FINC 349 LECTURE 11

Fixed-Income & Mortgages: Lecture Notes

0) Why the First Weeks Matter

• Review of Foundational Concepts:

  • Time Value of Money (TVM): Understanding the value of money over time.

  • Pricing Loans, Bonds, and Notes: How these financial instruments are valued.

  • Principal vs. Interest: Distinguishing between the original amount borrowed and the cost of borrowing.

• Learning Approach: Emphasizes repetition and practice, as these patterns are frequently encountered.

1) Fixed-Income vs. Equity (Big Picture)

• Fixed-Income (Debt):

  • Represents contractual payments which include interest and principal.

  • Resides on the right side of the balance sheet under liabilities.

• Equity:

  • Represents a residual claim; equity holders are paid only after debt obligations are met.

• Risk/Return Relationship:

  • Senior, collateralized debt has less risk than junior debt.

  • Junior debt has less risk than equity.

  • This reduced risk for debt translates to a lower required return for lenders.

2) Key Characteristics of Fixed-Income

• Coupon (Interest) Payments:

  • The periodic cash payments made to investors.

  • Serves as the "reward" or return for lending money.

• Principal:

  • The original amount borrowed.

  • Reduces only when principal is repaid; interest payments do not decrease the principal balance.

• Seniority:

  • Determines payoff priority: senior debt has priority over subordinated debt.

  • Senior debt is often secured by collateral, which can include real estate, inventory, receivables, or cash.

• Default/Bankruptcy:

  • Debt holders have priority over equity holders in the event of default or bankruptcy.

  • Debt contracts typically include provisions such as:

    • Covenants: Conditions that borrowers must uphold.

    • Indentures: Formal legal contracts detailing the terms of the debt.

    • Dispute Resolution: Mechanisms for handling disagreements.

    • Limits on Further Borrowing: Restrictions on a borrower's ability to take on more debt.

3) Mortgage = Loan Secured by Real Property

• A mortgage is specifically a loan where real property (residential or commercial) serves as collateral.

• Loans secured by other types of collateral (e.g., a jet) are not referred to as mortgages.

4) Payment Frequencies and Period Setup

• If payments are semiannual:

  • Number of Periods (N): Calculated as years \times 2 (e.g., for a 5-year loan, N = 5 \times 2 = 10 periods).

  • Periodic Rate (r_{periodic}): Calculated as annual \, rate / 2.

• Example: 1,000,000 loan at 7\% APR, semiannual

  • Periodic rate = 7\% / 2 = 3.5\%.

  • First period interest (if opening principal = 1,000,000) = 0.035 \times 1,000,000 = 35,000

5) Three Repayment Structures to Know

A) Bullet (Interest-Only + Principal at Maturity)

• Structure: Interest payments are made each period, and the entire principal is repaid in one lump sum ("bullet") at the end of the loan term.

• Example (semiannual):

  • Periods 1-9: Interest payment of $35,000 each.

  • Final period (e.g., period 10): Payment of $35,000 (interest) + $1,000,000 (principal).

B) Level Principal

• Structure: An equal amount of principal is repaid each period.

• Consequence: Interest payments decline over time because the outstanding principal balance decreases.

• Example (5 years, semiannual; 10 periods):

  • Principal repayment each period = $1,000,000 / 10 = 100,000.

  • Period 1:

    • Opening principal = $1,000,000

    • Interest = 3.5\% \times 1,000,000 = 35,000

    • Total payment = $100,000 (principal) + $35,000 (interest) = $135,000

    • Ending principal = $900,000

  • Period 2:

    • Opening principal = $900,000

    • Interest = 3.5\% \times 900,000 = 31,500

    • Total payment = $100,000 (principal) + $31,500 (interest) = $131,500

    • Ending principal = $800,000

  • Observation: Total payments decline over time because the interest component falls.

C) Level Debt Service (Level Payment / Annuity)

• Structure: The total payment made each period remains constant.

• Dynamic: Over time, the interest portion of the payment decreases, while the principal portion increases.

• Calculation: Requires annuity mathematics or a financial calculator (using variables like rate, N for number of periods, and PV for present value to determine the payment, PMT).

• Logic: Follows a similar table structure to other methods, but the total payment amount stays fixed.

6) Capital Structure & Financing Basics

• Capital Structure: The mix of debt and equity used to finance an organization's assets; represents the right side of the balance sheet.

• External Financing: Funding sourced from outside the firm, including debt and new equity issuance.

• Internal Financing: Funding generated from within the firm, primarily through retained earnings (a portion of net income).

• Example: If a project is financed with a 50% debt and 50% equity mix, and the loan amount (debt) is $1,000,000, then the total capitalization for the project is $2,000,000 (1,000,000 debt + 1,000,000 equity).

7) Capitalized Interest (Super Important)

• Definition: If interest payments are not made currently (either by design or due to missed payments), the unpaid interest can be capitalized, meaning it is added to the principal balance.

• Real-World Uses: Common in large projects (e.g., stadiums, bridges, power plants) during their construction or pre-operational phases when cash flows are not yet generated.

• Consequences:

  • The principal amount grows by the capitalized interest.

  • Borrowers end up paying interest on interest in subsequent periods because the opening principal balance is higher.

• Technical Default: If payments are underpaid or late, penalties (e.g., 1\%) may be assessed and also capitalized, further increasing the principal.

• Transition: Once the asset becomes operational and generating cash flows, regular debt service (principal and interest payments) typically begins.

8) Credit Quality & Down Payments

• Leverage in Mortgages: Mortgages are typically highly levered, meaning a large portion of the asset's value is financed by debt (e.g., 5–20% down payment implies 80-95% debt).

• Credit Quality Impact: Borrowers with better credit quality are often required to make lower down payments, reflecting greater lender confidence in their ability to repay.

• Example: For a $565,000 house with an 8\% down payment:

  • Equity (down payment) = 0.08 \times 565,000

  • Debt (mortgage) = 92\% of the house value.

9) Leverage & LBOs

• Leverage: The use of debt to acquire assets.

  • It is a powerful strategy when the returns generated by the acquired assets exceed the cost of the debt.

  • Tax Shield: Interest payments are typically tax-deductible, which further lowers the effective cost of debt.

• LBO (Leveraged Buyout):

  • A type of Mergers & Acquisitions (M&A) transaction that is financed predominantly by debt.

  • Optimal Conditions: Works best when the target company has large, predictable, and stable free cash flows, which are essential for servicing the high fixed debt obligations inherent in an LBO.

• Tax Deductibility of Interest:

  • Lowers the after-tax cost of debt.

  • Can reduce the Weighted Average Cost of Capital (WACC) for a firm, up to a certain point (beyond which, increased financial risk outweighs the tax benefit).

Foundational Concepts for Mastery

• Time Value of Money (TVM): Crucial for pricing loans, bonds, and notes.

• Principal vs. Interest: Distinguish between the original borrowed amount and the cost of borrowing.

• Learning emphasizes repetition and practice of these patterns.

Fixed-Income (Debt) vs. Equity

• Fixed-Income: Represents contractual payments (interest + principal); sits on the right side of the balance sheet as liabilities.

• Equity: Represents a residual claim, paid only after debt obligations are met.

• Risk/Return Hierarchy: Senior, collateralized debt (lowest \, risk) < Junior debt < Equity (highest \, risk). Lower risk implies a lower required return for lenders.

Key Characteristics of Fixed-Income

• Coupon Payments: Periodic cash payments (interest) to investors, acting as the 'reward' for lending.

• Principal: The original amount borrowed; reduces only when explicitly repaid, not by interest payments.

• Seniority: Determines payoff priority during default (senior debt has priority, often secured by collateral like real estate or inventory).

• Default/Bankruptcy: Debt holders have priority over equity holders. Debt contracts include covenants, indentures, and dispute resolution mechanisms, often limiting further borrowing.

Mortgages

• A mortgage is a loan specifically secured by real property (residential or commercial).

Payment Frequencies Setup

• For semiannual payments:

  • Number of Periods (N): years \times 2

  • Periodic Rate (r_{periodic}): annual \, rate / 2

• Example for a $1,000,000 loan at 7\% APR, semiannual: Periodic rate = 3.5\%, first period interest = $35,000

Three Repayment Structures

1. Bullet (Interest-Only + Principal at Maturity):

   • Only interest payments are made periodically.

   • The entire principal is repaid as a single lump sum ('bullet') at the loan's maturity.

   • E.g., for a $1,000,000 loan at 3.5\% periodic rate, periods 1-9 pay $35,000 interest; period 10 pays $35,000 (interest) + $1,000,000 (principal).

2. Level Principal:

   • An equal amount of principal is repaid each period.

   • Consequence: Interest payments decline over time because the outstanding principal balance decreases, leading to declining total payments.

   • E.g., for $1,000,000 over 10 periods, 100,000 principal is repaid each period. Period 1 total payment = $135,000 (100,000 principal + 35,000 interest on $1,000,000); Period 2 total payment = $131,500 (100,000 principal + 31,500 interest on $900,000).

3. Level Debt Service (Level Payment / Annuity):

   • The total payment made each period remains constant.

   • Over time, the interest portion decreases, and the principal portion increases within each fixed payment.

   • Requires annuity mathematics (e.g., using a financial calculator to determine PMT based on rate, N, and PV).

Capital Structure & Financing Basics

• Capital Structure: The mix of debt and equity financing assets; the 'right side' of the balance sheet.

• External Financing: Funds from outside the firm (debt, new equity issuance).

• Internal Financing: Funds generated within the firm (retained earnings).

• Example: $1,000,000 debt for a project with 50% debt/50% equity implies $2,000,000 total capitalization.

Capitalized Interest (Critical Concept)

• Definition: Unpaid interest is added to the principal balance, increasing the total debt.

• Real-World Use: Common in large projects (stadiums, power plants) during construction/pre-operational phases when cash flows are not yet generated.

• Consequences: Leads to principal growth, and borrowers effectively pay interest on interest in subsequent periods.

• Technical Default: Underpaid or late payments may incur penalties that are also capitalized.

• Transition: Regular debt service begins once the asset is operational and generating cash flows.

Credit Quality & Down Payments

• Leverage in Mortgages: Mortgages are typically highly levered (e.g., 5-20% down payment means 80-95% debt financing).

• Credit Quality Impact: Borrowers with better credit usually require lower down payments.

• Example: A $565,000 house with an 8\% down payment means 0.08 \times 565,000 equity and 92\% debt.

Leverage & LBOs

• Leverage: Using debt to acquire assets; advantageous when asset returns exceed debt costs.

• Tax Shield: Interest payments are tax-deductible, lowering the effective cost of debt and potentially reducing the Weighted Average Cost of Capital (WACC).

• Leveraged Buyout (LBO): An M&A transaction largely financed by debt. Best suited for target companies with large, predictable, and stable free cash flows to service high debt obligations.