Types of Debt Instruments
This article throws light upon the two main types of debt instruments. The types are: 1. Syndication of Loans 2. International Bond Market.
Type # 1. Syndication of Loans:
As the size of Indian loans increased, Indian banks found it difficult to take the risk singly. Regulatory authorities in most countries also limit the size of individual exposures.
This has led to two practices “Club Loans” and “Syndicated loans”.
Under Club loans, are a small group of banks joining together to form a club and give the loan.
Syndicated loans are a lead manager or group syndicate the loan by inviting participation of other banks. Traditionally, major commercial banks were lead managers. Lately, however, investment banks like Merill Lynch and Morgan Stanly have been active in the field. In large loans, the syndicate can comprise several hundred banks.
Given that syndicated loans can be quickly arranged, these have become the main source of financing for corporate acquisition.
Syndicated loans include a management fee (payable by the borrower either on loan signing or on first drawdown), a commitment fee (payable on the underwritten portion of the loan during the availability period) and agency fee (payable to the agent bank to cover administration costs incurred during the currency of the loans).
Syndicated medium term credits are not necessarily availed to finance projects. Many countries have used the proceeds for general balance of payment purposes, to finance domestic budget deficits or to finance existing external debt.
Syndication of Loans:
The size of loan is large, individual banks cannot or will not be able to finance singly. They would prefer to spread the risk among a number of banks or a group of banks is called ‘Syndication of Loans’. These days, there are large group of banks that form Syndicates to arrange huge amount of loans for corporate borrowers — the corporate that would want a loan but not be aware of those banks willing to lend.
Hence, Syndication plays a vital role here. Once the borrower has decided upon the size of the loan, he prepares an information memorandum containing information about the borrower disclosing his financial position and such other information like the amount he requires, the purpose, business details of his country and its economy. Then he receives bids (after this, the borrower and the lenders sit across the table to discuss about the terms and conditions of lending this process of negotiation is called ‘syndication’).
The process of syndication starts with an invitation for bids from the borrower. The borrower then mention the fund requirement, currency, tenor, etc. The mandate is given to a particular bank or institution that will take the responsibility of syndicating the loan while arranging the financing banks.
Syndication is done on a best effort basis or on underwriting basis. It is usually the lead manager who acts as the syndicator of loans, the lead manager has dual tasks that is, formation of syndicate documentation and loan agreement. Common documentation is signed by the participating banks or common terms and conditions.
Thus, the advantages of the syndicated loans are the size of the loan, speed and certainty of funds, maturity profile of the loan, flexibility in repayment, lower cost of fund, diversity of currency, simpler banking relationship and possibility of re-negotiation.
Steps Involved in Loan Syndication:
1. The borrower decides about the size and currency of the loan he desires to borrow and approaches banks for arranging the financing on the basis of business, purpose of the loan, etc.
2. For a name acceptable in the market, in general several banks or group of banks will come forward with offers indicating broad terms on which they are willing to arrange the loan. The bank offers to be the Lead Manager. In their offers, the lead manager would indicate the loan and its commitment and other charges and spreads over LIBOR on which they are willing to arrange the loan.
3. The borrower chooses the bid which appears to be the best to him in terms of the total cost of the package, other terms and conditions and the relationship factor, etc. on receiving the bid from various banks or groups of banks.
4. The loan gets finalised by both the borrower and the lenders on an information memorandum giving financial details and other details of the borrower. The lead manager would participate in the loan from lenders based on the information memorandum.
5. The entire fees would be showed by the participating bank (based on their participation) and lead manager.
6. The lead manager are liable to finance the balance amount is known.
7. The next step in finalisation of the loan agreement by borrowers and lender is done after the participants are known and the loan is published through a financial press.
The Important Provision of a Loan Agreement:
1. The loan agreement specifies the interest, commitment fees and the management fees that the borrower should pay to the lender.
2. Document pertaining to borrower’s financial position, overrun finance agreement, got approvals received (for e.g., Relating to tax, reduction at sources) tying up of other financial requirement (if required), certificates from lawyers, and other internal and external approval that would be required.
3. The primary or the secondary security against which the loan is taken will have to be decided.
4. The circumstances that are to be treated as default and suit against the borrower when the borrower is not servicing the loan, cross default clauses (aimed at giving the lenders the right to accelerate repayment of the loan in the event of the borrower or guarantor is in default under any loan agreement) etc. are decided.
5. Jurisdiction is an important element of any international loan agreement and it tells which country’s law is applicable.
1. Syndicated loan facilities can increase competition for your business, prompting other banks to increase their efforts to put market information in front of you in hopes of being recognised.
2. Flexibility in structure and pricing. Borrowers have a variety of options in shaping their syndicated loan, including multicurrency options, risk management techniques, and prepayment rights without penalty.
3. Syndicated facilities bring businesses the best prices in aggregate and spare companies the time and effort of negotiating individually with each bank.
4. Loan terms can be abbreviated.
5. Increased feedback. Syndicate banks sometimes are willing to share perspectives on business issues with the agent that they would be reluctant to share with the borrowing business.
6. Syndicated loans bring the borrower greater visibility in the open market. Bunn noted that “For commercial paper issuers, rating agencies view a multi-year syndicated facility as stronger support than several bilateral one-year lines of credit.”
Why a Syndicated Loan?
Lenders both banks and institutional providers tightened their belts for a couple of years, deals to minimise their risk or exposure. While lenders today may be cash-heavy, they are not looking to throw cash at every deal that crosses their desks.
Lenders may be reluctant to hold large amounts of debt from a single corporate customer, opting instead to take a piece of the deal and syndicating the remainder to other banks or institutional lenders. This strategy spreads the risk or exposure among multiple lenders. The borrower, benefits by increasing the borrowing capacity with multiple credit providers. And there are additional benefits.
1. Less-expensive financing than bonds, lower interest rates and upfront costs.
2. Prepayment may be available without penalty or premium.
3. Expanded access to non-credit products such as capital markets solutions and expertise.
Syndicated Loan Markets:
Syndicated Loans are international in their understanding, although certain geographical regions maintain unique attributes. The broad international markets are North America, EMEA and Asia. Within Asia, based upon size and volume of loans, Japan is often singled out as a significant market.
The syndicated loan market could be roughly divided into two “classes” of syndicated loans. The first, designed for smaller companies (loan sizes approximately between 20 to 250 million), feature funds usually lent by a fixed group of banks for a fixed amount.
In North America and Europe, larger loans than this are often open to be traded, so that they almost become more like a regular bond. Purchasers of these loans include hedge funds, pension funds, banks, and other investment vehicles. Asian markets have limited numbers of loans that are freely traded this way.
The second, until the subprime lending crisis, larger syndicated loans, although “agented” by one bank, were often sold to the international capital markets after repackaging into trusts and being sold as collateralized loan obligations. For larger loans, there was some evidence that the agent banks would often underwrite portions of these loans specifically for on selling as collateralised loan obligations.
This underwriting may have been in excess of the broader expected appetite of traditional lenders. With the collapse of many aspects of the international fixed income (lending) capital markets due to the subprime crisis, many banks were stuck with underwritten positions, potentially on terms they would not have lent on for the entire stated period of the business loan. These are known as “hung” or “stuck” underwrites or loans and have been responsible for a portion of the recent losses of financial institutions.
Type # 2. International Bond Market:
Bonds are IOUs issued by both public and private entities to cover a variety of expenses. For investors, bonds provide a cushion of stability against the unpredictability of stocks and should be a part of almost every portfolio.
In many, but not all, markets, bonds will move in the opposite direction of stocks. If stocks are up, bonds are down and if stocks are down, bonds are up. This is a very broad generalization, but one that helps explain why bonds are a good counter to stocks.
You have a wide variety of bonds to choose from and each type has certain characteristics.
In the 19th century, foreign issuers of bonds, mainly government and railway companies, used the London market to raise finances. Foreign bonds are bonds floated in the domestic market (currency from non-resident entities). As controls over movement of capital, government related, many foreign bonds were issued in the domestic markets of the USA, UK, Germany, Japan Netherlands, Switzerland, etc.
Modern Jargon refers to these as Yankee bonds, i.e., those issued in the USA, domestic market, Bulldog bonds in UK, Samurai bonds in Japan, etc. Offshore bonds which were formally known as Euro bonds are bonds issued and sold outside the home country of the currency of issue, e.g., A dollar bond sold in Europe is an offshore bond.
Regulatory requirements are less stringent when foreign bond issues are made on private placement basis rather than through an invitation to the general public to subscribe.
A bond underwritten by an international syndicate banks and marketed internationally in countries other than the country of the currency in which it is denominated is called a Euro bond. This issue is not subject to national restrictions.
A detailed discussion on Euro bonds is given below:
1. Euro bond market is almost free of official regulations.
2. The Eurobonds are the international bonds which is issued in a currency other than the currency or market it is issued.
3. Generally issued by international syndicate of banks and financial institutions.
Issuer of the Euro Bonds:
Usually, a bank specifies the follows:
1. Desired currency of denomination,
2. The amount and
3. The target rate.
1. Small par value and high liquidity,
2. Flexibility to the issuer,
3. For both individual and institutional investors and
4. No impact on Balance of payments.
Instruments or Types of Euro Bonds:
(1) Straight Bonds:
Bond which will pay back the principal on its maturity date at one stroke called bullet payment, will pay a specified amount of interest on specific dates, and does not carry a conversion privilege or other special features.
(2) Floating Rate Notes:
Floating Rate Notes (FRNs) are debt securities bonds, of any currency, that entitle the holder to regular interest coupons. FRN coupons are reset periodically to match the London/Euribor interbank offered rate. Typically, the rate agreed is the benchmark rate plus an additional spread and is reset every three to six months.
The interest rate is floating and set above or below the LIBOR.
Interest rates are revised every 3-6 months.
3. Risk and
Features of FRNs:
1. The reference rate,
2. The margin,
3. The reference period and
Some FRNs have special features such as maximum or minimum coupons, called capped FRNs and floored FRNs. Those with both minimum and maximum coupons are called collared FRNs. FRNs can also be obtained synthetically by the combination of a fixed rate bond and an interest rate swap. This combination is known as an Asset Swap.
(3) Flip-Flop FRNs:
Here, the investors have the option to convert the paper into flat interest rate instrument at the end of a particular period. World Bank had issued FRNs with perpetual life and having a spread of 50 basis point over the USA treasury rate. The investors have the option at the end of 6 months.
(4) Mismatch FRNs:
These notes have semi-annual interest payment though the actual rate is fixed monthly. This enables investors to benefit from arbitrage arising out of differential in interest rates for different maturities.
(5) Minimax FRNs:
These notes include both minimum and maximum coupons the investors will earn the minimum rate as well a maximum rate on these rates.
(6) Zero Coupon Bonds:
This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, let’s say a zero coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you’d be paying $600 today for a bond that will be worth $1,000 in 10 years.
A foreign bond is issued in a domestic market by a foreign entity in the domestic market’s currency. Bonds are regulated by the domestic market authorities and are usually given nicknames that refer to the domestic market in which they are being offered.
Since investors in foreign bonds are usually the residents of the domestic country, investors find them attractive because they can add foreign content to their portfolios without the added exchange rate exposure.
Types of foreign bonds include bulldog bonds, matilda bonds, and samurai bonds:
(1) Samurai Bonds:
A yen-denominated bond issued in Tokyo by a non-Japanese company and subject to Japanese regulations. Other types of yen-denominated bonds are Euroyens issued in countries other than Japan.
Samurai bonds give issuers the ability to access investment capital available in Japan. The proceeds from the issuance of samurai bonds can be used by non-Japanese companies to break into the Japanese market, or it can be converted into the issuing company’s local currency to be used on existing operations. Samurai bonds can also be used to hedge foreign exchange rate risk.
(2) Yankee Bonds:
A bond-denominated in IJS dollars and is publicly issued in the US by foreign banks and corporations. According to the Securities Act of 1933, these bonds must first be registered with the Securities and Exchange Commission (SEC) before they can be sold. Yankee bonds are often issued in tranches and each offering can be as large as $1 billion.
Due to the high level of stringent regulations and standards that must be adhered to, it may take up to 14 weeks (or 3.5 months) for a Yankee bond to be offered to the public. Part of the process involves having debt-rating agencies evaluate the creditworthiness of the Yankee bond’s underlying issuer.
Foreign issuers tend to prefer issuing Yankee bonds during times when the US interest rates are low, because this enables the foreign issuer to pay out less money in interest payments.
(3) Bulldog Bonds:
Sterling-denominated bond that is issued in London by a company that is not British. These sterling bonds are referred to as bulldog bonds as the bulldog is national symbol of England.
(4) Matilda Bonds:
An bend-denominated in the Australian dollar and issued on the Australian market by a foreign entity. It is also known as a “kangaroo bond”. Created in 1994, the market for matilda bonds is relatively small.
Medium Term Notes (MTNs):
A note that usually matures in five to ten years. A corporate note continuously offered by a company to investors through a dealer. Investors can choose from differing maturities, ranging from nine months to 30 years. Notes range in maturity from one to 10 years. By knowing that a note is medium term, investors have an idea of what its maturity will be when they compare its price to that of other fixed-income securities.
All else being equal, the coupon rate on medium term notes will be higher than those achieved on short- term notes. This type of debt program is used by a company so it can have constant cash flows coming in from its debt issuance; it allows a company to tailor its debt issuance to meet its financing needs. Medium term notes allow a company to register with the SEC only once, instead of every time for differing maturities.
Note Issuance Facility (NIF):
This is a medium term debt instruments which is issued for a short term, usually a year and can be handed over as and when required. A syndicate of commercial banks that have agreed to purchase any short to medium term notes that a borrower is unable to sell in the euro-currency market.
This facility under which banks provides credit is called Revolving Underwriting Facility (RUF). Interest rates on NIF is said with a spread over LIBOR. A variation of NIF is the multiple component facility. Here, a borrower is enabled to draw funds is a number of ways (short-term advances and banker’s acceptance, and of course, opportunities for choosing the maturity and currency).
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