What Are Corporate Bonds and Loans? | The Big Explainer | Refinitiv

One misconception about debt is 
that it's inherently bad, and   certainly there is a threshold. Managed 
prudently, which most companies will,   issuing bonds and loans can help grow businesses, 
create jobs and essentially help the economy. Welcome to The Big Explainer.   The corporate debt market is one 
of the largest financial markets,   but also one of the least well-known 
parts of the financial framework.   Corporates can borrow money or raise capital 
in many different ways and are at the heart   of any economy, but often this key part of 
the economic infrastructure gets overlooked. So the corporate debt market doesn't typically 
garner too many mainstream headlines and is   mostly known to those who only cover the market, 
but as part of the overall financial markets,   it's a huge piece in over 10 trillion dollar 
market here in the US. And it's also enormously   important on the corporate level, to enhance 
liquidity and potentially grow business,   either by using it to help finance an M&A 
transaction, or for other business investment.   One example I like to give where a credit 
helped change the trajectory of an industry,   back in late 2006, Ford Motor Company approached 
the syndicated loan market for the first time.   They wanted to get a much larger debt 
commitment to help with some restructuring,   as well as also liquidity to counter 
against a potential recession.   They issued an 18 billion dollar syndicated loan 
from a lender group, which practically doubled   the company's liquidity at the time.

Well, within 
six month’s time, credit markets started freezing   up due to the subprime mortgage crisis, and fast 
forward a little bit further to 2008 after Lehman   collapse, and the recession starts, the other two 
of the big three U.S. automakers, GM and Chrysler,   filed for bankruptcy and received government 
bailouts while Ford was able to scrape through,   and by avoiding bankruptcy, was even able to 
increase market share over its competitors.   Now there were other factors at play, Ford's 
loan wasn't the sole reason, but it certainly   put Ford in a better position at the time and 
really helped them navigate the recession.

Companies can raise capital in a variety of ways. 
Sometimes they will increase their debt levels   by issuing bonds, whilst on other occasions, they 
will borrow money directly from banks in the form   of loans, though the risk is usually spread across 
a number of lenders. One of the main differences   between bonds and loans will be duration. 
Bonds are usually longer dated than loans. The two main types of debt issues 
for companies are bonds and loans.   While there are some similarities between 
the two, they have different characteristics   that investors, may favour one over the 
other, depending on market conditions.

Bonds are a debt instrument that a company 
issues to investors. There is a bank involved,   but they act as a servicer rather than 
a lender. The bonds have long tenors,   can be as long as 10, 20, 30 years. The company 
pays back the principal of the bond at maturity   and throughout the life of the bond, investors 
are paid a regular fixed rate of interest.   Bonds are viewed as a more predictable asset, 
an investor knows what the return on investment   is going to be, as opposed to something like 
stocks. Now, a corporate loan, oftentimes called a   syndicated loan, is where a group or syndicate of 
lenders come together to loan money to a company.   So here the bank is the provider of the loan.

The 
reason it's a group of lenders rather than one is   to, 1. Open up an even larger commitment size 
to the borrower, and 2. Spread the risk around,   so instead of a two hundred million dollar loan 
for one borrower sitting in one bank's portfolio,   you have it spread amongst the larger group. 
Compared to bonds, loans are shorter in duration,   usually in the five to seven year range, 
although they can go longer at times,   and loans are a floating rate instrument which 
differentiates them from a fixed-rate bond. Loans have aspects which are similar to some   of the everyday instruments that 
households and consumers may use. There are two main types of corporate loans, 
revolvers and term loans. And it's typical   for a company that's issuing loans to include 
both types. I can draw a parallel to everyday   life for the difference between revolvers 
and term loans. A revolving loan behaves   just like a credit card. A company that has a 
revolving credit can borrow a portion of it,   repay part of that portion back, re-borrow more, 
etc.

Just like someone would with a credit card.   Revolving credits debt maturities 
usually in the three to five year range   and are used for normal course of business like 
covering payroll expenses. Quite often a company   may not even need to draw down on its revolving 
credit, they may have it as a 'just in case'.   The second type of loan is a term loan. Term loans 
behave just like a mortgage would. You have one   draw on the entire amount of the loan at inception 
and then it's repaid in regular installments over   the life of the loan. So it doesn't have that 
revolving nature to it of 'repay re-borrow'.   Term loans can also be used for a normal course of 
business, but they're also the main form of loan   used in an M&A financing.

Now there's also two key 
types of term loans worth making the distinction   between – pro-rata and institutional. A pro-rata 
term loan will have the same general terms as the   revolver, same pricing, same tenor, and those 
two components are held by the lending banks.   Those loans are less risky by nature 
than the other type of term loan,   the institutional term loan, which is larger 
in size, has higher pricing and longer tenor,   usually around seven years. That piece of the loan 
is sold by the banks to institutional investors   who are your hedge funds, pension funds, insurance 
companies and collateralized loan obligations.   This institutional piece of a leveraged loan 
is the closer compared to a high yield bond.   Investors looking for better returns will look 
to institutional term loans and high yield bonds.

Bonds and loans fulfill different requirements 
for corporate borrowers. But there are risky   loans and risky bonds. The risk profiles of 
bonds and loans can often be very similar. Even though bonds and loans are part of the fixed 
income category, which is viewed as a relatively   safe asset class compared to equities, they're 
not without risk. Both debt types typically get   tossed into two categories of risk profiles. The 
first is investment grade or in the bond market,   sometimes simply called a corporate 
bond. These are well-rated names,   you think along the lines as a chip 
stock, Disney, Coca-Cola, Microsoft.   Investment grade companies are usually rated 
triple B or better by rating agencies. Investment   grade loans and bonds are typically unsecured, 
meaning they're not backed by any collateral, and   since they're senior debt instruments, they'll sit 
above the equity in a company's capital structure,   so those investors will have priority to 
recoup losses in the case of a bankruptcy.   The investment grade market is very relationship 
driven. For instance, in the loan market,   the revolving loan itself is very cheap for the 
borrower to keep, so the lenders aren't making a   whole lot of money on it, but they are interested 
in more lucrative ancillary business that could   come from maintaining a relationship with that 
company.

Many investment grade borrowers don't   change up their lending groups over the years, 
it's a very consistent market in that way.   Now the other risk profile is the high 
yield or junk category, which is the   label in the bond market. And the equivalent 
in the loan market is the leveraged loan.   These are lower-rated companies, viewed riskier 
compared to the investment grade space. They're   usually rated double B or lower by the rating 
agencies. A leveraged loan is normally secured,   so it is backed with collateral, while a high 
yield bond is typically unsecured. So because of   that, the leveraged loan will sit higher up in the 
capital structure compared to the high yield bond. Once capital has been raised via a bond, the 
issuer needs to pay the pre-agreed interest or   yield generally on an annual basis. Corporate 
loans however, may have some ongoing criteria   which the recipients of the loan needs to 
meet throughout its lifetime. That said,   bonds and loans at the riskier end of the 
spectrum will have a lot of features in common.

So some other differences you'll see between loans 
and bonds. Loans oftentimes contain something   called maintenance covenants, which bonds do not. 
These are measures built into the agreement that   the borrower needs to maintain throughout the life 
of the loan. For example, maybe a financial ratio   like a debt to EBITDA level. Covenants allow the 
lending group some controls over how much risk the   borrower can take on throughout the loan. Another 
difference is high yield bonds will have longer   call protections than an institutional average 
loan. Call protection is the length of time during   which an issuer cannot refinance that debt. For a 
high yield bond the call protection could be five   years, sometimes higher, whereas in the leverage 
loan market, sometimes you'll see call protection   as low as six months. So if you're a borrower 
you're locked into that high yield bond for much   longer than a loan.

Now it's worth mentioning at 
times these two debt instruments, high yield bond   and institutional leverage loan, they seek some 
crossover of these characteristics. For example,   having a high yield bond as secured or an 
institutional term loan, having a lack of   maintenance covenants, and market sentiment can 
drive these sorts of patterns in the market. Perhaps one of the clearest distinctions between 
bonds and loans is how they're priced. Bonds tend   to be fixed and loans tend to be floating. A 
corporate's credit rating will also matter. Low   quality companies will nearly always have a higher 
charge than companies with a strong balance sheet. A key difference between bonds 
and loans is how they're priced.   Loans are a floating rate instrument, so 
they will be tied to an interest rate like   three-month LIBOR.

And then there will be an 
additional spread on top of that interest.   Bonds are normally fixed rate, so what was agreed 
upon at inception is carried throughout the life.   Both bonds and loans will be priced off of the 
borrower's risk profile. So if the borrower is   an investment grade name, they will be paying 
less for their loan or bond than a leverage or   high yield borrower. Besides the rating, lenders 
might look at the sector the borrower operates in   as well as the other pieces of the loan structure, 
tenor covenant package. Then they'll look at   what similar rated borrowers in similar sectors 
recently priced at in order to get a comparable.   In the loan market, oftentimes the pricing can 
increase or decrease throughout the life of   the loan. That's because what's spread over the 
interest rate can adjust depending on factors.   If pricing is tied to the company's 
rating and the company gets downgraded,   then that might trigger higher pricing within 
the loan. Sometimes loan pricing is tied to a   financial ratio like debt to EBITDA and 
can increase or decrease throughout the   loan depending on that ratio.

This is a way 
to bake into the agreement something for the   lenders to protect themselves If or when 
the company sees performance deteriorate. The quality of a company is clearly 
critical to its ability to access funding.   Whilst the Covid crisis has had a profound 
impact on the demand for debt and loans. The high yield bond market and institutional 
loan market, which is that riskiest piece in the   leveraged loan market, are both huge markets, each 
currently about one point two trillion in size.   Those sizes ebb and flow depending on investor 
appetite. In the few years prior to the Covid-19's   impact on the market, the institutional loan 
market was regularly putting up higher volume   numbers than the high yield bond market. Because 
loans are a floating rate, they are favored by   investors looking for higher yielding assets 
during a rising rate environment. Investors like   that option, especially going back a few years ago 
when the Federal Reserve was still hiking rates.   But as soon as they dropped rates back in 
March to counter the impact of the pandemic,   then later gave signals that they are not 
going to raise them again for some time,   investors started to look more towards 
high yield bonds.

You can see that with   the Lipper fund flows data, which shows that 
retail investors have been pouring money into   the high yield bond asset class since April 
while pulling money out of leveraged loans. The high yield market has seen a huge increase 
in interest during this pandemic period.   There are concerns that the corporate bond 
and loan markets are spiraling out of control. I think maybe one misconception about 
debt is that it's inherently bad, and   certainly there is a threshold. Carrying 
too much debt can be counterproductive,   we saw that before the Great Financial 
Recession with the mega leveraged buyouts,   over 20 billion debt sizes and some of those 
companies getting overburdened with it. But   those were more exceptions rather than the rule. 
Managed prudently, which most companies will,   issuing bonds and loans can help grow businesses, 
create jobs and essentially help the economy. The Covid crisis has seen a huge increase in 
issuance of both loans and bonds as companies   try to navigate the economic uncertainty.

The 
U.S. Federal Reserve is buying corporate debt   via its quantitative easing program, and this has 
encouraged many companies to tap the bond market.   Companies that probably shouldn't have been able 
to sell more debt have found it relatively easy   to do so. Though companies that were already on 
their last legs are having to pay penal rates.   The health of the corporate bond and loans market 
will probably define whether the U.S. will sink   into a deeper recession or not. If the fiscal 
and monetary stimulus of the U.S. government   can support bond prices and suppress loan costs, 
then U.S. corporates may be able to borrow their   way through the pandemic.

Eventually, however, 
it will be cash flows rather than borrowing   that will define the long-term 
outlook of the corporate sector..

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