The Big Explainer
What are corporate bonds and loans?
This week Roger Hirst is joined by David Puchowski, Refinitiv’s Director of Market Analysis, to help shed some light on corporate bonds and loans. The corporate debt market is one of the largest financial markets, but also one of the least well-known parts of the financial framework. Corporates can borrow money or raise capital in many different ways and are at the heart of any economy, but often this key part of the economic infrastructure gets overlooked.
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One misconception about debt is that it's inherently bad, and certainly there is a threshold. Managed prudently, which most companies will, issuing bonds and loans can help grow businesses, create jobs and essentially help the economy.
Welcome to The Big Explainer. The corporate debt market is one of the largest financial markets, but also one of the least well-known parts of the financial framework. Corporates can borrow money or raise capital in many different ways and are at the heart of any economy, but often this key part of the economic infrastructure gets overlooked.
So the corporate debt market doesn't typically garner too many mainstream headlines and is mostly known to those who only cover the market, but as part of the overall financial markets, it's a huge piece in over 10 trillion dollar market here in the US. And it's also enormously important on the corporate level, to enhance liquidity and potentially grow business, either by using it to help finance an M&A transaction, or for other business investment. One example I like to give where a credit helped change the trajectory of an industry, back in late 2006, Ford Motor Company approached the syndicated loan market for the first time. They wanted to get a much larger debt commitment to help with some restructuring, as well as also liquidity to counter against a potential recession. They issued an 18 billion dollar syndicated loan from a lender group, which practically doubled the company's liquidity at the time. Well, within six month’s time, credit markets started freezing up due to the subprime mortgage crisis, and fast forward a little bit further to 2008 after Lehman collapse, and the recession starts, the other two of the big three U.S. automakers, GM and Chrysler, filed for bankruptcy and received government bailouts while Ford was able to scrape through, and by avoiding bankruptcy, was even able to increase market share over its competitors. Now there were other factors at play, Ford's loan wasn't the sole reason, but it certainly put Ford in a better position at the time and really helped them navigate the recession.
Companies can raise capital in a variety of ways. Sometimes they will increase their debt levels by issuing bonds, whilst on other occasions, they will borrow money directly from banks in the form of loans, though the risk is usually spread across a number of lenders. One of the main differences between bonds and loans will be duration. Bonds are usually longer dated than loans.
The two main types of debt issues for companies are bonds and loans. While there are some similarities between the two, they have different characteristics that investors, may favour one over the other, depending on market conditions.
Bonds are a debt instrument that a company issues to investors. There is a bank involved, but they act as a servicer rather than a lender. The bonds have long tenors, can be as long as 10, 20, 30 years. The company pays back the principal of the bond at maturity and throughout the life of the bond, investors are paid a regular fixed rate of interest. Bonds are viewed as a more predictable asset, an investor knows what the return on investment is going to be, as opposed to something like stocks. Now, a corporate loan, oftentimes called a syndicated loan, is where a group or syndicate of lenders come together to loan money to a company. So here the bank is the provider of the loan. The reason it's a group of lenders rather than one is to, 1. Open up an even larger commitment size to the borrower, and 2. Spread the risk around, so instead of a two hundred million dollar loan for one borrower sitting in one bank's portfolio, you have it spread amongst the larger group. Compared to bonds, loans are shorter in duration, usually in the five to seven year range, although they can go longer at times, and loans are a floating rate instrument which differentiates them from a fixed-rate bond.
Loans have aspects which are similar to some of the everyday instruments that households and consumers may use.
There are two main types of corporate loans, revolvers and term loans. And it's typical for a company that's issuing loans to include both types. I can draw a parallel to everyday life for the difference between revolvers and term loans. A revolving loan behaves just like a credit card. A company that has a revolving credit can borrow a portion of it, repay part of that portion back, re-borrow more, etc. just like someone would with a credit card. Revolving credits debt maturities usually in the three to five year range and are used for normal course of business like covering payroll expenses. Quite often a company may not even need to draw down on its revolving credit, they may have it as a 'just in case'. The second type of loan is a term loan. Term loans behave just like a mortgage would. You have one draw on the entire amount of the loan at inception and then it's repaid in regular installments over the life of the loan. So it doesn't have that revolving nature to it of 'repay re-borrow'. Term loans can also be used for a normal course of business, but they're also the main form of loan used in an M&A financing. Now there's also two key types of term loans worth making the distinction between - pro-rata and institutional. A pro-rata term loan will have the same general terms as the revolver, same pricing, same tenor, and those two components are held by the lending banks. Those loans are less risky by nature than the other type of term loan, the institutional term loan, which is larger in size, has higher pricing and longer tenor, usually around seven years. That piece of the loan is sold by the banks to institutional investors who are your hedge funds, pension funds, insurance companies and collateralized loan obligations. This institutional piece of a leveraged loan is the closer compared to a high yield bond. Investors looking for better returns will look to institutional term loans and high yield bonds.
Bonds and loans fulfill different requirements for corporate borrowers. But there are risky loans and risky bonds. The risk profiles of bonds and loans can often be very similar.
Even though bonds and loans are part of the fixed income category, which is viewed as a relatively safe asset class compared to equities, they're not without risk. Both debt types typically get tossed into two categories of risk profiles. The first is investment grade or in the bond market, sometimes simply called a corporate bond. These are well-rated names, you think along the lines as a chip stock, Disney, Coca-Cola, Microsoft. Investment grade companies are usually rated triple B or better by rating agencies. Investment grade loans and bonds are typically unsecured, meaning they're not backed by any collateral, and since they're senior debt instruments, they'll sit above the equity in a company's capital structure, so those investors will have priority to recoup losses in the case of a bankruptcy. The investment grade market is very relationship driven. For instance, in the loan market, the revolving loan itself is very cheap for the borrower to keep, so the lenders aren't making a whole lot of money on it, but they are interested in more lucrative ancillary business that could come from maintaining a relationship with that company. Many investment grade borrowers don't change up their lending groups over the years, it's a very consistent market in that way. Now the other risk profile is the high yield or junk category, which is the label in the bond market. And the equivalent in the loan market is the leveraged loan. These are lower-rated companies, viewed riskier compared to the investment grade space. They're usually rated double B or lower by the rating agencies. A leveraged loan is normally secured, so it is backed with collateral, while a high yield bond is typically unsecured. So because of that, the leveraged loan will sit higher up in the capital structure compared to the high yield bond.
Once capital has been raised via a bond, the issuer needs to pay the pre-agreed interest or yield generally on an annual basis. Corporate loans however, may have some ongoing criteria which the recipients of the loan needs to meet throughout its lifetime. That said, bonds and loans at the riskier end of the spectrum will have a lot of features in common.
So some other differences you'll see between loans and bonds. Loans oftentimes contain something called maintenance covenants, which bonds do not. These are measures built into the agreement that the borrower needs to maintain throughout the life of the loan. For example, maybe a financial ratio like a debt to EBITDA level. Covenants allow the lending group some controls over how much risk the borrower can take on throughout the loan. Another difference is high yield bonds will have longer call protections than an institutional average loan. Call protection is the length of time during which an issuer cannot refinance that debt. For a high yield bond the call protection could be five years, sometimes higher, whereas in the leverage loan market, sometimes you'll see call protection as low as six months. So if you're a borrower you're locked into that high yield bond for much longer than a loan. Now it's worth mentioning at times these two debt instruments, high yield bond and institutional leverage loan, they seek some crossover of these characteristics. For example, having a high yield bond as secured or an institutional term loan, having a lack of maintenance covenants, and market sentiment can drive these sorts of patterns in the market.
Perhaps one of the clearest distinctions between bonds and loans is how they're priced. Bonds tend to be fixed and loans tend to be floating. A corporate's credit rating will also matter. Low quality companies will nearly always have a higher charge than companies with a strong balance sheet.
A key difference between bonds and loans is how they're priced. Loans are a floating rate instrument, so they will be tied to an interest rate like three-month LIBOR. And then there will be an additional spread on top of that interest. Bonds are normally fixed rate, so what was agreed upon at inception is carried throughout the life. Both bonds and loans will be priced off of the borrower's risk profile. So if the borrower is an investment grade name, they will be paying less for their loan or bond than a leverage or high yield borrower. Besides the rating, lenders might look at the sector the borrower operates in as well as the other pieces of the loan structure, tenor covenant package. Then they'll look at what similar rated borrowers in similar sectors recently priced at in order to get a comparable. In the loan market, oftentimes the pricing can increase or decrease throughout the life of the loan. That's because what's spread over the interest rate can adjust depending on factors. If pricing is tied to the company's rating and the company gets downgraded, then that might trigger higher pricing within the loan. Sometimes loan pricing is tied to a financial ratio like debt to EBITDA and can increase or decrease throughout the loan depending on that ratio. This is a way to bake into the agreement something for the lenders to protect themselves If or when the company sees performance deteriorate.
The quality of a company is clearly critical to its ability to access funding. Whilst the Covid crisis has had a profound impact on the demand for debt and loans.
The high yield bond market and institutional loan market, which is that riskiest piece in the leveraged loan market, are both huge markets, each currently about one point two trillion in size. Those sizes ebb and flow depending on investor appetite. In the few years prior to the Covid-19's impact on the market, the institutional loan market was regularly putting up higher volume numbers than the high yield bond market. Because loans are a floating rate, they are favored by investors looking for higher yielding assets during a rising rate environment. Investors like that option, especially going back a few years ago when the Federal Reserve was still hiking rates. But as soon as they dropped rates back in March to counter the impact of the pandemic, then later gave signals that they are not going to raise them again for some time, investors started to look more towards high yield bonds. You can see that with the Lipper fund flows data, which shows that retail investors have been pouring money into the high yield bond asset class since April while pulling money out of leveraged loans.
The high yield market has seen a huge increase in interest during this pandemic period. There are concerns that the corporate bond and loan markets are spiraling out of control.
I think maybe one misconception about debt is that it's inherently bad, and certainly there is a threshold. Carrying too much debt can be counterproductive, we saw that before the Great Financial Recession with the mega leveraged buyouts, over 20 billion debt sizes and some of those companies getting overburdened with it. But those were more exceptions rather than the rule. Managed prudently, which most companies will, issuing bonds and loans can help grow businesses, create jobs and essentially help the economy.
The Covid crisis has seen a huge increase in issuance of both loans and bonds as companies try to navigate the economic uncertainty. The U.S. Federal Reserve is buying corporate debt via its quantitative easing program, and this has encouraged many companies to tap the bond market. Companies that probably shouldn't have been able to sell more debt have found it relatively easy to do so. Though companies that were already on their last legs are having to pay penal rates. The health of the corporate bond and loans market will probably define whether the U.S. will sink into a deeper recession or not. If the fiscal and monetary stimulus of the U.S. government can support bond prices and suppress loan costs, then U.S. corporates may be able to borrow their way through the pandemic. Eventually, however, it will be cash flows rather than borrowing that will define the long-term outlook of the corporate sector.