Debt markets
Outline Instruments Participants Yield curve Risks 2
Debt instruments Bank loans most typical Reliance on private information Difficult to transfert to third party Government and commercial paper Bonds, bills, notes, Benefits for both lenders and borrowers Debt can be traded - liquidity Better terms of financing 3
Amounts outstanding of assets and derivatives Derivatives Derivatives Note: Trillions of US dollars as of 2011/2012. Source: BIS, World Bank
Bonds The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Types: corporate bonds, municipal bonds, as well as treasury/governmental bonds, notes and bills (collectively "Treasuries or Sovereign bonds).
Type of international bonds (2) Foreign bonds - issued by a foreign entity and denominated in domestic currency (yankee, samurai, bulldog, kangaroo bonds) Global bonds - a very large international bond issued by a single borrower that is simultaneously sold in multiple markets. Eurobonds - issued by a foreign entity and sold in a foreign currency
Credit risk Not all bonds are risk-free If you lend money to company, it may go bankrupt it is called credit risk You want to be rewarded for this risk More risky bonds have higher yield than risk-free bonds This difference is called risk premium and changes over time 7
Rating scales Moody s Standard & Poor s Description Aaa AAA Lowest credit risk highest quality Aa AA High quality A A Upper medium grade Baa BBB Medium grade Ba BB Lower medium grade B B Speculative Caa CCC High credit risk D D Highly speculative 8
Participants Issuers Governments Financial institutions Large firms Buyers Pension funds Mutual funds Insurance companies Banks Market makers 9
Main features of debt instruments Maturity redemption date Yield the cost of financing Coupon bonds Floating rate Inflation indexed Discount (zero-coupon) bonds Credit risk often rating attached Some asset backed Optionality included Right for borrower or lender to terminate the contract early Conversion option 10
Maturity Money market Up to 1 year Mostly used for liquidity management High activity of financial institutions Capital market Above 1 year Used for investment financing 11
Known cash flows Discount bonds t=0 price Face value t=t (maturity) Coupon bonds t=0 price Face value + coupon t=t (maturity) 12
Floating rate t 0 31/01/2010 31/07/2010 31/01/2011 31/07/2011 t T 13
Present and future value PV present value FV future value PV (1 i) FV PV FV 1 i 14
Discounting cash flows Pricing a bond PV CF CF 1 CF 2 CF 3 CF 4 CF CF CF ) 1 2 3 4 1 i 2 (1 i) 3 (1 i) (1 i 4 15
How much 100 received after X years is worth today? 16
Yield to maturity Yield of the bond tells us what will be our return if we invest in a given bond at this very moment and keep it until maturity Problem reversed you know present value, future values of cash flow and you have to figure out what interest rate would make them equal PV CF1 1 i CF2 (1 i) 2... CFn (1 i) n 17
Interest rates and bond prices There is close relationship between the interest rates and bond prices It is due to discounting the cash flow resulting from holding a bond If interest rate rise, the price of bond decreases (and vice versa) PV CF1 1 i CF2 (1 i) 2... CFn (1 i) n 18
Yield curve Usually we observe different YTM for bonds with different maturities but otherwise identical characteristics Yield curve relationship between maturity and the yield There are different yield curves for different currencies, bonds of different risks etc. 19
Interst rate Yield curve Maturity 20
Possible shapes of the yield curve Upward sloping (normal) long-term interest rates higher than short-term interest rates Flat long-term and short-term interest rates on the same level Inverted short-term interest rates higher than long-term interest rates Hump-shaped 21
Yield curve changes over time Source: ECB Monthly 11/2008 and 11/2010
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Yield curve types Zero-coupon rates - discount factors Swap curve Bond curve Difference between swap curve and bond curve - asset swaps Forward yields 24
Theories explaining shape of yield curve Expectations theory Segmented market theory Liquidity premium theory 25
Determinants of the yield curve Demand and supply on deposit market the cost of short-term liquidity Demand for Treasury bonds compared to issue size bond prices and asset swap rates Macroeconomic data (inflation, retail spending, industry output, GDP, current account) change in trends, jumps Short-term speculation technical analysis of yield curve changes 26
Yield curve and expectations If we assume that expectations theory is true, we can derive expectations about future interest rates from the yield curve Example: you observe the yield curve: Maturity (years) 1 2 3 4 Yield (%) 4.50 4.25 3.83 3.62 What are forward 1Y interest rates? 27
Forward rates Spot rates Forward rates Maturity 1 2 3 4 Spot rate 4.50 4.25 3.83 3.62 Forward rate ---????????? 28
Forward rates Maturity 1 2 3 4 Spot rate 4.50 4.25 3.83 3.62 Forward rate ---????????? (1+4.5/100)(1+???/100)=(1+4.25/100) 2???=4.00 29
Forward rates Spot rates Forward rates Maturity 1 2 3 4 Spot rate 4.50 4.25 3.83 3.62 Forward rate --- 4.00 3.00 3.00 30
Interest rate risk
Price and yield for fixed rate bonds price yield 32
Types of interest rate instruments Balance sheet Deposits/Loans Treasury bills Treasury bonds Commercial paper Off-balance sheet (interest rate derivatives) FX Swap FRA IRS CIRS 33
Duration Macaulay Duration weighted average maturity of discounted cash flows The higher coupon, the lower duration The longer residual maturity, the higher duration The higher yield, the lower duration Its a close approximation of modified duration which is a measure of bond s price sensitivity to interest rate (y-yield; k- coupon frequency) 34
Macaulay Duration Present value of cashflows Macaulay duration 35
Modified Duration A linear measure of price sensitivity to yield Percentage derivative of price (V) with respect to yield (y) Percentage change (approx.) in bond price if 1 percentage point (100 bp) change in interest rates 36
Price and yield for fixed rate bonds price True price-yield relationship (nonlinear, convex) Approximation with Modified Duration yield 37
Debt markets Derivatives and hedging IR risk
Forward rates Maturity 1 2 3 4 Spot rate 4.50 4.25 3.83 3.62 Forward rate ---????????? (1+4.5/100)(1+???/100)=(1+4.25/100) 2???=4.00 39
Forward rates Maturity 1 2 3 4 Spot rate 4.50 4.25 3.83 3.62 Forward rate --- 4.00?????? (1+4.25/100) 2 (1+???/100)=(1+3.83/100) 3???=3.00 40
Forward rates Spot rates Forward rates Maturity 1 2 3 4 Spot rate 4.50 4.25 3.83 3.62 Forward rate --- 4.00 3.00 3.00 41
Price for lending is interest rate So maybe contract for future interest rate? FRA 42
FRA Notional value x Actual interest rate level at settlement date - Forward level of interest rate derived from the yield curve today (contract interest rate) 4 3
Forward interest rate 2007-12-24 WIBOR O/N 4.13 1W 5.35 1M 5.65 3M 5.71 6M 6.00 9M 6.10 1Y 6.19 What is the level of 9x12 interest rate? (1+i 12 )=(1+0.75 i 9 ) (1+0.25 i 9x12 ) (1+6.19%)=(1+0.75 6.10%) (1+0.25 i 9x12 ) I 9x12 = 6.18% 44
After 9 months 2007-12-24 WIBOR O/N 4.13 1W 5.35 1M 5.65 3M 5.71 6M 6.00 9M 6.10 1Y 6.19 2008-09-24 WIBOR O/N 4.79 1W 6.10 1M 6.34 3M 6.59 6M 6.62 9M 6.65 1Y 6.65 45
At settlement date 46 6,80 6,60 6,40 6,20 6,00 5,80 5,60 5,40 5,20 5,00 1 2 3 4 5 6 7 8 9 10 11 12 Actual outcome 2007-12-24 2008-09-24 FRA quoted based on current yield curve, but the actual outcome is derived from the yield curve observed in the future
What if multiple payments? Lets try to have a contract for a number of payments IRS 47
Bank A Interest Rate Risk Bank A collects term deposits from households, mostly floating interest rate, on average WIBOR- 1% Many corporate clients took 5-year fixed interest rate loans, on average 7% 1. Does Bank A face interest rate risk? YES. Increase in market interest rates would cause decrease in Bank A income 48
Borrowers 7% Bank margin before hedging WIBOR Bank margin 9% 7%-(9%-1%)??? = -1% 8% 7%-(8%-1%)??? = 0% 6% 7%-(6%-1%)??? = 2% BANK A Wibor 1% Depositors
Bank A Solution Bank A decides to eliminate the risk using interest rate swap 2. Will the bank pay or receive fixed interest rate? The Bank receiving fixed interest rate from clients is interested in paying the fixed interest rate in hedging transaction. 50
Market maker Bank A observed the following quoting by Bank B (market maker) 3.What rate can Bank A ensure? Bank A may make a deal where it is obliged to pay 6.59% for five years in exchange for receiving WIBOR. Maturity bid offer 1 6.83 6.93 2 6.64 6.74 3 6.60 6.66 4 6.56 6.62 5 6.53 6.59 6 6.49 6.55 7 6.45 6.51 8 6.41 6.47 9 6.36 6.42 10 6.30 6.36
Bank A Borrowers 7% BANK A 6.59% Wibor Bank margin before hedging WIBOR Market maker Bank margin 9% -1% 8% 0% 6% 2% Depositors Wibor 1% Bank margin after swap WIBOR Bank margin??? 9% 1%+(7%-6.59%) = 1.41%??? 8% 0%+(8%-6.59%) = 1.41%??? 6% 2%+(6%-6.59%) = 1.41%
Bank C Interest Rate Risk Bank C specialises in mortgage lending, indexed to WIBOR, average 5-year maturity gaining WIBOR+1% Depositor base consists mostly of corporates, interested in fixed interest rate due to servicing needs of bonds issued by them. Average interest rate cost on this portfolio is 5.5% 1. Is Bank C exposed to interest rate risk? Yes, DECREASE in market interest rate would cause a decrease in bank profit 53
Bank C Solution Bank C decides to eliminate interest rate risk using interest rate swap 2. Will the bank pay or receive fixed interest rate in this transaction? Bank paying fixed interest rate to depositors will be interested in receiving fixed interest rate in the hedging transaction 54
Market Maker Transaction Bank C observes the following quoting by Bank B (market maker) 3. What interest rate can Bank C ensure? Bank C may make a deal where it will be entitled to receive for 5 years the interest rate of 6.53% in exchange for WIBOR Maturity bid offer 1 6.83 6.93 2 6.64 6.74 3 6.60 6.66 4 6.56 6.62 5 6.53 6.59 6 6.49 6.55 7 6.45 6.51 8 6.41 6.47 9 6.36 6.42 10 6.30 6.36
Bank C Borrowers Wibor+1% Bank margin before hedging WIBOR Bank Margin??? 9% (9%+1%)-5.5% = 4.5%??? 8% (8%+1%)-5.5% = 3.5%??? 4% (4%+1%)-5.5% =-0.5% BANK C Wibor 6.53% Market Maker 5.5% Depositors Bank margin after swap WIBOR Bank Margin??? 9% 4.5%+(-9%+6,53%)= 2.03%??? 8% 3.5%+(-8%+6.53%)=2.03%??? 4% -0.5%+(-4%+6.53%)=2.03%
Summary Borrowers Borrowers 7% 6.59% BANK A Wibor Wibor-1% BANK B IRS Market Maker 6.53% Wibor BANK C Wibor+1% 5.5% Depositors Depositors What are the motives for them? Banks A and C hedge interest rate risk Bank B trading (margin)
Market Maker - Quotes Bank B decided to quote to its clients the following IRS rates The clients decide to change their interest rate risk profile using IRS In each case determine IRS rates and estimate the effect for the client what interest rate can the client ensure Maturity bid offer 1 6.83 6.93 2 6.64 6.74 3 6.60 6.66 4 6.56 6.62 5 6.53 6.59 6 6.49 6.55 7 6.45 6.51 8 6.41 6.47 9 6.36 6.42 10 6.30 6.36
Issuer of a bond with floating rate coupon Client 1 3-year bond Wibor 0,1% Effective rate? 6.66% Wibor BANK B IRS Market Maker Client pays: (Wibor-0,1%) and 6.66% Client receives: Wibor So it pays net 6.56% Maturity bid offer 1 6.83 6.93 2 6.64 6.74 3 6.60 6.66 4 6.56 6.62 5 6.53 6.59 6 6.49 6.55 7 6.45 6.51 8 6.41 6.47 9 6.36 6.42 10 6.30 6.36
Issuer of a fixed coupon bond Client 2 10-year bond 5.50% Wibor Effective rate? 6.30% Client pays: Wibor and 5.50% Client receives: 6.30% It pays net Wibor 0.80% BANK B IRS Market Maker Maturity bid offer 1 6.83 6.93 2 6.64 6.74 3 6.60 6.66 4 6.56 6.62 5 6.53 6.59 6 6.49 6.55 7 6.45 6.51 8 6.41 6.47 9 6.36 6.42 10 6.30 6.36
Borrower Client 3 2-year loan on Wibor+0.20% Effective rate? Client pays: (Wibor+0.20%) i 6.74% Client receives: Wibor So it pays net 6.94% 6.74% Wibor BANK A IRS Market maker Maturity bid offer 1 6.83 6.93 2 6.64 6.74 3 6.60 6.66 4 6.56 6.62 5 6.53 6.59 6 6.49 6.55 7 6.45 6.51 8 6.41 6.47 9 6.36 6.42 10 6.30 6.36
Debt markets Corporate Perspective
Structure of Indebtness Senior Debt ASSETS Subordinated/ Mezzanine EQUITY
Priority Ranking Recovery Expectation Subordination Privileged Creditors Secured Creditors Unsecured Creditors Subordinated Creditors Shareholders
Senior Debt Most common form of bank loans and corporate loans Bonds are usually unsecured and bullet Loans typically secured and amortising Typical tenor: up to 5-7 years Lowest possible cost of financing Most restrictive covenants
Mezzanine Debt Structures Intermediate form between debt and equity E.g.: subordinated loans, preffered shares Second ranking security or unsecured Usually bullet repayment Cash interest + PIK interest (+warrants) Typical tenor: 5-10 years More expensive than senior No or limited dilution of shareholding
Debt Capacity Lenders want to ensure the Company has sufficient cash to service its debt obligations Where the Company gets money to service its debt? Is there anything that the Company needs to pay before the debt?
Cash Flows Free Cash Flows operating cash flow available for all capital structure investors Debt Service Where the Company gets money to service its debt? Is there anything that the Company needs to pay before the debt?
Security/collateral Collateral is always the second item considered by Lenders. Debt capacity goes first!!! Aims: Rank senior or pari-passue Achieve full recovery (overcollateralisation) The more liquid, the better Types: Financial Physical Intangible
Structural Subordination Holding Company Operating Subsidiary A Operating Subsidiary B
Restriction and covenants Why the lenders need to secure their rights prior to the disbursement?
Restriction and covenants Protect against deteriorating credit Agree on how the Company can be run Manage conflict between shareholders and creditors Covenants typically focus: Cash flows Subordination Event Risk
Afirmantive & negative covenants Access to information Maintain core business Maintain conditions of assets Real estate Indebtness Securities Investments, capex, asset sale Dividends
Covenants - examples Negative pledge Pari-passu Cross default Change of control Material Adverse Clause Other requirements Debt Service Reserve Account Cash Sweep Mechanism
Financial Covenants Debt service coverage ratio Interest coverage ratio Debt to EBITDA Current ratio Leverage ratio Tangible net worth
Ratio Overview LT Solvency Liquidity Performance Efficiency Investor
Performance Ratios Profit margin EBIT Margin EBITDA Margin Return on Equity Return on Assets
LT Solvency (Financial Risk) Ratios Debt to Assets Debt to Equity Debt to EBITDA Debt Service Coverage Ratio
Liquidity Ratios Current ratio Working Capital to Sales Interest coverage
Efficiency Ratios Inventory Days Receivables Days Payables Days
Investor Ratios Net profit per Share Dividend Yield Net Profit to Sales ROE
Debt Capacity After analysing the Company s financials, it is decided how much such Company can borrow. What if chosen ratios show different debt capacity?
Corporate Loan A situation a loan is given to an operating Company and therefore can be serviced with already exisitng cash flows and the proceeds from new investments Typical considerations: - Maximum leverage - Operating performance is important - Some form of cash-flow control - General business - Security of lower importance
Project Finance A situation where the debt is given for the purpuse of construction and/or operation of a distinct project and therefore its repayment is solely reliant on the performance of such project Typical consideration: Security on everything Equity Contribution Cash flow ratios Contractual obligations
Leveraged buy out Situation where the money is raised with purpuse to acquire another company, and the intention is that debt will be serviced with proceeds comming from such company Typical consideration: High leverage Detailed look at subordination Security on shares Managerial Control
Example 1. Energy Company 2010
Example 2. Media 2010