FI 4 Fixed-Income Markets for Corporate Issuers

Both non-financial corporations and financial institutions lean on borrowed money to run their day-to-day operations. A company raises external short-term financing to cover cash needs across its cash conversion cycle, to hold a liquidity buffer, and to capture supplier discounts. The funding may come from a bank or directly from investors in the money market, and it may be unsecured or backed by collateral, depending on the borrower’s financial strength, its general credit standing, and the local market convention.

Bank lines of credit

The most flexible and immediate route to short-term cash is a bank credit line. Three arrangements sit on a spectrum of reliability. Uncommitted lines and revolvers are used more often in the United States, while regular committed lines are more common elsewhere.

An uncommitted line of credit is the least reliable form of bank borrowing, as the name signals. The bank offers a credit line up to a stated principal amount for a set maximum maturity and charges a base or market reference rate (MRR) topped by a spread specific to the issuer, levied only on the principal actually drawn for the period it is used. Under normal conditions this is often the cheapest and most flexible external funding a firm can find, and banks usually extend it on an unsecured basis to clients who keep stable deposits with them, which lets the bank watch for warning signs such as falling account balances. The catch is that the bank can decline any request to draw the line, so a firm cannot treat it as a primary funding source: if conditions sour, the money may simply not be there, and substitutes can be costly or unavailable. Its main appeal is that the borrower pays nothing beyond interest on the balances outstanding, with no fee for merely having the line.

A committed (regular) line of credit is more dependable because it rests on a formal written commitment. It ties up more bank capital than an uncommitted line, although commitments of under a year (usually 364 days) keep that capital charge low. For a large borrower, banks often spread the exposure by forming a syndicate, a group of banks that each accept a preset share of the total commitment and of any drawdowns. Drawn amounts become short-term liabilities, typically classified as notes payable, and undrawn committed lines can serve as backup credit behind other financing such as commercial paper. Regular lines are unsecured and can be prepaid without penalty, but they still carry renewal risk at maturity, especially if a weakening borrower has drawn heavily. Unlike an uncommitted line, a committed line usually carries an upfront commitment fee, for example 0.50%, charged on either the full line or the unused portion for the commitment period.

A revolving credit agreement, or revolver (sometimes an operating line of credit), ranks as the steadiest, most dependable channel for short-term bank funding. Revolvers are multiyear commitments, so lenders normally attach covenants that compel or forbid particular actions by the borrower, much like the terms in a bond indenture. Otherwise revolvers resemble regular lines in their borrowing rates and commitment fees, and they may add optional medium-term loan features.

Secured loans and factoring

A company that lacks the credit quality for unsecured borrowing can pledge assets instead. A secured loan, also called an asset-based loan, requires the borrower to post collateral such as a fixed asset it owns, high-quality receivables, inventory, or marketable securities. The lender files a security interest, or lien, against the pledged assets, and that lien becomes part of the borrower’s financial record and credit report.

Receivables can raise cash in two related ways. Under an assignment of accounts receivable, the firm uses its receivables as collateral for a loan but stays responsible for collecting them. Under a factoring arrangement, the firm sells the receivables outright to a lender, the factor, usually at a substantial discount, and hands over both the credit-granting and the collection work. How deep that discount runs reflects how creditworthy the accounts are and how costly they will be to collect. Inventory can be pledged in similar ways.

Commercial paper

For some firms, bank loans cost more than debt raised directly in the market. Big, high-quality borrowers are able to sell unsecured short-term notes, called commercial paper (CP), either publicly or through a private placement. Commercial paper issued by corporations usually matures in less than three months and funds working capital, seasonal cash needs, or bridge financing (interim funds that carry the firm until permanent financing is arranged).

Maturing paper is normally repaid out of the proceeds of freshly issued paper, a practice called rolling over. This creates rollover risk: the chance that the issuer cannot place new paper when the old paper comes due. To contain that risk, investors typically insist that the issuer hold a committed bank backup line, known as a liquidity enhancement or backup liquidity line, so that maturing paper can be repaid in full even if a rollover fails. Because the maturities are so short, commercial paper markets react quickly to credit events, and outright defaults are rare. Beyond non-financial corporations, the largest issuers are financial institutions, governments, and supranational agencies. Paper sold in the international market is called Eurocommercial paper (ECP); it works much like United States commercial paper (USCP) but trades in much smaller sizes and is less liquid.

A bank needs short-term funding because of its role as an intermediary between borrowers and depositors. Apart from cash and central bank reserves, most of a bank’s assets are loans it has made or securities it has bought; its liabilities are the deposits it takes from households and firms, the securities it has sold, and its short-term borrowing. The spread it earns between the return on assets and the cost of liabilities is its net interest margin.

Deposits

Retail and commercial deposits are the primary short-term funding source for most banks. Many are checking accounts, or demand deposits, which have no stated maturity, exist for transactions, and pay little or no interest. Although these balances can be withdrawn at any time, the rebates on fees, uncommitted credit lines, and other bank services extended to commercial customers make demand deposits a stable base that supports both short-term and longer-term funding. For larger clients, operational balances that arise from clearing, custody, and cash management work are similarly steady, whereas rules requiring banks to hold liquidity reserves against less stable demand deposits make those a less attractive source.

Saving deposits tend to be kept for purposes other than transactions and frequently carry a fixed term. A certificate of deposit (CD) is a deposit with a preset maturity and interest rate, typically shorter than one year, that pays interest at maturity. A non-negotiable CD returns principal and interest to the original depositor at maturity and penalizes early withdrawal. A negotiable CD instead lets the holder raise cash early by selling it in the open market: the retail-facing form is a small-denomination CD, whereas large-denomination CDs supply wholesale funding drawn from institutional investors. As with commercial paper, CDs also trade in the Eurobond market.

The interbank market

The interbank market covers secured and unsecured short-term lending and borrowing between financial institutions. Unsecured loans and deposits here run from overnight to about one year at rates tied closely to a market reference rate, with banks pricing in counterparty credit risk and imposing counterparty limits.

Most banks are required to hold reserves at the central bank. Because some banks end a period with surplus reserves while others fall short, the imbalance is settled in the central bank funds market, where surplus banks lend to deficit banks. The rate at which these funds are borrowed and lent is the central bank funds rate, and central banks steer it toward a target rate or range using open market operations or the interest they pay on reserves. A bank that cannot borrow in the interbank market may turn to the central bank as a last resort through discount window lending, but that route usually requires posting collateral, comes at a rate above the central bank funds rate, and can invite closer oversight and restrictions. By far the usual form of secured borrowing between banks is the repurchase agreement, covered in the next section.

Commercial paper and asset-backed commercial paper

Large financial institutions dominate commercial paper issuance, using these unsecured notes to meet short-term needs and at times to carry longer-dated balance sheet assets like loans. About 60% of the yearly issuance volume originates with financial institutions, with non-financial corporations supplying the remainder. Like any issuer, a bank faces rollover risk when its funding needs outrun the maturity of its paper outstanding.

Banks also use a secured form of the instrument, asset-backed commercial paper (ABCP). The bank sells loans or receivables into a special purpose entity (SPE) that in turn issues debt and services it from the cash flows of those assets. The issuance runs in two steps: first the bank transfers short-term loans to the SPE in exchange for cash, and then the SPE issues ABCP to investors, supported by a backup credit liquidity line from the bank. This financing does not appear on the bank’s balance sheet, and the off-balance-sheet structure benefits both sides. The bank receives cash when the paper is issued and lowers its capital cost by providing undrawn backup liquidity rather than holding the loans to maturity, while investors buy a liquid short-term note whose interest and principal come from a loan portfolio they could not otherwise reach directly.

A major channel for secured short-term borrowing and lending is the repurchase agreement, or repo. A repo is the sale of a security paired with a matching promise by the seller to repurchase that same security (or one much like it) at an agreed price on a set future date, the repurchase date. The seller of the security is the cash borrower and the buyer is the cash lender.

Take a simple case. Today (t = 0) a US five-year Treasury note trades at its face value of USD100,000,000. The buyer takes delivery and pays the seller USD100,000,000. With a 30-day term, a 360-day year, and an annual repo rate of 0.25%, the seller commits to repurchasing the note 30 days later for USD100,020,833.

In effect the seller borrows USD100,000,000 cheaply on a short-term basis, with USD20,833 of interest due at maturity, since the Treasury note stands as collateral for the loan. Over the repo term the seller (cash borrower) keeps ownership of the security along with any actual coupon it pays, while the buyer (cash lender) earns the repo rate.

Because cash lenders care above all about liquidity and safety, most repos are very short-term deals backed by the highest-quality collateral, such as sovereign bonds. Terms run from overnight out to term repos, meaning any maturity beyond a single day. Rather than name one specific bond, a repo may reference a group of eligible securities, for example government bonds of a given maturity, which is a general collateral repo transacted at the general collateral repo rate.

Initial margin and the haircut

To guard against a shortfall if the collateral falls in value, the seller often posts collateral worth more than the cash received. That cushion is the initial margin.

A 100% initial margin means the loan is exactly collateralized, and any figure above that adds protection. The same cushion seen from the collateral side is the haircut, the reduction of the loan below the collateral value.

Variation margin

As the collateral price moves, a repo lets either side call for more collateral, or release some, to keep the security interest in line with the original margin terms. This adjustment is the variation margin: the gap between the margin currently required and the security price at time t.

A fall in the security price forces the cash borrower to post more collateral; a rise leaves the loan overcollateralized, so the borrower can request the release of excess collateral.

Parties usually agree on margining, on whether collateral may be substituted, and on events of default within a master repurchase agreement, a single legal document that governs all trades between them.

Participants turn to the repo market for three main reasons: to finance the ownership of a security, to collect short-term income from lending cash against collateral, and to obtain a specific security so as to short it.

Financing and secured lending

Institutions that trade securities or carry inventory often act as sellers and cash borrowers. Imagine an investor delivers a bond to a bank trading desk in return for cash. The bank must pay immediately even though it may only sell the bond onward later, so it raises the purchase amount from a second bank or an asset manager, handing over the just-acquired bond as collateral. The repo shrinks the bank’s funding requirement for that bond to a fraction of its purchase price, the fraction set by the initial margin.

From the buyer’s side, a repo is a collateralized short-term cash placement that carries little liquidity or default risk. Overnight deals secured by top-grade collateral pay the least; a lender can earn more by extending the term or by taking collateral that is less liquid or of lower quality. These lenders include banks, mutual funds, and pension funds, and on a bank’s balance sheet the positions appear as securities purchased under agreements to resell. Central banks also use repos, but for monetary policy: while reserve requirements and outright purchases and sales are more permanent tools, repos suit shorter-term, transitory adjustments, for example temporarily adding cash reserves to the banking system by lending cash against borrowed securities.

Borrowing a security to sell it short

Sometimes a buyer enters a repo not just to earn interest on cash but to obtain a specific security for another use. A hedge fund that expects a bond’s price to fall can borrow it through a repo, sell it in the cash market, and later buy it back to return. Viewed from the buyer’s (cash lender’s) perspective, this trade is often called a reverse repurchase agreement, or reverse repo.

A trade that demands delivery of one particular security is a special trade, done at a special collateral rate. When a specific security is in very high borrowing demand, its special repo rate can drop below the general collateral rate, or even below zero; at a negative repo rate the security buyer actually pays interest on the cash it has lent.

What moves the repo rate

Risks in repo financing

Repos are a widely used, relatively cheap source of short-term funding, but they carry structural risks, and leaning on them too heavily in a stressed market can push a firm toward distress or insolvency. Each side is exposed to the other failing to meet its obligations; the collateral reduces but does not remove that exposure. The key risks are:

• Default risk: the primary exposure despite the collateral. Collateral from a less creditworthy counterparty is more likely to be tested in a default and may then face illiquidity, adverse price moves, and legal or operational hurdles.
• Collateral risk: beyond being liquid and creditworthy, the collateral ought to bear little or no correlation to the counterparty’s own credit risk, so that credit exposure is diversified.
• Margining risk: collateral must be valued and variation margin transferred properly and on time; stressed markets can swing collateral values sharply, triggering margin calls and forcing further liquidations.
• Legal risk: the ability to enforce legal rights under the agreement.
• Netting and settlement risk: the ability to net a defaulting party’s obligations and to seize collateral or cash when settling the trade.

Participants often manage these risks through a third party. A repo done directly between two parties is a bilateral repo; under a triparty repo, both sides use a third-party agent. The agent, a custodian or clearinghouse, does not change the credit relationship in a default, but it creates cost efficiencies by giving access to a larger collateral pool and more counterparties and by specializing in valuing and safekeeping assets. Even so, the fact that repo funding is uncommitted, together with its very short (largely overnight) maturities, creates serious rollover and liquidity risks in a downturn. Firms must weigh the low cost of repo funding against the greater flexibility of pricier long-term debt and equity. In principle the collateral ought to reassure lenders enough to keep rolling trades; in practice, firms that have lost market confidence have suffered heavy losses, and even failure, precisely because they relied so heavily on repo funding.

Long-term debt provides a firm with steadier funding for both its short-term operations and long-term requirements like capital investment. Every issuer faces broadly similar capital allocation and capital structure decisions when it borrows long term, but its credit quality shapes the features it can offer and how readily the market will take its debt. Investment-grade (IG) issuers have a stronger capacity to meet future obligations from operating cash flows, while high-yield (HY) issuers are seen as more vulnerable. Credit quality matters more as maturity lengthens, because the chance of financial distress grows over time.

What IG and HY issuance share

Both issuers and investors weigh the risk of a maturity choice against its cost, the yield-to-maturity. Under normal conditions, longer maturities carry both higher interest rates (the government yield) and wider credit spreads for any single issuer. Consider BRWA Corporation, whose partial yield curve rises with maturity. An investor with a five-year horizon might reach for the higher yield of BRWA’s seven-year bond, but doing so means holding a bond longer than the horizon and having to sell a two-year bond in five years, which adds price risk; the investor also bears reinvestment risk if prevailing rates on received cash fall below the bond’s coupon. BRWA as issuer might instead prefer the lower yield of a three-year bond to fund a five-year project, but that adds rollover risk, the chance of refinancing at higher rates when the bond matures in three years. These trade-offs apply to IG and HY alike, though the wider spreads on high-yield debt sharpen the risk-versus-return balance for weaker credits.

Where IG and HY diverge

The gap between IG and HY bonds runs well past the size of the credit spread. Because an IG issuer can meet interest and principal from operating cash flows, most of its yield-to-maturity reflects the government benchmark rather than an issuer-specific spread. High investor confidence lets IG borrowers issue with little ongoing monitoring, choose flexible maturities (often up to 30 years), and accept few or no restrictive covenants. BRWA’s senior unsecured notes, for instance, rely only on operating cash flows for repayment, so their restrictions are limited to broad protections of investor claims, such as bars on sale-and-leaseback deals or pledging assets to a third party. IG bonds are fairly standardized, and frequent issuers often keep many general obligation unsecured bonds outstanding at different maturities, staggering those maturities to cut refinancing and rollover risk while keeping the option to raise more debt opportunistically.

High-yield issuers carry a higher expected likelihood of financial distress, so a larger share of their yield reflects an issuer-specific spread over the benchmark. With default more likely, their cash flows are more equity-like (that is, uncertain), and analysts focus on the potential loss given default and on the protections and secondary repayment sources available. Investors respond by imposing more constraints. The covenants in a bond’s indenture (or in a loan agreement) let lenders monitor performance against set criteria and act to restructure debt or protect their claims. VIVU’s 6.5% seven-year callable notes, for example, are secured, giving holders a claim on specific pledged assets as a secondary repayment source, and the indenture caps additional debt and limits both leverage (relative to operating cash flows) and distributions to shareholders. These constraints leave HY issuers far less flexibility and market access than IG issuers: under set conditions VIVU was barred from raising further debt unless that debt was subordinated or took the form of short-term working capital capped at 20% of the notes outstanding. HY maturities also tend to be shorter (about 10 years or less), and spreads and availability swing more over the economic cycle, so high-yield firms frequently have to rework their debt and renegotiate covenants to reach cheaper borrowing costs rather than simply issuing when conditions are good.

High-yield issuers often guard their flexibility by drawing on leveraged loans that allow prepayment, or by issuing bonds that carry contingency features. Callable debt lets the issuer redeem all or part of a bond before maturity at a fixed price: VIVU issued its 6.5% notes for seven years but retained the right to call them from the third year after issuance onward, at an opening call price of 103.25% of principal. An issuer that expects its creditworthiness to improve favors callable debt, because the value of the call feature rises as its borrowing costs fall. High-yield investors also gain when spreads fall and prices rise, but with callable debt their gains are capped at the call price. If VIVU could refinance in three years with cost savings whose present value tops the 3.25% call premium, calling the bonds and reissuing at a lower yield would make sense.

One notable exception is the fallen angel, a bond issued by a firm that was investment grade at issuance but has since been downgraded to high yield. Its likelihood of distress now resembles that of other HY issuers, yet its outstanding debt keeps investment-grade features: typically non-callable, with few covenants and longer maturities, because it was originally sold to IG investors when the firm was highly rated. The later slide in credit quality imposes losses on those original holders, many of whom must sell because the bonds no longer meet their portfolios’ minimum rating rules. That forced selling can drive prices down sharply, because the high-yield market spans only a small fraction of the investment-grade market.