Convertible Bond

High-Yield Bonds, Subordinated Debt,
and Loans
Course Objectives
Understand the capital stack, Comprehend the market dynamics Identify who issues these types
high-yield bonds, sub-debt and of each of these asset types of debt instruments and why
loans as investments
Analyze the key risks of each Understand how these assets

asset type trade
Corporate Finance Institute®

Capital Stack
Capital is the amount of money that the company has invested in it. The capital stack identifies the
priority of claims on a company’s assets.
Low Risk
Low Return
Senior Debt
Subordination
Subordinated Debt
Equity
High Risk
High Return

Capital Stack
Low Risk
Low Return
Loans
Senior Debt
High-Yield Bonds
Subordination
Subordinated Debt
Equity
High Risk
High Return

Capital Stack
Low Risk
Low Return
Senior Debt
Subordination
Subordinated Loans
Subordinated Debt Subordinated Bonds
Bank Capital
Equity
High Risk
High Return

High-Yield Bonds
Introduction to High-Yield Bonds
High-yield bonds (or speculative bonds) are bonds that are rated below investment grade.
Standard
Moody’s <Baa3 <BBB- Fitch <BBB-
& Poor’s
Return
High-Yield Bond Risk Investment Grade
Return
Risk
Introduction to High-Yield Bonds
1970 1980 1990

LBO Boom Drexel Burnham
1890 1989
Railroads Black Friday
RJR Nabisco Takeover by KKR
Raise Capital High-Yield

Takeover or “Junk
LBO Boom for LBO Market
Greenmail Bonds”
Bidders Collapse

High-Yield Bond Markets
High-yield bonds have developed into a mature and reputable market.
Expanding
Low Interest Tight Credit
High-Yield
Rates Spreads
Universe
Fund managers need to look into higher yield assets to

meet their investment benchmarks and goals.
Diversification Benefits

High-yield bonds have become an increasingly attractive investment class.
US High-Yield Bond Market

$2,500
$2,000 High-yield comprises ~15% of the corporate bond

(investment grade market) worth ~$8.1Trn
USD$ Billions
$1,500
US high-yield bond markets are the most
developed and liquid.
$1,000
$500
$0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Sources: Bank of America Merrill Lynch as of 31 December 2016; Securities Industry and
Financial Markets Association (SIFMA) as of 2014
The high-yield bond market is continuing to increase in size.
US Investment Grade Index
Downward Creep of
Credit Ratings
• Half of acquiring companies

have pushed leverage to junk-
rated levels
• Less AAA or AA ratings have

been given out
• Many high-rated companies

have failed
Source: Bloomberg Barclays Indices

High-Yield vs. Investment Grade Bond Returns
Like subordination, returns

increase as you move down bond
ratings and take on more risk.


Bloomberg Essentials

A yield curve is a snapshot of borrowing

costs for a specific issuer(s) for a specific
currency over a range of maturities (tenors).
BB- to BB+ High-yield
BBB- to BBB+ High-grade

A yield curve is a snapshot of borrowing

costs for a specific issuer(s) for a specific
currency over a range of maturities (tenors).
B- to B+

Diversification
High-yield bonds are great diversification measures from other asset classes as they are only
moderately correlated with other assets in the long-term.
30-Year Monthly Total US High Emerging Government

IG Credit S&P 500
Return Correlations Yield Markets Bonds
Investment Grade (IG)
0.53
Credit
S&P 500 0.58 0.29
Emerging Markets 0.50 0.48 0.55
Government Bonds 0.08 0.79 0.02 0.13
BB 0.94 0.63 0.56 0.60 0.21
B 0.98 0.50 0.57 0.58 0.06
CCC 0.90 0.34 0.53 0.50 -0.07
Source: Schroders plc

Diversification
High-yield bonds are great diversification measures from other asset classes as they are only
moderately correlated with other assets in the long-term.
01 Leverage and higher risk means that their higher yields and coupons offer
a buffer to movements in the underlying term structure of interest rates.
02 HY bonds tend to be short-maturity bonds with higher coupons, which

reduces the overall duration of the bond.
03 When rates rise, it tends to be during periods of economic growth, which

means stronger fundamentals and less chance of default for HY bonds.

High-Yield Bond Issuers
High-yield bonds are issued by entities outside of the “investment grade”.

Issuers of high-yield bonds are deemed to have a higher risk of nonpayment.
Higher yield to attract investors and

compensate for lower credit quality
Corporates
Asset-Backed Debt Load
Foreign Security (ABS)
Governments Special Purpose Earnings
Vehicles (SPVs)
Banks Cash Flow

High-Yield Bond Issuers
High-yield bonds are issued by entities outside of the “investment grade”.

Issuers of high-yield bonds are deemed to have a higher risk of nonpayment.
Why Issue High-Yield Bonds?
01 Unable to access equity markets

Debt Load
02 Unable to access bank lending Earnings
03 Balance sheet requirements Cash Flow

Issuing High-Yield Bonds
Most bond offerings are sold privately, thus they are made via confidential offerings to qualified
banks and accredited investors.
01.
Investment bankers work with debt Draft a prospectus and meet lead
capital markets (DCM) investors to provide “price-talk”.
• DCM staff give the issuer advice about currency, tenor, and structure
• DCM staff may involve anchor investors in a pre-sounding.
• Anchor investors are provided “price-talk”, which gives them an idea of the deal’s yield

01.
• Leads/bookrunners arrange a bond prospectus to take on a roadshow to meet and

negotiate with potential investors
• Sales staff training for the deal commences

01.
02. Allocate and distribute bonds to

Bond terms are finalized.
investors at a single price.
03. Market makers buy and sell bonds in

Bonds become “free-to-trade”.
the secondary market.

Investors also like to invest in high-yield bonds via primary issuances, as issuers and arrangers
will allow some room for the price to appreciate in the secondary market.
New issues offer good investors, such as the anchors, a larger

allocation of the bonds.
Prices may surge as underallocated investors look to buy

more of the deal in the secondary market.

High-Yield Bond Final Offering Circular
The bond prospectus outlines all the terms and conditions of the high-yield bond.
Offering/Preliminary Final
Prospectus Prospectus

Common Features of High-Yield Bonds
Different types of high-yield bonds have been invented to satisfy the needs of investors.
Years
Not callable
1–4
Smaller in Size Shorter Maturity Call Protection Year 5 Callable at par + 50% coupon (104.5%)
(~$1–1.5Bn) (10 years or less) (~5 Years)
Year 6 Callable at par + 33% coupon (103%)
Less liquid than

Technically denoted Protects investor’s
investment grade
as “high-yield notes” higher yields Year 7 Callable at par + 17% coupon (101.5%)
bonds
Year 8 Callable at par

Smaller average Call premiums after
Shorter duration
ticket size first call date

Common Features of High-Yield Bonds
Different types of high-yield bonds have been invented to satisfy the needs of investors.
Smaller in Size Shorter Maturity Call Protection Equity Make-Whole

(~$500MM) (10 years or less) (~5 Years) Clawback Call Provisions
Less liquid than Price where issuer

Lower investor Protects investor’s Repurchase bonds
investment grade can call bonds at
appetite higher yields with equity offering
bonds anytime
Smaller average Technically denoted Call premiums after Expires 3-4 years Issuer can avoid call
ticket size as “high-yield notes” first call date after bond issue structure issue

Other Features of High-Yield Bonds
Extendible/Reset Bonds
Maturity can be extended, or coupons can be

reset at designated times.
Set ‘final’ maturity date, with multiple call dates

before the final date.
Coupons reset at market level.

Payment-in-Kind (PIK) Bonds
Allows issuers to pay coupons either in cash or

some other form (e.g. common shares)

Step-up Bonds & Increasing-

Rate Notes (IRNs)
Coupons on step-up bonds increase only once at

a pre-set date. This rate is in effect until maturity.
Step-up bonds are called split-coupon bonds if

they begin as zero-coupon bonds.
Though rarely ever seen anymore, increasing-rate

notes have a step-up every quarter.

Put Provisions Equity Warrants Escrow Accounts
Bondholders can Money given to a

Attached to highly
accelerate third party to fulfill
speculative bonds
repayment transactions
Allows bondholders Created to cover a

Exercisable based
to purchase equity defined number of
on set conditions
at a later date interest payments

Investment Considerations
Given that high-yield bonds are generally riskier than investment grade bonds, the investment decision
process should be extra rigorous.
01. 02. 03.

Diversify across
Look at sell-side
issuers and Use rating agencies
research
industries
04. 05.
Adjust portfolio over
Monitor company
economic and
and industry news
market cycles

Key Risks of High-Yield Bonds
There are three major risks and concerns when investing in high-yield bonds.
2019: 5%
1.3% 14%
Default
2018 2008

Key Risks of High-Yield Bonds
There are three major risks and concerns when investing in high-yield bonds.
Credit
Default Deterioration/ Covenants
Downgrades

Credit Deterioration, Upgrades, and Downgrades
Credit quality changes can impact the price of high-yield bonds.
Fallen Angels Rising Stars Split Ratings
Former investment Companies whose bond Credit ratings can

grade companies that ratings have been sometimes be
have been downgraded increased due to an different across credit
to speculative grade increase in credit quality rating agencies

Covenants
Covenants are the most important thing to look at when buying high-yield bonds.
High-yield bonds tend to have more robust covenants

than investment grade bonds
Help avoid inherent conflict between debt and equity

holders
• Equity holders want to maximize returns
• Debt holders want to limit further leverage

Covenants
Covenants are the most important thing to look at when buying high-yield bonds.
01 Protecting the rights of the bondholder by not allowing more undue leverage.
02 Preserving cashflows within the company to first service the debt

outstanding.
03 Ensuring that the form and structure of the company and debt remains in
place.
04 Keeping productive assets within the firm.

Covenants
There are four main types of debt covenants to consider.
Positive Negative
Covenants Covenants
Financial Non-Financial
Covenants Covenants

Examples of Positive Covenants
Must provide annually audited Must provide specific financial Must achieve a certain
financial statements information such as aged threshold in certain financial
receivable analysis ratios
Must ensure facilities and Must perform regular Must provide management
factories are in good working maintenance of capital assets accounts
condition

Examples of Negative Covenants
Cannot change business Cannot sell assets without Cannot enter certain
ownership corresponding loan types of leases
repayments
Cannot issue debt more Cannot exceed certain Cannot partake in

senior than the current debt dividend limits certain M&A

Examples of Financial Covenants
Maintain a debt to equity Maintain a minimum Maintain a minimum

ratio within certain thresholds interest coverage ratio tangible net worth
Maintain a minimum debt Maintain a minimum Maintain a minimum fixed

service coverage ratio current ratio charge coverage ratio

Examples of Non-Financial Covenants
No changes in Key customers Key cash flow

business must be drivers should be
operations maintained sustained

Why Have Covenants
Covenants benefit both borrowers and lenders.
For Borrowers For Lenders

• Get clear expectations of • Prohibit certain actions by
the lenders the borrower
• Reduce the costs of • Ensure that the risk of the
borrowing loan or bond does not
increase

Trading High-Yield Bonds
High-yield bonds trade differently to their investment grade counterparts.
Investment
Trade on spreads to government bonds or swaps curves
Grade Bonds
High-Yield
Trade on cash basis
Bonds
Primary Market: Secondary Market:

New Issuances Over-the-Counter (OTC)

High-yield bonds trade differently to their investment grade counterparts.
Bid Offer
100.250 101.000
Wider Bid/Offer Spread

Issuer
Sector
Country
Rating

Issuer
Sector
Country
Rating

Issuer
Sector
Country
Rating

Issuer
Sector
Country
Rating
Are all bonds the same currency?

Issuer
Sector
Country
Rating
Are all the bonds the same seniority and rating?

Issuer
Sector
Country
Rating
Do these bonds have the same
covenant packages?

Issuer
Sector
Country
Rating
Are there material differences in the liquidity
of these issues?

Issuer
Sector
Country
Rating
Are there material differences in the liquidity
of these issues?

Issuer
Sector
Country
Rating
Are there new issues that are coming out
in this sector?

Issuer
Sector
Country
Rating

Issuer
Sector
Country
Rating

Tenders, Consents, & Restructurings
Tenders & Consents Restructurings
Tenders
An issuer offers to buy back outstanding
bonds, usually at a premium. The issuer
pays a fee to an investment bank to find
holders who are willing to sell back bonds.
Issuers buyback debt to reduce interest
costs, increase flexibility, or gain profits.
Consents
An issuer wishes to make changes to the
existing bondholder agreement and offers
bondholders a one-time payment to do so.

Tenders & Consents
Tenders
An issuer offers to buy back outstanding
bonds, usually at a premium. The issuer
01 Is the tender price close to the market or
does it provide a more favorable premium?
pays a fee to an investment bank to find
02
Is the incentive fee or payment substantial
Issuers buyback debt to reduce interest enough?
costs, increase flexibility, or gain profits.
Consents
03 If you do not tender or consent, will it impact
the price or liquidity of your own position?

Tenders & Consents Restructurings
Tenders Restructurings
An issuer offers to buy back outstanding Optionality is no longer in the hand of the
bonds, usually at a premium. The issuer bondholder and the bonds are effectively
pays a fee to an investment bank to find defaulted.
Issuers buyback debt to reduce interest The bondholder and issuer must negotiate
costs, increase flexibility, or gain profits. a new form of the bond or some way to
pay back the debt.
Consents

Tenders
LAS VEGAS, Feb. 18, 2020 /PRNewswire/ -- MGM Resorts International (the "Company") (NYSE: MGM) announced
today that it has commenced cash tender offers (the "Tender Offers") to purchase up to $750,000,000 in aggregate
principal amount.
Dollars per $1,000 Principal Amount of Notes
Title of CUSIP Aggregate Tender Cap Acceptance Tender Offer Early Total
Security Nos./ISIN Principal Priority Consideration Tender Consideration
Amount Level Premium
Outstanding
5.750% 552953 CE9 $1000,000,000 $325,000,000 1 $1,110.00 $30.00 $1,140.00
Senior Notes US552953CE90
due 2025
5.500% 552953 CF6 $1,000,000,000 $325,000,000 2 $1,100.00 $30.00 $1,130.00
Senior Notes US552953CF65
due 2027
4.625% 552953 CD1 $500,000,000 $100,000,000 3 $1,050.00 $30.00 $1,080.00
Senior Notes US552953CD18
due 2025

Consents
SÃO PAULO, March 17, 2020 /PRNewswire/ -- Yaborã Indústria Aeronáutica S.A. (the "Yaborã"), which is currently a
wholly-owned subsidiary of Embraer S.A. ("Embraer"), hereby announces the receipt of the Requisite Consents (as
defined below) in connection with its solicitation (the "Consent Solicitation") of consents ("Consents") of the Holders
(as defined below) of the following series notes (the "Notes"):
Title of Security CUSIP and ISIN Nos. Outstanding Principal Amount Consent Fee^(1)
5.150% Notes due 2022 CUSIP: 29082AAA5 US$500,000,000 US$1.50

ISIN: US29082AAA5
5.696% Notes due 2023 CUSIP: 29081YAD8 US$540,518,000 US$1.50

ISIN: US29081YAD85
& USG30376AB69
5.050% Notes due 2025 CUSIP: 29082HAA0 US$1,000,000,000 US$1.50
ISIN: US29082HAA05
5.400% Notes due 2027 CUSIP: 29082HAB8 US$750,000,000 US$1.50

ISIN: US29082HAB87

Restructurings
Restructurings occur when an issuer is

no longer able to meet the obligations
to service the bond.

Restructurings
Source: Bloomberg News; 3/10/2020

Restructurings
Source: Bloomberg News; 3/10/2020

Trading Defaulted Bonds
Bonds trade flat of accrued

interest, as the issuer cannot
honour their debt.
The price of the bond reflects

the recovery prospects of
the principal.
Prices tend to collapse around the same cash price level across maturities.

Defaults do not always mean your investment is wiped out.
January 2019
Chapter 11 bankruptcy
declared by PCG (Pacific Gas &
Electric)
December 2019
Bonds still trading above par

without accrued interest

Defaults do not always mean your investment is wiped out.
January 2019 Short Larger price drops & wider spreads

Maturity
Chapter 11 bankruptcy
declared by PCG (Pacific Gas &
Electric)
Long
Smaller price drops & tighter spreads
Maturity
December 2019
Market expects recovery via government
Bonds still trading above par bailout in the long run.
without accrued interest

High-Yield Bond Indexes
An index is a basket of representative financial instruments. Thus, a high-yield bond index is a basket
of high-yield bonds.
Bond indexes are administered by or in

conjunction with a global investment bank.
Indexes exist for certain purposes:
1. As a performance target
2. As an informational measure of the asset

class it is tracking
3. As a reference for index-linked products
• ETFS, ETNs, structured notes, etc.

High-Yield Bond Derivatives – Credit Default Swaps
Credit Default Swaps (CDS) are over-the-counter (OTC) derivatives between two parties that act like an
insurance policy. A CDS allows the buyer to protect themselves from potential default by a specific
issuer for a fixed period of time.
Default
CDS Buyer CDS Seller
Present defaulted bond
Receives entire par Receives periodic
value of bond in the payments to cover
case of default Par value of bond defaults.
CDS markets are usually illiquid for small, higher-risk speculative grade bonds.

CDSs trade on a standardized fixed coupon

(100bps or 500bps) that the credit protection
buyer must pay to the seller
The buyer must make an upfront payment that

reflects the difference in the discounted present
value of cash flows.
• Calculated using the standard coupon rate vs.

the current market rate, if the market credit
spread is greater than the coupon rate
• However, if the market credit spread is below

the standard coupon rate, the buyer would
instead receive the upfront payment

100 – 23 = 77bps
77bps x 5 years = 385bps
77bps x 5 years = 3.85%
Buyer receives the upfront payment because

AAPL’s market credit spread of 23bps is less than
the standardized fixed coupon of 100bps.
If instead, the market credit spread was 123bps,

the seller would receive the upfront payment.
CDS market credit spreads and cash bond

spreads issued by the same entity may not be the
same. This difference is called the basis.

$73 of $100 Notional
$64 of $100 Notional

Source: HIS Markit Ltd.

High-Yield Bond Derivatives – CDX Index
Markit CDX Index

Commodity Code Contract Series
CDX.NA.HY Mar. and Sept., one or two months listed at all times
Currency Price Quotation

USD Index Points
Min. Notional Minimum Price Fluctuation

Order Book: 1,000,000 The price quotation convention shall be .0001 index
Block Trades: In accordance with Rule 701(k) points; minimum price fluctuation may vary by trade
type
Max Notional
Order Book: 250,000,000 Listing cycle
All other execution methods: as agreed by counterparties Tenors of 1 through 10 years based on liquidity
Min Notional Increment Series

Order Book: 100,000 All series, initiated with series 1
All other execution methods: As agreed by counterparties

Markit CDX Index
• The index is rolled to the market twice every year
• Old series continue to trade and constituents may change between series
• The index provides a way for investors to be long or short a basket of high-yield
bond names
• The index allows investors to hedge their exposure to the market
• Investors can use the CDX to hedge their portfolio of high-yield names by longing
protection in sub-indexes offered by the CDX

100 CDS Obligations
Fixed Coupon (500bps)
Trade on % Basis

100 CDS Obligations
Fixed Coupon (500bps)
Trade on % Basis

Cash Bond:
89.239 plus
accrued interest
CDX:
Upfront fee of the
difference between
89.239 and 100.00,
discounted to today



Subordinated Debt
Subordinated Debt
Subordinated debenture bonds (sub debt) represent claims on the cashflow and assets of a company.
Sub debt ranks further down the capital structure than senior debt.
Low Risk
Low Return
Senior Debt
Subordination
Higher interest rate than senior debt Subordinated Debt
Loss absorption for debt Equity

High Risk
High Return

Subordinated Debt
Low Risk
Low Return
Why Issue Sub Debt?
Senior Debt
Subordination
01 Maximize shareholder value
02 Minimize cost of capital

Subordinated Debt
03 Maintain flexibility
Equity
High Risk
High Return

Subordinated Debt
Low Risk
Low Return
Why Issue Sub Debt?
Senior Debt
Subordination
01 Regulation
02 Funding arbitrage
Subordinated Debt
03 Credit rating considerations

Equity
High Risk
High Return

Forms of Subordination
Subordination of debt generally happens via three methods.
Collateral Contractual Structural

Subordination Subordination Subordination
The company pledges a The company and lender There are multiple
specific asset against a agree that the debt is companies in the
debt obligation behind the payment of company tree, with some
other obligations subordinate to others

Sub Debt vs. High-Yield Bonds
Subordinated High-Yield
Debt Bond



Market Size of Sub Debt
The market size of corporate sub debt is significantly smaller than bank sub debt.
USD $769Bn
Bank Sub Debt

USD
$50Bn
Corporate Sub Debt

Issuers of Sub Debt
The two main issuers of sub debt are corporates and banks.
Corporates Banks
Optimize balance sheet Required by regulations
Though classified differently, sub debt for corporates and banks serve the same purpose. It acts as a
buffer between senior debt holders and equity holders.

Optimal Ratios of Corporate Sub Debt
Subordinated debt holders will only supply so much debt.
Total debt / EBITDA ~ 5 to 6 times
EBITDA / Cash interest ~ 2 times
Equity funding ~ 30% to 35%.
The appropriate financial structure must be constructed

within these constraints.

Corporate Sub Debt vs. Bank Capital
The capital structure of banks differs from that of corporates.
Deposits
Senior Debt Senior Debt
Subordinated Debt Lower Tier II
Junior Sub Debt Upper Tier II

US Bank Holding Company Tier 1 –
Trust Preferreds
Trust Preferreds
Junior to Junior Sub Debt – US Bank Holding Company Tier 1 –

Newer Hybrid Structures Newer Hybrid Structures
Preferred Shares Preferred Shares – Tier 1
Common Shares Common Shares

Bank Capital
The Basel Accords are recommended banking regulations that are set by the Bank for International
Settlements (BIS) through the Basel Committee on Bank Supervision (BCBS).
Standards for…
Bank Capital Liquidity Funding

Bank Capital
Basel III
Capital Liquidity Leverage

Ratios Ratios Ratios

Bank Capital
Bank Sub Debt
Additional
Tier 2
Tier 1

Bank Capital
Encourage banks Protect taxpayers

to maintain a from footing the
financial buffer bill of bank rescue
The most efficient and certain source of bank capital is issuing bank sub debt.

Bank Capital
Components of Bank Capital

Regulatory capital consists of three categories:
1. Tier 2 Capital (gone-concern capital)
2. Additional Tier 1 (going-concern capital)
3. Common Equity Tier 1 (going-concern capital)
Risk-Weighted Assets
Assets on a bank’s balance sheet are weighted by risk.
Basel Accords • US treasuries are considered “zero-weight” risk assets
• Corporate debt below BB- ratings are 150% weight risk assets

Bank Capital
Tier 2 (T2)
CET1 + AT1 + T2 Due to come into
Non-CoCo Sub Debt ≥ 8% RWA
Low-Trigger CoCos effect after 2022
Additional Tier 1 (AT1)

CET1 + AT1
Preferred Shares ≥ 6% RWA
High-Trigger CoCos
Bank capital space
will increase as more
Common Equity Tier 1 (CET1) banks move towards
implementation of
Common Shares CET1
≥ 4.5% RWA Basel III
Retained Earnings

Subordinate to depositors and general creditors of the bank
01
T2
Minimum original maturity of 5 years.
02 Amortized on a linear basis for the last 5 years of its life

(20% per year).
03 No step-up coupons.
04 Banks need a strong capital position to call a bond or

must be approved to replace it with a similar T2 bond.

Similar to AT1, CoCo bonds also absorb losses the issuing

bank’s capital falls below a certain level.
01 Either converted into common equity or principal is

written down, based on certain triggers.
CoCo 02
03
Triggers occur if the issuing bank’s capital falls below a
pre-determined fraction of RWA.
Included in AT1 if trigger is high. Bolster’s the bank’s

equity if equity levels drop below 5.125% of RWAs.
04 Included in T2 if trigger is low. Converts after high-

trigger CoCos.

AT1 securities absorb losses when bank capital dips below

regulated levels.
01
Impose principal losses on creditors during distress
AT1
outside bankruptcy process.
02 Call date of at least 5 years. Banks can cancel interest

or dividend payments; Coupons are not cumulative.
03 Basel III recommends that banks maintain roughly

1.5% of RWAs as AT1 securities (4.5% CET1 + 1.5% AT1).

CET1 consists of the equity portion of a bank’s capital

structure, which is subordinate to all forms of debt.
01 Includes common shares
CET1 02 Includes retained earnings

Bank Capital – Senior Debt Example
Currency: USD
DB Call/Maturity Dates: 5 years
Issue Sizes: > USD $1Bn per bond








Bank Capital – Tier 2 Example







Bank Capital – AT1 CoCo Example






Trades on
dollar price

Sub Debt and Bank Cap Buyers
Bank cap has become an increasingly demanded product by investors.

Three major groups have been most active on the demand side of the primary market for bank cap.
Retail Investors and US Institutional European Non-Bank

Private Banks Investors Financial Institutions
Primarily in Asia Looking for alternative

Demand held back by
and Europe investment classes
lack of clarity about
regulatory treatment of
Seeking high nominal Considerably large
CoCos and bank cap
yield offered by CoCos investment sizes

Key Risks of Sub Debt and Bank Cap
The key risks of sub debt are similar to the key risks of high-yield bonds.
Collateral
Inflation
Subordination
Contractual
Yields
Subordination
Structural
Defaults
Subordination

Triggers Coupon Deferral

How many triggers are there? Are coupon deferrals cumulative?
Are they based on mechanical rules or Can coupons be paid in-kind?
at the bank supervisor’s discretion?
Are the triggers high or low?
Are they based on RWA?

Loss Absorption Mechanisms Regulatory Risk

What is the specific loss absorption Basel III is not fully implemented but
method? BCBS has already introduced changes
under Basel IV.
Issues tend to have different methods Will there be regulatory changes that
of absorbing losses, such as equity impact how these bonds trade?
conversion or principal writedown.

Leveraged Loans
Leveraged Loans
Loans have traditionally

been the domain of
commercial banks.

Leveraged Loans
Larger loans that cannot be

taken down by a single
bank may trade in the
securities markets.

Leveraged Loans
Leveraged loans are not

asset backed securities.

Leveraged Loans
Leveraged loans are loans issued by high-yield or lower-rated entities that already have a significant debt
load or have some history of financial distress.
Sub investment Interest rate of Loan purpose is Private equity

grade or high- LIBOR + 150bps more strategic sponsor
indebtedness or higher than operational involvement
Depending on transaction sizes, multiple banks may arrange the loan (origination) and then sell down
parts of the loans to other banks and institutional investors (syndication).

Leveraged Loans
Access Larger Balance Capital Utilize Tax

Raise Capital
Investor Base Structure Advantages
Depending on transaction sizes, multiple banks may arrange the loan (origination) and then sell down
parts of the loans to other banks and institutional investors (syndication).

Leveraged Loans
01. 02. 03.

Fund acquisitions Restructuring or Refinance existing
recapitalizations debt
04. 05. 06.

Refinance higher Fund dividends
Extend debt
cost debt or or share
maturities
preferred shares buybacks

Leveraged Loan Markets
The leveraged loan market has been steadily increasing.
2018 US Leveraged Loans Outstanding

$1,200
$1,150
USD$ Billions
$1,100
$1,050
$1,000
$950
$900
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Sources: LCD, an offering of S&P Global Market Intelligence; S&P/LSTA Leveraged Loan Index

Leveraged Loan Markets
The leveraged loan market has been steadily increasing.
European USA
Leveraged Loans Leveraged Loans
Growth:
€181Bn $1.7Trn $600bn
54% YoY
Dec 2018 Dec 2019
Sources: LCD, an offering of S&P Global Market Intelligence; S&P/LSTA Leveraged Loan Index

Leveraged Loan Buyers
Many new institutional investors are moving into the leveraged loan market.
RWA considerations are forcing banks to hold onto fewer leveraged loans. Additionally, banks have realized
that syndicated loans are less expensive and more efficient to maintain.
Loan Issuer (Borrower)
Arranging Bank(s)
Exchange Traded Hedge Funds &

CLOs
Funds Mutual Funds

Collateralized Loan Obligations (CLOs)
A CLO is an asset-backed security issued by a special purpose vehicle (SPV) whose sole purpose is to hold
and administer the portfolio of leveraged loans it acquires.
Senior Tranche
(AAA)
CLO
Holds senior Mezzanine
secured loans
Tranche (Mezz)
Issues bonds to
finance loan
purchases
Equity
Capital Structure
of CLOs

Senior Tranche
(AAA)
Interest Mezzanine
Payments Tranche (Mezz)
Equity
Capital Structure
of CLOs

Principal Purchase of New

Repayments Loans

Senior Tranche
(AAA)
In the case Interest Mezzanine

of losses: Payments Tranche (Mezz)
Equity
Capital Structure
of CLOs

Senior Tranche
LIBOR + 90bps
(AAA)
LIBOR + 150bps
Interest Mezzanine
Payments Tranche (Mezz)
LIBOR + 350bps
Equity Remaining Interest
Capital Structure
of CLOs

Originating Loans
Once a loan issuer has settled on the structure of the loan, they would pick a bank or group of lenders
to arrange the loan. The issuer may solicit bids from different arrangers.
Syndicate or sell down loans that are too

large for a single bank
Institutional
Other Banks
Investors
Anchor investors are informally approached to gauge appetite for the credit. The arranging bank will
also prepare a confidential information memorandum (IM) to qualified banks and investors.

Originating Loans
There are three main types of loan syndications or bookbuildings.
Underwritten Best-Efforts
Club Deal
Deal Syndication

Underwritten Deal
In an underwritten deal the arrangers guarantee the entire amount committed, then syndicate the
loan.
• If arrangers cannot get investors to fully subscribe the loan, Underwritten

they must absorb the difference Amount
• Difference can be sold later at a discount or premium

depending on market conditions
Total Deal
Two main reasons for underwriting loans:
Amount
• As a competitive tool to win mandates Subscribed
Amount
• To charge higher fees

Best-Efforts Syndication
In a best-efforts syndication, the arranger group commits to underwrite less than the entire amount
of the loan.
• If arrangers cannot get investors to fully subscribe the loan, Amending

the credit may not close Terms
• The terms may be amended if demand is weak – an

increase in pricing or structure
Total Deal
Main uses for a best-efforts syndication:
Amount
• Riskier borrowers Subscribed
Amount
• Complex transactions

Club Deal
In a club deal, a smaller loan is pre-marketed to a group of relationship lenders. This is done to maintain
relationships with all banks by avoiding favoring a single bank.
$30MM
Bank A
Used by the
borrower/issuer to
Company A
$30MM
maintain relationships
Bank B
with multiple lenders
$90 Million
Loan
$30MM
Bank C

Common Features of Leveraged Loans
Common features of leveraged loans are:
Maturity Early Ranking and

Size Redemption Structure
Minimum: $50– Typically

Senior secured or
125MM, $200MM Typically 6-8 years immediately
senior unsecured
recommended prepayable at par
Maximum: depends
on industry, credit, Floating rate
and market

Leveraged Loan Structures
There are four main types of leveraged loan structures:
2nd Lien
Revolver Term Loan Bridge Financing
Term Loan

2nd Lien
Term Loan
01 Usually structured along with a term loan
02 Used to provide liquidity and working capital for stronger borrowers
03 Mostly 364 day term but can be renewed annually
04 No amortization, amounts repaid may be borrowed
05 Fees are paid on drawn (margin) and undrawn (commitment fee) part of the facility

2nd Lien
Term Loan
01 Most common type of leveraged loan structure
02 Repaid either on a set repayment schedule (amortizing loan) or with a one-time

payment at maturity (bullet payment)
03 6–8 year maturity
04 Senior secured or senior unsecured
05 Maintenance covenants (covenant-lite structures in good markets)

2nd Lien
Term Loan
01 Similar to term loans with 2nd priority claim on collateral; second priority after
secured financing/1st lien term loans
02 Have less restrictive covenant packages than regular term loans; trade at a
wider spread than 1st lien counterparts
03 Usually structured along with term loan financing
04 7–8 year maturity; minimal annual amortization

2nd Lien
Term Loan
01 Short term, usually 12 months with rollover features
02 Temporary financing used to bridge to capital markets event (bank loan,

high-yield, equity)
03 Increasing/step-up interest rates if the loan is not repaid or taken out as expected
04 Structured with additional fees, such as commitment fees

Key Risks of Leveraged Loans
Investors face different types of risk when investing in leveraged loans.
Default Seniority Loss-Given- Security

Risk Risk Default Risk Risk

01 Most leveraged loans are covenant-lite or have no covenants.
02 High availability of funding and competition for loan mandates.
Covenant
Risk 03 Increased participation of non-bank lenders.
04 Maintenance covenants require borrowers to measure

and report financial tests every quarter.

01 The likelihood that a borrower won’t pay interest or principal

on time.
02 Based on issuer’s financials, industry risks, economic variables,

and other intangibles.
Default
Risk 03 Rating agencies provide an assessment but banks also have
internal risk management departments.
04 Most institutional investors depend on rating agencies.

01 Concerned with the issuer’s capital stack and how payments fit
into their “waterfall”.
Seniority
Risk 02 The further down an investor is on the capital stack, the less
seniority they have for receiving payments and collections.

01 Assumes that the borrower defaults.
02 Aims to understand how much an investor will lose given

a default scenario.
Loss-Given-
Default Risk 03 Assessed by looking at whether the loan is secured and at
the borrower’s other obligations.
04 Maintenance covenant tests can provide an early opportunity

to renegotiate terms in the case of credit deterioration.

01 Examines the collateral pledged against the loan.
02 Investors must consider the quality of the security, the legal

strength of the pledge, and if the collateral will be available.
Security
Risk
03 If the pledged collateral is unable to be claimed, the secured

loan holder would be reduced similar to unsecured debtholders.

Trading Loans
Many banks have origination, trading, and distribution teams that help originate, buy, and sell loans in
primary markets. After deals have closed, these teams shift to trading in the secondary market.
Where and how are loans traded?
• Investors trade loans through dealer desks at large

underwriting banks Loan Sale
• Dealer-to-dealer trading is done through a “street broker”
Assignment Participation

Trading Loans
Many banks have origination, trading, and distribution teams that help originate, buy, and sell loans in
primary markets. After deals have closed, these teams shift to trading in the secondary market.
Where and how are loans traded?
• Investors trade loans through dealer desks at large Borrowing

underwriting banks LIBOR Spread
Rate
• Dealer-to-dealer trading is done through a “street broker”
Traded at a spread to a base rate:
• If credit fundamentals of the company, sector, or industry Price: 101 101 – 100 25 bps
improve, loans may trade tighter than the specified spread =
4 per yr
Face Value: 100
• Price of the loan will adjust based on market spreads Spread: L + 200
Actual spread to call
Maturity: 4 years is 175bps.
• Spreads are tied to performance grids and adjust based on
different financial criteria

Trading Loans

Trading Loans

Trading Loans

Trading Loans

Trading Loans
The leveraged loan

market is not subject
to regulatory filings.

Trading Loans
Loans typically stay with

specialized investors.

Defaults
Technical Payment
Default Default

Defaults
Technical defaults occur when an issuer fails to meet a provision of the loan agreement.
Technical Default Consequence
• Issuer fails to meet covenant test • Lenders accelerate the loan and
force issuer into bankruptcy
• Issuer fails to meet reporting
requirements • Lenders and issuer agree on
amendment to waive violation
• Issuer commit other non-payment
related violations

Defaults
Payment defaults occur when an issuer misses a payment.
Payment Default Consequence
• Occurs when company misses an • Lenders can provide a forbearance

interest or principal payment agreement
• Usually pre-set period of time (e.g. • Lenders can accelerate or call the
30 days) for issuer to cure the loan
default (“cure period”)

Restructuring
As loans become more mainstream, they can cause indirect shocks that impact broader financial
markets.
US Levered Loan 2019 US Leveraged

Default Rate Loan Defaults
3% per year $23Bn

Source: S&P Source: Fitch

Restructuring
When issuers face default, they may choose to restructure their debt formally by entering
bankruptcy protection, or informally with lenders and creditors.
Refinancing
A borrower takes on a new loan at better terms than before
to pay off existing debt that is more expensive or restrictive.
Lenders do not want borrowers to walk away from debt as they would prefer to get something back,
rather than nothing.

Restructuring
Restructured $650MM
of leveraged loans into
equity under chapter 11
bankruptcy
Source: Bloomberg News

Trading Distressed Loans
Markets still exist even when a loan is distressed, in default, or in bankruptcy.
Distressed Loans
Trade ~80 cents to

the dollar
Deeply Distressed
Loans
Trade ~70 cents to

the dollar

Trading Distressed Loans
Markets still exist even when a loan is distressed, in default, or in bankruptcy.
Distressed Loans
Trade ~80 cents to Many funds are

the dollar
prohibited from holding
distressed loans. This
presents a buying
Deeply Distressed
Loans opportunity for private
equity firms.
Trade ~70 cents to
the dollar

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High-Yield Bonds, Subordinated Debt,

Analyze the key risks of each Understand how these assets

Corporate Finance Institute®

Corporate Finance Institute®

Corporate Finance Institute®

Subordinated Debt Subordinated Bonds

Corporate Finance Institute®

1970 1980 1990

Raise Capital High-Yield

Corporate Finance Institute®

High-yield bonds have developed into a mature and reputable market.

Fund managers need to look into higher yield assets to

Corporate Finance Institute®

High-yield bonds have become an increasingly attractive investment class.

US High-Yield Bond Market

$2,000 High-yield comprises ~15% of the corporate bond

The high-yield bond market is continuing to increase in size.

US Investment Grade Index

• Half of acquiring companies

• Less AAA or AA ratings have

• Many high-rated companies

Source: Bloomberg Barclays Indices

Corporate Finance Institute®

Like subordination, returns

Corporate Finance Institute®

Corporate Finance Institute®

Corporate Finance Institute®

A yield curve is a snapshot of borrowing

BB- to BB+ High-yield

BBB- to BBB+ High-grade

Corporate Finance Institute®

A yield curve is a snapshot of borrowing

Corporate Finance Institute®

30-Year Monthly Total US High Emerging Government

S&P 500 0.58 0.29

Emerging Markets 0.50 0.48 0.55

Government Bonds 0.08 0.79 0.02 0.13

BB 0.94 0.63 0.56 0.60 0.21

B 0.98 0.50 0.57 0.58 0.06

CCC 0.90 0.34 0.53 0.50 -0.07

Source: Schroders plc

Corporate Finance Institute®

02 HY bonds tend to be short-maturity bonds with higher coupons, which

03 When rates rise, it tends to be during periods of economic growth, which

Corporate Finance Institute®

High-yield bonds are issued by entities outside of the “investment grade”.

Higher yield to attract investors and

Corporate Finance Institute®

High-yield bonds are issued by entities outside of the “investment grade”.

Why Issue High-Yield Bonds?

01 Unable to access equity markets

03 Balance sheet requirements Cash Flow

Corporate Finance Institute®

• DCM staff may involve anchor investors in a pre-sounding.

Corporate Finance Institute®

• Leads/bookrunners arrange a bond prospectus to take on a roadshow to meet and

• Sales staff training for the deal commences

Corporate Finance Institute®

02. Allocate and distribute bonds to