Money and Capital Markets 21 C h a p t e r Eighth Edition Financial Institutions and Instruments in a Global Marketplace Peter S. Rose McGraw Hill / IrwinSlides.

Money and Capital Markets

2121C h a p t e r

Eighth Edition

Financial Institutions and Instruments in a Global Marketplace

Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

Business BorrowingBusiness Borrowing

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Learning Objectives

To look at how business firms issue debt securities and negotiate loans in order to raise funds in the money and capital markets.

To learn about the key factors affecting the volume of funds that businesses seek to raise in the financial system.

To see the often powerful impact that business borrowing has upon market interest rates and credit conditions.

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Introduction

Business firms draw on a wide variety of fund sources to finance their daily operations and to carry out long-term investment.

In 2000, nonfinancial business firms in the U.S. raised about $1,250 billion, of which approximately $860 billion was supplied from the financial markets through issues of bonds, stocks, notes, and other financial instruments.

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Factors Affecting Business Activity in the Money and Capital Markets

Many factors affect the extent to which business firms draw on the money and capital markets for external funds: Total funding demands of business firms Level and expected growth of internally generated

funds Condition of the economy Credit availability and interest rates

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Characteristics of Corporate Notes and Bonds

A note has an original maturity of five years or less, while a bond carries an original maturity of more than five years.

Both securities promise the investor an amount equal to the security’s par value at maturity plus interest payments at specified intervals.

They are generally issued in units of $1,000, and accompanied by indentures.

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Characteristics of Corporate Notes and Bonds

Corporate bonds tend to be issued with longer maturities when both interest rates and inflation are low.

Some corporate bonds are backed by sinking funds.

A considerable proportion of corporate bonds that are outstanding today carry call privileges.

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Characteristics of Corporate Notes and Bonds

During periods of rapid economic expansion, when the supply of credit is relatively scarce, the cost of borrowing rises.

Yields on the highest-grade bonds tend to move closely with government bond yields.

Yields carried by lower-grade corporate bonds are more closely tied to conditions in the economy and to factors specifically affecting the risk position of each borrowing firm.

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Characteristics of Corporate Notes and Bonds

The Signals that Corporate Bond Issues Send A bond issue that appears to be driven by an

unanticipated cash-flow shortage tends to lower the bond and equity prices of the issuer.

On the other hand, a new bond sold to expand the firm’s capitalization tends to send a positive signal to the market.

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Characteristics of Corporate Notes and Bonds

Common types of corporate bonds include: Debentures – bonds that are not secured by any

specific asset Subordinated debentures – junior securities Mortgage bonds – may be closed end or open end Income bonds – interest is paid only when income

is actually earned Equipment trust certificates – resemble leases Industrial development bonds (IDBs) – issued by a

local government borrowing authority

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Characteristics of Corporate Notes and Bonds

New types of corporate notes and bonds include: Discount bonds – include zero coupon bonds Floating-rate bonds Commodity-backed bonds – the face value is tied

to the market price of an internationally traded commodity

Medium-term notes (MTNs) – carry maturities of one to ten years

Investors in Corporate Bonds

Data Source: Board of Governors of the Federal Reserve System

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The Secondary Market for Corporate Bonds

The secondary market for corporate bonds is relatively limited compared to the markets for other long-term securities like common stock and municipal bonds.

The number of active individual investors is small and institutional investors tend to follow a buy and hold strategy.

Recently however, many institutions are looking at total performance and have become more aggressive.

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The Marketing of Corporate Notes and Bonds

New corporate bonds may be offered publicly in the open market to all interested buyers through a public sale, or sold privately to a limited number of investors via a private or direct placement.

The majority of corporate bond sales are public sales. Private placements are, however, popular among smaller companies and firms with unique financing requirements.

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The Marketing of Corporate Notes and Bonds

In a public sale, an investment banking firm or a syndicate of underwriters may either purchase the securities directly from the issuing company through a bidding process or guarantee the issuer a specific price for the securities.

In both approaches, the underwriter carries the risk of losses (or gains) when the securities are marked for sale in the open market.

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The Marketing of Corporate Notes and Bonds

In recent years, private placements have accounted for about 20% of market sales of corporate bonds.

Usually, periods of rising interest rates and reduced credit availability bring more borrowing companies into the public market, while falling interest rates often bring about a rise in private placements.

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The Volume of BorrowingIn the Corporate Bond Market

0

1,000

2,000

3,000

4,000

5,000

6,000

1961 1966 1971 1976 1981 1986 1991 1996 2001

Volume of OutstandingCorporate and Foreign Bonds$ billions

Data Source: Board of Governors of the Federal Reserve System

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The Volume of BorrowingIn the Corporate Bond Market

The growth in corporate borrowing is due to: inflation the increased use of financial leverage to boost

returns to corporate stockholders the development of international capital markets recent relatively-low interest rates the rash of corporate takeovers (leveraged

buyouts) and mergers

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Bank Loans to Business Firms

Commercial banks are direct competitors with the corporate bond markets in making both short-term and long-term loans to businesses.

Although growing numbers of corporations that once relied on banks for funds have turned to selling bonds in the open market, the volume of bank credit made available to business firms remains enormous.

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Bank Loans to Business Firms

The prime bank rate, or base rate, is the annual percentage rate that banks quote to their most creditworthy customers.

Traditionally, the prime rate was set by one or more of the nation’s leading banks, and the other banks followed the leader.

Nowadays however, prime rates are often pegged to the prevailing yields on Treasury bills and other money market instruments.

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Commercial Mortgages

The construction of office buildings, shopping centers, and other commercial structures is generally financed with an instrument known as the commercial mortgage.

Faced with inflation and a volatile economy, new forms have been developed: equity kicker indexing securitized commercial mortgages

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Money and Capital Markets in Cyberspace

More information about business borrowing can be found at: http://www.investinginbonds.com/ http://www.bondmarkets.com/default.shtml http://www.finpipe.com/ http://cbs.marketwatch.com/ http://www.mizuho-sc.com/english/index.html

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Chapter Review

Introduction Factors Affecting Business Activity in the

Money and Capital Markets

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Chapter Review

Characteristics of Corporate Notes and Bonds Principal Features Original Maturities Call Privileges Sinking Fund Provisions Yields and Costs The Signals that Corporate Bond Issues Send The Most Common Types of Corporate Bonds New Types of Corporate Notes and Bonds

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Chapter Review

Investors in Corporate Bonds The Secondary Market for Corporate Bonds The Marketing of Corporate Notes and Bonds

The Public Sale of Bonds Private Placements of Corporate Bonds

The Volume of Borrowing in the Corporate Bond Market

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Chapter Review

Bank Loans to Business Firms The Prime, or Base, Interest Rate

Commercial Mortgages