Bank debt and amortization.

Hi all, I was looking through WSO technical guide and in the Bond/Debt section, it mentioned "Bank debt is secured by the assets of the company and therefore normally commands lower interest rates. The trade off is that it will typically amortize and may have maintenance covenant." Could someone explain why amortization of the principal a down side? I would think that amortization of principal would be good since it decreases the principal and hence future interest payments.

 
poasb40:

Thanks for the reply so amortization means mandatory payment in the case of bank loans? Also, arn't bond payments fixed as well?

Yes, amortization is a mandatory paydown on the loan written into the credit agreement.

Bond payments are fixed but they are interest payments, not principal paydown. Some times a bond will have a special call provision (can call 10% of the principal @ 103 during the non-call period is one I've seen multiple times on senior secured bonds) but usually they are non-amortizing with a bullet at maturity.

MM IB -> Corporate Development -> Strategic Finance
 

Yes. In addition to the strategic factors above, it also hurts the issuer on an NPV basis due to something called "bond duration". Google it if you want a full explanation. Mine is very mickey mouse.

You need to get a PV of each separate payment multiplied by the payment interval (e.g end of period 2 =2), then divide over the price of the bond. Assuming a 5% interest rate, a 5%, 10 year zero coupon bond would have a duration of 10 because 10 is the "averaged"(of sorts, not literally average) time it takes to receive the cash.

An amortized bond will have more payments weighted toward time zero, so it will have a much shorter duration. This means that you have, in addition to constraining your financial flexibility, effectively issued a bond with a shorter repayment period than a non-amortizing bond.

Lower Duration -> less present value effect -> higher NPV cost to issue debt.

 

I work in a buy-side bank loan group and we're seeing the majority of major new issues have ammorts of 25bps/quarter with a bullet payment (repayment of the full principal balance) at maturity. In most cases we just expect the debt to be refinanced at maturity. Mandatory principal payments, in most cases, are minimal in order to maximize FCF and not constrict the company's cash flow too much just as SECfinance said. A lot of our borrowers do chose to make voluntary prepayments on a quarterly basis though. There are also, in many cases, protective covenants that say something like "mandatory amortization payments may not exceed 50% of FCF" to protect the company from default during a downturn.

 

To be more granular: term loan 'A' (true bank loans extended by lending institutions) will normally have aggressive (5-15% per year for leveraged loans depending on how asset intensive the company is and how fast these values deteriorate) amortization profiles, while term loan 'B' (loans extended by institutional investors and prime loan funds, referenced in the BLG post above) have the 25bps/quarter amortization. More flexibility but higher interest on the B loans usually, and also more syndication fees.

 

Can testify to two as well. At the moment I'm dealing with some real estate securities that "amortize" but it's by a negligible amount: less than 0.1% of the outstanding principal(not base, outstanding) every month.

I'm not sure why you would even bother putting in that small an amount of amortization for something with a medium term maturity.

 

To echo some of the comments above, you can really think of this as just risk vs. return for both sides. For the equity holder, raising debt is cheaper because the amount of risk to the lender is lower (collateralized against assets and if the world blows up their loss is backstopped by a specific asset valuation amount).

With regards to amortization and its effect on the interest rate, you just have to think of it from a cashflow perspective. Equity is always paid after debt, so if there is amortization every period, you'll be losing cashflow in those earlier periods than vs. that of a bullet bond (non-amortizing). For the debt holder, they're getting their principle back earlier and that is a sigh of relief for them. As a result, the cost of debt would decrease vs. that of a non-amortizing bond.

This is the driving principal behind why PE would issue dividend recaps. They believe they can take on more debt, which does decrease their future cashflows to equity (higher debt service from new loan), however, they get more money upfront which is worth more due to their higher cost of capital. The tax benefits of the interest are also a plus but the core of it is really the big early upfront vs. the cashflow over time.

 

Something else to keep in mind regarding amortization from the borrowers perspective...

If a borrower is a fund instead of a corporate, the ability to sweep cash flow back to LPs or reinvest free cash flow into new investments, all while deferring principal repayment, juices IRRs. Just think time value of money... It's better to return to LPs now and pay modest interest on the principal than it is to repay the bank and have a larger lump sum return to LPs later.

 

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