Introduction to Corporate Bonds

[RomWharf1]

First of all, we need to understand what a bond is.

Companies generally have 2 main ways of getting financing, which are equity or debt:

• Equity financing can either be selling all or part of the shares of a subsidiary, or issuing new shares of the parent company.
• Debt financing is a lot more varied in terms of options available. Most debt financing involves borrowing money against a fixed return – hence the term “Fixed Income” widely used. Some debt will not be considered “fixed income” because of its structure (i.e., floating interest rate for example).

When coming from the investor’s side, investing in debt is less risky than investing in equity, but also provides less upside. This is due to the difference in seniority between debt and equity: Equity will be the most junior tranche in the company’s capital structure whilst debt will generally be senior to equity (often separated into multiple tranches according to their seniority). On the one hand, this is safer for debt investors in case of default because they will be repaid first whilst equity will be repaid last. This means equity investors are likely to recover only part of their investment whilst debt investors might recover most (or even all) of it. On the other hand, should the company perform very well, debt investors will be limited to the coupon they charge, whilst equity investors will get all the upside when selling their shares which will have gained value. They will also get the benefit of receiving dividends if the company issues some to the shareholders.

From the company’s point of view, debt will be the preferred financing structure given it is generally cheaper. Indeed, corporations will be limited to paying the coupon on the debt but will retain all the upside if the company performs well.

There are two main types of debt financing which are bonds, or term loans:

• Bonds are instruments where many investors - for example Fixed Income teams from asset managers - will come in to participate. It is called “primary” if the investor comes in when the bond is just issued by the company. The secondary market is when this bond is then sold from the primary investor on to other investors.
• Loans are generally from a bank. Most of the time, a single bank will underwrite (i.e., provide the financing using their own cash) the loan and then sell on some tranches down the line to credit investors, or just keep it all on its book. Alternatively, a consortium of a few banks can come together to underwrite the loan and then also sell on to other investors (or keep it).

Generally, bonds terms are more flexible and less constraining in terms of financial covenants, but a company would need to be quite mature to be able to issue bonds and gain the market’s trust.

When the bond comes to maturity the company will have to repay it. To do so, it has a few options: issuance of equity, sell down some selected asset, or refinance the debt with a new bond (or loan). Depending on the market environment, a company might prefer to sell some assets to focus its business on some operations because interest rates are high, and the company wants to reduce its overall leverage. This could provide certainty as sell side mandates are often successful. Refinancing is not straight forward, and a company might fail to refinance with debt if it fails to convince investors that the company can take on the same (or more) debt. For example, current investors might need liquidity and will not want to extend or refinance their current instrument, whilst other lenders might consider the actual leverage to be too high. If the company is unable to repay its debt, it will then be in default. This means that they will be forced to repay the debt, most likely by selling shares or assets.

Finally, how does a group issue a bond?

First of all, they will need to get in touch with an advisor (investment bank or broker) to help them with the process (unless they have the teams in-house, which is quite unlikely given the complexity). The advisor will have two main roles:

1. Guide the company throughout the process and gather as much information (that investors will request) as possible.
2. Provide a wide portfolio of investors that they believe will be interested in the transaction, based on their experience and knowledge of these investors. They will also be the intermediary between the company and the investors, managing Q&A, due diligence, etc.

Once the roadmap is agreed, the advisor will put together materials to present the transaction to investors. This will initially be a teaser to understand whether the investor would be interested in pursuing the deal at all. In parallel, the company will work with lawyers to put together an offering memorandum, or a prospectus. This prospectus will be the most important document: It will most likely be a few hundred pages long and contain, amongst other things, details on the company itself, financials, potential risks involved for investors and finally terms and conditions for the bond. The prospectus is also where the difference between a term loan and a bond comes in: for a loan, terms will generally be sent by the lender, and it will be for the company to agree/negotiate these. On the contrary, the prospectus is produced by the company and sent to the market for investors to look at and invest in the bond.

Once investors are identified, a more detailed presentation will be shared with them, essentially summarizing what is, or will be, in the prospectus. Brokers are generally helpful in these situations given they will have a wide range of contacts and will be able to execute the transaction when investors decide to buy the bond issued by the company.

This process is generally quick and can be closed in less than 3-4 months. To have closing certainty, the company will generally try to have “firm” interests from as many investors as possible before announcing the bond issuance publicly. This is to avoid announcing a transaction that ended up being smaller than expected, or that could not be closed because of a lack of investors. This is to avoid having to publicly announce negative news to the market.

 

[magellan1]

Thanks for the detailed explanation. I would like to add a few things.
Convertible loans and bonds are other important financing tools that pay a fixed return but convert into equity in some circumstances. One of the main benefits of this type of financing is that it allows companies to keep a constant leverage ratio and avoid debt overhangs. Investing in a convertible bond is somewhat similar to buying a fixed-income instrument and an equity option in the same company.
Another very popular option for debt repayment that you didn't mention is using the cash generated from operations (payments from clients, profit, etc).
Finally, many companies like Google issue bonds even if they don't need debt to have a credit rating and reference interest rate.
Having a good credit rating can be very helpful during difficult economic environments when credit dries up.

 

[JustAnotherHuman1]

Thanks for sharing. Would be great if you can write another article on how to price bonds, how they trade hands on secondary markets and how the yield curve (the base rate) affects it.

I’d also add that a common interview question is why do companies raise debt financing if they have tonnes of cash reserves? The answer is: it’s tax-deductible!

 

[AugustusSeptimius1]

Thanks for the detailed explanation. I would like to add a few things.
Convertible loans and bonds are other important financing tools that pay a fixed return but convert into equity in some circumstances. One of the main benefits of this type of financing is that it allows companies to keep a constant leverage ratio and avoid debt overhangs. Investing in a convertible bond is somewhat similar to buying a fixed-income instrument and an equity option in the same company.
Another very popular option for debt repayment that you didn't mention is using the cash generated from operations (payments from clients, profit, etc).
Finally, many companies like Google issue bonds even if they don't need debt to have a credit rating and reference interest rate.
Having a good credit rating can be very helpful during difficult economic environments when credit dries up.

This is a really good addition to the already pretty comprehensive post. Great info!