640 Part Seven Debt Financing
bre44380_ch24_618-651.indd 640 10/05/15 12:54 PM
Debt Covenants
We saw earlier that bond issues may contain covenants that restrict companies from taking
actions that would increase the risk of their debt. For publicly issued bonds these restrictions
are often mild. In the case of privately placed debt, the covenants are generally more severe.
Since privately placed debt keeps the borrower on a fairly short leash, it is quite common for
a covenant to be breached. This is not as calamitous as it may sound. As long as the borrower
is in good financial health, the lender may simply adjust the terms of the covenant. Only if
covenants continue to be violated will the lender choose to take more drastic action.
Covenants on bank loans and privately placed bonds are principally of three kinds.^51 The
first and most common covenant sets a maximum fraction of net income that can be paid out
as dividends. A second set of covenants, called sweeps, state that all or part of the loan must
be repaid if the borrower makes a large sale of assets or a substantial issue of debt. The third
group places conditions on key financial ratios, such as the borrower’s debt ratio, interest
coverage ratio, or current ratio.24-4 Commercial Paper and Medium-Term Notes
Commercial Paper
Banks borrow money from one group of firms or individuals and relend the money to another
group. They make their profit by charging the borrowers a higher rate of interest than they
offer the lender.
Sometimes it is convenient to have a bank in the middle. It saves the lenders the trouble
of looking for borrowers and assessing their creditworthiness, and it saves the borrowers the
trouble of looking for lenders. Depositors do not care to whom the bank lends: They need only
satisfy themselves that the bank as a whole is safe.
There are also occasions on which it is not worth paying an intermediary to perform these
functions. Large well-known companies can bypass the banking system by issuing their own
short-term unsecured notes. These notes are known as commercial paper (CP). Financial
institutions, such as bank holding companies and finance companies,^52 also issue commercial
paper, sometimes in very large quantities. For example, in 2014 GE Capital Corporation had
$25 billion of commercial paper in issue. The major issuers of commercial paper have set up
their own marketing departments and sell their paper directly to investors, often using the Web
to do so. Smaller companies sell through dealers who receive a fee for marketing the issue.
Commercial paper in the United States has a maximum maturity of nine months, though
most paper is for fewer than 60 days. Buyers generally hold it to maturity, but the company or
dealer that sells the paper is usually prepared to repurchase it earlier.
Commercial paper is not risk-free. When California was mired in the energy crisis of 2001,
Southern California Edison and Pacific Gas and Electric defaulted on $1.4 billion of commercial
paper. And in 2008 Lehman Brothers filed for bankruptcy with $3 billion of paper outstanding.
But such defaults are rare. The majority of commercial paper is issued by high-grade, nationally
known companies,^53 and the issuers generally support their borrowing by arranging a backup
line of credit with a bank, which guarantees that they can find the money to repay the paper.^54(^51) For an analysis of loan covenants in privately placed debt see M. Bradley and M. R. Roberts, “The Structure and Pricing of
Corporate Debt Covenants,” Quarterly Journal of Finance 5 (June 2015), pp. 1–37.
(^52) A bank holding company is a firm that owns both a bank and nonbanking subsidiaries.
(^53) Moody’s, Standard and Poor’s, and Fitch publish quality ratings for commercial paper. For example, Moody’s provides three ratings,
from P-1 (that is, Prime 1, the highest-grade paper) to P-3. Most investors are reluctant to buy low-rated paper. For example, money-
market funds are largely limited to holding P-1 paper.
(^54) For top-tier issuers the credit line is generally 75% of the amount of paper; for lower-grade issuers it is 100%. The company may not
be able to draw on this line of credit if it does not satisfy bank covenants. Therefore, lower-rated companies may need to back their
paper with an irrevocable line of credit.