Welcome to Corporate Fixed Income!
Hello there! Today, we are diving into the world of how companies borrow money. Think of this chapter as the "Credit Card and Loan" section for big corporations. Instead of going to a local bank for a small personal loan, these companies tap into global markets to raise millions (or billions!) of dollars. Don't worry if this seems a bit heavy at first; we will break it down into simple, bite-sized pieces.
Why is this important? As a CFA candidate, you need to understand where companies get their cash and what happens if they can't pay it back. This knowledge is the foundation for analyzing corporate risk and return.
1. Sources of Debt: Where Do Companies Get Money?
Companies generally have two main "neighborhoods" where they can borrow money: Bank Loans and Public/Private Debt Markets.
A. Bank Loans (Private Debt)
Bilateral Loans: This is a simple one-on-one deal. One bank lends money to one company. It’s like you borrowing $20 from a single friend.
\nSyndicated Loans: If a company needs a massive amount of money (more than one bank wants to risk), a "syndicate" or group of banks joins together to provide the loan. One bank usually acts as the "lead" to manage the process.
B. Commercial Paper (Short-Term Debt)
\nCommercial Paper (CP) is like a "short-term IOU." It is an unsecured, short-term debt instrument issued by companies to meet immediate needs like payroll or inventory.
\nKey Features:
\n- Maturity: Usually very short (overnight to 270 days).
\n- Cost: Often cheaper than a bank loan.
\n- Credit Quality: Only companies with high credit ratings can usually issue CP because it is unsecured (no collateral).
\n- Rollover Risk: This is the risk that a company can't issue new CP to pay off the old CP when it matures. It's like trying to get a new credit card to pay off your old one and being denied!
Did you know? Most Commercial Paper is issued at a discount. This means if the face value is \$1,000, you might buy it for \$980 today and get the full \$1,000 in a few months. Your profit is the "interest."
C. Corporate Bonds (Long-Term Debt)
These are the "standard" bonds you hear about. They have longer maturities and can be Public (traded on exchanges) or Private (sold directly to big investors like insurance companies).
Key Takeaway: Short-term needs = Commercial Paper. Long-term needs = Corporate Bonds. Large, complex needs = Syndicated Loans.
2. The "Pecking Order": Seniority and Security
If a company goes bust (bankruptcy), who gets paid first? This is called Priority of Claims. Think of it like a waterfall: the money flows to the top people first, and if there's anything left, it trickles down to the bottom.
Seniority Levels (From First Paid to Last Paid):
1. First Lien Loan / Senior Secured: These guys have a specific "claim" on an asset (like a building or a factory). If the company fails, they take the building.
2. Second Lien / Junior Secured: They also have a claim, but only after the First Lien folks are satisfied.
3. Senior Unsecured: This is the most common type of corporate bond. No specific asset is backing it, but they are high up in the "unsecured" line.
4. Subordinated (Junior) Debt: These investors are further down the line. They take more risk for a potentially higher interest rate.
5. Equity (Stockholders): They are at the very bottom. They only get paid if everyone else is 100% satisfied.
Quick Review Box:
Secured = Backed by collateral (an asset).
Unsecured = Backed only by the company's promise to pay.
Seniority = Your place in the line for payment.
3. Bond Covenants: The Rules of the Game
Investors aren't silly; they want to make sure the company doesn't do anything reckless with their money. They use Covenants, which are legally binding "rules" in the bond contract.
Affirmative Covenants (The "Dos"): These require the company to do certain things.
Example: "You must pay your taxes on time" or "You must maintain a certain level of insurance."
Negative Covenants (The "Don'ts"): These prevent the company from doing things that might hurt bondholders.
Example: "You cannot take on more debt" or "You cannot sell your main factory without permission."
Mnemonic Tool: Think "A" for Affirmative = Action (Doing something). Think "N" for Negative = No (Stop/Don't do something).
4. Credit Risk and Ratings
How do we know if a company is likely to pay us back? We look at their Credit Rating provided by agencies like Moody’s, S&P, or Fitch.
The Two Big Categories:
1. Investment Grade (IG): These are the "safe" companies. They have ratings of Baa3/BBB- or higher. They pay lower interest because they are less likely to default.
2. Non-Investment Grade (High Yield / Junk Bonds): These are the "risky" companies. They have ratings below Baa3/BBB-. They must pay a much higher interest rate to tempt investors to take the risk.
Important Concept: Credit Spread
The Credit Spread is the extra interest a corporate bond pays compared to a "risk-free" government bond.
\( Corporate Bond Yield = Risk-Free Rate + Credit Spread \)
If the economy looks scary, credit spreads usually widen (get bigger) because investors demand more reward for the extra risk.
5. Trading and Settlement
Corporate bonds don't usually trade on a physical floor like the New York Stock Exchange. Instead, they trade in the Over-the-Counter (OTC) market.
How it works: It’s a network of dealers using computers and phones.
Liquidity: This is a big deal in Fixed Income. Some corporate bonds trade every day (Liquid), while others might not trade for weeks (Illiquid).
Settlement: When you buy a corporate bond, the trade usually "settles" (money and bond change hands) on a T+2 basis (Trade date plus two business days).
Common Mistake to Avoid: Don't assume all corporate bonds are easy to sell quickly. While stocks are very liquid, many corporate bonds are "buy and hold" and can be difficult to sell at a fair price in a hurry.
Final Key Takeaways
1. Companies use Commercial Paper for short-term cash and Bonds for long-term projects.
2. Secured debt is safer than unsecured debt because it has collateral.
3. Covenants protect bondholders by setting rules for the company.
4. Investment Grade bonds are safer (BBB- and above); High Yield bonds are riskier.
5. Most corporate bonds trade OTC and settle in T+2.
Great job! You've just cleared a major hurdle in understanding how the corporate world stays funded. Keep practicing those definitions, and the "waterfall" of seniority will become second nature!