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Introduction To Bonds Notes

LPC Law Notes > Corporate Finance Notes

This is an extract of our Introduction To Bonds document, which we sell as part of our Corporate Finance Notes collection written by the top tier of Cambridge And Oxilp And College Of Law students.

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Corporate Finance: SGS 9: Introduction to Bonds INDEX OF ABBREVIATIONS
- RIE - Recognised Investment Exchange
- IPO - Initial Public Offering
- PR - Prospectus Rules
- LR - Listing Rules
- DTR - Disclosure Guidance and Transparency Rules
- LP - Listing Principles
- PLP - Premium Listing Principles
- FSMA 2000 - Financial Services and Markets Act 2000
- RAO - Financial Services and Markets Act 2000 Regulated Activities Order 2001
- FPO - Financial Services and Markets Act 2000 Financial Promotions Order 2005
- MAR - Market Abuse Regulations
- CJA - Criminal Justice Act 2002
- FSA - Financial Services Act 2012
- UK CGC - UK Corporate Governance Code
- RCF - Revolving Credit Facility
- LSE - London Stock Exchange
- AIM - Alternative Investment Market
- FCA - Financial Conduct Authority
- MAC - Material Adverse Change
- EoD - Event of Default NATURE AND CHARACTERISTICS OF BONDS
- Capital Markets - Markets on which capital is raised + where borrower seeking capital is matched with lender willing/able to provide such capital.
- Debt Capital Markets - Markets on which BONDS are bought/sold - increasingly popular source of capital post 2008 financial crisis + due to unpredictability/instability of stock markets.
- Bonds - Form of debt security issued in connection with borrowing arrangement whereby loan advanced for specific term + is repayable on maturity date.
- Borrower (issuer) sells bond certificate to 1/more lenders (investors/bondholders) for specified amount of cash.
- Bond Certificate - States that loan made to issuer for PAR VALUE/PRINCIPAL AMOUNT stated on bond certificate.
- Issuer pays interest (COUPON) over life of bond + when bond matures, issuer must repay par value/principal amount to holder of bond at maturity date.
- Form of Debt - Bond is a form of debt + appears on issuer's balance sheet as a current liability (maturity date within 1 year) or non-current liability (maturity date over 1 year from date of balance sheet) - do NOT give investor voting/other equity related rights at meetings of issuer's shareholders.
- 'Principal Amount' - Also known as 'par value,' 'nominal value,' 'face value' and 'redemption value' - amount stated on bond certificate as the amount repayable under the bond on the maturity date.
- Maturity Date - 'Final Redemption Date' - Date on which term of bond lapses + issuer must pay back principal amount borrowed to holder of bond certificate on that date (subject to early redemption at instance of issuer/investor where permitted by terms of the bond).
- Perpetual/Undated Bond - Bond with no maturity/redemption date - investor can only recover principal amount by selling bond to another investor OR if issuer unilaterally elects to redeem the bond.
- Interest/Coupon - Interest paid by issuer to investor in relation to specified interest periods during lifetime of bond - interest expressed as a percentage of the principal amount of the bond - 4 interest rate options possible: (1) Fixed Rate Bonds - 'Plain Vanilla Bonds' - rate of interest fixed at specific percentage of principal amount which CANNOT be changed during term of bond. (2) Floating Rate Bonds - Interest rate set as aggregate of chosen base rate (e.g. LIBOR) + additional small percentage (investor's margin) so that rate of interest fluctuates according to changes in chosen base rate whilst preserving investor's margin. (3) Variable Rate Bonds - Rates of interest fixed at outset BUT vary in accordance with pre-determined schedule throughout the term of the bond (e.g. 5% for first 2 years, 4% for next 3 years and 3% thereafter until maturity date). (4) Zero-Coupon Bonds - Bonds sold without agreement for issuer to pay interest on principal amount to investor
- bond sold (i.e. amount issuer receives) at a substantial discount to principal amount BUT issuer required to pay full principal amount on maturity date so that investor's return derived solely from difference between discounted price paid for the bond and the full principal amount received on maturity/redemption date.
- Marketability - How easily/readily bonds may be traded on debt capital markets - if bonds are highly marketable they are low-risk investments as investor knows they can readily/easily realise their investment by selling bond on market, leading to increased demand for bonds and lower interest rates - opposite effect for less marketable bonds (i.e. 1

greater risk due to inability to readily realise investment meaning that investor will demand higher rates of interest in order to purchase bonds).
- Security - Majority of bonds are NOT secured + investors rely on pari passu ranking in order of payment on insolvency + negative pledge clauses for protection against claims of issuer's other creditors.
- Payments Free of Withholding Tax - Issuer will normally undertake to make all interest payments free of tax.
- Where issuer required by law to withhold tax on interest payment to investor (i.e. pay interest NET of tax), terms of bond will usually require the issuer to GROSS UP interest payment so that investor does not receive less interest than initially agrees as a result of tax deductions.
- Issuers will generally refuse to issue bonds subject to tax laws which require withholding of tax + will demand terms of bond allow for redemption of bond if applicable tax laws change to require withholding of tax due to onerous obligation grossing up places on issuer.
- Quoted Eurobond Exception - Interest can be paid GROSS of tax by UK issuers on quoted Eurobonds (bonds listed on recognised investment exchange).
- Issuers - Borrowers - companies/governments/banks/supranational organisations/public authorities.
- Investors - Lenders - Bonds usually sold on primary debt capital markets to banks underwriting bond issue + then sold on to banks/financial institutions/high-net-worth individuals on secondary market - investors either retain bonds until maturity OR sell bonds on debt capital markets to realise investment prior to maturity date. WHY ISSUE BONDS?
(1) Advantages of Raising Finance Through Bond Issues (a) Greater Range of Investors - Globalisation of debt capital markets allows issuers access to large/diverse pool of funds/investors meaning that issuers with larger financing needs are more likely to obtain required amounts of capital.
- Minimum size of bond issue generally smaller than minimum amount of a loan issue so greater range of investors financially capable of investing in bonds. (b) Lower Financing Costs - Broader investor base (i.e. greater number of participants in bond markets) + fewer restrictions on transfers of bonds makes bonds more marketable/liquid than loans - reduces risk for investors who will be able to realise their investments more easily by selling bonds they hold on debt capital markets - makes bonds easier to issue and reduces interest rates payable due to fact that lower risk investments do not have to offer as large returns to attract investors. (c) Greater Flexibility - Issuer can deal in variety of currencies (i.e. take advantage of currency swaps to reduce cost of borrowing) + can deal with greater range of investors, rather than just banks/institutional investors.
- Bond terms usually contain less onerous undertakings/financial covenants/events of default clauses due to lower risk of default amongst bond issuers.
- Market size/range of investors allows for greater flexibility in relation to size/maturity/interest on bonds compared to most commercial loans.
- Issuers issuing bonds at a fixed rate of interest can take advantage of lower rate of interest for duration of bond term even if market interest rates rise during the bond term. (2) Disadvantages of Raising Finance Through Bonds (a) Credit Rating - Bond markets generally only accessible to issuers with good credit rating (i.e. 'investment grade companies') - excludes many potential issuers. (b) Greater Publicity - Greater disclosure/publicity associated with bond issue given that many bonds are listed - corporate acquisition often financed by way of loan finance rather than bond issue due to need for confidentiality offered by loan finance process prior to completion BUT buyer may then refinance the loan by way of corporate bond issue after completion once need for confidentiality has ceased. (c) Greater Regulation - Fact that majority of Eurobonds are listed means that there are more regulatory requirements to comply with (e.g. disclosure/continuing obligations) than in case of loan finance. (d) Higher Transaction Costs - Initial transaction costs are higher for bond issuer than for borrower under loan agreement due to greater number of documents/parties/regulatory requirements involved. (e) Lengthier Process - Greater number of parties involved + greater number of documents to be drafted + greater number of regulatory requirements to comply with means that bond issues generally take longer than negotiation of loan agreement BUT time can be saved if bond issue effected by way of a PROGRAMME. (f) Relationship with Investors - Smaller number of lenders under loan agreement than there are investors in bond issue which can make it more difficult to maintain good communications/relations with all investors on a bond issue, which can reduce likelihood of investors re-investing in further bond issues by the issuer in the future. BOND MARKETS
- Debt Capital Markets - Forum for bond trading where issuers/borrowers seeking capital are matched with investors who possess capital and are seeking to generate a return on that capital by lending it to issuers.
- Eurocurrency - Any currency held OUTSIDE country of country of origin (e.g. Eurodollars are US Dollars held outside the USA).
- Eurobond - Bond targeted at international market because it is either: (a) denominated in a Eurocurrency (i.e. currency other than currency of place of issue - UK company proposing UK bond issue in US Dollars); or 2

(b) denominated in currency of place of issue but sold to international investors outside the place of issue (e.g. UK company issuing Sterling bonds to US investors).
- Primary Debt Capital Markets - Market on which newly issued bonds sold by issuer to first investors - usually involves sale of bonds to banks underwriting the bond issue.
- Secondary Debt Capital Markets - Market for all subsequent dealings in bonds - issuers NOT involved in bond dealings on secondary market BUT banks/financial institutions which purchase bonds on primary market act as brokers on secondary market when selling on those bonds to other investors.
- Liquidity of Bond - Key to ensuring that bond markets function effectively + that bonds are desirable to investors - free transferability of bonds also a requirement for clearing/listing of bonds.
- Bearer Bonds - Transfer of bond effected by way of delivery alone - no other formality requirements apply.
- Registered Bonds - Transferee's name must be registered in register of bondholders for legal ownership of bond to transfer from transferor to transferee.
- Selling Restrictions - Laws in particular jurisdictions which regulate the offer/sale of debt securities within those jurisdictions - restrict the way in which/to whom bonds may be sold within that jurisdiction.
- Aim to protect investors and prevent tax evasion by requiring bonds sold in that jurisdiction to be approved by securities regulators/comply with rules prescribed by securities regulators (e.g. requirement for listing procedure to be followed or for sale to be restricted to sophisticated investors only).
- UK selling restrictions derive from FSMA 2000 + EU Prospectus Directive + Prospectus Rules.
- Selling restrictions include contractual restrictions imposed on the bond issuer in order to avoid breach of applicable selling restrictions in jurisdictions where the issue is taking place. TYPES & FORM OF BONDS + CREDIT RATING (1) Types of Bond
- 'Plain Vanilla Bond' - Debt security with simple, usually fixed-rate, interest payment schedule which matures at par value on single maturity date with no additional features (e.g. limits on interest payments + linking interest rate/principal amount to performance of another asset + adjusting interest rate by reference to specified base rate).
- Equity Linked Bonds - Bonds issued by a company which are LINKED to shares in that company - 2 forms: (a) Convertible Bond - Allows/requires investors to return bond to issuer at future date in exchange for issue of SHARES IN THE ISSUING COMPANY ONLY to the investor - investor ceases to be a creditor and becomes a member of the company with equity-related rights in issuing company. (b) Exchangeable Bond - Investor has the right to exchange bonds for shares in company OTHER THAN ISSUER (e.g. issuer's parent company).
- Government/Sovereign Bonds - Bonds issued by national governments - generally considered very low risk as government can use other means of raising capital in order to fund interest payments/repayment of principal amount on maturity (e.g. raising taxes/quantitative easing) BUT risk associated with some sovereign bonds has increased postfinancial crisis (e.g. Greek default).
- Notes - Not legally distinguishable from bonds BUT traditional distinction between (a) Bonds - Debt securities with fixed rate of interest + term of 3 years or more; and (b) Notes - Debt securities with fixed/floating rate of interest + term of less than 3 years.
- Medium Term Note (MTN) Programmes - Used by large companies which frequently issue bonds to allow for quick/easy access to debt finance through debt capital markets - involves agreement between issuer and banks pursuant to which banks agree to manage a series of bond issues by that issuer up to a maximum aggregate amount.
- Base Prospectus - Master offering document produced by issuer which applies to all issues throughout the MTN Programme.
- Final terms - Published in addition to base prospectus prior to each specific issue in course of MTN Programme
+ applies to/defines terms of that specific issue.
- Commercial Paper - Short-term debt security of less than 12 months issued by companies as part of an MTN Programme. (2) Forms of Bonds
- Bearer Bond - Bond transferable by delivery alone with no other formality required - whoever is in possession of the bond is deemed to be the owner and is entitled to interest payments + person in possession of bond on maturity date entitled to payment of principal amount from issuer.
- Registered Bond - Bond where legal ownership passes only when transferee's name entered on register of bondholders held by issuer - registered bond holder entitled to interest payments + payment of principal amount by issuer on maturity date.
- Global Bonds - Certificate representing total aggregate value of bonds issued in course of a single issue.
- EU Prospectus Directive 2003: 'Retail Issue' - Bonds issued in minimum denominations of LESS THAN EU100,000 or equivalent in other currencies (e.g. bond issue with aggregate value of PS30 million effected by way of issue of bonds individually worth PS10,000).
- Definitive Bond - Bearer/registered bond which is in PAPER CERTIFICATE FORM - few bonds held in this way due to dematerialisation of bond markets + increased use of electronic clearing systems. 3

(3) Credit Rating
- Credit Rating Agencies - Moody's + Standard & Poors + Fitch - credit rating agencies rate issuers/bond issuers on basis of risk of default - smaller the risk of default the better the credit rating.
- Credit ratings given on scale ranging from 'AAA' to D on basis of risk associated with issuer/issue (e.g. secured issue will carry less risk and receive higher credit rating).
- Credit rating agencies provide rating at request of issuer + monitor market throughout bond term and make revisions to credit rating in response to developments affecting the issuer/market which may affect issuer's ability to pay interest/repay principal amount on maturity.
- Sub-Investment Grade Bonds - 'High yield' or 'junk bonds' - bonds with credit rating of below BBB - considered speculative investment with greater risk of default by issuer on interest payments/repayment of principal amount on maturity.
- Consequences of Credit Rating - Ratings act as primary indicator of risk for investors + investors generally demand greater rate of interest for bonds with lower credit rating due to higher risk - financial institutions often not permitted to hold any/more than prescribed number of sub-investment grade bonds to minimise exposure to issuers/bonds with high risk of default.
- Not Compulsory - Issuer does NOT have to seek a credit rating for a bond issue + must apply to credit rating agency for a rating. (4) Clearing Systems
- Clearing Systems - Institutions used by capital debt markets to electronically record transactions + collect interest/other payments on behalf of bondholders and take custody of global bonds - avoids need for transfer of paper consideration/bond certificates.
- Participants - Major banks/financial institutions own/finance/use clearing systems - smaller/individual investors acquiring bonds on secondary debt capital markets do NOT have accounts clearing systems.
- ISIN/CUSIP Number - Unique number allocated to bond issue to allow it to be identified in electronic clearing system.
- Depository Trust Company (DTC) - Main clearing system in US.
- Euroclear/Clearstream - Main clearing systems in Europe on which majority of Eurobonds held - most major banks/financial institutions have accounts with both Euroclear/Clearstream + Euroclear/Clearstream have accounts with each other to facilitate transfers between the two clearing systems.
- Depository - Financial institution appointed by clearing system to act as custodian of global bonds ('common depository' is a bond depository jointly appointed by both Euroclear/Clearstream).
- Classic Global Note Structure - Once issued, global bond will be delivered to appointed global bond depository which will hold/safeguard global bond on behalf of clearing system - individual bonds then sold to investors on primary debt capital markets and traded on secondary debt capital markets - trading of bonds usually by electronic transfer on clearing systems. PARTIES INVOLVED IN BOND ISSUES (1) Main Parties
- Issuer - Borrower issuing/selling bonds - may be company/government/public authority/bank/supranational organisation.
- Guarantor - 3rd party which guarantees issuer's obligations under terms of the bond issue - often another group company/parent company in case of corporate bond issue.
- Investor - Lender to whom bond issued/sold - bonds usually sold to banks underwriting bond issue on primary debt capital markets before then being sold on to other banks/institutional investors/high-net-worth individuals on secondary debt capital markets.
- Investors either retain bonds to receive interest payments/repayment of principal amount by issuer on maturity OR sell bonds on secondary debt capital markets to other investors in order to realise their investment prior to maturity date. (2) Managers
- Lead Manager - Generally an investment bank which acts as issuer's relationship bank or has obtained mandate from issuer after approaching issuer with business plan - prestigious position for which banks charge large fees BUT position of risk as lead manager takes ultimate responsibility for success/failure of the issue (i.e. substantial reputational damage is bond issue unsuccessful).
- Co-Managers - Collection of banks which assist bank acting as Lead Manager with management/underwriting of bond issue.
- Function 1: Assessing/Advising - Lead manager assesses market risk + advises issuer on structure/timing/pricing/
target market in relation to the bond issue after considering factors such as: terms of bond + identity of issuer + market conditions - aims to advise issuer on the cheapest way of raising the amount of capital required.
- Function 2: Managing Issue - Lead manager responsible for managing bond issue, including: (a) forming underwriting syndicate ('building the book'); (b) negotiating documents + ensuring that all conditions precedents satisfied + advising on choice of law/jurisdiction; 4

(c) conducting due diligence; (d) organising roadshows for institutional investors; (e) advising on appointment of trustee/fiscal agent/lawyers; and (f) co-ordinating different stages of bond issue (e.g. launch/signing/listing/closing).
- Function 3: Forming Syndicate - Lead manager forms group of banks who underwrite issue by agreeing to buy bonds from issuer on primary debt capital markets - members of syndicate will then resell bonds to investors in secondary debt capital markets.
- 'Building the Book' - Process conducted by lead manager as soon as it has obtained mandate from issuer - lead manager contacts other banks to determine whether they would be interested in participating in the syndicate and buying bonds/underwriting bond issue.
- Allows lead manager to advise on 'pricing of bond' = setting interest rate offered by issuer at correct level to balance need for issuer to obtain finance as cheaply as possible against need to make sure bonds are attractive to investors with interest rate reflecting level of risk associated with the issuer/bond issue.
- Greater the demand from investors the lower the proposed interest rate BUT lower the demand from investors the higher the proposed interest rate (may also result in lead manager advising the issuer to alter the terms of the bond issue to make the bonds more attractive to potential investors).
- Function 4: Liaising with Listing Authority - If issuer listing the bond then lead manager will liaise with relevant listing authorities (UKLA for listings in UK) by providing documents to listing authority + advising issuer on compliance with listing rules/procedures.

(3) Fiscal Agent or Trustee
- Fiscal Agent/Trustee - Entity appointed by issuer to administer bond issue until maturity of bond + ensure smooth operation of bond throughout its term.
- Fiscal Agent (Issuer's Representative) - Bank appointed by issuer with powers of fiscal agent set out in Fiscal Agency Agreement.
- Fiscal agent administers payment of interest/principal amount on behalf of issuers which are not capable of making payments directly to bondholders + act as principal paying agent for such issuers.
- Performs administrative functions such as: publishing notices to bondholders + acting as depository for issuer's financial information + maintaining records relating to bond issue.
- Does NOT OWE A DUTY OF CARE to bondholders - generally CHEAPER than a trustee + generally used to administer bonds on Eurobond markets.
- Trustee (Bondholder's Representative) - Professional trust corporation (division of bank or independent trust corporation) with powers recorded in trust deed - appointed by issuer BUT represents interests of bondholders + owes common law DUTY OF CARE to bondholders in relation to exercise of its powers (unlike a fiscal agent).
- Similar administrative powers to fiscal agents (e.g. acting as depository for issuer's financial information + issuing notices to bondholders) BUT will NOT administer scheduled payments to bondholders on behalf of issuers (unlike fiscal agents).
- Trustees have greater powers to act on behalf of bondholders (e.g. calling default + agreeing to minor nonprejudicial matters on behalf of bondholders) BUT will usually only act on express instructions of bondholders to reduce risk of liability to bondholders.
- Where trustee appointed, bondholders CANNOT sue issuer directly and must act through the trustee.
- Fiscal Agent or Trustee: Relevant Factors - Factors relevant to issuer's decision as to whether to appoint fiscal agent or trustee include: (a) Security - Where bond issue secured, trustee holds security on behalf of bondholders (who will change as bonds traded) - allows bondholders at any one time to benefit from beneficial interest in security, legal title to which is held by the trustee - ensures that bondholders benefit from security interest without need for formal transfer of security interest every time bond traded.
- Fiscal agent CANNOT hold security interests on behalf of bondholders because it acts as issuer's agent.
- Where bond issue secured, a TRUSTEE MUST BE APPOINTED to hold security interest on behalf of bondholders. (b) Non-Standard Bonds - Issue of convertible bonds or bonds with complex financial covenants usually involve appointment of TRUSTEE due to trustee's ability to represent bondholders/act on bondholder's behalf during conversion of bonds/in relation to issues arising out of complex financial covenants. (c) Subordination - Terms of issuer's bond may require it to make full payment of sums due under one set of bonds before making payments in respect of another set of issued bonds OR bond issue may be structured in tranches, with some tranches ranked above others in order of repayment.
- TRUSTEE acting on behalf of bondholders may be appointed to enforce/coordinate compliance with subordination scheme BUT will NOT making payments on behalf of issuer.
- NOT essential to appoint trustee where bond issue involves subordination of payments as subordination can be provided for in terms of bond issue and applied by fiscal agent when making payments to bondholders on behalf of issuer. 5

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