CAT / FIA FFM Syllabus C. Managing Cash Balances - NCL - debts - Notes ^{11 / 13}

Debt

• Is a liability of the business

• Pays interest which is tax deductible

• Does not represent ownership in the firm

Debt comes in many forms

Straight long-term debt (also called “loan capital”) includes:

• Bonds

  Secured by a mortgage on tangible assets of the firm

• Debentures

  Unsecured corporate debt

The term “bonds” is commonly used for both categories above.

In the event of default:

1. Debt holders with a security interest over assets enjoy a prior claim in the event such assets are sold

2. Debenture holders can be paid only after (secured) bondholders have been repaid.

Other types of securities

• Convertible debt

  This is debt which is convertible (at the option of the convertible debt holder) into equity, based on pre-defined “conversion” conditions

• Subordinated loans

  Refers to any kind of debt which ranks inferior to more senior debt; it cannot be repaid until more senior-ranked creditors have been repaid

• Warrants

  A security giving the holder the option to buy common shares from a company for a pre-set price valid for a period of time. These are usually tradable in a secondary market and therefore have a market price

• Deep discount bonds

  Debt issued with a very low or no (zero) coupon, so that the issue price will be far below the par value of the bond. 

  Such instruments with no coupon are also called “pure-discount” or “zero” bonds.

• Junk (high yield) bond

  A speculative debt instrument that either carries no rating or a low rating by the rating agencies (below “investment grade”);

• Redeemable bond

  A bond which the issuer has the right to redeem prior to its maturity date, under certain conditions. 

  The company pays the interest and the original amount (capital) back.

Types of interest rates

1. Fixed rates

   Interest rates can be set at a specific percentage rate and not change during the contractual period of a loan.

   Bonds issued with fixed (rate) coupons (making them “fixed rate” instruments) will vary in value as market interest rates change.

2. Floating rates

   Floating rates fluctuate with the movement in market interest rates.

   They are used in debt instruments and (bank) loan contracts by defining how the interest rate is to be set on a periodic basis.

Security

Loan notes will often be secured.
 
Security may take the form of either a fixed charge or a floating charge.

1. Fixed charge

   Security can be related to a specific asset or group of assets, typically land and buildings. 

   The company would be unable to dispose of the asset without providing a substitute asset for security, or without the lender's consent.

2. Floating charge

   With a floating charge on certain assets of the company (for example inventories and receivables), the lender's security in the event of a default of payment is whatever assets of the appropriate class the company then owns 

   The company would be able to dispose of its assets as it chose until a default took place.

Whatever form the security takes, if the interest on the loan is not paid, the lenders or loan note holders can try to realise the security, to recover their investment.

Unsecured loan notes

Not all loan notes are secured. 

Investors are likely to expect a higher yield with unsecured loan notes to compensate them for the extra risk. 

The rate of interest on unsecured loan notes may be around 1% or more higher than for secured loan notes.