What are debt instruments that commercial banks commonly offer?
A debt instrument is a fixed income asset that allows the lender (or giver) to earn a fixed interest on it besides getting the principal back while the issuer (or taker) can use it to raise funds at a cost. Debt acts as a legal obligation on the issuer (or taker) part to repay the borrowed sum along with interest to the lender on a timely basis. A debt instrument can be in paper or electronic form.The Economic Times, Jul 10, 2017
What is Commercial Paper (CP)?
Commercial Paper (CP) is an ‘IOU’ issued by a company for short term funding. Paper is issued for periods up to 12 months but more often for 1- and 3-month periods. Banks act as intermediaries between issues and investors, and may also provide a back-up facility in case an insufficient number of investors can be found.
Commercial paper programmes normally require two ratings by reputable agencies, which invariably insist on adequate back-up facilities being in place. The issue of commercial paper is subject to different rules as to maturity, size, type of issuer etc. in different countries. In theory, CP can be traded between investors, but it is more usual for paper to be issued in a size and maturity to suit investor requirements.
A bank can issue commercial paper to raise the funds needed. It can then sell these short-term securities to institutional investors, such as money market funds, at a discount. The bank receives the funds it needs, while the investors receive a return in the form of interest payments on the commercial paper. The bank repays the face value of the commercial paper when it matures.
What are Medium Term Notes (MTN)?
MTNs are obligations for periods of over a year and up to 5 years, but longer maturities are possible to suit investor demand. They are similar to bonds, but with more flexibility in terms of their maturity and the conditions under which they can be issued and traded.
Unlike CP, they contain covenants more common in bond documentation, but can provide more flexibility than bonds in that relatively small amounts can be issued in a size, maturity, and currency to meet pockets of investor demand.
A bank can issue medium-term notes to raise capital needed. The notes can be sold to institutional and individual investors, who receive periodic interest payments and the return of the principal when the notes mature. The bank benefits from a steady source of financing for its expansion plans, while the investors benefit from a potentially higher return compared to a savings account or short-term investments.
What are Corporate Bonds?
Corporate Bonds are issued for minimum amounts of USD100 million and sometimes for billions of dollars. Maturities are generally 5 to 10 years but in most markets can be for 25 years or longer.
Coupons are almost always fixed for the period, but can be structured as deep discount, zero coupon or index-linked. It is possible to issue floating rate notes (most issues by banks are FRN’s) but these are more usually issued by corporates under an MTN programme. The common currencies are USD, Euro and sterling.
The most liquid market is in investment grade bonds i.e. those rated BBB-/Baa3 or higher, but there is an established high yield market in the US and a growing one in Europe, for bonds with a speculative grade rating of BB+/Ba1 or lower (also known as ‘junk bonds’). Bonds can be registered (like shares) or bearer instruments.
What are Eurobonds?
Eurobonds are (strictly speaking) corporate bonds issued outside the issuer’s home country (e.g. US company issues US bonds in Luxembourg) trading outside the jurisdiction of any particular country.
In practice, most sterling bonds issued in London by UK issuers are Eurobonds since domestic sterling bonds are registered and most issuers and investors prefer bearer bonds. They are publicly traded debt instruments with a standard format listed on a recognised exchange, usually London or Luxembourg. Eurodollar bonds make-up the largest segment of the Eurobond market but the Euro/euro bond market is growing fast.
What is Yankee Bond?
A US domestic bond sold primarily to the US market, issued in dollars by a non-US issuer registered with the SEC. Similar nomenclature applies to other markets (Bulldog in the UK, Samurai in Japan).
What is 144A bond?
A quasi-public US bond, not registered with the SEC but tradable by qualifying institutional investors in secondary markets.
What is private placement?
Bonds not traded nor listed but placed directly with a small group of investors who normally hold to maturity.
What is Securitisation?
Securitisation is the issue by a special purpose company (SPV) of a financial instrument (bond, commercial paper or medium-term notes) whose repayment comes from cash flow generated from a pool of assets dedicated for this purpose.
As an example, a bank ‘sells’ (with or without recourse) a portfolio of mortgages to a SPV, which is ‘bankruptcy remote’ from the originating company. The SPV issues a financial instrument whose repayment is secured on the mortgages.
If the value of the security exceeds the amount of the financial instrument (‘over-collateralisation’) rating agencies will often rate the instrument higher than a similar issue by the originating company, thus achieving a lower cost of debt. Sometimes a high rating is achieved through a third-party guarantee by e.g. an insurance company.
Click to learn Special Purpose Entity / Vehicle (SPE / SPV).
What are Bank Loans?
Bank loans are loans provided by commercial banks on a bilateral basis (i.e. an arrangement between the borrower and one bank) or with a group of banks (a syndicated loan).
They differ from bonds in a number of respects:
- Loans are extremely flexible with negotiable currency, drawdown, maturity, and repayment profiles
- Loans can be very quick to arrange and are often used as acquisition bridge financing pending refinancing in the bond market
- They can be arranged for smaller and larger amounts than are normally available in the bond market
- Tradability is limited (although this is changing) and many borrowers like to know who holds their debt
- Covenant protection tends to be much stronger.
What is Factoring?
Factoring is the outright sale of trade receivables/trade debtors on an on-going basis to a specialised factoring house or specialised department of commercial banks. The sale can be with or without recourse to the originating company.
Factoring is a financing option where a company sells its accounts receivable (outstanding invoices) to a third-party factoring company in exchange for immediate cash. This allows the company to receive a portion of the payment owed to it by its customers sooner, rather than waiting for the full payment to be made at a later date.
What is Leasing?
Leasing is a tax-efficient method of financing asset purchase, sometimes off-balance sheet. The legal ownership of the asset remains with the lessor during the lease period and the user of the asset (the lessee) will compensate the lessor for the use of the asset.
Depending on accounting principles governing the lessee’s accounts, the lease will be treated as a finance lease or an operating lease. In the former case, the lessee will show the asset and a corresponding liability on its balance sheet, lease rentals are divided into an interest and repayment element, and the asset is depreciated. Operating leases are those where there is a substantial residual value at the end of the lease period. The asset is off-balance sheet and lease rentals are accounted for as Sales, General and Admin expenses.