#15476 - Introduction To Bonds - Debt Finance

Introduction to Bonds

• Eurobond market

• Bond = debt security, "IOU" for a specific term, repayable on the maturity date.

• Borrower = issuer issues (sells) bond certificate to; lender = investor/bondholder for consideration - occasionally there will be a guarantor for the issuer

  • Made at par value/principal amount stated on bond certificate

  • Issuer pays interest (the coupon) annually or semi-annually

  • On maturity, borrower pays back par value to investor holding the bond.

    • Can have bonds with no specified maturity date.

• Depending on the length of time to maturity, a bond will appear on the issuer’s balance sheet under Non-current liabilities. If due within one year = current liabilities.

• Marketability: highly-marketable = very liquid market.

• Generally unsecured, particularly eurobonds (investors rely on pari passu ranking (order of payment on insolvency) and negative pledge undertakings for protection)

• Issuer normally undertakes that all payments will be free of withholding tax (gross-up + redemption provisions if withholding tax becomes payable)

  • Quoted eurobond exemption = no withholding tax

• Domestic market: bonds denominated in local currency (dominant issuer = national government)

• Euro(international market: eurocurrency = currency held outside country of origin. Either denominated in foreign currency or sold to foreign investors.

• Foreign bonds: bond denominated in a local currency and sold to local investors but issued by a foreign company.

• Primary capital market = newly issued bonds sold by issuer to first investors (usually the purchasers will be the underwriting banks)

• Secondary capital market = first investors sell the bond on.

Types of Bonds

• Interest rates (more options than for syndicated loans):

  1. Fixed rate bonds (most common) - % of nominal value

  2. Floating rate notes: base rate (e.g. LIBOR) + margin --> vary according to base rate

  3. Variable rate bonds: will vary according to a pre-determined schedule

  4. Zero-coupon bonds: to be attractive bonds must be issued at a deep discount, then the investor gets a return once the nominal value is paid back.

• Equity-linked

  1. Convertible bonds: investor has option/obligation to hand bond back to issuer for shares (conversion ration & other terms set out in bond docs)

2. Exchangeable bonds: right to exchange into shares of a company other than the issuer.

3. Bonds with warrants: warrant gives holder right to call for delivery of shares pf issuer against payment of a set price (warrant can be separated from the bond)

• Government/corporate:

  • Generally considered lower risk (until financial crisis)

• Notes:

  • Bonds = debt securities with fixed rate of interest (term of 3 years+)

  • Notes = securities with floating rate of interest/fixed rate but short maturity (below 3 years)

• Medium Term Note ('MTN') programmes:

  • Common for large companies who want to issue bonds frequently and quickly

  • Enter into agreement with banks to manage a series of future bond issues up to maximum aggregate amount

    • Master offering document (base prospectus)

    • Final terms for each specific bind

  • Stand alone bond issues are less common in practice.

  • Programme = costly to set up initially but has long term benefits of speed and cost effectiveness.

• Commercial paper:

  • Short term debt certificates (less than 12 months) --> cheaper than MTN

  • Not listed, less regulation

  • Tend to be issued at a discount rather than bearing interest.

• Plain vanilla bonds:

  • Bonds with no added features + fixed interest rates

Form of Bond

• Bearer: transferable by delivery (to whoever is in possession) (common in Europe)

• Registered: transferrable by registration with issuer (common in US)

• Global: certificate representing the total amount of bonds issued in a single issue (transactions in smaller values are done electronically)

  • Permanent/temporary

• Definitive: paper certificate form (few in issue)

Transfer

• Transferability = ease (bearer easier than registered)

• Negotiability = equity's darling can take good title

• Listed/unlisted = most bonds are listed

• Selling restrictions = vary between jurisdictions (strict in US) + contractual restrictions imposed by issuer to avoid breach of any regulations.

  • Financial Services and Markets Act 2000 & Prospectus Directive 2003/71/EC: need prospectus to offer to public unless "qualified investor" - s.86 FSMA

• Usually electronic transfer

Factors to assess risk & fix price

1. Identity of issuer - financial health

2. Issuer's sector of activity

3. Maturity date - longer term = higher risk

4. Extra features

5. Prevailing market conditions and interest rates

6. Credit rating from agencies on bond itself and issuer

Par value never changes but market value fluctuates - this does not affect issuer's obligations under the bond if interest rate fixed.

Credit rating:

• AAA --> D (below BBB = speculative nature)

• Moody’s, Standard & Poor’s and Fitch

• Issuers pay fee & make a presentation

  • Agency then monitors the bond throughout its life and adjusts the rating

  • Ratings are crucial = esp. since financial institutions are not permitted to hold sub-investment grade or high yield bonds.

Clearing systems: electronic book entries for bond transfers

• Owned and financed by major banks - 'participants': each have a cash and a securities account.

  • Depository = institution appointed to be custodian of global bonds.

• Individual participants hold securities through participants.

• Eurobonds = 'Euroclear' and 'Clearstream' - US = 'DTC'

Market Organisations

• International Capital Markets Association (ICMA) - quasi regulator

• Guidelines/standard documents (not legally binding but generally observed)

Roles:

• Lead manager = bank which arranges the bond (takes on prestige + reputation risk:

  • Asses and advise on risk

  • Manage entire issue procedure (underwriting syndicate)

  • Form syndicate (primary market purchasers)

  • Liaise with listing authority (UKLA)

• Fiscal agent (cheaper, useful where trustees not recognised)

  • Bank - administers payments, no duty of care to bondholders, admin functions

  • Fiscal agents in each jurisdiction + principal paying agent

• Trustee (preferable where bond secured, complex terms, subordination)

  • Professional trust corporation, represents interests of bondholders, ensure everything runs smoothly throughout life of bonds, bondholders will sue issuer through trustee.

• Lawyers, auditors