Chapter 19
Business Borrowing: Corporate
Bonds, Asset-Backed
Securities, Bank Loans, and
Other Forms of Business Debt
 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.
19-2
Introduction
 Business firms draw on a wide variety of
fund sources to finance their daily
operations and to carry out long-term
investment.
 In 2006, nonfinancial business firms in the
U.S. raised nearly $1.9 trillion, of which
approximately $516 billion was supplied from
the financial markets through issues of
bonds, stocks, notes, and other financial
instruments.
19-3
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
19-4
Characteristics of
Corporate Notes and Bonds
 Maturity definition
 A note has an original maturity of five years or
less
 A bond carries an original maturity of more
than five years
 General characteristics

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An amount equal to the par value at maturity
Interest payments at specified intervals
Generally issued in units of $1,000
Accompanied by indentures
19-5
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
19-6
Characteristics of
Corporate Notes and Bonds
 During rapid economic expansion
 The supply of credit is relatively scarce
 The cost of borrowing rises
 Yield movements
 Yields on the highest-grade bonds tend to
move closely with government bond yields
 Yields carried by lower-grade corporate bonds
 More tied to conditions in the economy
 Also tied more to factors specifically
affecting the risk position of the borrower
19-7
Characteristics of
Corporate Notes and Bonds
For a bond that matures in 10 years:
 Interest charges on debt are tax
deductible, so k’ = k (1 – t)
19-8
Characteristics of
Corporate Notes and Bonds
Signals Corporate Bond Issues May Send
 A bond issue that appears to be driven by
an unanticipated cash-flow shortage
 Tends to lower bond prices of the issuer
 Tends to lower equity prices of the issuer
 A new bond sold to expand the firm’s
capitalization tends to send a positive
signal to the market
19-9
Characteristics of
Corporate Notes and Bonds
 Common types of corporate bonds
Debentures – Unsecured by a specific asset
Subordinated debentures – junior securities
Mortgage bonds – 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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19-10
Characteristics of
Corporate Notes and Bonds
 Innovations in corporate debt include:
 Discount bonds – including zero coupon
bonds
 Floating-rate bonds
 Commodity-backed bonds – face value is
tied to the market price of an
internationally traded commodity
 Inflation-linked corporate notes
 Medium-term notes (MTNs) – carry
maturities of one to ten years
19-11
Asset-Backed Securities
Issued by Corporations
 Securitization
 The process that gives rise to the creation
of asset-backed securities (ABS)
 Example: Packaging group of home
mortgages
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Usually with federal agency guarantees
Removed from the lenders’ balance sheets
Placing them in a separate trust account
Selling securities backed by mortgages
With the help of an investment bank
19-12
Asset-Backed Securities
Issued by Corporations
19 - 13
19-13
Asset-Backed Securities
Issued by Corporations
 Securitization may:
 Reduce the cost of raising funds
 Grant companies greater control over their
balance sheets
 Help a company avoid the issuance of
additional balance-sheet debt
 Improve the apparent financial strength of an
issuing firm
 Permit greater asset diversification
 Provide a new source of company earnings
19-14
Asset-Backed Securities
Issued by Corporations
19 - 15
19-15
Investors in Corporate Debt
The market is institution dominated
 Pension funds prefer public corporate debt
 Insurance companies frequently prefer
private placement
Foreign institutions are a very dynamic
sector of the market
 Many dealers are international
 Many of the debt instruments are for
foreign takeovers of U.S. companies
 Many more are ways to access dollars
19-16
Investors in Corporate Debt
Rapid growth in debt instruments in the
U.S.
 Not matched by rise of U.S. resident bond
holdings
 Differential filled by foreign investors
 Bonds by U.S. companies between 1995 and
2006
 Tripled from $2.5 trillion to $8.2 trillion
 Foreign investment went from $461 billion to
$2.7 trillion
19-17
Investors in Corporate Debt
Principal Investors in Corporate and Foreign Bonds, 2006
Source: Board of Governors of the Federal Reserve System,
Flow of Funds Accounts: Financial Assets and Liabilities, Fourth Quarter 2006.
19-18
The Secondary Market for
Corporate Debt
 The secondary market for corporate debt
 Relatively limited compared to the markets
for other long-term securities
 The number of active individual investors is
small
 Institutional investors tend to follow a buy
and hold strategy
 Some changes in strategies more recently
 Many institutions are looking at total
performance
 Have become more aggressive
19-19
The Marketing of Corporate Debt
 Corporate bonds may be offered publicly
 Through a public sale
 Sold privately to a limited number of investors
via a private or direct placement
 The majority of offerings are public sales
 Popular with firms having unique financing
requirements
 Private placements are common among
smaller companies
19-20
The Marketing of Corporate Debt
The decision of small firms is often a
function of the nature of the market
 Economies of scale in public issuance of debt
 So relatively cheaper for firms with large
debt issuances
 For smaller firms with less debt the public
market is relatively more expensive
 The flexibility of private issues
 More easily address potential agency costs
 Allow smaller debt issues
19-21
The Marketing of Corporate Debt
 A public sale uses an underwriter
 An investment banking firm or a syndicate
of underwriters may do one of two things
 Purchase the securities directly from the
issuing company through a bidding
process
 Guarantee the issuer a specific price
 The underwriter carries the risk of
losses (or gains) when the securities
are marked for sale in the open market
19-22
The Marketing of Corporate Debt
 Private placements have accounted for
about 10% of market sales of corporate
bonds
 Interest rates influence the private
versus public decision
 Rising interest rates bring more borrowing
companies into the public market
 Falling interest rates often bring about a
rise in private placements
19-23
The Volume of
Borrowing by Corporations
19-24
The Volume of
Borrowing by Corporations
 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
19-25
The Volume of
Borrowing by Corporations
Also more borrowing due to corporate
stock retirements
 A significant growth in popularity
 Among larger corporations
 Stock retirements exceeded $400 billion for
the year ending in June 2006
 Was only $130 billion in 2001
 Various factors for the expansion
 More M&A activity
 More companies tapping the debt market
19-26
Bank Loans to Business Firms
 Commercial banks are direct
competitors with the corporate debt
markets
 Making both short-term and long-term
loans to businesses
 Growing numbers of corporations have
turned to selling securities in the open
market
 The volume of bank credit for business
firms remains enormous
19-27
Bank Loans to Business Firms
The Fed has been carrying out
surveys
 Examine business lending practices
 Look at banks across the U.S.
Surveys indicate bank lending tends
to be short-term
 Average maturity of commercial and
industrial loans (value-weighted) was 524
days in February 2007
 Longer term loans averaged 54 months
19-28
Bank Loans to Business Firms
 The prime bank rate, or base rate
 The annual percentage rate that banks
quote to their most creditworthy
customers
 Tend to be unsecured
 Often require compensating balances
 These tend to be short-term loans
 Traditionally, the prime rate was set by one
or more of the nation’s leading banks
 Now, prime rates are often pegged to the
prevailing yields on Treasury bills
19-29
Commercial Mortgages
 Commercial mortgage
 The construction of commercial structure
 Office buildings
 Shopping centers
 Other commercial structures
 Faced with inflation and a volatile economy,
new forms have been developed:
 equity kicker
 indexing
 asset-backed securitization
19-30
Markets on the Net
 American Capital Advance at
americancapitaladvance.com
 Amerimerchant at amerimerchant.com
 Asset Securitization Report at
asreport.com
 Bankrate.com at bankrate.com
 Bond Market Association at
www.investinginbonds.com/
 Bond Market Association – European
Issues at www.bondmarkets.com/
19-31
Markets on the Net
British Bankers’ Association at
www.bba.org.uk
Business.com at www.business.com
CBS Marketwatch at
www.cbs.marketwatch.com/
CNN/Financial at www.cnnfn.com
 Financial Pipeline at www.finpipe.com
 Mortgage 101 at www.mortgage101.com
19-32
Markets on the Net
 National Association of Small Business
Investment Companies at nasbic.org
 REBUZ – Commercial Mortgages at
www.rebuz.com
 Small Business Notes at
smallbusinessnotes.com
 St. Louis Federal Reserve Bank research
at research.stlouisfed.org/fred2
 Wikipedia at en.wikipedia.org
19-33
Chapter Review
 Introduction to business borrowing
 Factors affecting business activity in
the money and capital markets
19-34
Chapter Review
 Characteristics of corporate notes and
bonds
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

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Principal features
Recent trends in original maturities
Call privileges
Sinking fund provisions
Yields and costs
Signals corporate bond Issues may send
The most common types of corporate
bonds
 Innovations in corporate debt
19-35
Chapter Review
 Asset-backed securities Issued by
corporations
 Investors in corporate debt
 The secondary market for corporate debt
 The marketing of corporate debt
 Public sales
 Private placements
 The volume of borrowing by corporations
19-36
Chapter Review
 Bank loans to business firms
 The volume of bank credit supplied to
businesses
 The prime, or base, Interest rate on
business loans
 Other examples of base rates for business
loans
 Commercial mortgages
19-37