Risks Drive Debt Spreads

The return investors receive for owning a debt instrument, whether a loan or a bond, is driven by the various risks of owning debt.  This Job Aid from Financial Training Partners does a good job in explaining the major risks faced by debt...

Primary and Secondary Markets for Corporate Debt

In earlier posts, we compared the pricing of corporate loans and corporate bonds.  Here, we’ll look at how these markets interact, both in primary issuance and secondary market trading.  First, some definitions:   The Primary Market is where financial instruments are sold from the issuer to investors.  This is often referred to at underwriting (in the bond and equity markets) or syndication (in the loan market).  As part of this process, securities often pass through an intermediary, such as an investment bank. The Secondary Market is where financial instruments are sold from investor to investor.  The issuer is not involved, and there is no underwriter (although there are brokers, and many underwriters also trade securities in the secondary market).   The Investors In the loan market, banks and institutions (such as collateralized debt obligations (CDOs) and prime rate funds) are the most active investors. In the bond market, institutions (such as mutual funds, pension funds, insurance companies and CDOs) are the most active investors; banks rarely buy corporate bonds. The key to rational pricing in these markets are the crossover investors – institutions, such as CDOs and certain other investment funds, that can buy loans and bonds in the primary and secondary markets.  By analyzing the relative value of loans and bonds, they decide which to buy.  For example, if the spread between loans and bonds is very large, investors may buy the bonds and shun the loans.  This increased demand for bonds will bring down their spreads in the secondary market, while the lack of demand for loans will increase their spreads in the secondary market.  Eventually, the...

Loan – Bond Relative Value

In our last post, we described how to compare the cost of a floating rate instrument, such as a loan, to the cost of a fixed rate instrument, such as a bond.  For one company, Jarden Corporation, we showed that the bond’s cost is 50 basis points higher than the loan’s cost.  Since both debt instruments were issued by the same borrower, shouldn’t they cost the same?   Corporate Finance 101 Whenever there is a difference in the cost or return of two financing instruments, corporate finance theory tells us to look to the risk differences between the two.  This applies if you are looking at it from the perspective of the issuer or the investor.  For this post, we will continue the Jarden example, comparing a loan and a bond for a non-investment grade issuer (note that the product terms, pricing, and risk characteristics for investment grade issuers are dramatically different).   Investor: Risk vs. Return As with Jarden, the yield on non-investment grade (i.e. “high yield”) bonds is typically higher than the yield on non-investment grade (i.e. “leveraged”) loans.  This is because high yield bonds are more risky to own than leveraged loans, for these reasons:   Priority: Loans to non-investment grade companies are typically senior and secured, while bonds to these same companies are typically subordinated and unsecured.  Thus, in a bankruptcy, the loans should get repaid before the bonds. Maturity and Amortization:  Corporate loans rarely come due beyond 6-7 years from issuance, whereas high yield bonds often mature in 10 years.  In addition, bonds typically have “bullet” maturities (i.e. all the principal comes due at...