Bank Debt vs Corporate Bonds
The most common form of corporate debt is Bank Debt, which at the most basic level is conceptually the same as any other loan or credit product from a local retail bank (but just done on a larger scale, often through a corporate bank).
On the other hand, we have Corporate Bonds, which are normally raised once the maximum amount of bank debt is raised. Or, the borrower might desire less restrictive covenants, which comes at the expense of a higher interest rate.
In This Article
- Bank Debt: Summary Overview
- Lender Incentive Differences: Bank Debt vs. Bonds
- Private vs. Public Debt Financing
- Cost of Capital / Interest Rate
- Bank Debt: Advantages
- Lower Cost of Capital
- Flexible Debt Structuring
- No Prepayment Penalties (or Minimal Fees)
- Confidentiality in Filings
- Institutionalized, Risk-Averse Investor Base
- Bank Debt: Disadvantages
- Collateral Requirements (1st or 2nd Lien)
- Restrictive Debt Covenants
- Refinancing Risk
- Corporate Bonds: Advantages
- Investment-Grade vs. Speculative-Grade Debt
- Fixed Pricing: Unimpacted from Interest Rate Volatility
- Less Restrictive Covenants
- Longer Tenors
- Corporate Bonds: Disadvantages
- Higher Cost of Capital
- Non-Callable Feature & Call Premiums
- “Make-Whole” Provision
- Capital Structure: Equity and Debt Financing
Bank Debt: Summary Overview
In the chart below, there are brief descriptions of each:
|Senior Secured Debt Tranches|
|Revolving Credit Facility (“Revolver”)||
|Term Loan A (“TLA”)||
|Term Loan B (“TLB”)||
Lender Incentive Differences: Bank Debt vs. Bonds
The distinct commonalities among the senior secured loans are the lower costs of capital (i.e., cheaper source of financing) and pricing based on a floating rate (i.e., LIBOR + Spread).
- For term loans, there is typically a floor to maintain a minimum yield threshold of the lender
- If LIBOR drops below a certain level, the floor serves as a form of downside protection
- The main driver of return is the coupon on the debt, and then the receipt of the principal at maturity
- When it comes to senior lenders, capital preservation is the main priority – hence, the often-extensive creditor agreements
- The borrower has also pledged its collateral to back the debt, which further protects the interests of the lender
- Since leveraged loans are secured by collateral, they are considered the safest debt capital
In comparison, the main features of bonds are their fixed pricing (as opposed to floating) and the longer tenor. Unlike bank debt, the yield on bonds, therefore, does not change regardless of the interest rate environment.
- This means the pricing attached to the bond is adequate for the lender, and the return meets their lending threshold
- Since the lender is unsecured and lower in the capital structure, these lenders tend to be more returns-oriented – but the extra attention paid to the yield is reasonable because the lender is taking on extra risk (and should thereby be compensated for the additional risk)
- While bank debt lenders are focused on capital preservation of their loans, bond lenders concentrate on ensuring an adequate return is received
Hence, bank debt can be paid back early with no (or minimal) prepayment fees, whereas bond lenders charge a premium – the bank lender is glad to de-risk its investment, but for a bond lender, any prepayment lowers the return (i.e., the return of principal and a decent yield is not enough, instead the return of principal plus the “targeted” yield must be met).
Private vs. Public Debt Financing
One notable difference between the two is that bank debt is raised in a private transaction between:
- The company is in need of debt capital and looking to raise financing
- The lender(s) that provide the debt capital – that can range from an individual bank, a syndicate of banks, or a group of institutional investors
On the other hand, corporate bonds are issued to institutional investors in public transactions registered with the SEC.
- Similar to how equities are traded on the public markets, these corporate bonds trade freely on the secondary bond market.
- In fact, the secondary bond market is actually much larger than the equity secondary market in terms of size as well as daily trading volume.
Cost of Capital / Interest Rate
In general, bank debt is priced cheaper in terms of the interest rate because:
- Most, if not all, bank debt lenders require the debt to be secured by the borrower’s assets – thus, the collateral can be seized by the lender in the case of default or covenant breach
- In the event of bankruptcy or liquidation, bank debt is first in line (i.e., highest seniority) with the highest chance of receiving full recovery
- By being at the top of the capital stack, bank debt is safer from the perspective of the lender
- Since the lender is secured, the Senior Secured Lenders hold higher negotiating leverage when it comes to bankruptcies (i.e., their interests are prioritized)
For the reasons stated above, a company will thus often maximize the amount of bank debt that bank lenders would be willing to lend before using riskier, more expensive types of debt instruments.
The chart below summarizes the pros/cons that will be discussed in this article:
Bank Debt: Advantages
Lower Cost of Capital
The most compelling benefit of borrowing from banks, as mentioned earlier, is that the pricing on bank debt is lower relative to other riskier tranches of debt.
With the lower risk comes a lower interest rate – hence, the notion that bank debt is the cheaper source of financing.
The pricing of debt is a function of its placement in the capital structure and seniority in terms of priority of repayment in the case of liquidation.
Unlike bonds, bank debt is priced at a floating rate, meaning that its pricing is tied to a lending benchmark, most frequently LIBOR plus a specified spread.
For example, if a bank debt is priced at “LIBOR + 400 basis points”, this means the interest rate is the rate at which LIBOR is at in the present moment plus 4.0%.
In addition, floating-rate instruments normally have a LIBOR floor to protect the investor against very low-interest-rate environments and to make sure they receive a minimum yield that satisfies their threshold.
Continuing off the previous example, if the LIBOR floor is 2.0%, that means that the interest rate cannot dip below 6.0% (i.e. downside protection for the debt investor).
Floating vs. Fixed Rates – Quick Concept Check
To ensure you not only understand the difference between floating and fixed debt pricing but also understand when each would be preferable from the perspective of a debt investor, answer the question below:
Q. “When would a debt investor prefer fixed rates over floating rates (and vice versa)?”
- Falling Interest Rates: If interest rates are expected to fall in the near-term future, investors would prefer fixed rates
- Rising Interest Rates: If interest rates are expected to increase, however, investors would prefer floating rates instead
Flexible Debt Structuring
There are a number of ways that bank debt can be structured that end up being a fit for both the bank and the borrower. Structuring bank debt can be flexible because of the bilateral nature of the product.
The only two parties to a contract are:
- Corporate Borrower
- Lending Bank(s)
In effect, the loan can accordingly be tailored to meet the needs of both.
In recent years, the willingness of banks (which are known to be less lenient on debt terms) has loosened up a bit due to the rise of other lenders, such as direct lenders. This is the reason behind the increase in “covenant-lite” loans.
No Prepayment Penalties (or Minimal Fees)
In addition, most bank debt with the exception of certain term loans or mortgages will have limited or less onerous prepayment penalties (subordinated secured credit may have higher prepayment penalties).
For example, revolvers (similar function as credit cards) can be paid down at any time, causing interest expense to go down due to a lower outstanding balance.
This offers flexibility for operations if cash flows from the business are stronger than expected (and in the reversed scenario as well).
Bank debt, especially bilateral loans, can also be more structured – with concessions made in terms of interest in exchange for tighter terms or vice versa (the smaller the borrower, the less wiggle room there is for negotiation).
Confidentiality in Filings
The final pro for bank debt is how they are generally confidential, which can be favorable to borrowers who want to limit the amount of publicly disclosed information.
Even if the borrower publicly uploads credit documents such as the loan agreement, bankers will want commercial terms such as pricing or quantum of commitments to be redacted from the filings.
Institutionalized, Risk-Averse Investor Base
While this can be arguably a pro or a con depending on the circumstances, the investor base for bank debt is comprised of commercial banks, hedge funds/credit funds (often opportunistic investments), and collateralized loan obligations (“CLOs”).
Bank lenders tend to place more weight on downside protection and reducing risk, which indirectly leads to the borrower making more risk-averse decisions.
For larger firms who can access investment banking services and public debt capital markets in developed economies such as the US or the UK, bonds often become more relevant as a funding source due to their function as a slightly more permanent piece of capital with fewer restrictions on operations.
For the largest and most sophisticated firms, it is not uncommon to see that most of their debt is comprised of unsecured notes/bonds, with most of their outstanding bank debt being characterized by fairly loose covenants in line with the bonds (i.e. less stringent terms).
The investor universe for corporate bonds includes hedge funds, bond mutual funds, insurers, and HNW investors – with the fixed income nature of returns being appropriate for their investing mandates.
But the “yield-chasing” aspect of lending is more prevalent in the corporate bond market, although this is the minority as opposed to the majority.
Bank Debt: Disadvantages
Collateral Requirements (1st or 2nd Lien)
So, you may be wondering: “Why is bank debt cheaper than corporate bonds?”
The simple answer to that question is bank debt is priced at a lower interest rate because of being secured, meaning that the lending agreements contain language that the bank debt is backed by collateral (i.e. the assets of the borrower can be seized).
If the borrower were to run into distress and undergo bankruptcy, the senior debt with its 1st or 2nd lien has the highest priority in receiving recovery.
Bank debt is priced at a lower interest rate since the lender is at lower risk as the debt is backed by the collateral – thereby, making it the safest claim.
The assets of the borrower were pledged as collateral to get favorable financing terms, so if the borrower were to be liquidated, the bank lenders have a legal claim on the pledged collateral.
Hence, bank debt is the most likely to receive a full recovery in the case of a liquidation, whereas lenders lower in the capital structure would be concerned about:
- The dollar amount of recovery to be received (if any)
- Or, the form of consideration (i.e., debt could be converted into equity in the post-bankruptcy company)
This typical requirement of having to post collateral against a loan from senior lenders encumbers assets while limiting the ability to pledge assets for incremental capital raising or fundraising.
1st vs. 2nd Lien Debt: Differences
Formally, the lien is defined as the seniority and the priority of payment to a debt holder relative to the other tranches.
The lien is a legal claim against the assets of a borrowing company (i.e. used as collateral) and the right to seize those assets first in forced liquidation/bankruptcy scenarios.
- 1st Lien Debt: The highest seniority, 1st lien, is fully secured by the company’s assets and has the first claim to collateral in a liquidation/bankruptcy scenario
- 2nd Lien Debt: Right below 1st lien loans sits 2nd lien where compensation is provided only if there’s collateral value remaining once 1st lien lenders are repaid in full
As one would expect, 1st lien debt is associated with senior secured debt such as a revolver and term loans from banks. In contrast, 2nd lien debt is riskier and more expensive for borrowers – consisting of higher-yield debt instruments.
Restrictive Debt Covenants
Another drawback of bank debt, in addition to the collateral requirement, is the use of covenants that reduce operating flexibility – albeit, covenants have loosened up in recent years by banks to compete better amidst new institutional lenders offering better pricing terms with fewer restrictions.
Covenants are legally binding obligations made by the borrower to comply with a certain rule at all times or when taking a specific action.
One benefit to posting collateral is assuming adequate coverage / over-collateralization.
For example, imagine $200 of property pledged as collateral against a $100 loan, lenders may allow for a higher leverage multiple (Debt / EBITDA) or not have any restrictions on leverage.
Bank covenants usually include maintenance financial covenants, which require the financial situation to stay within certain parameters.
An example would be a leverage covenant such that Debt / EBITDA is no more than 3.0x at the end of each fiscal quarter. The company would then have to ensure that this financial threshold is maintained.
Covenants reduce the ability to return capital to shareholders (dividends, share repurchases, opportunistic purchases of subordinated debt) and could be an overhang on operations.
For example, there may be impediments to being able to pursue attractive acquisitions or pursuing a capital program that management likes because of maximum leverage covenants or other constraints.
Principal repayments for bank debt also tend to not be one bullet payment like it is for corporate bonds.
Rather, the principal of the bank debt is amortized over the life of the loan. Amortization also increases debt service needs and reduces cash flow available to equity holders or to be redeployed into operations.
Bank debt maturities are often much shorter than how far bonds can go out, making refinancing a regular front-of-mind consideration.
While bank debt interest is typically lower than that of corporate bonds, the interest rate is floating and based on LIBOR or the prime rate plus a margin.
While the margin is known (although often dependent on a credit rating or leverage as defined in the credit agreement), LIBOR or the relevant benchmark rate is not.
Corporations generally do not like this interest rate volatility as it serves as an extra unknown.
Bank debt lenders also tend to be a more obstinate counterparty in potential restructuring negotiations versus noteholders – many of whom may have purchased the security at below par value.
Banks do not want to concede and take mark-to-market losses or take provisions, partially as a function of their business model where not losing money is paramount.
Corporate Bonds: Advantages
Investment-Grade vs. Speculative-Grade Debt
Default risk directly leads to a higher interest rate to compensate the investor for the additional risk taken – otherwise, it would be difficult to receive interest from lenders.
Before we can delve into the pros and cons of corporate bonds, one key distinction that must be clearly defined is the difference between investment-grade and speculative-grade debt.
- Investment-Grade Debt: Investment-grade debt (often called high-grade debt) has a credit rating above BBB/Baa and represents a category of debt issued by corporations with a strong credit profile. Investment-grade debt is considered safe, given the low risk of default.
- Speculative-Grade Debt: Speculative-grade debt (otherwise known as high-yield debt) has a credit rating below BB/Ba is offered by more leveraged corporations with riskier credit profiles.
Clearly, given the increased risk of default associated with speculative-grade debt, the interest rates on these types of debt instruments will be substantially higher to compensate investors for taking on the additional risk (i.e. less favorable terms).
Fixed Pricing: Unimpacted from Interest Rate Volatility
Due to being considered riskier from the lower positioning in the capital structure, bonds are priced higher but at a fixed rate.
Since bonds are fixed-rate coupon instruments, the short-term effects of an interest rate hike are mitigated and there is more predictability in terms of pricing – despite being on the higher end and a costlier option of debt financing.
For example, a $300mm bond with a 6% coupon is going to pay $9mm semi-annually for its entire tenor.
Less Restrictive Covenants
While bank debt may also be offered at a fixed rate, this usually implies that there will be an embedded option (and accordingly a higher cost of capital).
Although bonds also have covenants, they tend to be less restrictive than the ones that banks demand, as banks tend to be more risk-averse (i.e. require pledging collateral, restrictive terms).
The corporate bond market is as big as it is in part because of the drawbacks of having bank debt in the capital structure.
“Covenant-Lite” – Key Terminology
When a bond is described as being “covenant-lite,” it means that it comes with less restrictive covenants.
The benefit to corporations is that they can be unrestrained in terms of what they can (and cannot) do from an operational and financial standpoint.
Covenant-lite bond indentures (i.e. bond contracts) usually arise when the debt markets are hot and credit investors are willing to sacrifice creditor protections in exchange for higher interest rates.
Because the investor universe is larger (more participants) in the bond market versus the bank debt market, there is better trading liquidity in secondary markets (it is easier to buy and sell bonds and there are lower trading frictions).
Bonds being issued at market terms will improve trading liquidity, as covenant review becomes simpler for secondary investors and they are able to generate comfort quickly.
Bonds are also attractive to corporations due to the longer-term maturities of bonds, making them a more “permanent” form of capital.
Corporate bonds can even extend out as long as 30+ years in certain instances, as these are negotiated to satisfy the needs of both parties.
A situation when this would be beneficial would be if a borrower raised debt in the form of bonds when interest rates were low, and then over the course of the next few years, the interest rate rises substantially.
Regardless of the change in interest rates, the cost of debt is unchanged for the borrower.
In contrast, the pricing of senior debt would increase as its priced at a floating rate.
Corporate Bonds: Disadvantages
Higher Cost of Capital
Typically, bonds are priced at a fixed rate with semi-annual payments, have longer terms than loans, and have a balloon payment at maturity.
Compared to bank debt, bonds are costlier with diminished flexibility in regards to prepayment optionality.
A fixed interest rate means the interest expense to be paid is the same regardless of changes to the lending environment. A fixed interest rate is more common for riskier types of debt, such as high-yield bonds and mezzanine financing.
Since bonds come with less restrictive covenants and are usually unsecured, they’re riskier for investors and therefore command higher interest rates than loans.
Non-Callable Feature & Call Premiums
To first define what callable bonds mean, this is when bond indentures (i.e. contracts) stipulate that the bond issuer/borrower can recall the bonds at a pre-determined price after a certain period.
Once a bond becomes callable, the borrower may repay some (or all) of the debt balance and pay less interest.
From the viewpoint of borrowers, a callable bond that can be redeemed prior to maturity enables them to:
- Have the discretion to retire debt ahead of schedule using excess free cash flows
- Reduce the amount of leverage risk on its balance sheet – which can prevent coming close to covenant breaches
- Opt to refinance at lower interest rates if the lending environment has improved
Bonds will oftentimes have call protection clauses that last two or three years (denoted as NC/2 and NC/3, respectively). Or, bonds can be issued as NC/L in certain cases, which means the bond is not callable for the term’s entire term.
For example, a 5% bond can be recalled after 2 years at $110 for $100 of par value and $107.5 after 2.5 years and so on.
However, the one caveat to redeeming HYBs prior to maturity is that the associated fees could offset the savings on interest from the perspective of the borrower (often referred to as the “call premium”).
Callable Bond Features: Lenders’ Perspective
From the lender’s perspective, a callable bond gives more optionality to the issuer; hence, resulting in higher interest rates when compared to non-callable bonds.
The reason that the prepayment option can be unattractive to lenders is that by enabling the borrower to repay a portion of the debt principal ahead of schedule without incurring any penalties, the yield received is reduced – all else being equal.
If the borrower had paid down a substantial percentage of the principal off early, the annual interest payments (i.e. proceeds to the lender) would be reduced in future years since interest is based on the amount of principal remaining.
To prevent this from occurring, the call protection feature prohibits borrowers from prepayment until a specified duration has passed, which implies receiving more interest expense in the early years.
Another consideration is that without the non-redeemable period and call premium, the burden of needing to find another borrower to lend to at the same (or similar) rate is placed on the lender – thus, the inclusion of such clauses and prepayment fees.
An attempt to redeem debt prior to the call period triggers a make-whole provision and is punitive relative to the face value of the debt (or the trading value in some cases).
The “make-whole” provision, as the name suggests, “makes whole” the bond investors who need to be compensated for not being able to hold the bonds to their maturity.
As a result, the bonds must be redeemed following a calculation that ensures a hefty premium to the current market price of the bonds.
Conversely, bond indentures (bond contracts) tend to follow a fairly rigid formula which is market standard (in-line with previous and relatively current bond issues for similar borrowers) as standardization is necessary for debt investors to get on board quickly.
Note, there are a number of options available to corporations to retire debt opportunistically to get around the make-whole or call premium, including buying back bonds on the open market or tendering an offer at terms that are less attractive than the make-whole or call premium that the borrower and its investment bankers feel would be compelling to investors.
Capital Structure: Equity and Debt Financing
Up to now, we’ve talked about the debt piece of a company’s capital structure.
The capital structure of a company typically consists of a mixture of debt (both bonds and bank debt) and equity, as both debt and equity capital come with their distinct advantages and disadvantages.
In order to formulate an “optimal” capital structure, the risk profile of the specific company must be assessed in detail.
Examples of influential factors include revenue cyclicality, the end markets served, diversification in the use-cases / end-users, and customer concentration to list out a few.
Once a company reaches a certain stage of growth and maturity in its lifecycle, usually it is inevitable for the management team to opt for some debt financing as normally more favorable rates are offered to borrowers with an established track record of profitability.
For this reason, it is ordinary to see a company’s leverage ratios increase in direct proportion with how established the company becomes in a particular market (i.e. once the company has determined its target customer base, go-to-market strategy, and niche).
Companies oftentimes choose to raise debt capital as opposed to issuing equity because debt does not dilute the value amongst existing equity shareholders, provides a “tax shield” benefit from interest expense, and in general has a lower cost of capital (WACC) in part due to having seniority in the capital structure and in some cases, a lien on the borrower’s collateral (i.e. thus requiring a lower rate of return).
On the flip side, debt financing comes with less flexibility in that interest expense is fixed (the exception being PIK toggles), introduces default risk, often has restrictive covenants, and comes with an expiry date (i.e. the mandatory repayments of debt principal).
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