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Chapter 19
Business Borrowing: Corporate
Bonds, Asset-Backed Securities,
Bank Loans, and Other Forms of
Business Debt
19 - 2
 Learning Objectives 
• To look at how business firms issue debt securities and
negotiate loans in order to raise funds in the money and capital
markets.
• To learn about the key factors affecting the volume of funds
that businesses seek to raise in the financial system.
• To see the often powerful impact that business borrowing has
upon market interest rates and credit conditions.
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Introduction to Business Borrowing
• Business firms draw on a wide variety of fund sources to
finance their daily operations and to carry out long-term
investment.
• In 2003, nonfinancial business firms in the U.S. raised over
$1.6 trillion, of which approximately $300 billion was
supplied from the financial markets through issues of bonds,
stocks, notes, and other financial instruments.
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Factors Affecting Business Activity in the
Money and Capital Markets
• Many factors affect the extent to which business firms draw on
the money and capital markets for external funds:
- Total funding demands of business firms
- Level and expected growth of internally generated funds
- Condition of the economy
- Credit availability and interest rates
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Characteristics of Corporate Notes and Bonds
• A note has an original maturity of five years or less, while a
bond carries an original maturity of more than five years.
• Both securities promise the investor an amount equal to the
security’s par value at maturity plus interest payments at
specified intervals.
• They are generally issued in units of $1,000, and accompanied
by indentures.
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Characteristics of Corporate Notes and Bonds
• Corporate bonds tend to be issued with longer maturities when
both interest rates and inflation are low.
• Some corporate bonds are backed by sinking funds.
• A considerable proportion of corporate bonds that are
outstanding today carry call privileges.
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Characteristics of Corporate Notes and Bonds
• During periods of rapid economic expansion, when the supply
of credit is relatively scarce, the cost of borrowing rises.
• Yields on the highest-grade bonds tend to move closely with
government bond yields.
• Yields carried by lower-grade corporate bonds are more
closely tied to conditions in the economy and to factors
specifically affecting the risk position of each borrowing firm.
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Characteristics of Corporate Notes and Bonds
• For a bond that matures in 10 years:
• Interest charges on debt are tax deductible, so k’ = k (1 – t).
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Characteristics of Corporate Notes and Bonds
Signals that Corporate Bond Issues May Send
• A bond issue that appears to be driven by an unanticipated
cash-flow shortage tends to lower the bond and equity prices
of the issuer.
• On the other hand, a new bond sold to expand the firm’s
capitalization tends to send a positive signal to the market.
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Characteristics of Corporate Notes and Bonds
• Common types of corporate bonds include:
Debentures – bonds that are not secured by any specific asset
Subordinated debentures – junior securities
Mortgage bonds – may be closed end or open end
Income bonds – interest is paid only when income is actually
earned
- Equipment trust certificates – resemble leases
- Industrial development bonds (IDBs) – issued by a local
government borrowing authority
-
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Characteristics of Corporate Notes and Bonds
• Innovations in corporate debt include:
- Discount bonds – including zero coupon bonds
- Floating-rate bonds
- Commodity-backed bonds – the face value is tied to the market
price of an internationally traded commodity
- Inflation-linked corporate notes
- Medium-term notes (MTNs) – carry maturities of one to ten
years
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Asset-Backed Securities Issued by
Corporations
• The process that gives rise to the creation of asset-backed
securities (ABS) is known as securitization. It involves:
- Packaging groups of home mortgage loans, usually with
guarantees issued by federal agencies, removing them from the
lenders’ balance sheets, and placing them in a separate trust
account.
- Selling the new securities backed by the packaged loans in the
open market with the help of an investment bank or other
securities firm.
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Asset-Backed Securities Issued by
Corporations
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Asset-Backed Securities Issued by
Corporations
• Securitization may:
- Reduce the cost of raising funds
- Grant companies greater control over their balance sheets
- Help a company avoid the issuance of additional balance-sheet
debt
- Improve the apparent financial strength of an issuing firm
- Permit greater asset diversification
- Provide a new source of company earnings
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Asset-Backed Securities Issued by
Corporations
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Investors in Corporate Debt
Principal Investors in Corporate and Foreign Bonds, 2004*
Source: Board of Governors of the Federal Reserve System,
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Flow
of Funds
Accounts: Financial Assets
and The
Liabilities,
FirstCompanies,
Quarter Inc.,
2004.
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Markets,
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The Secondary Market for Corporate Debt
• The secondary market for corporate debt is relatively limited
compared to the markets for other long-term securities like
common stock and municipal bonds.
• The number of active individual investors is small and
institutional investors tend to follow a buy and hold strategy.
• Recently however, many institutions are looking at total
performance and have become more aggressive.
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The Marketing of Corporate Debt
• New corporate bonds may be offered publicly in the open
market to all interested buyers through a public sale, or sold
privately to a limited number of investors via a private or
direct placement.
• The majority of corporate bond sales are public sales. Private
placements are, however, popular among smaller companies
and firms with unique financing requirements.
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The Marketing of Corporate Debt
• In a public sale, an investment banking firm or a syndicate of
underwriters may either purchase the securities directly from
the issuing company through a bidding process or guarantee
the issuer a specific price for the securities.
• In both approaches, the underwriter carries the risk of losses
(or gains) when the securities are marked for sale in the open
market.
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The Marketing of Corporate Debt
• In recent years, private placements have accounted for about
10% of market sales of corporate bonds.
• Usually, periods of rising interest rates and reduced credit
availability bring more borrowing companies into the public
market, while falling interest rates often bring about a rise in
private placements.
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The Volume of Borrowing by Corporations
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The Volume of Borrowing by Corporations
• The growth in corporate borrowing is due to:
- inflation
- the increased use of financial leverage to boost returns to
corporate stockholders
- the development of international capital markets
- recent relatively-low interest rates
- the rash of corporate takeovers (leveraged buyouts) and mergers
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Bank Loans to Business Firms
• Commercial banks are direct competitors with the corporate
debt markets in making both short-term and long-term loans to
businesses.
• Although growing numbers of corporations that once relied on
banks for funds have turned to selling securities in the open
market, the volume of bank credit made available to business
firms remains enormous.
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Bank Loans to Business Firms
• The prime bank rate, or base rate, is the annual percentage
rate that banks quote to their most creditworthy customers.
• Traditionally, the prime rate was set by one or more of the
nation’s leading banks, and the other banks followed the
leader.
• Nowadays however, prime rates are often pegged to the
prevailing yields on Treasury bills and other money market
instruments.
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Commercial Mortgages
• The construction of office buildings, shopping centers, and
other commercial structures is generally financed with an
instrument known as the commercial mortgage.
• Faced with inflation and a volatile economy, new forms have
been developed:
- equity kicker
- indexing
- asset-backed securitization
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Markets on the Net
• Bond Market Association at www.investinginbonds.com/
• Bond Market Association – European Issues at
www.bondmarkets.com/
• CBS Marketwatch at www.cbs.marketwatch.com/
• CNN/Financial at www.cnnfn.com
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Markets on the Net
• Financial Pipeline at www.finpipe.com
• Mortgage 101 at www.mortgage101.com
• REBUZ – Commercial Mortgages at www.rebuz.com
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Chapter Review
• Introduction to Business Borrowing
• Factors Affecting Business Activity in the Money and Capital
Markets
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Chapter Review
• Characteristics of Corporate Notes and Bonds
-
Principal Features
Recent Trends in Original Maturities
Call Privileges
Sinking Fund Provisions
Yields and Costs
Signals Corporate Bond Issues May Send
The Most Common Types of Corporate Bonds
Innovations in Corporate Debt
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Chapter Review
•
•
•
•
Asset-Backed Securities Issued by Corporations
Investors in Corporate Debt
The Secondary Market for Corporate Debt
The Marketing of Corporate Debt
- Public Sales
- Private Placements
• The Volume of Borrowing by Corporations
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Chapter Review
• Bank Loans to Business Firms
- The Volume of Bank Credit Supplied to Businesses
- The Prime, or Base, Interest Rate on Business Loans
- Other Examples of Base Rates for Business Loans
• Commercial Mortgages
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