Chapter 4

1. Chapter 4 Primary Market Making： Debt Underwriting

2. Mezzanine Finance • Background • The emergence of firms that specialize in arranging such buyouts e.g. KKR, Wesray and Clayton ＆ Dubil, First Boston, Morgan Stanley, Merrill Lynch • The development of the junk bond market • Hostile • Friendly • The tremendous amount of liquidity available within the international banking system • Traditional：loans, real estate, etc • Recent：mezzanine finance, private equity, etc • The increasing investment in the U.S. companies

3. Characteristics • A mezzanine issue occupies one or more intermediate positions in the corporate capital structure between the senior debt and the common equity e.g. Subordinated debt, junior subordinated debt, preferred stock, warrants, stock appreciation rights • It is placed privately, and carries an intermediate term that ranges from 5 to 12 years • It is designed to fill the financing “gap” between the senior lender will provide and the amount of equity capital the principal are willing to commit • Expensive borrowing • 400-700 basis points over treasuries • Average cost of mezzanine capital 20-30﹪

4. Mezzanine issues are illiquid and are likely to have much tighter covenants • Limiting the issuer’s flexibility to sell assets • Take on additional debt • Distribute cash to investors • It almost always include an equity component, warrants • 3-6 yrs life • Put option that allow the investor to sell the warrants back to the issuer • Call option that allow the issuer to redeem them

5. Government Bonds • Characteristics • Government issues only, debt securities, including Treasury securities, agency securities and municipal securities. • Treasury securities market has very liquid, and homogeneous investments, including T-bills, T-notes and T-bonds. T-bills are issued in maturities of 91 days, 182 days, and 364 days. • Agency securities fill a niche between corporate debt securities and Treasury securities. Most of the issuers are mortgage market-related, including the Government National Mortgage Association (GNMA), the Federal Home Loan Bank (FHLB), the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC). • Municipal Notes Bonds were tax-exempt, General Obligation bonds and Revenue bonds are backed by tax authorities and specific projects, respectively, which is riskier? The underwriting agreement is negotiated and competitive bidding.

6. Convertible Bonds • Characteristics • Convertible bond is a cheap source of capital • Lower coupon rate • Issue at premium • The cost of convertible debt is a weighted average of the explicit interest charges and the implicit opportunity costs associated with the conversion or equity option • Convertibles are not much affected by changes in company risk；the rationale for the use of convertibles is the relative insensitivity of their value to the risk of the issue company • Convertibles are accompanied by a call provision

7. Junk Bonds • Background • Hurt by unexpected inflation during the 1970s, investors has sought higher returns and greater flexibility • Premium yields • Shorter duration • Traditional loss-protection measures were inadequate in a rapidly change environment • High credit quality (Interest rate volatility) • Bond covenants (Mass corporate restructuring) • Drexel Burnham began underwriting junk bonds • Provide liquidity (Secondary market) • Merger and acquisition (LBO)

8. Characteristics • Junk bonds are those rated below Bb by Moody’s or below BB by S＆P’s • Private Placement vs. public issues • Convertible vs. straight debt • Low-rated municipal bonds • Low-rated preferred stock • The attraction that junk bonds hold for investors is a high expected return 1977-86 Junk bonds 11.04﹪ (return) AAA bonds 9.60﹪ Treasury bonds 9.36﹪ • Junk bonds actually had lower total risk than did their investment-grade counterparts 1977-86 Junk bonds 2.86﹪ (S.D.) AAA bonds 3.73﹪ Treasury bonds 4.02﹪

9. The “ Risk and Return Paradox ” of junk bonds • Shorter duration： Junk bonds values are less sensitive to interest rate fluctuations • Sensitive to assets fluctuation： Junk bonds are protected by smaller equity cushion than investment grade bonds, and thus are more sensitive to fluctuation in the value of the issuing firm’s assets, i.e. sector, industry, and firm-specific factor risk (diversifiable) • Investing in junk bonds is regarded as a covered call option strategy • Junk bond value move up and down with the value of the issue firm’s assets --- common stock long • The upward movement is truncated for junk bond because of call provision --- write a call

10. Euro-bonds • Background • Market booming between 1975 and 1988 • U.S. corporate borrowing grew at 63﹪ annually • Extraordinary favorable borrowing rates • 25 to 100 basis points below • International investment bankers involved • Underwritten by an international syndicate of investment bankers • Regulation and deregulation • 1960 U.S. restrain the outflow of funds • Integration of international capital market after the October crash in 1987

11. Characteristics • The majority of bonds are fixed-rate, unsecured, straight debt and are listed on a major exchange b) Euro-bond market was dominated by individual investors who purchase securities through anonymous bank accounts and who preferred short-term maturity • Liquidity needs • Foreign exchange risk • Euro-bonds have different features from domestic bonds • Annual coupon payment (Semiannual) • Short maturity (3-10 years) • No registration requirement • Smaller issue size • Bearer (anonymous accounts)

12. Lyons • Background • The Lyon is highly successful financial product introduced by Merrill Lynch in 1985 • The Liquid Yield Option Note • A complex securities, a zero coupon, convertible, callable, and puttable bond • Merrill Lynch was the largest Cash Management Accounts (CMAs) manager • Few direct equity investment, large balance • Risk all or a fraction of the interest with their principle remained intact in their CMA • Convertible  equity investment put  recover principal • Merrill Lynch’s efforts to search for LYON issuers • Investment-grade rating and volatile stock price is rare • 3﹪ spread

13. Characteristics • A LYON is a combination of four features, i.e. zero coupon, convertible, callable and puttable • Zero-coupon • Conversion option • At any time • At conversion ratio • Put option • The investors • At a specific date • At pre-determined exercise prices that increase through time • Call option • The issuers • At any time subject to same call protection • At fixed exercise prices that increase through time • Investment may respond to the call by choosing either to accept redemption payment or convert their bonds into stock