2) Bond market participants Flashcards
Chapter 14
What are Credit rating agencies?
Provide bond ratings → Indication of the default risk inherent to the bond.
What are the functions of Credit Rating Agencies? (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)
Who are the credit rating agencies? (3)
1) Moody
2) Standard and poor (S&P)
3) Fitch
What are credit ratings assigned on? (3)
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
Who are the major issuers/borrowers? (4)
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
Who are the major investors/lenders? (3)
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
What are intermediaries?
Provide a service to the issuers and also known as the in-between issuers and investors
Who are the intermediaries? (4)
- 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
What are government/ treasury bonds?
Governments issue bonds (debt) to finance their budget deficits, capital projects, etc.
What are the characteristics of government bonds? (4)
- 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):
Why are governemtn bonds used as a benchmark to determine YTM? (3)
- Risk free (default risk)
- Very liquid; easy to buy & sell.
- Interest rate risk still applies.
Why are government bonds considered risk free? (4)
- 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).
What are corporate bonds?
Issued by companies (private & public)
What are the characteristics of corporate bonds? (3)
- Riskier than government bonds
- Higher yield than government bonds; Investors want higher return because of default risk
- Difference between the two yields = yield spread
What are the factors affecting yield spread between government and corporate bonds? (3)
- 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.
What are factors that drive a bonds credit rating? (5)
- Revenue & spending – fiscal strength
- Debt
- Economic growth
- Labor market dynamics
- Financial statements of a firm
Why are these factors selected when analysing the credit worthiness of a bond?
Note: All factors considered when assigning a rating will influence the cash generating capacity, revenue & expenses of the company.
To what extent are credit ratings relevant to intermediaries? (3)
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)
What are the bond rating symbols? (3)
- 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)
