6. Debt Offerings

Synthetic securitizations

Almost the same goal as traditional securitization can be achieved through credit derivatives (synthetic securitizations) Main difference: No cash generation in synthetic securitization

Hybrid securities

Blend of debt & equity Simplest is convertible bond Convertible bond: Holder has option to exchange securities for fixed number (conversion ratio) of common shares Also combination of debt with warrants

Debt offerings

Bond offerings Securitization process & hybrid instruments Loan syndication

Bought deal: Alternative issuing procedure

Book-runner buys entire issue from issuer, thus setting terms prior to announcement Corresponds to fixed-price approach of equity offerings Approach allows a reduction in issuance time BUT higher uncertainty for IB about offering outcome Used when mkt conditions are stable and lot of liquidity available

Invitation amount

Book-runner should specify invitation amount (portion of loan each bank should commit to join syndicate) Each bank then decides their invitation amount to subscribe

High yield corporate bonds

Called junk bonds Quality below BBB May have been: - Rated non-investment grade at time of issuance (original-issue high yield bonds) - Downgraded to non-investment grade Downgraded bonds fit into 2 categories: - issuer voluntarily significantly increased debt as a result of leveraged buyout or recapitalization - issues downgraded for other reasons

Credit ratings & bond pricing

Credit rating: Opinion about likelihood of default of issuer or issue made by issuer Impacts: - Credit spread (interest paid by issuer) - Gross spread (fee paid by issuer to IB) - Min capital requirements by banks (Basel Capital Regulations) - Possibility of some institutions to buy securities (insurance companies, pension funds)

Syndicated loans: Why?

Effective way to limit single-name exposure Generate fees which help diversify bank income based on interest margin Participating banks might get lending opportunities even if they lack origination capacity in a certain industry/geographical area

Securitization: Why?

Efficient funding: - Issuer's credit rating becomes irrelevant. Issuer with B rating but with AAA assets can raise funds at AAA rather than B by securitizing AAA assets - Lower cost - Alternative investor base Improving balance sheet structure: - Improves capital utilization - Releases capital Enables better utilization of resources Risk management

Syndicate loan fees

Fees paid by borrower to syndicate: Arrangement fee: Compensates for creating syndicate and underwriting risk. Computed against underwritten amount (the committed amount) Sub-underwriting fee: Part of arrangement fee is paid to compensate sub-underwriters for underwriting risk Closing fee: Compensates for credit screening. Computed against portion of loan actually granted

Bond categories

Fixed rate: Straight bond (fixed coupon) and zero-coupon bond Floating rate: Coupon payments indexed to a reference rate. Sometimes coupon payments are capped or floored Equity related: Convertible bonds, bonds with equity warrants ABS: Asset backed securities issued by a vehicle and backed by some assets as part of securitization process

Fully underwritten vs Best Effort

Fully underwritten loan: Book-runner commits loan amount. Borrower will receive money anyway even if loan is under-subscribed Best effort loan (also "arrangement"): Book-runner commits only its final take (portion of loan amount that would have been finally provided)

Syndication strategies

Fully underwritten vs Best effort Sole mandate vs Joint mandate General syndication vs Sub-underwriting plus general syndication

Oversubscription

If deal is oversubscribed, 2 solutions: - Increase deal size - Scale back (reduce final take of syndicate banks: on a pro-rata or discretional basis)

Credit enhancement techniques

Internal: - Tranching: Bonds issued in several tranches with different seniority (subordinate bonds absorb any losses increasing quality of senior bonds) - Over-collateralization: Value of assets transferred to SPV is higher than value of bonds issued to cover any shortfall - Cash collateral: Cash account set by originator as collateral to bonds External: Originator purchases external guarantee from bank or insurance company

Pool of assets general characteristics

Large volume to facilitate statistical analysis Stable history of defaults, delinquencies Sufficient diversification Basic lender's credit quality Assets transferable and unencumbered

Syndicated loans: What?

Loans granted by pool of banks organized in a syndicate. Other lenders are insurance companies & hedge funds Different from bond offerings as syndicate is lender. Can be considered hybrid instruments as combine characteristics of commercial & investment banking Dominant source of money for general purpose as well as for M&A, LBO, etc.

Syndicate structure

Mandated arranger: One bank acting as lead, getting mandate and negotiating loan Book-runner: Bank coordinating syndication process (preparing info memorandum, inviting banks to join syndicate) Most of the time two are the same

Asset Backed Securities

Mortgage Backed Securities (MBS) ABS: Credit cards, trade receivables, etc. Collateralised Debt Obligation (CDO) Collateralised Loan Obligation (CLO): Bank loans Collateralised Bond Obligation (CBO): Securities

Credit enhancement

Most securitization transactions involve credit enhancement

Bond offerings

On-shore (national): - Domestic market (e.g. bond issued & traded in Italy) - Foreign market (e.g. bond issues and traded in US by German issuer) Off-shore (Eurobond market): Bonds denominated in one currency but issued in countries other than the country issuing the denominating currency (e.g. USD denominated bonds issued in Japan by Australian firm)

Timing of bond issue

Origination (14 days): Mandate, terms of issuance (type, maturity, coupon etc.), credit opinion, pre-marketing Book-building (10 days): Announcement of issuance terms, pricing of bond Stabilization (14 days): Stabilization mechanism based on overallotment of securities

Securitization: What?

Process by which loans or receivables are re-packaged and placed to bond investors Risk transferred from originator bank/firm Allows transformation of illiquid assets into tradeable securities Generates cash for originator which can be used to expand business without increase in equity capital

Pool of Assets & ABS

Quality of ABS is mostly determined by quality of securitized assets Any asset whose CF can be reasonably predicted can be securitized: credit cards, trade receivables, bank loans, toll road receipts, royalty payments

Hybrid security motivations

Reduction of information asymmetry Cheap debt: CFO believes that market is over-estimating risk of firm Mandatory convertibles receive equity credit ratings by agencies: issuer can raise capital whilst preserving its credit quality and paying tax-deductible interest

General syndication vs Sub-underwriting plus general syndication

Single-step general syndication: - Book-runner invites several banks to join syndicate - Each bank receives documentation to assess deal credit risk - Each bank decides whether to join syndicate Can take up to a year during which the book-runner runs underwriting risk (fully underwritten deal) Two-step strategy, sub-underwriting + general syndication: In first few weeks after getting mandate, book-runner invites sub-underwriters to underwrite (commit) a portion of loan amount thus lowering underwriting risk

Sole mandate vs Joint mandate

Sole mandate: In equity/bond offering, book-building procedures mitigates or eliminates underwriting risk (syndicate underwrites issue after canvassing potential investors). --> Banks prefer to be sole book-runner Joint mandate: In fully underwritten syndicated loan there is real underwriting risk. Risk depends on rating of borrower, loan features (tenor, interest rates, collateral, covenants), condition of money market --> joint mandate might be useful

Bond issuing process: Syndicate & Fee

Syndicate structure same as equity Fee: - Management fee - Underwriting fee - Selling concession Fee extracted by discounts on prices at which bonds are sold to syndicate banks See book for e.g.