4.) Raising Capital through Debt Instruments - Interest Bearing Securities Flashcards
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A medium to long-term debt security. Typical maturity I.e. repayment of a bond is more than one year from its original issue date
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A bond is a MEDIUM to LONG-term debt security. Typical maturity I.e. repayment of a bond is MORE THAN one year from its original issue date
A bill is a SHORT-term debt security. Typical maturity, I.e. repayment of a bill is LESS THAN one year from its original issue date
Note difference in maturity dates between bonds and bills
Define the different types of debenture
If it’s a secured debt instrument given over specific assets, it’s known as a ‘fixed charge’
If the instrument is secured over a class of assets, it’s known as a ‘floating charge’
Define loan stock
Loan stock usually refers to unsecured debt securities. The stockholder has no legal charge over any of the company’s assets. To provide assurances to the stockholder, it is usual that loan stock is guaranteed by a parent company to ensure timely payment of interest and capital
Loan stocks, like debentures, usually carry a fixed coupon and have a redemption date
Define and briefly describe debt securities
Tradable instruments issued to investors in return for borrowed funds. Thee instruments pay a rate of interest (coupon) on a six-monthly basis. The capital amount (principal) is repaid in full at some point in the future
Define coupon
The annual interest rate paid on a bond, expressed as a percentage of the face value.
It is also referred to as the “coupon rate,” “coupon percent rate” and “nominal yield.”
Define a bond
A medium to long-term debt security. Typical maturity I.e. repayment of a bond is more than one year from its original issue date
Define a bill
A short-term debt security. Typical maturity, I.e. repayment of a bill is less than one year from its original issue date
Describe the difference between a bond and a bill
A bond is a MEDIUM to LONG-term debt security. Typical maturity I.e. repayment of a bond is MORE THAN one year from its original issue date
A bill is a SHORT-term debt security. Typical maturity, I.e. repayment of a bill is LESS THAN one year from its original issue date
Note difference in maturity dates between bonds and bills
Define debentures
Debentures usually have some security available to the stockholder (investor) to enforce their rights against the company of the company doesn’t pay out on the coupon or principal amount.
If it’s a secured debt instrument given over specific assets, it’s known as a ‘fixed charge’
If the instrument is secured over a class of assets, it’s known as a ‘floating charge’
Debentures, like loan stocks, usually carry a fixed coupon and have a redemption date
Define loan stock
Loan stock usually refers to unsecured debt securities. The stockholder has no legal charge over any of the company’s assets. To provide assurances to the stockholder, it is usual that loan stock is guaranteed by a parent company to ensure timely payment of interest and capital
Loan stocks, like debentures, usually carry a fixed coupon and have a redemption date
Describe the difference between loan stocks and debentures
Loan stock usually refers to unsecured debt securities. The stockholder has no legal charge over any of the company’s assets. To provide assurances to the stockholder, it is usual that loan stock is guaranteed by a parent company to ensure timely payment of interest and capital
Debentures usually have some security available to the stockholder (investor) to enforce their rights against the company of the company doesn’t pay out on the coupon or principal amount.
If it’s a secured debt instrument given over specific assets, it’s known as a ‘fixed charge’
If the instrument is secured over a class of assets, it’s known as a ‘floating charge’
In terms of similarities, note that both Debentures and loan stocks usually carry a fixed coupon and have a redemption date
Briefly describe why companies issue debt instruments
To raise large sums of money
Define the most common types of debt instruments
Fixed Rate, Floating Rate and Zero Coupon Bonds
Bulldogs
Local Authority Stocks
Local Authority Fixed Loan Stocks
Local Authority Negotiable Loans
Company Loan Stock
Convertible Loan Stock
Define Fixed Rate, Floating Rate and Zero Coupon Bonds, in terms of being one of the most common debt instruments
Fixed rate bonds (straights) will pay the same rate of interest on specified dates each year until the maturity date. Floating rate bonds (variable rate bonds) will pay interest at a rate that’s adjusted on specific dates or at regular intervals.
Zero coupon bonds pay no interest
To compensate the investor for the lack of income over the life of the instrument, the final redemption price is far higher than the original issue price. This has the effect of rolling over the interest over the lifetime of the bond
Define another name for straights
Fixed rate bonds
Define another name for floating rate bonds
Variable rate bonds
Define Bulldogs, in terms of being one of the most common debt instruments
Loan stocks issued by foreign borrowers in sterling, which are traded on the London Stock Exchange
Define Local Authority Stocks, in terms of being one of the most common debt instruments
Stocks issued by UK Local Authorities (corporate stocks). These stocks are charged against the assets of the issuing Local Authority.
Interest is paid to investors net of basic income tax
Define another name for Local Authority Stocks
Corporate Stocks
Define Local Authority Fixed Loan Stocks, in terms of being one of the most common debt instruments
Fixed rate investments whose capital cannot normally be redeemed early by the investor unless a penalty charge is paid.
Interest is paid net of basic rate tax, reclaimable by non-taxpayers.
These stocks aren’t marketable
Define Local Authority Negotiable Loans, in terms of being one of the most common debt instruments
Also known as Yearlings
These bonds have a life of no more than two years.
Normally issued at par and are marketable.
Interest is paid net of basic rate tax
What are yearlings also known as?
Local Authority Negotiable Loans
Define Company Loan Stock, in terms of being one of the most common debt instruments
Tradable debt issued by companies, which may or may not be backed by specified assets held in the issuing company’s name. Interest is paid at stated intervals, and is paid net of basic rate tax. Capital gains are tax-exempt
Define Convertible Loan Stock, in terms of being one of the most common debt instruments
A fixed interest loan stock that carries the right to convert into ordinary shares on the terms and conditions set out in the company’s articles of association.
The stockholder has the right, but not the obligation, to convert within the stated time.
If conversion rights aren’t exercised by the expiry date, the stock will then revert to a conventional loan stock.
It will usually trade in the market at a premium to the equivalent ordinary shares to reflect the lower risk and greater income potential.
Companies might consider issuing convertible loan stock due to its attractiveness to investors and therefore it would have the potential to raise more capital than if it was a straight issue. It is also considered a suitable alternative to a rights issue. Interest on dent capital is paid before tax, making it a lesser net cost of the company than the issue of share capital
Describe why companies might consider issuing Convertible Loan Stock
Companies might consider issuing convertible loan stock due to its attractiveness to investors and therefore it would have the potential to raise more capital than if it was a straight issue. It is also considered a suitable alternative to a rights issue. Interest on dent capital is paid before tax, making it a lesser net cost of the company than the issue of share capital
Define a domestic bond
A domestic bond refers to one in which the nationality of the issuer, the denomination of the bond and the country of issue are all identical. E.g. A UK company issuing sterling bond in London.
Domestic markets are regulated by the domestic authorities (regulators) in order to protect investors
Define foreign bonds, and give examples
A foreign bond refers to one in which the nationality of the issuer is different to that of the denomination of the bond and the country of issue. E.g:
Yankee bonds - issued in the US market by non-US borrowers
Bulldogs - issued in the UK market by non-UK borrowers
Samurais - issued in the Japanese market by non-Japanese borrowers
Define international bonds
An international bond (Eurobond) is one in which the nationality of the issuer, the denomination of the bond and the country of issue are all different. For example, a U.K. company issuing a euro denominated bond in the USA.
Investors in almost any country can acquire Eurobonds
Interest is paid gross of any tax
They’re issued in bearer form, making them anonymous instruments
Define overseas bonds, and give examples
Foreign governments can issue an overseas bond, for example:
T Bonds: Issued by US or Canadian Government - maturity exceeding 10 years
T Notes: Issued by US or Canadian Government - maturity period 2 - 10 years
Bunds: Issued by German Government - longer term maturity, up to 30 years
OATS: Issued by French Government - Maturity of 4 - 30 years
BONOS: Issued by Spanish Government - any maturity period
Define the common features of all bond types
Bond Certificate
Interest Payments
Guaranteed Debt
Debt Status
Governing Law
Forms of Issue
Define and describe the Bond Certificate feature of bonds of all types
The certificate states the terms and conditions of the borrowing. It establishes the debt and the obligation of the issuer to repay the investor a fixed principal sum on a specified future date, I.e. the redemption date. It also states shat interest will be paid and when the investor will receive it during the life of the bond
Define and describe the Interest Payments feature of bonds of all types
The interest payable (coupon) is usually expressed as a percentage of the principal. The interest is paid up until the time that the bond is redeemed by the issuer
Define and describe the Guaranteed Debt feature of bonds of all types
Bonds are viewed as a more secure investment when compared to equities. Should the issuer go into liquidation, stockholders will be repaid BEFORE shareholders as they are creditors of the company.
Bonds are ranked in seniority of repayment in the event of liquidation of the issuer. An unsubordinated bond carries an unconditional obligation that they will be repaid ahead of obligations to all other creditors of the issuer.
Lower ranking bonds are called ‘subordinated’ or ‘junior’ bonds
Define and describe the Debt Status feature of bonds of all types
A bond can be secured against a company’s assets (debenture) giving the holder legal claim against the asset should the issuer default on the coupon or principal amount.
It can also be unsecured, giving the investor little protection
Define and describe the Governing Law feature of bonds of all types
The terms and conditions of the debt instrument are detailed on the reverse of the certificate, and both parties are entering into a legal contract.
Legal claims are adjudicated in the jurisdiction of the country under whose law the instrument was issued.
Define the Forms of Issue feature of bonds of all types
Bonds may be issued in bearer or registered form
Define and describe how bond prices are quoted
Similar to gilt prices, bond prices are generally quoted in quantities of £100 nominal value, with the yield determining the return that the investor should expect to receive
Bonds are marketable securities, with prices affected by usual market conditions - supply and demand, interest rate changes, the issuer’s credit rating, economic conditions, etc
Bond prices are quoted in terms of how much will be paid by the buyer, or received by the seller, for a nominal amount. The nominal amount represents the sum that will be paid back to the investor when the bond is redeemed
Define Flat Yield (running yield, interest yield) and the formula for calculating it
The flat yield calculates the interest return of the bond a based on its current market value. It doesn’t take into account the fact that the return on capital may be affected between the time the bond is purchased to its redemption date
The formula is:
Coupon rate divided by market rate X 100
E.g. An investor buys a bond that has a 8% coupon and is trading at a market price of £112 (per £100 nominal) with 6 years to maturity
8 divided by 112 X 100 = 7.14%
Define Redemption Yield (Yield to Redemption) and the formula for calculating it
The redemption yield takes into account the annualised gain or loss to capital encountered by the bond holder between the time of purchasing the bond and the redemption date. This is achieved by adjusting the flat field as follows:
Flat field + (par - market price) divided by years to maturity =
E.g: 7.14 + (100-112) divided by 6 = 5.14%
Note that if a bond is bought above par (100), then the redemption yield will be less than the flat yield as the annualised capital loss is deducted. If a bond is bought below par (100), then the redemption yield will be more than the flat yield ad the annualised capital gain is added
Define the main considerations specific to investment in debt instruments
As well as the investor’s tax position, investment aims, etc the main considerations specific to debt instruments include:
Interest is a debt and is payable by the company irrespective of whether profits are redeemable
The loans are redeemed at par, leaving no scope for capital gains unless the leans are purchased below par
Interest remains the same irrespective of inflation
Is the loan stock formally rated by a credit rating agency, and if so what is the rating? This will provide a useful guide as to the riskiness of the loan
Compare the interest yield and redemption yield with yields on gilts to assess whether the return warrants the extra risk when compared to a secured investment like gilts
What is the financial standing of the company?Does it appear that it can maintain its commitment to pay interest over the term of the bond and repay capital on redemption?
Is the loan secured or unsecured? What other creditors will need to be repaid in the event of liquidation?