Eighth edition

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CORPORATE FINANCE

PRINCIPLES AND PRACTICE

DENZIL WATSON & ANTONY HEAD

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CHAPTER 5 LONG-TERM FINANCE: DEBT FINANCE, HYBRID FINANCE AND LEASING

138

House of Fraser on hunt for financingStruggling department store chain says so far no talks have progressedBy Scheherazade Daneshkhu and Javier Espinoza

House of Fraser, the struggling department store

group, has held refinancing talks with Alteri

Investors, the London-based turnround specialist,

in the latest sign of financial stress at the 169-year

company.

The talks, first reported in the Sunday Times, have

ended but they come as the company seeks to refi-

nance or extend the terms of £224m of debt that

matures in July 2019, four months after the UK

leaves the EU.

The retailer which was bought by China’s Sanpower

in 2014 on the promise of expanding the brand in

that country, sought to allay concerns on Sunday,

saying: ‘House of Fraser is a privately-owned busi-

ness and we have the full financial support of our

shareholders.’

British retailers have had a dismal start to the year

– the worst since 2013 – as they grapple with rising

business rates and other costs, while struggling to

fill their stores with customers who are increasingly

buying online.

Maplin, the electronics retailer and the UK arm of

Toys R Us, both fell into administration while

Mothercare, Carpetright and New Look have all

been renegotiating terms with landlords or lenders.

House of Fraser also had a tough Christmas trading

period with sales 2.9 per cent lower in the six weeks

to December 23 than the same period in 2016. It

promised £16m of cost cuts this year on top of last

year’s £10m. The group has also been seeking rent

reductions from some of its landlords.

Alteri, which is backed by US buyout giant Apollo

Global Management, was involved in the sale of

struggling Jones Bootmaker to Endless in 2017 and

in the acquisition of CBR Fashion Group from EQT

earlier this year.

House of Fraser said: ‘As you’d expect in the current

market, finance providers are keen to talk to retail-

ers,’ but added that ‘under the terms of the current

banking facilities, the talks did not progress’.

The stumbling block appears to have been that most

of House of Fraser’s assets are already held as secu-

rity by its existing lenders, led by HSBC bank.

The lenders recently hired EY, the professional ser-

vices group, as an adviser, according to Sky News on

Friday. The group was brought in to assess whether

the lenders’ investment in the business is safe,

according to one person familiar with the situation.

Moody’s, the rating agency, in December down-

graded its rating on House of Fraser to Caa1, from

B3, meaning that it deemed the group’s creditwor-

thiness had deteriorated to ‘very high credit risk’

from ‘speculative’.

House of Fraser has a £175m bond maturing in 2020,

which trades at a significant discount to face value.

Net debt at the beginning of last year, the last pub-

licly available figure, was £224m.

Sanpower injected further uncertainty into the

retailer’s future this month when it unexpectedly

announced the sale of a 51 per cent stake in House

of Fraser to Wuji Wenhua, a Chinese tourism group.

Source: Daneshkhu, S. and Espinoza, J. (2018) ‘House of Fraser on hunt for financing’, Financial Times, 25 March.© The Financial Times Limited 2018. All Rights Reserved.

Vignette 5.1

Questions

1 Explain why refinancing is important to House of Fraser.

2 Discuss why House of Fraser is having difficulty refinancing its debt.

5.1 BONDS, LOAN NOTES, LOAN STOCK AND DEBENTURES

139

Petrobras century bond makes more sense than first appearsBy Ralph Atkins

Petrobras is a Brazilian state oil company engulfed

last year by a multibillion-dollar bribery and kick-

back scandal. Would global investors really lend it

money for 100 years? Well, yes, they would. Bids this

week for a ‘century bond’ issued by Petrobras were

more than five times higher than the $2.5bn issued.

Century bonds are not unprecedented. Past big issu-

ers have included France’s EDF utility. In April,

Mexico’s government issued 100-year bonds denomi-

nated in euros. Petrobras, however, has extended

further the boundaries of corporate bond markets,

which have expanded rapidly in an era of historic

borrowing costs. It allowed the troubled Brazilian

energy group to lock in financing until 2115 – by

when the world might be using energy beamed back

from Mars.

Doubtless, it also left many scratching their heads

about what the new issue told us about the post-2007

crisis financial system. One wrong conclusion

would be that investors acted crazily. True,

Petrobras has problems, as does Brazil’s economy.

The bonds, however, yielded a temptingly high 8.45

per cent. Rather, the deal highlighted how ultra-low

global interest rates and quantitative easing are

reshaping the corporate debt market, breaking

down bonds’ traditional role as supposedly safer

alternatives to equities.

Investing in a bond that will not be redeemed until

way beyond a normal human’s lifespan might seem

to imply reckless assumptions about the issuer’s

survival chances. The beauty of bond market

maths, however, means such existential questions

are largely irrelevant when proper account is taken

of payments to be made so far into the future. If

this week an investor bought Petrobras bonds with

a par value of $1,000 and used 8.45 per cent as the

‘discount rate’, the present value of the final 2115

payment on the bond – the return of the $1,000 plus

a coupon – would be just 26 cents. So whether the

bond is eventually redeemed or not makes scant

difference. Similar calculations explain why Mexico

could issue a €1.5bn 100-year bond – even though

some would question whether Europe’s single cur-

rency will be around in a decade let alone a century.

What matters instead for the nearer-term perfor-

mance of Petrobras’s bonds as tradable securities

will be trends in its perceived creditworthiness, and

global interest rates. The latter could push bond

yields higher – and prices down – but improvements

in the energy group’s fortunes would work in the

opposite direction, justifying lower yields and

higher bond prices.

Petrobras’s century bond may still be sending warn-

ing signals. It did not help calm fears about the large

inflows in recent years into emerging market corpo-

rate bonds – and the risk of a disruptive correction

if the US Federal Reserve starts lifting interest rates

later this year. ‘It is a sign of euphoria,’ warns

Alberto Gallo, head of credit research at Royal Bank

of Scotland. ‘It is a clear sign that the market has

disconnected from macro and micro fundamentals.’

Longer bonds allow pension and insurance compa-

nies to better match their future liabilities. But they

may amplify market swings; bond maths means

Vignette 5.2

by attaching a call option to the bond issue, as this gives the company the right, but not

the obligation, to buy (i.e. redeem) the issue before maturity. Early redemption might be

gained in exchange for compensating investors for lost interest by paying a premium over

nominal value. Redemption at a premium can also be used to obtain a lower interest rate

(coupon) on a bond.

It is possible, but rare, for a bond to be irredeemable. The permanent interest-bearing

shares (PIBs) and perpetual sub bonds (PSBs) issued by some building societies are an

example. However, as Vignette 5.2 shows, strong companies can issue bonds with very long

redemption dates.

➨

CHAPTER 5 LONG-TERM FINANCE: DEBT FINANCE, HYBRID FINANCE AND LEASING

140

Vignette 5.2 (continued )

small changes in interest rates produce proportion-

ally bigger price movements on longer-dated bonds.

Century bonds strengthen the trend towards com-

pany and government debt maturing ever further

into the future. The proportion of new issuance

with maturities longer than 10 years is the highest

since 2007, according to JPMorgan.

In the sell-offs that have punctuated recent market

activity, bonds have appeared to act more like equi-

ties. ‘We have to get more used to thinking of bonds

as ‘risky’ assets,’ says Stephanie Flanders, chief mar-

ket strategist for Europe at JPMorgan Asset

Management. ‘When you see a bond with a high yield,

you know it is going to have particular risk attached.’

If investor interest is understandable, a harder

question is why Petrobras wanted to issue 100-year

debt. The answer is: because it could. Massive inves-

tor demand gave it a chance to storm back to capital

markets with a headline grabbing bond issue, boost-

ing confidence and setting a benchmark that should

make future issues easier. Shorter-term bonds

might not have been much cheaper. These are diffi-

cult times for Petrobras but global financial condi-

tions are in its favour.

Source: Atkins, R. (2015) ‘Petrobras century bond makes more sense than first appears’, Financial Times, 4 June.© The Financial Times Limited 2015. All Rights Reserved.

Questions

1 Explain why the capital repayment on the century bond is currently of little value.

2 Discuss the reasons why investors were attracted to the century bond issue.

5.1.3 Floating interest rates

While it is usual to think of bonds as fixed interest securities, they may be offered with a

floating interest rate linked to a current market interest rate, for example, 3 per cent (300

basis points) over the three-month LIBOR or 2 per cent (200 basis points) above bank

base rate. A floating rate may be attractive to investors who want a return that is consist-

ently comparable with prevailing market interest rates or who want to protect themselves

against unanticipated inflation. A fixed interest rate protects investors against anticipated

inflation since this was part of the fixed rate set on issue. Floating rate debt is also attractive

to a company for hedging against falls in market interest rates (see ‘Interest rate risk’,

Section 12.1.1) since, when interest rates fall, the company is not burdened by fixed inter-

est rates higher than market rates.

5.1.4 Bond ratings

A key feature of a bond is its rating, which measures its investment risk by considering the

degree of protection offered on interest payments and repayment of principal, both now

and in the future. The investment risk is rated by reference to a standard risk index. Bond

rating is carried out by commercial organisations such as Moody’s Investors Service, Stand-

ard & Poor’s Corporation and Fitch Group. Each rating is based on analysis of the expected

financial performance of the issuing company as well as on expert forecasts of the eco-

nomic environment. Institutional investors may have a statutory or self-imposed require-

ment to invest only in investment-grade bonds; a downgrading of the rating of a particular

5.1 BONDS, LOAN NOTES, LOAN STOCK AND DEBENTURES

141

bond to speculative (or junk) status can therefore lead to an increase in selling pressure,

causing a fall in the bond’s market price and an increase in its required yield (see ‘The valu-

ation of fixed interest bonds’, Section 5.6). The standard ratings issued by Moody’s Investors

Service for long-term fixed interest corporate debt are summarised in Table 5.1, while

Vignette 5.3 illustrates how increased gearing can change credit ratings.

Aaa Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk

Aa Obligations rated Aa are judged to be of high quality, with very low credit risk

A Obligations rated A are considered upper-medium grade, with low credit risk

Baa Obligations rated Baa are considered medium grade, with moderate credit risk and so may possess certain speculative characteristics

Ba Obligations rated Ba are considered speculative, with substantial credit risk

B Obligations rated B are considered speculative, with high credit risk

Caa Obligations rated Caa are considered speculative, with very high credit risk

Ca Obligations rated Ca are highly speculative and in or close to default, with some prospect of recovering principal and interest

C Obligations rated C are the lowest rated and typically in default, with little prospect of recovering either principal or interest

Note: Moody’s appends numerical modifiers 1, 2 and 3 to each generic rating classification from Aa through Caa, indicating higher-end ranking, mid-range ranking and lower-end ranking respectively of its generic rating category.

Table 5.1 Moody’s Investors Service’s bond ratings

AT&T downgraded after Time Warner deal closesBy Alexandra Scaggs

AT&T’s credit rating was downgraded to two

notches above junk by two rating agencies on

Friday, after the US telecommunication giant com-

pleted its $80bn acquisition of Time Warner.

Analysts at Moody’s and S&P Global Ratings each cut

their ratings one level – to Baa2 and BBB, respectively

– because of the significant amount of debt the acqui-

sition adds to AT&T’s balance sheet. The combined

company’s net debt will total $180bn, and the analysts

estimate that is more than 3.5 times its earnings before

interest, tax, depreciation and amortisation, or ebitda.

The deal will also make AT&T the largest non-finan-

cial debt issuer in the US by far, they said. Such scale

introduces the risk that bond fund managers’

demand will be damped by limits on how much debt

they can hold from any individual company

‘Investors can only have a certain amount of expo-

sure to any particular issuer, which reduces demand

and puts pressure on pricing of debt,’ said Allyn

Arden, credit analyst with S&P Global Ratings.

Its tie-up with Time Warner is expected to offer just

$1.5bn of annualised cost savings, which is ‘mini-

mal’ even with the expected revenue synergies of

$1bn, Mr Arden said.

The combined company has $2bn of debt maturing

this year and nearly $9bn maturing next year,

according to filings. Moody’s analysts expect AT&T

to maintain good liquidity over the next year, but

added that it may eventually need to cut its divi-

dend to compete with new media and technology

industry competitors.

Vignette 5.3

➨

CHAPTER 5 LONG-TERM FINANCE: DEBT FINANCE, HYBRID FINANCE AND LEASING

142

Vignette 5.3 (continued )

‘The sheer amount of debt commits AT&T to sizea-

ble annual maturity obligations for the long term

thereby making the company beholden to the health

of the capital markets,’ the analysts said in their

downgrade note Friday.

As part of the cash- and equity-funded acquisition,

AT&T will take on Time Warner’s debt, which totals

more than $15bn. To strengthen its current rating,

the company could take other actions besides cut-

ting its dividend, the analysts said. Those include

selling assets, delaying or reducing its capital

expenditures or issuing more equity.

The downgrade follows the Department of Justice’s

decision not to seek to further delay the acquisition

pending a possible appeal. The DOJ had initially

challenged the deal on antitrust concerns, but a

federal judge approved it earlier this week.

Source: Scaggs, A. (2018) ‘AT&T downgraded after Time Warner deal closes’, Financial Times, 15 June.© The Financial Times Limited 2018. All Rights Reserved.

Questions

1 Explain why AT&T has been downgraded.

2 What effect will the downgrading have on AT&T’s ability to raise further debt?

5.1.5 Deep discount and zero coupon bonds

There is clearly a relationship between redemption the terms, the coupon rate and the

issue price of bonds. This relationship is explored in more detail in ‘The valuation of fixed

interest bonds’ (see Section 5.6), which deals with valuating debt securities. It is possible

for a company to issue a bond at a price well below its nominal value in exchange for a

lower interest rate coupled with redemption at nominal (or at a premium to nominal) on

maturity. Such a security, referred to as a deep discount bond, will be attractive to investors

who prefer to receive a higher proportion of their return in the form of capital gains, as

opposed to interest income. Different personal taxation treatment of interest income and

capital gains will also be a factor influencing the preferences of individual investors.

The lower servicing cost of deep discount bonds may be attractive if cash-flow problems

are being experienced or are anticipated, for example if the cash raised by the new issue is

to be used in an investment project whose returns are expected to be low in its initial years.

If no interest at all is paid on a bond issued at a deep discount, so that all of the return to

investors is in the form of capital appreciation, it is called a zero coupon bond. The general

attractions of zero coupon bonds to the issuing company are similar to those of deep dis-

count bonds. However, these advantages must be weighed against the high cost of redemp-

tion compared with the amount of finance raised.

5.1.6 New issues

Debt finance is raised in the new issues market (the primary market) through lead banks,

which will seek to place blocks of new bonds with clients through advance orders prior to

the issue date. This process is referred to as book building. Several banks may join forces in

a syndicate in order to spread the risk associated with providing debt finance.