2) Bond market participants

Question 1

What are Credit rating agencies?

Answer 1

Provide bond ratings → Indication of the default risk inherent to the bond.

Question 2

What are the functions of Credit Rating Agencies? (2)

Answer 2

• Evaluate issuer and put a rating on the bond (Controversial → Paid by the issuer)
• Investors use ratings to decide on YTM & whether to invest or not (Poor rating = higher YTM)

Question 3

Who are the credit rating agencies? (3)

Answer 3

1) Moody
2) Standard and poor (S&P)
3) Fitch

Question 4

What are credit ratings assigned on? (3)

Answer 4

1) Company/issuer analysis : financial position, management, SWOT, etc.
2) Debt characteristics : the specific assets and or revenue sources securing the bond
3) Economic characteristics

Question 5

Who are the major issuers/borrowers? (4)

Answer 5

1) Governments: Budget deficits, projects

2) Parastatals & Municipalities: To fund investments e.g. Transnet, Eskom, etc.

3) Corporates: To fund investments e.g. Barloworld, Anglo American

4) Banks: To fund their lending portfolio E.g. ABSA, FNB, Investec

Question 6

Who are the major investors/lenders? (3)

Answer 6

1) Pension funds & Hedge funds
2) Asset managers e.g. unit trusts, Old Mutual, etc.
3) Banks: Market-making, trading accounts and liquid asset requirements e.g. ABSA, FNB

Question 7

What are intermediaries?

Answer 7

Provide a service to the issuers and also known as the in-between issuers and investors

Question 8

Who are the intermediaries? (4)

Answer 8

• Investment banks & security houses/brokers
• Most important when bonds issued for the 1st time
• Hired by issuer to be the middleman
• Hired to market bond, advise issuers (coupon rate, YTM, etc), deal with all documentation,
  underwrite the bond

Question 9

What are government/ treasury bonds?

Answer 9

Governments issue bonds (debt) to finance their budget deficits, capital projects, etc.

Question 10

What are the characteristics of government bonds? (4)

Answer 10

• Maturities between 10 & 30 years
• Interest and principal repaid from taxes.
• Used as a benchmark to determine YTM of other bonds.
• Risk free (default risk):

Question 11

Why are governemtn bonds used as a benchmark to determine YTM? (3)

Answer 11

• Risk free (default risk)
• Very liquid; easy to buy & sell.
• Interest rate risk still applies.

Question 12

Why are government bonds considered risk free? (4)

Answer 12

• Government can print more money to pay bonds and debt (issuer is in control)
• They can raise taxes
• They can sell state resources to get money
• The government can even tax your debt amounts (make rules as they wish).

Question 13

What are corporate bonds?

Answer 13

Issued by companies (private & public)

Question 14

What are the characteristics of corporate bonds? (3)

Answer 14

• Riskier than government bonds
• Higher yield than government bonds; Investors want higher return because of default risk
• Difference between the two yields = yield spread

Question 15

What are the factors affecting yield spread between government and corporate bonds? (3)

Answer 15

• Default risk: Risk that a lender takes on in the chance that a borrower will be unable to make the required payments on their debt obligation
• Tax premium: Investors want additional return because government bonds are not taxed but corporate bonds are (coupon)
• Liquidity risk premium: Government bonds are more liquid and the lack of liquidity when compared to
  corporate bond is another reason investors demand higher return.

Question 16

What are factors that drive a bonds credit rating? (5)

Answer 16

1. Revenue & spending – fiscal strength
2. Debt
3. Economic growth
4. Labor market dynamics
5. Financial statements of a firm

Question 17

Why are these factors selected when analysing the credit worthiness of a bond?

Answer 17

Note: All factors considered when assigning a rating will influence the cash generating capacity, revenue & expenses of the company.

Question 18

To what extent are credit ratings relevant to intermediaries? (3)

Answer 18

1) Helps them see where the YTM is; as they use YTM to set coupon rate.

2) Intermediaries offer underwriting services.
- Use ratings to decide whether to underwrite or not.
- Bad rating → won’t underwrite.

3) They assist in determining the RRR (Required rate of return)

Question 19

What are the bond rating symbols? (3)

Answer 19

• AAA or Aaa = good ability to raise finanance at lower interest rates
• Ba or BB = Lower rated bonds have higher potential for higher returns but more risk
• Above black line = investment grade
• Below black line = non-investment grade 9speculative)