RAISING DEBTPrivate and Public Debt• Public debt— Bonds sold to the general public— A “Prospectus” or “Offering Memorandum” describes a public debt offering• Private debt— Bank loans• Common types of bank loans: Term Loan, Revolving Line of Credit• Banks loans are often syndicated and collateralized— Private placements• A bond issue that is sold to a small group of investors rather than the general publicPrivate or Public?• Advantages of Public Financing— Unlimited Investor Base— Liquidity• Advantages of Private Financing— No registration with SEC— No need to reveal potentially confidential information— Easier to renegotiate (dealing with fewer investors)Seniority• Seniority describes the bondholder’s priority in claiming assets in default• “Secured” debt is collateralized with specific assets, has the highest priority• “Senior” debt has higher priority than…• “Junior” or “Subordinated” debt has lower priority• Lower seniority  higher yieldBond Covenants• Covenants are restrictive clauses in a bond contract that limit the issuer from taking actions that may undercut its ability to repay the bonds• For example, covenants may:— Restrict the ability to pay dividends or sell assets— Restrict further new debt— Specify minimum capital and liquidity ratios• With more covenants, a firm can reduce its costs of borrowing— Reduction in borrowing cost can outweigh the loss of flexibility associated with covenants— Especially important if firm may be in a position to take value-destroying actions where equity-holders’ interests is opposed to debt-holders’ interestsAsset-Backed Securities• An Asset-Backed Security (ABS) is a security that is constructed by pooling other financial securities— The ABS’s cash flows come from the cash flows of the underlying securities — The process of making a new security by pooling together other underlying securities is called “securitization”— ABSs are often divided into “tranches” that are assigned different repayment priority• Types of asset-backed securities include:— Mortgage-backed securities— Student loan-backed securities — Securities backed by auto loans, credit card receivables, etc • Collateralized debt obligation (CDO) is A re-securitization of other asset-backed securitiesLet’s take a closer look at the debt securities issued as part of the Hertz LBO• Financing the deal ($15.2 Billion) involved $11.1 Billion in new debt:Callable bonds• Callable bonds can be repaid (retired) by the issuer before maturity• Call Provisions:— Call Date— Call Price— Call PremiumCall features of the Hertz LBO Bonds:The Price of Callable Bonds• A firm will call a bond (rather than repurchase it) if the call price is lower than the market price of a bond— E.g. if call price is the par value and the bond is trading at a premium• Investors will pay less for a callable bond than for an otherwise identical non-callable bond• Yield to Call: — The yield of a callable bond calculated under the assumption that the bond will be called on the earliest call date• Yield to Worst: — The lower of the yield to call or yield to maturityConvertible bonds• Convertible bonds gives the bondholder an option to convert each bond into a fixed number of common stock • Conversion Ratio: The number of shares each bond (usually per $1000 of face value) can be converted to • Conversion Price: Implied stock price when converted• Convertible bonds are worth more to an investor than an otherwise identical non-convertible bond— Firms are therefore able to pay lower interest rates by issuing convertible bondsExample: Conversion Price• Consider a convertible bond with a $1000 face value and a conversion ratio of 20— If you converted the bond into stock on its maturity date, you would receive 20 shares— If you did not convert, you would receive $1000• By converting the bond you essentially “paid” $1000 for 20 shares, implying a “conversion price” per share of $1,000/20 = $50.Convertible Bond Value• When a firm’s stock price is higher than the conversion price, convertible bond’s price is close to the value of the converted shares• When a firm’s stock price is low, the value is close to the value of a non-convertible (“straight”) bondMarket Reactions to Security Offerings• Stock price reactions to various security offerings:—Equity Issues -3% (30% of money raised)—Convertibles -2%—Public Bonds 0%—Bank Loans +2%•