What is Bank Debt?
Bank Debt is the most common form of corporate debt, which at the most basic level is conceptually the same as any other loan or credit product from a local retail bank (but just done on a larger scale, often through a corporate bank).
On the other hand, we have corporate bonds, which are normally raised once the maximum amount of senior debt is raised. Or, the borrower might desire less restrictive covenants, at the expense of higher interest.
Bank Debt Types and Features
Examples of Bank Loans
The distinct commonalities among the senior secured loans are the lower costs of capital (i.e., cheaper source of financing) and pricing based on a floating rate (i.e., LIBOR + Spread).
- For term loans, there is typically a floor to maintain a minimum yield threshold of the lender
- If LIBOR drops below a certain level, the floor serves as a form of downside protection
- The main driver of return is the coupon on the debt, and then the receipt of the principal at maturity
- When it comes to senior lenders, capital preservation is the main priority – hence, the often-extensive creditor agreements
- The borrower has also pledged its collateral to back the debt, which further protects the interests of the lender
- Since leveraged loans are secured by collateral, they are considered the safest debt capital
In comparison, the main features of bonds are their fixed pricing (as opposed to floating) and the longer tenor. Unlike bank debt, the yield on bonds, therefore, does not change regardless of the interest rate environment.
- This means the pricing attached to the bond is adequate for the lender, and the return meets their lending threshold
- Since the lender is unsecured and lower in the capital structure, these lenders tend to be more returns-oriented – but the extra attention paid to the yield is reasonable because the lender is taking on extra risk (and should thereby be compensated for the additional risk)
- While bank debt lenders are focused on capital preservation of their loans, bond lenders concentrate on ensuring an adequate return is received
Hence, bank debt can be paid back early with no (or minimal) prepayment fees, whereas bond lenders charge a premium – the bank lender is glad to de-risk its investment, but for a bond lender, any prepayment lowers the return (i.e., the return of principal and a decent yield is not enough, instead the return of principal plus the “targeted” yield must be met).
Private vs. Public Debt Financing
One notable difference between the two is that bank debt is raised in a private transaction between:
- The company is in need of debt capital and looking to raise financing
- The lender(s) that provide the debt capital – can range from an individual bank, a syndicate of banks, or a group of institutional investors
- Similar to how equities are traded on the public markets, these corporate bonds trade freely on the secondary bond market.
- In fact, the secondary bond market is actually much larger than the equity secondary market in terms of size as well as daily trading volume.
Interest Rate on Bank Debt
In general, bank debt is priced cheaper in terms of the interest rate because:
- Most, if not all, bank debt lenders require the debt to be secured by the borrower’s assets – thus, the collateral can be seized by the lender in the case of default or covenant breach
- In the event of bankruptcy or liquidation, bank debt is first in line (i.e., highest seniority) with the highest chance of receiving full recovery
- By being at the top of the capital stack, bank debt is safer from the perspective of the lender
- Since the lender is secured, the senior secured lenders hold higher negotiating leverage when it comes to bankruptcies (i.e., their interests are prioritized)
For the reasons stated above, a company will thus often maximize the amount of bank debt that bank lenders would be willing to lend before using riskier, more expensive types of debt instruments.
The chart below summarizes the pros/cons that will be discussed in this article:
Advantages of Bank Debt
Lower Cost of Capital
The most compelling benefit of borrowing from banks, as mentioned earlier, is that the pricing on bank debt is lower relative to other riskier tranches of debt.
With the lower risk comes a lower interest rate – hence, the notion that bank debt is the cheaper source of financing.
The pricing of debt is a function of its placement in the capital structure and seniority in terms of priority of repayment in the case of liquidation.
Unlike bonds, bank debt is priced at a floating rate, meaning that its pricing is tied to a lending benchmark, most frequently LIBOR plus a specified spread.
For example, if a bank debt is priced at “LIBOR + 400 basis points”, this means the interest rate is the rate at which LIBOR is at the present moment plus 4.0%.
In addition, floating-rate instruments normally have a LIBOR floor to protect the investor against very low-interest-rate environments and to make sure they receive a minimum yield that satisfies their threshold.
Continuing off the previous example, if the LIBOR floor is 2.0%, that means that the interest rate cannot dip below 6.0% (i.e. downside protection for the debt investor).
Floating vs. Fixed Rates
To ensure you not only understand the difference between floating and fixed debt pricing but also understand when each would be preferable from the perspective of a debt investor, answer the question below:
Q. “When would a debt investor prefer fixed rates over floating rates (and vice versa)?”
- Falling Interest Rates: If interest rates are expected to fall in the near-term future, investors would prefer fixed rates
- Rising Interest Rates: If interest rates are expected to increase, however, investors would prefer floating rates instead
Flexibility of Structuring Bank Debt
There are a number of ways that bank debt can be structured that end up being a fit for both the bank and the borrower. Structuring bank debt can be flexible because of the bilateral nature of the product.
The only two parties to a contract are:
- Corporate Borrower
- Lending Bank(s)
In effect, the loan can accordingly be tailored to meet the needs of both.
In recent years, the willingness of banks (which are known to be less lenient on debt terms) has loosened up a bit due to the rise of other lenders, such as direct lenders. This is the reason behind the increase in “covenant-lite” loans.
No Prepayment Penalties (or Minimal Fees)
In addition, most bank debt with the exception of certain term loans or mortgages will have limited or less onerous prepayment penalties (subordinated secured credit may have higher prepayment penalties).
For example, revolvers (similar function as credit cards) can be paid down at any time, causing interest expense to go down due to a lower outstanding balance.
This offers flexibility for operations if cash flows from the business are stronger than expected (and in the reversed scenario as well).
Bank debt, especially bilateral loans, can also be more structured – with concessions made in terms of interest in exchange for tighter terms or vice versa (the smaller the borrower, the less wiggle room there is for negotiation).
Confidentiality in Filings
The final pro for bank debt is how they are generally confidential, which can be favorable to borrowers who want to limit the amount of publicly disclosed information.
Even if the borrower publicly uploads credit documents such as the loan agreement, bankers will want commercial terms such as pricing or quantum of commitments to be redacted from the filings.
Institutionalized, Risk-Averse Investor Base
While this can be arguably a pro or a con depending on the circumstances, the investor base for bank debt is comprised of commercial banks, hedge funds/credit funds (often opportunistic investments), and collateralized loan obligations (“CLOs”).
Bank lenders tend to place more weight on downside protection and reducing risk, which indirectly leads to the borrower making more risk-averse decisions.
For larger firms who can access investment banking services and public debt capital markets in developed economies such as the US or the UK, bonds often become more relevant as a funding source due to their function as a slightly more permanent piece of capital with fewer restrictions on operations.
For the largest and most sophisticated firms, it is not uncommon to see that most of their debt is comprised of unsecured notes/bonds, with most of their outstanding bank debt being characterized by fairly loose covenants in line with the bonds (i.e. less stringent terms).
The investor universe for corporate bonds includes hedge funds, bond mutual funds, insurers, and HNW investors – with the fixed income nature of returns being appropriate for their investing mandates.
But the “yield-chasing” aspect of lending is more prevalent in the corporate bond market, although this is the minority as opposed to the majority.