ch 15: Debt Financing
Imagine you want to borrow money from the bank. If you promise to give them your car if you can't pay them back, the bank feels safer.
Because it's safer for the bank, they might lend you more money or charge you less extra money (interest) .
In the business world, when a company does this—using something it owns (like equipment or inventory) as a guarantee—it's called an asset-backed line of credit.
1. Unsecured Debt (The "Promise")
This is a loan based purely on the company's promise to pay. No specific items are set aside as a guarantee.
If the company fails: These lenders have to wait in line to get the leftovers after all the secured lenders have taken their share.
The Types:
Notes: An unsecured IOU that gets paid back relatively quickly (in less than 10 years).
Debentures: An unsecured IOU for a longer period (10 years or more).
2. Secured Debt (The "Claim Check")
This is a loan backed by a specific piece of the company's property. If the company fails, the lender gets to take that specific property.
If the company fails: These lenders get to seize the asset that was promised to them.
The Types:
Mortgage Bonds: Secured specifically by real estate (land or buildings).
Asset-Backed Bonds: Secured by any other kind of asset (like machinery, trucks, or inventory).
Important Note: While people often say "bonds" for everything, the text points out that technically, a "corporate bond" is always secured.
Senior Debt (First in line): These are the first people in line. When the company has money (or sells its stuff in bankruptcy), these guys get paid first.
Subordinated Debenture (Last in line): This is a new IOU the company sells that is less important than the old ones. These lenders have to stand at the back of the line.
The Result:
Because the people at the back of the line might not get any money if the company runs out, they charge a higher interest rate (10.5%) as a risk fee. The people at the front charge a lower rate (8.875%) because their money is safer.
The Main Idea: Two Different Risks
Hertz issued bonds (junk bonds) to raise money. They sold them in two different currencies: US Dollars and Euros.
Even though both bonds are equally safe (or risky) regarding Hertz going bankrupt, they have different interest rates because of Currency Risk.
The Currency Risk Explained
The Dollar Bond (8.875%): If you are a US investor, this is safe from currency issues. You gave dollars, you get dollars back.
The Euro Bond (7.875%): If you are a US investor, this is tricky. You gave dollars to buy Euros, but eventually you need to turn those Euros back into dollars.
The Danger: What if the Euro loses value against the dollar while you hold the bond?
Example: If the Euro drops in value, when you cash out your Euros, you get fewer dollars back than you started with.
Why the rate is lower: In this specific case, the Euro bond rate (7.875%) is actually lower than the Dollar bond. This usually means investors think the Euro is stable or they are European investors who don't need to convert back to dollars.
The Big Picture
When a government (like the U.S.) needs money because it spends more than it collects in taxes, it borrows money by selling Treasury Securities. These are essentially IOUs from the government.
Because the U.S. government is considered very safe (it can always print money to pay you back), these are seen as the safest investments in the world.
The Four Types of U.S. Treasury Debt
Think of these like different "flavors" based on how long until the government pays you back.
1. Treasury Bills (Short-term)
Time: A few days up to 1 year.
Type: "Discount" bonds. You buy them for less than face value (like $980), and when they mature, the government gives you the full $1,000. The difference is your interest.
2. Treasury Notes (Medium-term)
Time: 2 to 10 years.
Type: "Coupon" bonds. They pay you interest every 6 months until they mature.
3. Treasury Bonds (Long-term)
Time: 30 years (often called "long bonds").
Type: Also "coupon" bonds. They pay interest every 6 months.
4. TIPS (Inflation-Protected)
Time: 5, 10, or 30 years.
The Twist: These protect you from inflation.
How: If prices go up (inflation), the value of your bond increases, so your interest payments go up too. If prices go down (deflation), the government guarantees to give you at least your original money back.
How to Buy Them (The Auction)
The Treasury sells these at an "auction":
Regular people (Noncompetitive): They just say "I want to buy $1,000 worth." They automatically get it.
Big investors (Competitive): They say "I will buy $1 million, but only if I get a certain interest rate."
The Treasury accepts the lowest rates first until they raise all the money they need. Everyone pays the same final rate (the "stop-out yield").
Other Cool Terms
STRIPS: These are "do-it-yourself" zero-coupon bonds. Big banks take a normal Treasury bond, cut it into pieces (separating the final payment from all the interest payments), and sell each piece as its own mini-bond that pays nothing until it matures.
Taxes: You have to pay federal tax on the earnings, but no state or local taxes.
The Main Attraction: No Federal Tax
The key feature of a municipal bond is that you don't pay federal income tax on the interest you earn.
Because of this, they are called "tax-exempt" bonds.
Sometimes, if you live in the state where the bond was issued, you don't pay state or local taxes on it either.
How They Work
Payments: Most pay interest twice a year (semiannually).
Maturity: They often come as "serial bonds," meaning parts of the loan mature at different times (e.g., some mature in 5 years, some in 10, some in 20).
Coupon Types:
Fixed: The interest rate stays the same forever.
Floating: The interest rate changes over time based on a benchmark (like Treasury bills).
Where the Money Comes From (The Guarantee)
There are two main ways these bonds are backed:
Revenue Bonds (Project-Based): The money to pay you back comes from a specific project.
Example: A bond to build a toll road. The toll money paid by drivers is used to repay the investors.
General Obligation Bonds (Government Promise): Backed by the government's ability to tax its citizens. It's a promise using the "full faith and credit" of the city or state.
Double-Barreled: An extra-safe version where the government pledges both general tax money and a specific fee to repay you.
The Risk
Munis are not as safe as U.S. Treasury bonds. Sometimes cities or projects run out of money and can't pay back the bondholders.
Detroit (2013): Defaulted on $7 billion.
Puerto Rico (2016): Defaulted on $74 billion (the biggest in U.S. history).
The Big Idea: Turning "IOUs" into Investments
Normally, you buy a bond from a company. With an ABS, you are buying a piece of a pool of loans.
Think of it as a bundle of debt (like credit card bills, car loans, or mortgages) wrapped up and sold to investors as a single product.
The investors get paid when the regular people pay their car notes or mortgage payments.
The Main Types
1. Mortgage-Backed Securities (MBS)
What it is: A bundle of home loans (mortgages).
How it works: Homeowners pay their monthly mortgage. After the bank takes a small fee, that cash is "passed through" to you, the investor.
The Risk (Prepayment): People might pay off their mortgage early (if they move or refinance). You get your money back early, and you have to find somewhere else to reinvest it.
2. The "Government" Backing
Ginnie Mae: Explicitly backed by the U.S. government. Very safe.
Fannie Mae & Freddie Mac: Not explicitly backed by the government, but everyone assumed the government would save them if they failed (which happened in 2008).
3. Private ABS & CDOs
Private ABS: Bundles of other loans (car loans, credit card debt, student loans).
CDO (Collateralized Debt Obligation): This is a "bundle of bundles." Banks take a bunch of existing ABS (the risky ones) and bundle them again.
Tranches: These bundles are sliced into pieces with different risk levels.
Senior Tranche (Top Slice): Gets paid first. Low risk, low interest.
Junior Tranche (Bottom Slice): Gets paid last. High risk, high interest.
What Went Wrong in 2008? (Subprime Crisis)
Banks bundled risky subprime mortgages (loans to people with bad credit).
They sliced them into CDOs. The top slices were rated "AAA" (very safe) even though the underlying loans were junk.
For a while, it worked because house prices kept rising. If someone couldn't pay, they just sold the house or refinanced.
When house prices stopped rising and then fell, everyone stopped paying at once.
Since the loans were all tied together in these bundles, even the "safe" top slices lost almost all their value.
Why 2020 Was Different
During the COVID pandemic, mortgage defaults didn't spike like in 2008 because:
There were fewer risky "subprime" loans.
The government allowed people to pause payments (forbearance).
House prices didn't crash.
1. Call Provisions (The Company's "Get Out of Jail Free" Card)
A callable bond gives the company the right to force the bondholders to sell the bond back early at a specific price (the "call price").
How it works:
The company sets a call date (the earliest day they can force the buyback).
They set a call price (usually higher than face value, like 105%).
The extra 5% is the call premium (a little bonus for the investor being forced out).
When do they use it?
When interest rates drop.
Example: If a company issued bonds at 10% interest, but now rates are 5%, they want to cancel the expensive 10% bonds and borrow new money at 5%.
They "call" the old bonds, pay the call premium, and refinance cheaper.
Why investors hate it:
If rates drop, investors get their money back early and have to reinvest it at the new, lower rates. Because this risk is annoying, callable bonds pay higher interest than normal bonds.
Yield to Call vs. Yield to Worst:
Yield to Call: What you earn if the bond is called early.
Yield to Worst: The lower of the two yields (maturity or call). This is what smart investors look at to see the worst-case scenario.
The Problem It Solves
Imagine you borrow $100 million but promise to pay it all back in one lump sum 30 years from now.
The Risk: When Year 30 comes, you might not have $100 million cash on hand. It's a huge, scary bill.
The Solution: The Sinking Fund
A sinking fund is like a forced savings plan or a diet plan for debt. The company agrees to pay off the bond bit by bit over time, instead of all at once at the end.
How it works:
Every year, the company sets aside money and gives it to a trustee (a neutral third party).
The trustee uses that money to buy back some of the bonds from investors.
Over time, the number of bonds shrinks.
Why it's good for everyone
For the Company: They avoid the shock of a massive "balloon payment" at the end. It's easier to manage small payments over time.
For the Investor: It's safer. Because the company is paying off the debt gradually, the risk of the company going bankrupt and not paying you back goes down every year.
Important Terms
Balloon Payment: If the sinking fund payments aren't enough to pay off all the debt, the big chunk left at the end is called the "balloon."
Combination: A bond can have both a sinking fund (paying off bit by bit) AND a call provision (the right to pay off extra early).
The Big Idea: A Bond with a "Upgrade" Button
A convertible bond is a normal bond that comes with a special power: The investor can choose to turn it into company stock.
Think of it like a hybrid car. It starts as a safe, gas-powered vehicle (the bond). But if you want more speed, you can flip a switch and turn it into an electric vehicle (the stock).
How it Works
The Bond: You lend the company money, and they pay you interest (just like a normal bond).
The Option: You have the right to exchange your bond for a set number of shares of the company's stock.
The Math (Conversion Ratio):
Example: A $1,000 bond with a conversion ratio of 20.
This means you can swap the bond for 20 shares of stock.
Conversion Price: $1,000 ÷ 20 shares = $50 per share.
When do you push the button?
You only convert if the stock price goes above $50.
If stock = $40: You keep the bond. (Why take $40 stock when you can have $1,000 cash?)
If stock = $75: You convert immediately. (You turn your $1,000 bond into 20 shares worth $1,500!)
Why Companies Love This (Lower Interest)
Because this "upgrade button" is valuable to investors, companies can pay lower interest rates on convertible bonds than on regular bonds. Investors accept lower cash payments in exchange for the chance to hit the jackpot if the stock takes off.
The "Callable" Twist
Sometimes companies add a call provision to a convertible bond.
The company says: "We are calling back the bond. Take your cash... or convert now."
If the stock price is high, the investor will choose to convert.
This lets the company force the investors to make a decision early and turn into shareholders, wiping the debt off the books.
The Big Idea: Buying a Company with Borrowed Money
A Leveraged Buyout (LBO) is when a group of investors buys a public company (one listed on the stock market) and takes it private.
The twist: They don't use much of their own cash. They borrow most of the money to pay for it.
"Leveraged" means "using debt."
The Hertz Example (Simple Timeline)
The Purchase: A group bought Hertz for $15.2 billion. They paid mostly with borrowed money (debt).
The Result: Hertz was now a private company, but it was crushed under a huge pile of new debt.
The Plan: Use the company's profits to pay down that debt over time.
The Exit (IPO): In 2006, after paying down some debt, they took Hertz public again (IPO) to let the investors cash out.
Why do it?
For the buyers: They can buy a huge company without putting up much cash. If the company succeeds, they make a fortune.
The Risk: The company is now drowning in debt. If the business struggles, it can go bankrupt (which almost happened to Hertz later).
Other Famous LBOs
Dell Computer (2013): Michael Dell bought back his company to fix it away from the public eye.
QTS Realty (2021): Bought by Blackstone.
The Story: From Coffee Shop to IPO to LBO
This is the life story of a company. It shows how a business raises money at different stages, from a single shop to a public company, and eventually back to private ownership.
Stage 1: The Beginning (Sole Proprietorship)
1984: Hannah starts one coffee shop with $50,000 of her own money.
Type: Sole Proprietorship (she owns 100%).
Stage 2: Angel Investor (First Outside Money)
1985: Hannah needs $75,000 for a roasting machine.
The Deal: Natasha invests $75,000 for a 40% stake.
Result: They incorporate. Total shares = 1,000,000.
Hannah: 600,000 shares (60%)
Natasha: 400,000 shares (40%)
Stage 3: Bank Debt (Expansion)
1999: They open 5 stores.
Financing: They borrow $500,000 from a bank (Term Loan). No new shares issued.
Stage 4: Venture Capital (The Big Pivot)
2000: They switch from selling coffee in shops to roasting and selling beans wholesale. They need $3 million for a new factory.
The Deal: VC firm (Bayou Partners) invests $3 million for 1,000,000 new shares (50% of the company).
Valuation Math:
Post-Money Valuation: $3 million ÷ 50% = $6 million.
Pre-Money Valuation: $6 million - $3 million = $3 million.
Stage 5: More VC Funding (Growth)
2003: Bayou invests another $4 million for 1,200,000 new shares.
2006: Bayou invests another $8 million for 1,500,000 new shares.
2007: 400,000 shares given to employees.
Stage 6: IPO (Going Public)
2008: They sell 2,000,000 shares to the public at $12/share.
Total Raised: $24 million.
The Twist: This includes some of Bayou's old shares (secondary) and new shares for the company (primary).
Stage 7: SEO (Another Stock Sale)
2009: They sell more shares at $20/share.
The Payout: Founders (Hannah & Natasha) and Bayou sell some of their personal shares to cash out.
Stage 8: LBO (Going Private Again)
2010: The stock price crashes to $5. Hannah buys the company back.
The Deal: She offers $7.50/share for the remaining 7.4 million shares.
Total Cost: $55.5 million.
How she paid:
Her own cash: $7 million.
Bank Debt: ? (We have to calculate this).
Convertible Bond: $30 million (5% coupon, convertible to 50 shares per $1000, callable in 5 years).