Explain how bonds and loans are structured, priced and rated, and estimate debt capacity.
Agencies (S&P, Moody's, Fitch and, prominent in Canada, Morningstar DBRS) grade an issuer's ability to pay.
| Category | S&P and Fitch | Moody's |
|---|---|---|
| Highest quality | AAA | Aaa |
| High quality | AA, A | Aa, A |
| Lowest investment grade | BBB (down to BBB-) | Baa (down to Baa3) |
| High yield (speculative) | BB, B | Ba, B |
| Distressed | CCC and below | Caa and below |
The line between BBB- and BB+ matters: many investors may hold only investment-grade debt, so falling below it (becoming a fallen angel) raises borrowing costs sharply.
Coupon = yield on the government benchmark of the same maturity + a credit spread. With the 5-year benchmark at 4.00% and a spread of 150 basis points, the coupon is 5.50%. The spread reflects the rating, the sector, the maturity, market conditions and a small new-issue concession.
An investment-grade issue is usually announced, marketed, priced and allocated in one day off a shelf prospectus. A high-yield issue takes a one to two week roadshow.
Maturity; fixed or floating coupon; ranking (senior secured, senior unsecured, subordinated); call provisions (the issuer's right to repay early, usually with a premium after a non-call period); and covenants.
Maintenance covenants, typical of bank loans, are tested every quarter, for example debt/EBITDA below 4.0x. Incurrence covenants, typical of bonds, are tested only when the company takes an action such as borrowing more or paying a dividend. Covenant-lite loans have no maintenance tests.
| Instrument | Rate | Security and ranking | Holders |
|---|---|---|---|
| Revolving credit facility | Floating | Senior secured | Banks |
| Term loan A | Floating, amortizing | Senior secured | Banks |
| Term loan B | Floating, small amortization, repaid at maturity | Senior secured | Institutional lenders, loan funds |
| High-yield bonds | Fixed | Usually unsecured | Bond funds |
| Mezzanine or subordinated debt | High fixed rate, sometimes with equity warrants | Subordinated | Specialist funds |
Private credit funds now lend directly to many mid-sized and larger buyouts, replacing syndicated loans with a single negotiated facility.
Lenders size debt as a multiple of EBITDA and check coverage. A company with EBITDA of 200 can borrow 4.5x in total, or 900:
Lenders also test free cash flow after capex and tax against scheduled repayments, and run a downside case.
Maple bonds are Canadian-dollar bonds issued in Canada by foreign borrowers. Green and sustainability-linked bonds tie proceeds or coupons to environmental targets. Securitization pools loans such as mortgages, car loans or credit card balances and sells bonds backed by the cash flows.
A company's existing 5-year bonds trade at a spread of 140 basis points over Government of Canada bonds. Investors want a small reward for buying new supply, the new issue concession, of about 10 basis points. The new 5-year bond prices at 150 basis points over the benchmark. With the benchmark at 3.50%, the coupon is 5.00%.
A term loan B pays SOFR + 3.50% and is sold at 99 (an original issue discount of 1 point). With SOFR at 4.00%, the cash coupon is 7.50%. Assuming the loan is repaid in about four years, as is typical, the discount adds roughly 1 / 4 = 0.25% a year, for a yield of about 7.75%. Many loans also have a SOFR floor, so the coupon does not fall below a set level if rates drop.
A company's loan has a maintenance covenant of debt/EBITDA no higher than 4.0x. Debt is 700. When EBITDA was 200, leverage was 3.5x. After a bad year EBITDA falls to 160 and leverage rises to 4.375x: a breach. The company must negotiate a waiver or amendment, usually paying a fee and a higher interest rate, or face default. This is why lenders insist on maintenance covenants and borrowers prize covenant-lite terms.
Investment-grade bonds often have a 'make-whole' call: the issuer can repay early only by paying the present value of the remaining payments, discounted at a small spread over treasuries, which usually makes early repayment unattractive. High-yield bonds have a non-call period, then call prices that step down toward par. Loans can usually be repaid at par after a short soft-call period.
Lenders also test whether cash flow covers all fixed obligations: (EBITDA minus capex minus cash taxes) / (interest + scheduled principal + lease payments). Below about 1.0x, the company cannot meet its fixed obligations from operations.
Direct lenders, often funds run by large asset managers, now provide much of the financing for mid-sized buyouts. They offer speed, certainty and flexible terms in exchange for higher spreads. Because the loans are not traded, their valuations are set by the lenders themselves, which regulators watch closely.
Find a recent bond issue by a company you follow. Record the size, maturity, coupon, rating and the spread over the government benchmark on the pricing date. Then compute the company's debt/EBITDA and interest coverage after the issue.
Educational content only; not investment, tax or legal advice. Companies, tickers and figures are illustrative examples, not recommendations. Rules, rates and limits change, so check current details with the regulator, exchange or tax authority before relying on them. Worked examples are not forecasts. Written by Elizabeta Dimoska. RiskStock is not a registered dealer or adviser.