4.) Raising Capital through Debt Instruments - Interest Bearing Securities

Question 1

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Answer 1

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

Question 2

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Answer 2

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

Question 3

Define the different types of debenture

Answer 3

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’

Question 4

Define loan stock

Answer 4

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

Question 5

Define and briefly describe debt securities

Answer 5

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

Question 6

Define coupon

Answer 6

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.”

Question 7

Define a bond

Answer 7

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

Question 8

Define a bill

Answer 8

A short-term debt security. Typical maturity, I.e. repayment of a bill is less than one year from its original issue date

Question 9

Describe the difference between a bond and a bill

Answer 9

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

Question 10

Define debentures

Answer 10

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

Question 11

Define loan stock

Answer 11

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

Question 12

Describe the difference between loan stocks and debentures

Answer 12

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

Question 13

Briefly describe why companies issue debt instruments

Answer 13

To raise large sums of money

Question 14

Define the most common types of debt instruments

Answer 14

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

Question 15

Define Fixed Rate, Floating Rate and Zero Coupon Bonds, in terms of being one of the most common debt instruments

Answer 15

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

Question 16

Define another name for straights

Answer 16

Fixed rate bonds

Question 17

Define another name for floating rate bonds

Answer 17

Variable rate bonds

Question 18

Define Bulldogs, in terms of being one of the most common debt instruments

Answer 18

Loan stocks issued by foreign borrowers in sterling, which are traded on the London Stock Exchange

Question 19

Define Local Authority Stocks, in terms of being one of the most common debt instruments

Answer 19

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

Question 20

Define another name for Local Authority Stocks

Answer 20

Corporate Stocks

Question 21

Define Local Authority Fixed Loan Stocks, in terms of being one of the most common debt instruments

Answer 21

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

Question 22

Define Local Authority Negotiable Loans, in terms of being one of the most common debt instruments

Answer 22

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

Question 23

What are yearlings also known as?

Answer 23

Local Authority Negotiable Loans

Question 24

Define Company Loan Stock, in terms of being one of the most common debt instruments

Answer 24

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

Question 25

Define Convertible Loan Stock, in terms of being one of the most common debt instruments

Answer 25

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

Question 26

Describe why companies might consider issuing Convertible Loan Stock

Answer 26

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

Question 27

Define a domestic bond

Answer 27

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

Question 28

Define foreign bonds, and give examples

Answer 28

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

Question 29

Define international bonds

Answer 29

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

Question 30

Define overseas bonds, and give examples

Answer 30

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

Question 31

Define the common features of all bond types

Answer 31

Bond Certificate

Interest Payments

Guaranteed Debt

Debt Status

Governing Law

Forms of Issue

Question 32

Define and describe the Bond Certificate feature of bonds of all types

Answer 32

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

Question 33

Define and describe the Interest Payments feature of bonds of all types

Answer 33

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

Question 34

Define and describe the Guaranteed Debt feature of bonds of all types

Answer 34

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

Question 35

Define and describe the Debt Status feature of bonds of all types

Answer 35

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

Question 36

Define and describe the Governing Law feature of bonds of all types

Answer 36

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.

Question 37

Define the Forms of Issue feature of bonds of all types

Answer 37

Bonds may be issued in bearer or registered form

Question 38

Define and describe how bond prices are quoted

Answer 38

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

Question 39

Define Flat Yield (running yield, interest yield) and the formula for calculating it

Answer 39

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%

Question 40

Define Redemption Yield (Yield to Redemption) and the formula for calculating it

Answer 40

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

Question 41

Define the main considerations specific to investment in debt instruments

Answer 41

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?