaid). Ownership of equity gives the right (but not an automatic entitlement) to share in the profits of the business, after all other stakeholders (employees, debt holders, the taxman) have been paid. Companies are under no obligation to pay dividends, and dividends cannot be offset against tax.

Owning equity is the riskiest form of investment in a company. Ordinary shareholders are the last to be paid in the event of the business failing. As compensation for this risk, equity holders generally earn the highest return. Investors in public listed companies are free to sell their shares without requiring the approval of the company. The returns for investors are a combination of dividends and capital appreciation. 

Introduction to Capital Markets

Introduction

Financing for governments and corporations was originally dominated by a bilateral relationship between borrower and bank. As economies and companies grew, there was a need to raise larger and larger amounts of finance and with this came the need to distribute the risks that had become too large for a single bank.

The capital markets have become the means to achieve this diversification by allowing the issuance of tradable debt and equity securities by companies and governments. Initially, these markets had a physical nature but they have increasingly become “de-materialised”, becoming either an electronic trading system or even just a web of interested parties. The capital markets are generally regulated by institutions such as the Securities and Exchange Commission in the US and the Financial Services Authority in the UK, but the international and virtual nature of these markets poses a constant challenge to national regulators.

 

The market can be divided into primary and secondary. The primary market is where new issues in debt or equity are arranged by investment or universal banks. New equity issues are rarer than new debt issues and once launched, will generally trade on a recognised stock exchange such as the New York or London Stock Exchange.

Debt capital markets are more diverse and include the money markets where short-term loans and deposits are traded, the foreign exchange market where currencies are bought and sold, and the long‑term debt market where bonds are bought and sold. While there is no central market such as a stock exchange for the debt markets, the debt markets will have similar infrastructure such as settlement systems, trading conventions and inter-dealer brokers.

The debt capital markets have become far more important in the last 30 years, as the role of banks has shifted from the conventional “lend and hold” approach to a model whereby banks originate loans and distribute them on the capital markets. The final holders of the securities include insurance companies, pension funds and individuals.