FINS1612 Chapter Notes - Chapter 10: Loan Covenant, Commercial Bank, Interest Rate Risk
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Financial Institutions, Instruments and Markets
8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips
Chapter 10
Medium- to long-term debt
Learning objective 1: Explain term loans and fully drawn advances, including their structure, loan
covenants, and the calculation of a loan instalment
• The financial system provides corporations with a wide range of medium- to long-term loan
and debt facilities. These facilities allow a corporation to diversify its funding sources and
match its cash-flow requirements.
• The sources of medium- to long-term debt may be intermediated finance provided by
financial institutions or direct finance obtained from either the domestic or the international
capital markets.
• A common form of intermediated debt is the term loan or fully drawn advance. The main
providers of term loans are the commercial banks. However, investment banks, finance
companies, insurance offices and credit unions also provide term loans to the business sector.
• Term loans are provided to fund a specific purpose or project for a fixed period of time.
• The repayment structure of a term loan may be amortised (each periodic instalment
incorporates an interest component and also a principal repayment component), interest only
(each periodic instalment only comprises the interest due on the full loan amount) or deferred
(repayment is deferred for a period until the business project generates positive cash flows).
• The normal practice is to price a variable-rate loan at a margin above a reference interest rate.
The margin will reflect the level of credit risk of the borrower.
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• During the term of a variable rate loan, the interest rate will be periodically reset in relation
to changes in the specified reference rate, such as LIBOR, BBSW or the bank’s own prime
rate.
• The bank bill swap rate (BBSW) is the mid-point of prime banks’ bid and offer rates for
eligible securities in the NCD and BAB secondary markets and is published by the AFMA.
Thomson-Reuters publishes LIBOR daily.
• A range of fees may also apply, including an establishment fee, a periodic service fee, a
commitment fee or a line fee.
• Issues that a lender will consider when determining an interest rate and the margin include
the credit risk of the borrower, the term of the loan and the loan repayment schedule.
• A loan contract may include a range of loan covenants to protect the lender. They include
positive covenants, which state actions that must be taken by a borrower (e.g. provision of
financial statements), and negative covenants, which limit the actions of a borrower (e.g.
minimum debt to equity ratio).
• The formula used to calculate the instalment on a term loan (when payments occur at the end
of each period) is:
Learning objective 2: Describe the nature, purpose and operation of mortgage finance and the
mortgage market, plus calculate an instalment on a mortgage loan
• Mortgage finance is a term loan with a specific type of security attached, being a mortgage
registered over land and the property thereon. The borrower (mortgagor) conveys an interest in
the land to the lender (mortgagee).
• If a borrower defaults on loan repayments, the lender has the right of foreclosure, whereby
the lender will take possession of the land and sell it to recover the amounts outstanding.
• The mortgage market is very large and includes both residential mortgage loans and commercial
mortgage loans.
• A further protection for the lender may be a loan condition that requires the borrower to take
out mortgage insurance. This is normally required where the loan-to-valuation ratio is above
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80 per cent.
• The formula to calculate the instalment on a mortgage loan is:
• Some mortgage lenders use a process of securitisation to finance continued growth in their
mortgage lending. The lender sells a parcel of existing loans to a trustee of a special-purpose
vehicle. The trustee funds this purchase by issuing new securities such as bonds into the
capital markets. The cash flows due on the mortgage loans held by the special-purpose
vehicle are used to pay interest and principal commitments due on the bonds.
Learning objective 3: Discuss the bond market, in particular the structure and issue of debentures,
unsecured notes and subordinated debt
• A corporate bond is a long-term debt security that pays specified periodic interest payments
(coupons) for the term of the bond and the principal is repaid at maturity.
• Corporate bond issuers require a good credit rating issued by a credit rating agency to be able
to issue securities direct into the capital markets.
• Debentures and unsecured notes are corporate bonds.
• A debenture is a corporate bond with security attached. The security is a charge over the
unpledged assets of the borrower. This will include a fixed charge over permanent assets and
a floating charge over other assets such as stock that pass through the business. If the
borrower defaults, the floating charge is said to crystallise and become a fixed charge; the
borrower will then take possession of the assets.
• A covered bond is a bond issued by a commercial bank that is supported by a claim over
mortgage securities held by the bank.
• An unsecured note is a corporate bond with no security attached.
• Corporate bonds may be offered as public issues, family issues or private placement. Bonds are
typically sold at face value; however, issues may include discounted, deep discounted, zero-coupon
and deferred-interest debentures.
• A public issue of bonds requires a prospectus that provides detailed information on the issuer
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Document Summary
The main providers of term loans are the commercial banks. The margin will reflect the level of credit risk of the borrower. Thomson-reuters publishes libor daily: a range of fees may also apply, including an establishment fee, a periodic service fee, a commitment fee or a line fee. The borrower (mortgagor) conveys an interest in the land to the lender (mortgagee). This is normally required where the loan-to-valuation ratio is above. 80 per cent: the formula to calculate the instalment on a mortgage loan is, some mortgage lenders use a process of securitisation to finance continued growth in their mortgage lending. The lender sells a parcel of existing loans to a trustee of a special-purpose vehicle. The trustee funds this purchase by issuing new securities such as bonds into the capital markets. The cash flows due on the mortgage loans held by the special-purpose vehicle are used to pay interest and principal commitments due on the bonds.
