The debt capital markets (DCM) teams of investment banks work in a fast-paced environment, which is unusual for an advisory role in the sector. While the mergers & acquisitions (M&A) and equity capital markets (ECM) teams focus on a long-term, slow-moving, pipeline, DCM bankers rely much more on volume.
Issuing debt capital can be easier than financing through equity (the interest payments are fixed, regular and tax-exempt) and can allow a company to expand its profits indefinitely – provided the revenue it makes from investing the capital exceeds the costs of paying interest on it. National and local governments also finance some of their operations with debt.
If you work within a DCM team at an investment bank, you’ll be dealing with saleable units of debt called bonds, which pay interest and are typically issued for long-term periods rather than paid off within a year. DCM teams help clients to raise new debt or refinance/reissue existing debt after the initial bond has reached maturity. And they provide access to a global pool of debt investors.
As with equity capital, DCM is divided into primary and secondary markets. Bonds are initially sold directly by companies or governments on primary markets at a price set by the issuer. In the more active secondary markets, however, the issuer has no control over price, which is set by supply and demand and may be higher or lower than the original value
DCM is also called the fixed-income market because most bonds pay a fixed amount in interest until their redemption date (i.e. when the original issuer has to pay back the money on the bond to whoever owns it at that time). For example, a bond worth $100 might pay out $10 a year, making the interest rate, or yield, 10%. The yield on the bond is inversely related to the price the bond is bought or sold for, meaning if the price of the bond falls, then its yield rises. Even though its price on the market may fluctuate, its face value remains the same and at the end of the fixed period it can be redeemed for the price it was issued at, in this case $100.
As a financing tool, debt capital does have its disadvantages compared to equity: unlike dividends, interest payments to bondholders must be met in full and on time. If debt makes up a large part of a company’s capital structure during a business downturn, for example, the cost of serving the interest could potentially push the company into bankruptcy.
Bond markets dwarf equity issuance – there were $3.27 trillion-worth of debt deals globally in the first half of 2015, according to Dealogic, versus $545.1bn in equity markets. Bonds also come in all shapes and sizes in order to serve different purposes for issuers and to appeal to different types of investors. Here are some of the main categories:
Investment-grade bonds: These bonds make up most of the debt market. They carry a comparatively low risk of the issuer defaulting on its payment obligations, so they pay a lower interest rate. A bond is considered investment grade if its credit rating is BBB- or higher by Standard & Poor’s or Baa3 or higher by fellow rating agency Moody’s. The money raised from investment-grade bonds typically goes towards funding working capital and business operations.
High-yield bonds (as known as junk bonds): As the name implies, these bonds pay a higher interest rate that their investment-grade counterparts – investors can expect at least 150 to 300 basis points greater yield. But they are also considered a more dangerous investment because they are issued by companies that are more likely to default and can’t acquire capital more cheaply. High-yield bonds come with a credit rating below ‘BBB’ from S&P and below ‘Baa’ from Moody’s. They are often used in more exotic transactions such as leveraged buyouts and dividend recaps.
Government bonds: National governments also sell bonds, usually denominated in their domestic currency, to investors to fund their operations. Government bonds are typically called Treasury bonds in the US and gilts in the UK. They are seen as safer than corporate bonds, but their terms still depend on how creditworthy the market determines them to be. US Treasury bonds are considered the closest to being risk free, while those issued by Greece have been put at the opposite end of the spectrum recently because of the country’s debt crisis.
Emerging markets bonds: These are issued in less developed countries, mainly by governments rather than companies. Increased economic and political risks mean they tend to have a lower credit rating than other government bonds.
Municipal bonds: The US boasts a big market for municipal bonds, which are issued by a variety of local governmental bodies, including cities, school districts, counties and even publicly owned airports and seaports.
Convertible bonds: They have most of the features of ordinary bonds but investors can choose to convert them into a predetermined amount of the issuing company’s equity at certain times during their life. They typically offer lower interest rates in exchange for the benefit of convertibility. Companies often issue these bonds because the alternative, issuing stock, may create the impression that their share price is overvalued.
Covered bonds: Backed by cash flows from mortgages or public sector loans, covered bonds can be a lower-cost alternative for companies wanting to expand without issuing a normal unsecured bond.