In this chapter we will discuss company borrowings in more detail, analysing them as long-term and short-term borrowings.
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Security given to the lender
Any borrowings can be secured in one of two ways:
A fixed charge
When we take out a mortgage on our house, the building society or bank has a fixed charge on our property. They have a legal right to our house if we do not pay our mortgage, and we cannot sell our house without the lender’s permission. Fixed charges on company’s assets work in exactly the same way. The lender has the legal right to specified assets and the com- pany cannot dispose of these assets without the lender’s permission. The asset normally then has to be replaced by another asset. Fixed charges tend to be given on long-term fixed assets such as land, properties and ships. There may also be a provision for securing other assets, if the value of the secured assets falls below an agreed figure.
If the company falls into arrears or defaults on the agreement the lender can either:
● repossess and sell the assets, giving any surplus to the company. This is also known as foreclosure;
● appoint a receiver to receive any income from the asset (e.g. property rents).
A floating charge
This is a general charge on the company’s assets. Floating charges usually relate to short- term fixed assets (plant and machinery, and vehicles) and current assets. Whilst the lender has the legal right to a group of assets, the company may continue to manage those assets in the normal course of business. After all, the company has to be able to sell its stock, otherwise it will be unable to trade!
It is also common for a lending bank to require a company to seek the bank’s permission before giving security to anyone else – this is called a negative pledge.
Some loans may be secured, but they rank after all the other borrowings in the event of a liquidation. These are called ‘subordinated loans’.
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Long-term borrowings
A long-term loan
The simplest form of long-term borrowing is a long-term bank loan. A traditional long-term loan is rather like an endowment mortgage, but without the endowment policy. All the com- pany has to do on a day-to-day basis is pay interest, the loan is repaid either in full at the end of the term, or in stages. It is also possible to take the loan in stages; if the company does not want all the money at once, it can draw it down in specified tranches. The loan could either be with one bank or syndicated amongst a number of banks.
Debentures and unsecured loan stock
A debenture is simply a document that acknowledges or creates company debt – effectively it is an IOU. It is a negotiable instrument for a specified amount that must always be trans- ferred in its entirety. It is usually, but not always, secured and is covered by either a deben- ture deed or a trust deed:
● a debenture deed– details the security offered for the debenture;
● a trust deed– contains all the details of the debenture, including the interest payable and the security available to debenture holders. It will also include any clauses that restrict the operations of the company.
When the debenture is issued to a number of holders, or listed on the stock market and, therefore, available to the general public, a trustee will be appointed. The trustee, usually either an insurance company or a specialist debenture company, represents the debenture holders. The trust deed contains all the details of the issue, other than the issue price and will include clauses covering the following:
Borrowing details
There will be a covenant, by the company, covering payment of interest and repayment of the debenture. The repayment details will include the redemption price, repayment date (or period), and any other redemption arrangements.
Security
The security of the debenture issue, if any, will be detailed (further information on the type of security that may be offered to debenture holders is given earlier in the chapter). Most debentures are secured, even though they may not be reported as such in the company’s accounts. They become secured on breach of covenant, when debenture holders often have a legal mortgage on all the company’s properties. Consequently, there will be a clause specifying the events that trigger the enforceability of the security (for example, non-pay- ment of interest or the appointment of a receiver).
Subsequent borrowings
Any additional borrowing usually would have to rank equally (pari passu) with the deben- ture, or be subordinate to it in the event of a liquidation. There may even be restrictions placed on prior borrowings and the company’s overall borrowing limit.
Trustee powers
There will be clauses giving the trustees power to repossess the properties, or appoint a receiver, when the security becomes enforceable. The trustee may also have the power to approve modifications to the debenture terms and conditions.
Bonds
There is no real difference between a debenture and a bond, both are sold to the general pub- lic and they may be secured or unsecured. Bonds are actually defined as debentures in the Companies Act (s 744 defines a debenture as including debenture stock, bonds and any other security of a company, whether secured or unsecured).
Bonds are also negotiable instruments that are offered to the general public and may, or may not, be secured on the company’s assets. The bondholder’s rights, and the company’s duties, are covered by a trust deed. A bondholder is entitled to receive a stream of interest pay- ments, and the repayment of the principal at maturity. Before a company has a bond issue it will have the debt credit rated. There are two types of rating agencies looking at companies:
(1) agencies that look at the company from a supplier’s point of view (e.g. Dun and Brad- street) and help to answer the question, ‘Will I get paid if I supply goods to this company?’
(2) agencies that look at the company from the investor’s point of view (e.g. Standard and 6 What sort of borrowings does a company have?
Poor, Moody) to help to answer the question, ‘Will I lose all my money if I invest in this company?’
It is the latter group of agencies that rates corporate debt, and the best quality corporate debt is rated triple A. The rating is very important as it affects both the ability to sell the bonds and the rate of interest that the company will have to pay. The higher the rating, the lower the risk; the lower the risk, the lower the interest! Bond interest is called the ‘coupon’
and is expressed as a percentage of the face value of the bond. The face value of the bond may not be the same as the current bond price. Bond prices are influenced by two things:
(1) relative interest rates, if current interest rates are 6 per cent and the bond is paying 10 per cent the investors will be prepared to pay a premium to buy the bond;
(2) the current credit rating of the company, if the credit rating has fallen the interest rate will not reflect the current level of risk and the bond price will fall.
There are many different types of bonds found in company accounts. Banks and compa- nies have been very innovative, custom designing bonds to attract specific investors. They have been an ideal vehicle for financial innovation, as there are four variables which can be modified:
(1) The security given for the bond
For example, banks issue bonds that have our mortgages and credit card balances as collat- eral.
(2) The coupon paid
For example, some bonds are issued that do not pay interest, these are called Zeroes. They are issued at a discount. For example, a £10 million five-year bond may be issued for £6.209 mil- lion. This has an implied interest rate of 10 per cent and the value of the bond would increase by 10 per cent a year. All other things being equal, at the end of the first year the bond would be worth £6.83 million, at the end of the second £7.513 million, and so on, until the end of the fifth year when the investors would receive the £10 million. Some bonds increase the interest over the life of the bond (these are called step-up bonds), others reduce it (step-down bonds).
(3) The repayment of the principal amount borrowed
For example, the repayment of the principal in some bond issues is index linked. In others, the bond may be issued in one currency and repaid in another (these are called dual currency bonds).
(4) The bond maturity
For example, a bond may have two options on maturity – it might have a maturity of 30 years, with an option to reduce this to ten years (a retractable bond). Alternatively it could have a maturity of ten years with an option to extend it to 30 years (an extendible bond).
Eurobonds
Large companies often issue Eurobonds. If we are to understand a Eurobond we must under- stand what the term ‘Euro’ is. A currency goes ‘Euro’ when it is traded outside of the coun- try of origin, and its banking regulations. Japanese yen on deposit in London are Euroyen;
American dollars deposited in Tokyo are Eurodollars. Euro does not mean European. A
Eurobond is simply a bond that is issued outside the country of its currency and has few restrictions on its issue and trading.
Companies do not keep a register of Eurobond holders (they may for a domestic or foreign bond). The bond is sold in bearer form (whoever holds the bond claims the interest and repayment of the principal). As Eurobond interest has no tax deducted at source, they are very attractive to investors who wish to keep their affairs secret from the tax authorities!
Eurobonds are available to large, internationally known, high-quality borrowers.
Convertibles
Bonds and other loan stocks, for example debentures, may have rights that enable the hold- ers to convert their loans into ordinary shares, rather than cash. From a company’s point of view, this enables it to get cheaper borrowing, as the coupon on a convertible bond will nor- mally be lower than on a normal bond. This arises from the fact that the value of a convert- ible bond consists of two parts – the value of the bond and its potential value as shares.
Therefore, the price of a convertible is influenced by two factors:
(1) the normal basis for bond valuation, i.e. corporate ratings and relative interest rates;
(2) the market value of the company’s shares.
If the company’s share price is rising the bond value will rise, as the value of the conver- sion option increases. Consequently, the markets regard convertible bonds as a form of deferred equity. Pricing convertibles is much more complicated than a conventional bond as the pricing formula has to take account of both the share option and the bond.
The holder of the convertible has the option of converting his bond into ordinary shares at a predetermined rate during a specified period. Usually the holder cannot convert into shares during the first two or three years, or for a number of years at the end of the bond’s life. (The period between the issue of the bond and the conversion period is called the rest period, and the period after the conversion period is called the stub.) Companies like to have this rest period at the end. It is a breathing space, because if the holders have decided not to take the conversion option, the company’s performance is probably poor.
The fact that the convertibles are effectively deferred equity gives the company both prob- lems and opportunities. Issuing convertibles requires the permission of the shareholders unless:
● they are part of a rights issue; or
● they are part, or the whole, of the consideration given for an acquisition.
In acquisitions they can be used to steer the victim’s shareholders away from accepting the cash alternative. If the victim’s shareholders have been holding their shares for the yield, and the predator’s shares have a low yield, a straightforward share exchange would be unattractive.
Convertibles could be the solution, as it is possible to structure the convertible issue to give a higher initial income. Convertibles tend to attract investors who are looking for income, but who wish to have the benefit from any improvement in the market’s performance.
Convertibles can, therefore, have advantages to both the issuer and the holder. The issuer benefits from cheaper interest rates and the holder has flexibility. The holder has the oppor- tunity to benefit from improvements in the company’s share price, but if the price falls, the holder can take repayment in cash. Holders pay for this flexibility by taking a small loss in their income.
We know that the holders of convertibles are hoping to benefit from market movements in the company’s share price. There is a risk, however, that the holder may not benefit from market improvements if the company is taken over, outside of the conversion period. Con-
6 What sort of borrowings does a company have?
sequently, to make the convertibles more attractive, most companies have some form of bid protection clause in their convertibles. This protection could be structured in different ways.
The holder could be compensated by structuring a redemption premium linked to the pre- miums that would have been paid in the previous years. Alternatively, the protection could be simply an enhancement of the conversion terms.
Warrants
A company may issue warrants that give holders the opportunity to subscribe for shares in the company at a future date. As the price is usually fixed above the current share price, the warrant has no initial value. If the share price rises above the fixed price, the warrant will start to have an intrinsic valueequal to the difference between the current share price and the fixed price. The warrant-exercise period generally starts soon after the issue date and, when they are issued with debt, they are usually traded separately from the bond and become exer- cisable when the bond is fully paid.
Warrants are sometimes issued to improve the attractiveness of a bond issue. For example, it may be difficult to have a fixed-rate bond issue if inflation is high, but it could be made more attractive to investors if warrants were attached. Or, in the same way as a convertible, a company could issue warrants to reduce the coupon that it would have to pay on the bond.
The equity entitlement of the warrants, in relation to the issue price, varies from company to company. The greater the equity entitlement, the greater the saving in coupon. It is this flexibility of warrants that makes them a useful addition to debt when a company is involved in a takeover. They can significantly reduce the coupon that has to be paid on the bond.
However, they are less attractive if the company is hoping to get a cash inflow from the war- rant. Warrants are rarely exercised until close to the exercise date.
Mezzanine finance
Mezzanine finance is a term used by venture capitalists to cover debt–equity hybrids. They can be in the form of:
● redeemable preference shares (usually with a conversion option)
● convertible debt
● debt with warrants attached.
This finance is commonly associated with management buy-outs where the amount of equity that can be issued is limited, as is the amount of debt that can be raised. If the finance is in the form of loans, they are usually subordinated, and therefore have a higher interest rate to compensate for the increased risk.
Sinking funds
Some debentures make provisions for part, or all, of the borrowing to be repaid by a sinking fund.Money is transferred to a sinking fund to enable loans to be repaid. The original con- cept is very like our endowment policies, but without the life cover. The company invests a sum of money each year, usually in safe investments, such as government securities. The sums, together with the interest, accumulate and are shown on the balance sheet. When the debentures have to be repaid (redeemed) there should, with luck, be sufficient money to repay the borrowings. This sounds very familiar to anyone with an endowment policy, the only difference is that there is no intermediary investing the money. This method is so simple that it is rarely used. Two other forms of sinking funds have emerged to allow earlier repayment of the debt: non-cumulative sinking funds and cumulative sinking funds.
Non-cumulative sinking funds
In this case the company puts aside sufficient money each year to redeem a fixed amount of the borrowings. This is often expressed as a fixed percentage. The sinking fund is non-cumu- lative as the interest does not accumulate. The early repayment means that the average life of the debenture may not be what it seems. This is illustrated in the following example.
A company issues a twenty-year debenture. A sinking fund is established to redeem the deben- tures at the rate of 3 per cent a year at the end of years five to 19, leaving 55 per cent of the debentures to be redeemed at the redemption date. Redemption is at par. The average life of the debenture is calculated by working out the average life of the debentures that are redeemed by the sinking fund and weighting this by the percentage of the total that will be redeemed by the sinking fund. In our example the average life of the debentures redeemed through the sinking fund is 12 years and 45 per cent are redeemed by the fund. Calculating the average life is now a matter of simple arithmetic:
(12 x 0.45) + (20 x. 0.55) = 16.4 years
This average return is important as it will affect the lender’s return that is discussed later in the chapter.
Cumulative sinking funds
In a cumulative sinking fund the amount that the company uses to redeem the debentures is variable, as it is a fixed amount of cash coupled with the interest that has been saved by the prior redemption of the debentures. This is illustrated in the example below.
Continuing our previous worked example, the issue was as above, but comprised £10 million debentures, paying 10 per cent interest. The first ten years’ calculations are shown in Table 6.4.
Most of the debentures are redeemed through the sinking fund; only £468 000 are redeemed in year 20. As different amounts are redeemed each year, the average life of the issue is calcu-
6 What sort of borrowings does a company have?
EXAMPLE
EXAMPLE
Redemption of a twenty-year bond issue (ten years) Table 6.4
End of year Fixed cash @ Interest saved Debentures Total Remaining 3% redemption on debentures redeemed in redemptions to debentures
redeemed the year date
1 0 0 10 000
2 0 0 10 000
3 0 0 10 000
4 0 0 10 000
5 300 0 300 300 9 700
6 300 30 330 630 9 370
7 300 63 363 993 9 007
8 300 99 399 1 392 8 608
9 300 139 439 1 832 8 168
10 300 183 483 2 315 7 685