Bonds Flashcards
1
Q
- What are Bonds?
A
- A bond is a security that is issued in connection with a borrowing arrangement. It is effectively an ‘IOU’: a loan for a specific term, repayable on a specific date (the maturity date) and usually paying interest.
- · A bond is a form of debt which can be traded (bought and sold) in the capital markets.
· The bond is effectively a debt obligation represented by a certificate, also referred to as a debt security.
2
Q
- Key elements of bonds
A
- ‘Nominal/par/face/redemption value’ – each of these terms are used interchangeably to mean the amount stated on the certificate, which is generally equal to the amount repayable on maturity.
- ‘Maturity/redemption’ - the maturity or final redemption date is the date on which the issuer must pay back the principal amount borrowed. The bond terms may include provisions allowing the issuer to redeem, or the investor to require redemption of, the bond earlier than the final redemption date. The date on which this occurs is known as the redemption date. Some bonds may not have any fixed final redemption date at all. These are called undated or perpetual bonds. The investor will receive interest every year and can only get the principal back by selling the bond to another investor or if the issuer decides to redeem the bond.
- ‘Interest/coupon’ - Throughout the life of the bond the issuer will make payments of interest in relation to specified interest periods (usually annual or semi-annual payments). These payments are also known as coupon payments. The interest payable is usually expressed as a percentage of the par value. The word coupon is used to mean interest. Historically, when bearer bonds were in paper (as opposed to electronic) form, in order to be paid interest, the investor would have to detach a coupon from the bond certificate and present it to the issuer or the issuer’s paying agent to obtain payment of the interest.
- ‘Marketability’ – this relates to how easily/readily a bond can be bought and sold on the international debt capital markets. This is a fundamental concept as the marketability of bonds ensures that bonds are attractive to investors since they know they can easily realise (sell) their investment. This makes bonds a comparatively low risk and attractive investment, which in turn allows companies to raise finance more easily while paying a relatively low interest rate. When bonds are highly marketable, this makes markets very liquid. To have a highly liquid market there must be a high trading volume and a high number of debt securities.
- ‘Unsecured’ - bonds, and in particular eurobonds, are not usually secured. This is market practice. Investors rely on pari passu ranking and negative pledge undertakings in the bond terms for protection. This said, secured high yield bonds have become more prevalent as the volume of leveraged finance has grown in recent years.
- ‘Quoted eurobond exemption’- provided the bonds are listed on a recognised stock exchange (which includes the London Stock Exchange), the quoted eurobond exemption from UK withholding tax will apply. This exemption allows a UK issuer to pay gross interest on the bonds.
3
Q
- Who issues and buys bonds?
A
- Issuers ‘Borrowers’
· Corporate issuers
· Governments
· Local municipalities
· Supranational organisations
· Banks
· Public bodies
· Special purpose vehicles (SPVs) - Investors ‘Lenders’
- The first purchasers of the bonds (on the primary market) will be the banks underwriting the bond issue. The bonds will then be sold on the secondary market to other banks, financial institutions such as insurance companies and pension funds and sometimes high net worth individuals. However, we are all indirect participants as the financial institutions use funds received from individuals to buy bonds (e.g. pension funds, ISA managers, and insurance companies).
- Investors can either keep (hold) the bond until the due date or sell it (trade) to other investors on the capital markets to realise their investment earlier than the maturity date.
4
Q
A
5
Q
- Why issue and raise finance through bonds?
A
- Potential number of investors much greater as not limited to banks and others willing to hold loans:
· The globalisation of the capital markets allows issuers to have direct access to a very large and diverse pool of funds both in terms of currencies and types of investors (including institutional investors such as insurance companies and pension funds).
· The minimum denomination of securities which can be issued is frequently smaller than the smallest participation which can be taken in a syndicated loan. This increases the number of investors that can hold bonds.
· Issuers with large financing needs are more likely to obtain the required amounts. - Lower financing costs:
· The broader investor base mentioned above means the risk associated with a particular bond issue is spread out over a wide number of investors. As the interest paid by a borrower to an investor is directly linked to the risk that the investor takes, the lower the risk, the lower the interest. Therefore, bonds can provide cheaper financing for the borrower.
· Bonds are treated more favourably for capital adequacy purposes.
· Bonds are readily tradeable through international clearing systems. Although loan agreements may allow banks to transfer their loan participations to other banks, there is limited secondary trading. Since bonds are easily tradeable, investors know that they can realise their investment easily without having to wait until the maturity date. This reduces the investment risk for them and, as a result, the interest paid by the issuer is lower. - More flexibility
· Choice of currency/type of investor: since the capital markets are truly international, if it is cheaper to borrow in a particular currency, the issuer can do so even if it does not need that currency. It can then enter into a swap agreement with a bank to obtain the currency it needs. Also, it does not need to tailor its borrowing terms to appeal to banks, as there are many other types of investors in the capital markets. In particular: - Bonds have less onerous covenants: traditionally, bond terms have imposed less stringent undertakings and financial covenants on the borrower than loan agreements have. This is for two main reasons:
o historically, the companies that issued bonds were investment grade i.e. carrying a low risk of default; and
o since investors are all over the world and difficult to trace, it would be difficult for issuers to obtain waivers as needed. As a result, undertakings and covenants cannot be too restrictive in a bond issue.
· Bonds have more flexible terms: market size and the variety of investors means that size and maturity of debt can be more varied than in most commercial loans. In particular, capital market debt can often be borrowed for longer periods and at fixed rates of interest.
6
Q
- Disadvantages of raising finance through bonds
A
- Credit rating - bond markets are generally only accessible to companies with a good credit rating. This precludes many potential issuers because investors will be more willing to invest in a company with a good credit history and reputation. However there has been a growth in high yield bonds (these are bonds that are issued by companies with non-investment grade ratings).
- More public disclosure and publicity - there is far more public disclosure and publicity in relation to a bond issue (although issues are often privately placed) compared to a syndicated loan. This is one reason why acquisition finance is generally raised initially through a loan even if that loan is subsequently refinanced via a corporate bond issue, as one company intending to acquire another will need confidentiality.
- More regulation – most eurobonds (referred to later) are listed and this means that there is much more regulation (in terms of disclosure requirements and continuing obligations) than in the case of loans.
- Higher transaction cost - initial transaction costs tend to be higher in bond issues as there are more parties, more documents and more regulatory requirements involved.
- Timing: longer to put in place – the more parties involved, documents to be drafted and regulations with which to comply, the longer the bond issue can take. Note there are significant time savings in the case of a bond issued under a euro medium-term note programme (known as an EMTN programme).
- Relationship with investors - as the number of investors in a loan (the lending syndicate) is generally smaller than in the case of bonds, the borrower is more likely to be able to maintain a relationship with its investors in a loan context. This can be extremely beneficial for a company that needs further funds quickly or that needs to obtain a waiver. It is much more difficult to communicate with investors on the capital markets, and even more so to obtain a quick and effective response to satisfy the concerns of the borrower.
- Renegotiation of terms - with a loan it is possible to negotiate with the lenders if the borrower finds itself in financial difficulties. With bonds, it is unlikely the issuer will even know the identity of the investors. Renegotiating the terms of a bond is therefore a lengthy, costly and uncertain process. This process can also be fraught with complex legal questions if different classes of bondholders have different interests.
7
Q
- Where are bonds bought and sold?
A
- Capital markets are markets on which capital (i.e. finance) is raised. The markets are where those who want capital (the borrowers) and those who have capital (the lenders) can meet and be matched. There is no physical market place, rather the capital markets are made up of the global offer of cash available from investors and the global demand for cash by borrowers. Most bond trading takes place electronically, through electronic exchanges. Bond dealers and brokers buy and sell bonds over the phone or their computers. The trades are then settled through the electronic clearing systems.
- Primary/ Secondary capital markets - the primary market is where newly issued bonds are first sold by the issuer to the first investors. The first purchasers of the bonds (on the primary market) will be the banks underwriting the bond issue. The secondary market is where all subsequent sales of bonds take place.
- Domestic market - bonds sold on a domestic market are bonds denominated in the local currency of that market and sold to investors within that market by a local issuer. E.g. a Sterling denominated bond, issued in the UK by a UK registered company and sold to UK investors. The dominant issuer in most domestic markets will be the national government.
- Euro (international) market
- The prefix euro is not related to the EU currency. It is linked to the concept of eurocurrencies. A eurocurrency is a currency held outside of its country of origin. For example, euroyen is Yen held outside Japan, eurodollars are US Dollars held outside the US etc. The prefix euro is now synonymous with international. So a eurobond is a bond targeted at the international market either because it is:
· a bond denominated in a eurocurrency i.e. a currency other than that of the country of issue e.g. a UK company issues a US Dollar bond; or
· a bond denominated in the currency of its country of issue but sold to international investors (who would be using a eurocurrency to buy the bond) e.g. a Sterling denominated bond, issued in the UK and sold to Japanese investors.
8
Q
- Different interest rates on the bonds:
A
- Fixed rate bonds: the rate is fixed when the bond is issued and for the duration of the bond issue. The rate tends to be a specific percentage of the nominal value.
- Floating rate bonds: similar to a floating rate for a loan, the rate will consist of two elements. A benchmark rate, for example SONIA, plus a set percentage (the margin). The rate of interest payable on the bond will vary according to the benchmark rate at the time the interest is calculated.
- Variable rate bonds: this is a hybrid between fixed and floating rate bonds. The rates will be fixed (i.e. the investor will know from the outset what rates will be payable) but will vary over time according to a pre-determined schedule. Example: 5% for the first 3 years, 4% for the next 3 years and 3% thereafter until the final redemption date.
- Zero-coupon bonds: some bonds will pay no interest at all during their term. These are known as zero-coupon bonds. In order to make such zero-coupon bonds attractive, the bonds are issued (sold) at a deep discount - i.e. for an amount below their nominal value. At maturity, the full nominal value will then be paid back to the investor. As a result, the investor’s return comes from the difference between the issue price and the payment of par value at maturity.
- Index-linked bonds: these are bonds whose principal amount and coupon payments are linked to an index, such as inflation linked bonds which are linked to a consumer retail price index (RPI). Inflation linked bonds have their principal and coupon ‘uplifted’ to reflect inflation in line with the RPI. The investor’s return is protected against being eroded by the effects of inflation.
- Step-up bonds: these are bonds where the initial fixed interest rate moves up to another pre-determined fixed rate after a given time or on occurrence of a specified event, such a failure to fulfil one of the conditions of the bonds.
- Equity-linked bonds:
- Convertible bonds: the investor has the option (or sometimes the obligation) to hand the bond back to the issuer at a future date in exchange for shares in the issuer. At that point, the investor ceases to be a creditor of the issuer and becomes an equity holder with equity-related rights. The amount of shares received for each bond which is exchanged (the conversion ratio) and other terms relating to the conversion will be set out in the bond terms.
- Exchangeable bonds: these are similar to convertible bonds. The difference is that the bonds give the investor the right to exchange its bonds into shares of a company other than the issuer (e.g. the issuer’s parent).
- Bonds with warrants: These are bonds that have a separate feature attached to them called a warrant. The warrant gives the holder the right to call for delivery of, for example, shares of the issuer against payment of a set price at a future date or during a specified future period. The bondholder can either (i) keep the bond and the warrant and use the warrant to acquire equity on the specified date (if any), (ii) keep the bond and sell the warrant separately to another investor, or (iii) sell both the bond and warrant together.
- Sovereign bonds
· The terms of sovereign bonds (bonds issued by governments) will differ from those of corporate issued bonds due to the identity of the issuer. Debt issues by a national government have historically been considered at the lower end of the risk spectrum (or even risk-free), as a government can employ different measures to guarantee repayment. However, this picture has been somewhat dented by the recent financial crisis (in particular in the eurozone) which has seen certain governments struggle to service their debt obligations (broadly due to a combination of high existing borrowing and low economic growth), leading to default. This in turn has resulted in increases in sovereign debt borrowing costs and moves to stabilise countries at risk of default through much publicised bailouts. Sovereign governments can also enter into voluntary restructuring arrangements with its creditors if it is at risk of defaulting.
9
Q
- There is no legal difference between ‘Bonds’ and ‘Notes’ and the terms are used interchangeably. Usually:
A
· bonds are debt securities with a fixed rate of interest and a term of three years or more; and
· notes are either debt securities with a floating rate of interest (called floating rate notes or FRNs) or debt securities with a fixed rate of interest, but with a short maturity period, usually below three years.
- The term ‘Notes’ often describe more private issuances of debt securities such as private placement notes, notes issued as part of a private securitisation and loan notes issued in connection with a private equity-backed acquisition.
10
Q
- Plain vanilla bonds?
A
- This is jargon used in the markets to mean a bond that has no added features such as convertibility. It is a straight debt security and usually has a fixed interest rate.
11
Q
- High yield bonds?
A
- These bonds generally offer a bondholder a higher return on its investment than other types of bonds because they are deemed to be more risky. Such bonds are thought to carry a greater risk of the issuer defaulting on its payment obligations under the bonds. They are also known in the market as “junk bonds” or sub-investment grade bonds.
12
Q
- Global bond?
A
- Bonds can be issued in any denomination but note that bonds issued in minimum denominations of less than €100,000 (or the equivalent in other currencies) are categorised as a ‘retail’ issue and bonds issued in a minimum denomination of €100,000 or above are categorised as a ‘wholesale’ issue.
- A global bond is a word-processed certificate representing the total amount of bonds issued in a single issue. Because bonds tend to be traded electronically, individual investors now rarely receive bonds in paper form. As a result, on issue, a single global bond in certificate form is created and held by a custodian bank called the common depositary.
- A global bond may start as a temporary global bond, which can be exchanged for a permanent global bond after a certain period. Both the temporary and permanent global bonds will commonly be word-processed documents printed by the solicitors to the lead manager (the bank arranging the bond issue). The use of global bonds saves the costs involved in security printing definitive bonds. The main use of temporary global bonds is as a way of controlling the distribution of the bonds on the primary market to comply with selling restrictions
13
Q
- Bearer/registered:
A
- Bearer bond: means a bond is transferable by delivery. Whoever is in possession is the owner (like a banknote).
- Registered bond: legal ownership passes when the transferee’s name is entered into a register of bondholders held by the issuer.
- For historical reasons, bonds in Europe tend to be in bearer form, whereas in the US they tend to be registered in order to comply with US securities regulations and tax laws.
14
Q
- Definitive bond?
A
- This is the bond as it is traditionally known – i.e. in paper certificate form. A definitive bond, like a global bond, can be bearer or registered. It is security printed.
15
Q
- Transfers of bonds – key factors?
A
- Transferability – ease of transfer is essential for the bond markets to function efficiently and to make bonds attractive to investors. Other than delivery, there are no formalities to be satisfied for the legal transfer of a bearer bond. In the case of a registered bond, the transferee’s name must be registered in the register of bondholders for legal ownership to be transferred.
- Negotiability – negotiability is another essential factor to ensure bond markets function efficiently. This means a bona fide purchaser for value without notice of a prior encumbrance can take good title (i.e. possibly better than the seller’s).
- Listed/unlisted
- Selling restrictions – selling restrictions are a summary of the laws in particular jurisdictions regulating the offer and sale of debt securities in those jurisdictions. Their effect is to impose restrictions on the sale of bonds (i.e. the way the bonds are sold or to whom they can be sold) and they are enforced by securities regulators in most jurisdictions around the world. As such, they vary from country to country. The purpose of selling restrictions is to protect the issuer from inadvertently breaching local securities laws and to prevent tax evasion. Their effect is that any bond sold in a particular jurisdiction must have been approved by local regulators, which generally means going through a listing procedure. Where the issue has not been subject to such scrutiny, then the bonds cannot be sold freely. Generally, when bonds have not been listed in a particular jurisdiction, sales to sophisticated investors (meaning financial institutions and professionals) are permitted while sales to the public at large are prohibited.
- It is also important to note that selling restrictions are contractual restrictions imposed by the issuer to avoid any breach of regulations. Usually the bond documents (namely the subscription agreement, offering document and bond certificate) will contain a general selling restriction and country-specific selling restrictions for those jurisdictions where the bonds may be marketed.
- Electronic transfer – most bonds are now transferred by electronic entry through the clearing systems.
- Price of bonds
- Risk and return for investors
· When an issuer talks about pricing a bond, this generally refers to the interest rate it will offer to investors (although it may also refer to the amount the investor pays for the bond if that is not equal to the principal amount). The price at which the issuer decides to issue a bond depends on a number of factors, but the primary factor is the amount of risk involved for the investor. The higher the risk, the higher the return an investor will expect to receive. If the interest rate does not adequately reflect the risk, the bond will not sell well.
16
Q
- The starting point is the rate offered on a government security of the country of the currency of issue. This rate will then be increased depending on factors such as:
A
- The identity of the issuer: the better the financial health of the company, the lower the interest.
- The issuer’s sector of activity.
- The maturity date: the longer the loan, the higher the risk and the higher the interest.
- Extra features e.g. secured, guaranteed or equity-linked bonds: such features will allow the issuer to pay a lower interest rate.
- Prevailing market conditions and interest rates.
- Credit rating obtained from credit rating agencies (on the bond itself and the issuer).
17
Q
- Rating a bond:
A
· Issuers (including sovereign issuers) and each of their bond issues can be rated separately by institutions called credit rating agencies. The smaller the risk of default on the bond the better the rating. For example, for Standard & Poor’s the best possible rating is AAA, the worst is D. Anything below BBB- is considered to be of a speculative nature with respect to the borrower’s capacity to pay interest and repay principal. These bonds are referred to as sub-investment grade, high yield or junk bonds. Each credit rating agency has a similar scale.
· A credit rating agency will analyse the risk both of the issuer and of that particular issue. For example, a secured issue will carry less risk than a non-secured issue, even if it is by the same issuer.
18
Q
- Credit rating agencies:
A
· Three of the main credit rating agencies in the UK are Moody’s, Standard & Poor’s and Fitch. Their ratings are similar and tend to move in line with one another.
· To obtain a rating, issuers need to pay a fee and prepare a presentation about the bond issue and themselves to the agencies. The credit agency will then assign a rating to the issue.
· The credit agencies’ role is then to monitor the market throughout the life of the bonds and change their rating (by way of upgrades or downgrades) according to developments relating to the issuer and/or the markets which may affect the issuer’s ability to repay the bonds. For example, during the sovereign debt crisis, Standard & Poor’s downgraded the rating of Eurozone countries such as Portugal, Cyprus and Greece to below investment grade. The idea is that investors can rely on ratings to decide whether to invest in a bond.
· However, the credit rating agencies’ efficiency in doing this has been controversial and the agencies have been criticised. In particular, market participants considered that in a number of cases rating agencies merely followed the markets and changed their ratings when investors had already lost money and everybody knew where the risks lay. Rating agencies have also been criticised over the accuracy of their credit ratings and possible conflicts of interest.
