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Heriot-Watt Management Programme

Securities Markets 1

Ian Hirst

Michael A Kerrison

Alexandra Berketti

School of Management and Languages

Heriot-Watt University

Edinburgh EH14 4AS, United Kingdom.

Version 2010.1


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Heriot-Watt Management Programme

School of Management and Languages


Edinburgh

Scotland

UK

EH14 4AS

Telephone +44(0) 131 451 3864

Fax +44(0) 131 451 3865

E-Mail [email protected]

http://www.sml.hw.ac.uk/external

First published 2000 by Heriot-Watt Management Programme (ISBN: 0-273-64538-2).

Republished 2009 (ISBN: 978-1-907291-29-6).

This edition published in 2010 by Heriot-Watt Management Programme.

Copyright Heriot-Watt Management Programme.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system,or transmitted in any form or by any means, electronic, mechanical, photocopying, recording,or otherwise without the prior written permission of the Publishers. This book may not be lent,

resold, hired out or otherwise disposed of by way of trade in any form of binding or cover otherthan that in which it is published, without the prior consent of the Publishers.

Distributed by Heriot-Watt University.

Heriot-Watt Management Programme : Securities Markets 1

ISBN 978-1-907291-43-2

Printed and bound in Great Britain by Graphic and Printing Services, Heriot-Watt University,

Edinburgh.


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AcknowledgementsIan Hirst MA, MBA, PhD is Professor of Finance at Heriot-Watt Univerity. He studied for hisPhD at the University of Chicago and has taught at several universities in the UK, the USA andAustralia. His teaching experience covers undergraduate, postgraduate and executive levels.His research interests centre on stock market prices and activity. He is the author of articleson share valuation and stock market behaviour, has written a textbook on Business InvestmentDecisionsand has also produced a number of case studies on coporate finance.

Michael A Kerrison is the Director of Educational Policy Development and Solutions at the ifsSchool of Finance.

Mr Kerrison is a qualified Chartered Accountant, an affiliate Member of the Chartered Instituteof Bankers in Scotland and graduated with first class honours in accountancy and financefrom Dundee University. He is an active researcher and has published and presented papersin the field of accountancy and finance education. He has been awarded grants to enablethe development of educational courseware supporting learning on accountancy and financeprogrammes in ratio analysis, introduction to basic mathematics in finance and capital investmentappraisal. He continues to keep a close involvement with accountancy, banking and investment

professional institutes through positions as examiner and visiting lecturer.

Mr Kerrison has been invited to and has helped to develop and deliver finance courses onmodern portfolio theory and the role of Capital Markets for European Business Schools andColleges in France and Hungary. He combines his professional knowledge with his experienceas a lecturer, programme designer and courseware developer in designing the materials for thisprogramme.

Alexandra Berketti BSc, MSc, PhD is a senior Economist of the Hellenic Capital MarketCommission and a visiting Professor at ICBS College. She studied for her doctorate at Heriot-Watt University, from where she graduated with a PhD in Actuarial Science. Her current researchinterests center on regulatory issues that ensure the development of a single European financialmarket. She is professionally involved with the Committee of European Securities Regulators

(CESR) participating in expert groups dealing with Market Abuse and the revised InvestmentServices Directive.


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Contents1 Bonds 11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.2 The size and growth of the bond markets . . . . . . . . . . . . . . . . . . 2

1.3 Basic bond characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.4 Bond issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.5 Bond purchasers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81.6 Types of bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

1.7 Bond default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

1.8 Bond rating agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171.9 Bond ratings and efficient markets . . . . . . . . . . . . . . . . . . . . . . 201.10 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211.11 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2 Bond Yields, Prices and Bond Swaps 232.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242.2 Bond yields with annual coupon payments . . . . . . . . . . . . . . . . . . 242.3 Bond yields with semi-annual coupon payments . . . . . . . . . . . . . . . 25

2.4 Interest yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2.5 Real yields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2.6 Bond price quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

2.7 Bond issuance and bond trading . . . . . . . . . . . . . . . . . . . . . . . 302.8 Bond swaps (Interest rate swaps) . . . . . . . . . . . . . . . . . . . . . . . 31

2.9 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

2.10 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

3 Bond Price Sensitivity 393.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

3.2 Bonds and risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

3.3 The price/yield relationship . . . . . . . . . . . . . . . . . . . . . . . . . . 41

3.4 Using duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453.5 Characteristics of duration numbers and duration calculations . . . . . . . 463.6 Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

3.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52


4 Yield Curves and the Term Structure of Interest Rates 554.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574.2 Drawing the yield curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

4.3 The shapes of yield curves . . . . . . . . . . . . . . . . . . . . . . . . . . 59

4.4 The economic interpretation of yield curve shapes . . . . . . . . . . . . . 624.5 Spot rates and forward interest rates . . . . . . . . . . . . . . . . . . . . . 63

4.6 Approximate yield curve calculations . . . . . . . . . . . . . . . . . . . . . 67

4.7 Yield curves and bond investment . . . . . . . . . . . . . . . . . . . . . . 684.8 The pure expectations hypothesis (PEH) . . . . . . . . . . . . . . . . . . . 70


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ii CONTENTS

4.9 The liquidity preference hypothesis . . . . . . . . . . . . . . . . . . . . . . 73

4.10 Preferred habitat/market segmentation . . . . . . . . . . . . . . . . . . . . 74

4.11 Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

4.12 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78


5 Currency Exchange Rates 815.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

5.2 Dealing in the Foreign Exchange Market . . . . . . . . . . . . . . . . . . . 83

5.3 Exchange rate arrangements among markets . . . . . . . . . . . . . . . . 845.4 International swift codes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 865.5 Exchange rate quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . 88

5.6 Bid-offer prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

5.7 Cross exchange rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

5.8 Triangular arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 925.9 Overview of strong currencies . . . . . . . . . . . . . . . . . . . . . . . . . 93

5.10 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

5.11 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107


6 International Exchange Rate Parity Theories 1116.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

6.2 Determining foreign exchange rates using the fundamental approach . . . 113

6.3 Foreign exchange rate parity theories . . . . . . . . . . . . . . . . . . . . 1146.4 Determining foreign exchange prices using Technical Analysis . . . . . . 133

6.5 Determining foreign exchange prices using other approaches . . . . . . . 135

6.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1396.7 Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141


7 International Portfolio Diversification 1457.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

7.2 Risk and return in portfolios: the core principles . . . . . . . . . . . . . . . 1477.3 Risk diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1517.4 Diversifying risk in world markets . . . . . . . . . . . . . . . . . . . . . . . 152

7.5 Other factors to consider when investing in international markets . . . . . 155

7.6 The efficient frontier and a world market portfolio . . . . . . . . . . . . . . 157

7.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1617.8 Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1627.9 Review Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

8 Measuring Portfolio Risk, Return and Performance 1658.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

8.2 Portfolio returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1678.3 Portfolio risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170

8.4 Benchmarking performance . . . . . . . . . . . . . . . . . . . . . . . . . . 171

8.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

8.6 Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175





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CONTENTS iii

Answers to questions and activities 1761 Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176

2 Bond Yields, Prices and Bond Swaps . . . . . . . . . . . . . . . . . . . . 179

3 Bond Price Sensitivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

4 Yield Curves and the Term Structure of Interest Rates . . . . . . . . . . . 1855 Currency Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . 188

6 International Exchange Rate Parity Theories . . . . . . . . . . . . . . . . 190

7 International Portfolio Diversification . . . . . . . . . . . . . . . . . . . . . 193

8 Measuring Portfolio Risk, Return and Performance . . . . . . . . . . . . . 195




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Chapter 1

Bonds

Contents

1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.2 The size and growth of the bond markets . . . . . . . . . . . . . . . . . . 2

1.3 Basic bond characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.4 Bond issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

1.5 Bond purchasers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

1.6 Types of bond . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

1.7 Bond default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

1.7.1 Declaring default . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

1.8 Bond rating agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

1.9 Bond ratings and efficient markets . . . . . . . . . . . . . . . . . . . . . . 20

1.10 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21


Learning Objectives

On completion of this chapter students should be able to understand:

The basic characteristics of bonds;

The major categories of bond issuers and bond purchasers;

The different types of bond that may be issued;

What happens when bonds default

The function and activities of bond rating agencies


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2 Chapter 1. Bonds

1.1 Introduction

This chapter will explain the basic types of bonds that are issued in financial markets

and the main categories of issuers. It will look at the rights which investors acquire when

they buy bonds and how these rights can protect (or, sometimes, fail to protect) investorsif the bond goes into default. It will also look at the role of Rating Agencies, which play a

very important part in the functioning of bond markets.

1.2 The size and growth of the bond markets

Bond markets are enormous. They play a central role in the global financial system. In

2001 there were 33 trillion dollars of bonds outstanding. Of these, about 15 trillion dollars

were bonds issued by companies and the remainder by Governments or government-linked agencies.

The bond markets have also been growing rapidly. The total nominal value ofoutstanding bonds in 1996 was about 25 trillion dollars, and this amount grew by about

34% over the subsequent 5 years. Why have bond markets been growing so quickly?

One important reason has been the trend in financial markets to securitisation and to

disintermediation.

Bonds are securities, so an increased use of bonds is called securitisation. They are

loans which are marketable. Loans which are not marketable are made by banks. Bankloans and bonds are, for many issuers, alternatives. They are both types of debt. A bank

is an intermediary. The saver makes a deposit in the bank and the bank then lends themoney on to the borrower. This process of intermediation has a cost. In particular, the

bank has its own capital and it has to earn a return on that capital.

The bond markets bring savers and borrowers together directly. Intermediaries (such as

banks) are not required. For this reason, the switch from bank finance to bond finance

is called disintermediation. The financial markets have found that, in many cases,

disintermediation or securitisation is the most efficient form of finance. Bond marketshave grown as a result. Although banks have grown too, they have not grown as fast asbond markets. Sometimes an intermediary can add value. Banks, for example, can be

more flexible in their lending than the bond markets.

A bank borrower who is in financial difficulty can meet with his banker and, perhaps,negotiate a change in the loan agreement. A bond issuer cannot meet or negotiate with

the hundreds of investors who own its bonds. The issuer may not even know who the

bondholders are, and they will be a constantly changing group as the bonds are bought

and sold.

Securitisation - the case of the Rock dinosaurs

The great era of Rock and Roll was the 1960s and the 1970s. Many of the great starsfrom that era are still performing. They are known as Rock dinosaurs. Their music is

still played on radio and their music still sells on CDs. The Rock dinosaurs are rich.

Suppose you are a banker and a Rock dinosaur comes to you for a loan. How will

you react? Rock dinosaurs (although they vary greatly in their way-of-life) are often not




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1.3. Basic bond characteristics 3

ideal borrowers. Expensive life-style, wild parties, alimony to ex-wives, maintenance

payments for numerous children. . .. Bankers like to lend money to sober, reliable and

responsible borrowers.

But there is another way. A bond can be issued, and the cash to repay the bond cancome from the royalties on the back-catalogue of songs from the Rock dinosaurs past.

Legal arrangements are made so that bondholders have the first claim to the royalty

income. They dont have to worry about the Rock dinosaurs life-style and behaviour. Aslong as the old songs keep selling, they will get their money.

So a good answer to give the rock-star when he comes asking for a loan is Yes, I can

certainly get the money for you - but I have a better idea than a bank loan. Why dont

you issue a bond?

1.3 Basic bond characteristics

Bonds come in many different varieties as this chapter will soon explain. However, a

basic plain vanilla bond would have the following characteristics.

Unit

100 nominal or face value. This is the principal amount of the bond. It is the amount

which will be paid to the bondholder when the bond is redeemed at the end of its life.

Coupon Rate

Suppose the coupon rate is 7%. This would mean that each 100 nominal bond wouldpay 7 in interest each year. The coupon is a percentage of the principal amount of the

bond. The coupon rate is set when the bond is issued and remains the same throughoutthe bonds life. The coupon rate will be, roughly, the interest rate at the time the bond is

issued.

Payment Frequency

Some bonds pay interest annually, some semi-annually and some quarterly. Semi-

annual payment is most common in the UK. For a 7% coupon bond, this would mean

that each 100 (nominal) bond would make interest payments of 3.50 at 6 monthly

intervals.

Redemption

When the bond is redeemed (or reaches maturity) the nominal value is repaid to thebondholder and the bond ceases to exist. The repayment of the 100 (the principalamount) will coincide with the final interest payment. The life of a bond, from issue to

redemption, is generally in the range 5-30 years.

A bond is normally described as Name of Issuer Coupon Rate Redemption Year.

British Land is a large real estate company in the UK. It has a bond outstanding whichis

British Land 63/4 2028.

Bond is an American term. In the UK, bonds are often called by other names, such as

Loan Stock or, for bonds with a specific legal structure, Debentures. However, the




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American term is now commonly used world-wide and we shall use it in this module.

A bondholder has the right to be paid the coupon rate of interest and, eventually, to the

repayment of the principal. Owning a bond which has been issued by an organisation

does not give ownership of that organisation and does not give any right to influencethe running of the organisation. Bonds differ from shares in this respect. A shareholder

in a company has a right to receive the annual report, a right to attend and vote at

the annual general meeting and a right to propose resolutions or to propose individualsas directors. Bondholders are not involved in any of these activities. For example, a

company can be taken over, and new management with new policies can be introduced,without the bondholders being involved or consulted in any way.

Companies will normally only have one class of shares. All shareholders are equal.

Every share carries one vote. When new shares are issued, they carry exactly thesame rights as the old ones.

With bonds, the situation is different. Generally a new issue of bonds will have adifferent coupon rate and a different redemption date from the ones that preceded it.

Organisations will typically have a number of different bond issues outstanding at thesame time.

1.4 Bond issuers

Bond Issuers must be credit-worthy organisations. No-one would lend money to an

organisation if they did not believe it would repay the debt. They must also be large

organisations. Bond issues of less than 50 million or $100 million would be rare. Bonds

are marketable securities and a successful market needs constant activity by buyers and

sellers. A small issue of bonds would be held by a small number of investors and wouldnot generate sufficient trading activity. The main categories of bond issuers are:

Sovereigns

States raise money partly through taxes and partly by issuing bonds. If they want toraise money quickly or to meet a temporary need, then bond finance is more convenient.

Some states are unstable or lack a strong, reliable institutional structure. They will be

unable to issue bonds because no one will buy them.

A sovereign state is usually the largest issuer of bonds in its own currency and theseform the benchmark. Bonds from other issuers are priced in relation to the sovereign

benchmark bonds.

Examples

1. The Kingdom of Italy

In the mid 19th century the Kingdom of Italy was created from the variety of smaller

states that had previously existed in the Italian peninsula. A new Italian parliament was

created. Soon, the new finance minister was able to announce that Kingdom of Italy

bonds had successfully been sold in London.

Wild cheering and celebrations broke out in the parliament. The new state had passed




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1.4. Bond issuers 5

a key test. In the eyes of the world it was a stable, creditworthy institution.

2. Alexander Hamilton

In the 18th century, when the American colonists had won their war of independence

against Britain, they founded the United States of America. The first finance minister

(Secretary of the Treasury) was Alexander Hamilton. To pay the costs of the war ofindependence, the individual states had issued bonds and, in several cases, these

bonds were in default. The states were not paying the interest that had been promised.

Hamilton insisted that the new United States government should take over these statebonds and make the promised payments. He made sure that the necessary taxes were

raised to make these payments. When small whiskeydistillers refused to pay excise tax,he personally led the troops to crush their resistance. He was not very popular.

But the benefit of a high credit rating was soon clear for the young Republic. In 1803 theUnited States had the chance to buy Louisiana from France. Louisiana was a huge

territory stretching from the Mississippi River to the Rocky Mountains and covering about

a million square miles. How could the United States afford such a large purchase? No

problem - it had established its credit-worthiness. It could, and did, issue bonds.

Today, the United States is the most credit-worthy borrower in the world. For more than

two centuries, it has always paid its debts. States have defaulted, and cities in the US

have gone bankrupt, but not the Federal government.

A financially secure government has been an enormous advantage in the economicgrowth and development of the United States. Credit-worthiness, once lost, is very

difficult to restore. The United States government established its financial credibility

at the very beginning. Some countries in Latin America have not succeeded after200 years. The impeccable credit standing of the United States is sometimes called

Hamiltons Blessing.

Sovereign bond issues, especially from major industrial economies, are generally low-risk. But they are not free of default-risk.

How likely is default?

Default is less likely when the bond is issued in the sovereign governments own

currency. Most British government bonds are denominated in British pounds. Ifnecessary the British government could singly provide the currency needed to repay

them. So default is unlikely. If a Latin American country issues bonds denominated in

US dollars then repayment may be more difficult and default is more likely.

What happens if default takes place? Can legal action be taken against a sovereign

state? Every bond issue specifies which countrys legal system is to be used if there is

a default. Most sovereign issues will specify the laws of the issuing country. Within its

own boundaries, a sovereign state makes the law. Suing a sovereign state in its owncourts is not likely to be successful.

However, some sovereign bonds specify a different jurisdiction. Latin American

countries, for example, have often issued bonds denominated in US dollars andgoverned by the law of New York State. These bonds are largely sold to US investors.In case of default, they can sue in the New York courts and can win the right to seize




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6 Chapter 1. Bonds

any assets, within the US, owned by the debtor nation. If the sovereign borrower has

a state owned airline, the bondholders can seize any of its aircraft that land in the US.

Sovereign governments will be keen to avoid this sort of embarrassment.

The other tactic for sovereign bondholders is patience. A sovereign government maydefault and, at the time, there is not much that the bondholder can do about it. But, some

time in the future, the sovereign government will want to borrow again. Will investors be

willing to buy new bonds when the old bonds are in default? Making a settlement onthe old bonds may be a necessary condition for a sovereign government to return to the

credit markets.

Example : Tsarist Bonds

In 1917 a Communist Revolution took place in Russia. The new Communist government

defaulted on all the bonds issued by the previous Tsarist governments. The Communistgovernment had nothing to do with the financial markets of the capitalist world.

In 1991 the Communist system in Russia collapsed. The post-Communist government

had to negotiate a settlement on old bonds, which had been in default for 70 or more

years, before they could issue new ones.

International Agencies

The International Bank for Reconstruction and Development (usually called the World

Bank), the European Investment Bank, and other international bodies are majorbond issuers. These international agencies are controlled by the major industrialisedcountries. This gives them a high credit rating.

Local and Regional Governments

Some countries give bond-issuing powers to city or provincial governments. The UK

does not. British cities and regions do not issue bonds, nor do the devolved governments

in Scotland, Wales and Northern Ireland.

But, in Germany, the states (the Lnder) can issue bonds. In the US there is a verylarge market in bonds issued by states and cities. It is a curious feature of the federal

system of government in the US that interest on these bonds (called Municipal bonds)is exempt from federal income tax.

Local government units can default. Cities in the US sometimes default on their debt.

Generally, however, local and regional governments are low-risk borrowers. Most

sovereign states would try to avoid defaults by local units. These defaults might affect

their own credit rating.

Agencies and Para-statal Organisations

Sovereign states often set up state-owned organisations to carry out specific tasks.

Sometimes these organisations are set up like ordinary companies in which thegovernment owns 100% of the shares. Sometimes these organisations are created

by special legislation.




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1.4. Bond issuers 7

Examples of major state-owned bond issuers are Electricit de France (electricity

generation, distribution and supply in France), PDVSA (the Venezuelan oil company),

and Federal National Mortgage Association (FNMA, called Fannie Mae), which issues

bonds in the US backed by mortgages on US homes.

Fannie Mae is a government agency, but it is financially distinct from the US government

itself. It is unlikely, but perfectly possible, that it could default on its bonds. The US

government has not provided a legal guarantee that its bonds will be paid.

Corporates

Bonds are a very important source of long-term finance for companies around the world.To issue bonds, a company will need to get a satisfactory rating from one or more of the

leading bond rating agencies. How these agencies operate and how they award ratingswill be explained later in this chapter.

Corporate bonds vary greatly in their level of default risk. Until the 1980s almost allcorporate bonds, at the time they were issued, were regarded as safe. They had high

ratings and a fairly low coupon rate. However, in the 1980s there was a new developmentin the corporate bond market. Companies started to issue High-Yield bonds (also

known as Junk bonds). Previously, the only high risk-of-default/high yield bonds were

bonds which had originally been issued as low risk, but the issuing company had got

into financial difficulty. These bonds were called fallen angels. Junk bonds were knownto be high-risk bonds at the time they were issued. There was a significant likelihood

that they would go into default. But the coupon was set at a sufficiently high level to

compensate for this risk.

Example : Michael Milken

Why did junk bonds suddenly appear in the 1980s? One man was largely responsible,

Michael Milken, who worked for the US investment bank Drexel Lambert.

In the early 1980s, interest rates in the US were high (policy makers were using high

interest rates to try and reduce the level of inflation) and share prices were low.

Mr Milken saw that

Investors would like to buy bonds that offered very high interest rates. The recent

performance of the stock exchange discouraged them from buying shares.

With share prices low, it was possible to buy companies cheaply (for example, bytake-overs). These acquisitions could be funded by issuing high-yield bonds. If

interest rates were to fall, the bonds were designed in such a way that they could

be repurchased and replaced with cheaper debt. So many businesses found itattractive to issue high-yield bonds.

Historically there was evidence that high-yield fallen angel bonds had given

investors good returns. Mr Milken drew attention to this evidence whenencouraging investors to buy high-yield bonds.

The high-yield bond market grew very rapidly and was energetically promoted byMr Milken. Mr Milken was perhaps a little too energetic. He fell foul of US securitieslaw and went to prison. Drexel Lambert went out of business. But the high-yield




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8 Chapter 1. Bonds

bond market has flourished ever since.

Mr Milken was a pioneer. But remember the old Business School saying. What do

pioneers get? Arrows in their backs.

Corporate bonds are private sector financial claims. In the event of default, a standard

legal process will operate, normally without any government intervention. The processof default will partly be governed by the legal arrangements under which the bond wasissued. This is not a law module, but there will be a short discussion of different legal

clauses associated with bond issues later in this chapter.

The default process will also be affected by the legal jurisdiction in which it takes place.

Developed countries have very different systems. In France, the process of restructuring

a company that cannot pay its debt gives great importance to preserving as many jobsas possible. In the US, companies can go into Chapter 11 reorganisation and managers

keep their jobs while they try to negotiate new arrangements with the companyscreditors. In Britain, the priority is getting as much money back for bondholders and

other creditors as possible. Both managers and other employees may lose their jobs as

part of this process.

Why is London such a giant financial centre? One reason is that the legal system in theUK strongly protects the rights of creditors (including bondholders) and shareholders.

Investors from around the world are happy to invest their money in London.

1.5 Bond purchasers

There are three main types of buyer.

Insurance Companies - Life Insurers have to pay out when their policyholders die.Every individual death is unpredictable, but the laws of statistics mean that an insurance

company, with many thousands of policyholders, can predict fairly accurately how many

of them will die each year and how much money it will have to pay out. Bonds are verysuitable investments under these circumstances. They pay fixed amounts of money in

future years. The insurance company can buy a portfolio of bonds so that the cash

inflow each year from the bonds will match the expected cash outflow each year topolicyholders who have died.

Insurance companies also write annuity policies. These give the policyholder an annual

payment for each year until they die. For these policies, too, the insurance companycan calculate the expected pattern of future cash outflows and match them by suitable

purchases of bonds.

Pension Funds - Pensions are very similar to annuities. If pensions are fixed in moneyterms, then bonds are suitable assets to match a pension funds liabilities. If pensions

are to be protected against inflation, then bonds may not be so suitable. The assets of

most pension funds will be invested in a mixture of bonds and equities.

Private Investors - Investing in bonds has not been very popular with private investorsin the UK. Britain has experienced substantial inflation and since bonds offer an income




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1.6. Types of bond 9

which is fixed in money terms, UK bondholders have suffered from this. In countries

such as Switzerland or Germany, where inflation has been considerably lower, private

investors buy considerable quantities of bonds.

1.6 Types of bond

Bonds can be categorised in several different ways.

Term to maturity - Most bonds have a specified date on which they are redeemed.

A bond with more than 15 years before redemption is generally called long-dated; 5-15 years is medium dated and less than 5 years is short-dated. When bonds are

first issued, it is rare for them to have less than 5 years or more than 30 years before

redemption.

A few bonds have no redemption date; they will pay interest forever. They are sometimescalled perpetuities, irredeemables, or undated bonds. The UK government has

irredeemable bonds outstanding. They were originally linked to the financing of theGreat War 1914-18. Almost 100 years later, they are still in existence. There is no fixed

redemption price, but of course, if the UK government wanted to terminate these bonds,

it could buy them in the market at the open market price.

Most bonds are bullet bonds. The whole bond issue will be redeemed on a single date.

This may not suit the issuers cash flow. It might prefer to divide the redemption process

over a number of years. This can be done in two ways.

1. Divide the bond issue into different tranches each with a different redemption

date. One tranche in, say 2010, one in 2012, one in 2014 and one in 2016.

The danger here is that each tranche is smaller in market value than the overall

package. If the tranches are too small, the marketability of the bonds will suffer.

2. Establish a sinking fund. The sinking fund provides for the issuer to make

additional payments each year (separate from the interest payments) to retire

part of the debt. Sometimes the debt to be retired is bought in the market atthe market price. Sometimes, however, the issuer has the right to repurchase

a specific number of bonds each year at the nominal price. If the market price

is above the nominal price, bondholders will not volunteer to have their bonds

redeemed. The numbers of all the bond certificates will be put into a hat and thenumbers of the ones to be redeemed will be drawn by lot. In this way, by using asinking fund system, all the bonds are identical and the marketability of the bond

issue is increased. The bondholders face some uncertainty. They do not know

when each of the bonds they hold will be redeemed. But an institution that holds

a large number of bonds will have a fairly accurate idea of how many of its bonds

will be retired at each redemption date.

Interest and principal payments - For straight bonds the interest and principal

payments are fixed at issue for the life of the bond. However some bonds make interest

and redemption payments that are protected against inflation. The coupon rate on thesebonds is generally low, about 2 per cent or 3 per cent, but all the interest and principalpayments are increased in the proportion




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10 Chapter 1. Bonds

Price index at the time of paymentPrice index at the time the bond was issued

These are known as index-linked bonds. The bondholder knows the purchasing power

of each of the payments he will receive, but he does not know exactly how much money

he will get. Inflation is a major risk for bondholders, so bonds offering inflation protectioncan be attractive. Several major developed countries (including US, UK, Canada, France

and Sweden) have issued sovereign index-linked bonds.

One major UK company, the supermarket group Tesco, has issued Limited priceindexation (LPI) bonds. Each year, the interest payment is increased in line with inflationup to a maximum of 5 per cent.

Why issue such a bond? In fact this is an example of creative bond design. In the UK,

certain pensions must be index-linked each year up to a maximum of 5 per cent. Thepension payment does not have to match any inflation level above 5 per cent. So the

Tesco LPI bond exactly matches the needs of an important class of bondholder and,

from Tescos point of view, it is much more attractive to offer LPI than to offer protectionagainst all possible future rates of inflation.

Investment bankers draw very high salaries for inventing financial investments, like LPI

bonds, which suit the needs of both bond issuers and bondholders.

A Floating Rate Note (FRN) makes interest payments which vary every six monthsaccording to changes in the short-term interest rate. In the UK, the benchmark for FRNs

is usually the 6 month LIBOR (London Inter-bank Offer Rate) and the interest rate paid is

a specified spread above this level. The spread might be 50 basis points (0.5%). So for

a six month period over which LIBOR (in the relevant currency) was 4.70%, the interest

paid by the bond would be 4.70% + 0.50% = 5.20% of the nominal value.

Both index-linked bonds and FRNs offer bondholders some protection against inflation.Index-linkers offer protection directly. FRNs offer some protection because interest rates

tend to rise when inflation rises. Note that, with an FRN, the bond issuers compensate

for inflation during the life of the bond. The final repayment of principal is fixed in moneyterms. If inflation (and interest rates) rise, then compensation is made through higher

payments during the life of the bond. With an index-linker, much of the compensation is

likely to come in the increased principal repayment at redemption.

Zero-coupon bonds, as their name implies, make no interest payments at all. When

they are issued, they are sold at a substantial discount from the nominal value. The

bondholders return simply comes from the fact that the bond is redeemed at a higher

price than it was originally sold.

The cash payments relating to a zero are very simple. But zeros create complex

accounting and tax issues. The issuing company will have to record a charge each

year in its profit and loss statement. And bondholders may have to pay tax each year

- on the basis that the bond is expected to rise in value each year - even though theyhave received no cash income. The tax authorities are always quick to close loopholesin the tax system.

Repayment Options - These are a variety of bonds where the bond issuer or the

bondholder has options over the final redemption of the bond.

1. Callable Bonds- A callable bond gives the issuer the option to redeem the bond ata fixed price before the final redemption date. For example, a 12-year bond with a




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coupon of 8 per cent issued in 2003 might be callable at its nominal value (100)

on specified dates in 2009, 2011, 2013. The call provision is triggered by the bond

issuer and the bonds will only be called if early redemption creates value for the

issuer (and reduces value for the bondholder). In general, call provisions reduce

the price at which a bond can be sold when it is first issued and keep the pricelower throughout the bonds life.

The bond issuer will exercise the call if he can refinance the bond at a lower interest

rate than the implicit rate he pays if he leaves the bond outstanding. If the bond iscallable at par, then the issuer will call if current interest rates fall below the couponrate at which the bond was issued.

Bonds are not usually callable in the first five years of their lives. Sometimes theprice at which the bond is callable is above the nominal value. Since the costs of

calling a bond and replacing it with other debt are significant, issuers will not callunless they can make a substantial improvement in the interest rate that they pay.

Most corporate bonds in the US are callable. This feature is less common in the

UK.

2. Puttable Bonds - A puttable bond gives the bondholder the right to demand that

the issuer redeem the bond early. The bond agreement will spell out the specific

dates at which the holders can exercise the put and the prices at which the issuer

must redeem.

A put feature makes the bond more valuable to the holder. Market prices of

bonds with a put option will, other factors equal, be more valuable than those

without. Bondholders will exercise their put option if they can earn a higher return

by reinvesting the redemption money than if they continue to hold the bond.Put options are not as common as call options. Bond issuers are reluctant to agree

to a put option. If interest rates rise, the company will be forced to refinance itsdebt at a higher interest rate. Since rises in interest rates are often associated with

economic recession, the company may find that the increased cost of debt comes

at an inconvenient time.

Bondholders may exercise the put in other circumstances. If the companys credit

rating deteriorates, the market price of the bonds will fall and the redemption price

received through the put-option may look attractive to bondholders. The need to

find cash to redeem the bond at a time when the companys financial position is

already weak can put the company into financial difficulty.

Generally, companies will try to avoid put clauses in their bond agreements,

although bond purchasers may ask for them. So bonds with put clauses tend

to be issued by companies in a weak bargaining position. And, if the companyis financially weak to start with, the chances that the put option will cause trouble

(with bondholders exercising at an inconvenient time) are increased.

3. Convertible bonds- A convertible bond gives bondholders the right to convert each

bond into a specific number of shares in the issuing company on specific future

dates. For example each 100 nominal of XYZ plc 9% 2018 (issued in 2003) might

be exchangeable for 40 XYZ shares on specified dates in 2006, 2007 and 2008.This exchange rate will be set so that conversion is only worthwhile if the share

price rises by about 20 or 30%.




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12 Chapter 1. Bonds

Generally, opportunities for conversion will come in the earlier part of a bonds

life. Company management will usually want to encourage bond conversion. By

increasing equity and reducing debt it strengthens the financial position of the

company. Option holders tend to delay exercising their options as long as possible.

By setting a final date for conversion after, say, 5 years, bondholders are forced tomake up their minds. If the bond is not converted at that stage, it simply continues

as an ordinary straight bond for the remaining years of its life.

A convertibility feature makes a bond more attractive to bondholders (other factorsequal) and enables an issuing company to set a lower coupon rate on its bonds.

Notice that the callability and convertibility features of a bond may interact. If

company management would like bondholders to convert, but bondholders arereluctant to kill their option by exercising it, management may be able to call the

bonds. This will force bondholders to make up their minds. Either they convert orthey face early redemption. Company management will try to time the call so that

conversion is the lesser of two evils. This is known as forced conversion.

4. Exchangeable bonds - these bonds are similar to convertibles, except that the

shares acquired if the bondholder exercises his exchange option are not shares inthe bond issuing company. So a company will only issue exchangeables if it has a

large shareholding in another company that it would be happy to sell. Perhaps the

company has sold a subsidiary and has agreed to accept shares rather than cash.

Why not simply sell the shares? The company that owns them may feel that the

price it would get is currently too low. By issuing an exchangeable it may dispose of

the shares at a considerably higher price. And, even if the exchangeability option

is never taken up, the company will have reduced the interest cost of the bond by

offering the exchangeability option. As with convertibles, exchangeable bonds aregenerally designed so that exchange would take place at a price 20-30% above

the current price level of the share.

5. Domestic, Foreign and International Bonds - A domestic bond is one for which

the bond issuer, the bondholders and the banks organising and trading the issue

are all located in the same country. The law governing the issue is the law of this

country.

A foreign bond is one where the bond issuer is located in country A, but everything

else (the bondholders, the banks organising the issue, the relevant law etc) is in

country B.

This is a foreign bond in the country B bond market. It will be denominated in

country Bs currency. Foreign bonds have a long history going back to the 19th

century. For example mining companies and railway companies based in SouthAmerica would issue foreign bonds in the UK or US bond markets. Foreign bonds

go by a number of colourful names. For example a foreign bond in the UK domestic

market is a Bulldog bond, in the US market a Yankee bond, in the Japanese

market a Samurai bond and in the Spanish market a Matador bond.

An international bond is often called a Eurobond, and this module will generally

use this term. A Eurobond is sold to bondholders in a variety of different countries

which may or may not include the country where the bond issuer is located. The

currency denomination of a Eurobond can be the currency of any major developedeconomy. The governing law can be the law of any major financial centre.




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However, the process of issuing the bond will not come under the jurisdiction of

any national authority.

In the US, the Securities and Exchange Commission (SEC) sets out the rules for

issuing a domestic bond or a foreign bond in the US bond market. There aresimilar regulatory bodies in the UK, France etc. A Eurobond, however, escapes allthese regulatory nets.

The Eurobond market is very large, there are several trillion (= million million)

dollars of bonds outstanding (at nominal value). The market has grown rapidlyand continues to grow rapidly. Why?

One reason is tax efficiency. Eurobonds pay interest without any deduction of tax

at source. So they cannot be issued directly by a US company. The US appliesa withholding tax to bond interest. The Eurobond will be issued by a subsidiary

company located in a country with no withholding tax and a suitable tax treaty withthe US (or other headquarters country of the issuing company). The Netherlands

Antilles is popular although it is not very easy to find on a map. (Try looking off the

coast of Venezuela).

Eurobonds are bearer securities. There is no register of who owns the bonds. If

you have a bond in your possession, you are assumed to be the owner or his agent

and you can collect the coupon payments. Figure 1.1 shows what a Eurobond

looks like (although the real thing is elaborately engraved to discourage forgery.Some bonds are so attractively engraved that they are considered works of art.

They are collected, after redemption, by people called scripophilists).

Figure 1.1: Illustration showing the general layout and appearance of a EurobondEvery six months the holder of the bond will cut off the coupon which has reached

its payment date and present it at the bank. He will get the interest payment in

exchange.

This payment system makes it difficult for the authorities to collect tax on theinterest payments. There is a widespread suspicion that many Eurobond holders

do not declare their interest income. For individuals who collect some or all of their

income in cash, and who take the money to Switzerland or Luxembourg to buyEurobonds and collect the interest, it is very difficult for the tax authorities to get

their share. It is said that the typical buyer of Eurobonds is a Belgian dentist.

Who gains from the tax-efficiency of Eurobonds? The bondholders, of course, butnot only the bondholders. Bond issuers can get away with offering lower couponrates if the coupons are going to be paid in a tax-efficient way. The losses fall




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14 Chapter 1. Bonds

on the tax authorities. The gains are divided between the bond issuers and the

bondholders.

At one point in the 1990s, the Coca-Cola corporation could sell bonds with a lower

coupon than the US treasury. It was not such a good credit risk, of course. Butthe Treasury bonds were fully taxable, while Coca-Cola issued eurobonds. Theeurobonds were more attractive to many bondholders.

1.7 Bond default

Bondholders have no voting rights and no power to replace management if they thinktheir money is being badly used. Any protection that bondholders have must be written

into the bond agreement at the time that the bond is issued. These protections come

in three main forms - Covenants, Security and Seniority. Each will be discussed in turn.Also this section will consider the process by which a bond is declared to be in default.Bond default will be explained in the context of corporate bonds.

Covenants (also known as Indentures) - If the financial position of the bond issuer

deteriorates, eventually it will be unable to make a coupon payment. However, the

bond issuing company might be badly managed for a long period of time before

this stage was reached.

Bondholders would like to see provisions in the bond agreement that will create a

default-event before all the money has gone. When a bond goes into default, the

issuer is immediately liable to redeem the bond at its nominal value (and there maybe additional penalties). Bondholders want a declaration of default while there isstill enough money available to do this.

Bond covenants are usually based on accounting ratios. For example, they might

specify that the Debt/Equity ratio must not rise above 100%, that the Net Asset

Value of the company must not fall below 200 million, that the companys profit

number must be positive, or that Net Working Capital must be at least 100 million.If accounts are produced semi-annually, the default can only be triggered at two

points of time in any given year. However, the issuers finance director will havethe covenants in mind, and if there is a danger that they will be breached, he will

take rectifying action. He may sell-off loss making subsidiaries or cancel risky new

investments. This, of course, is exactly what the bondholders would want him todo.

Security - Certain specific assets owned by the company may be pledged as

security for the bond. Often the assets are land or buildings, but other assets are

also used. Intellectual property rights, such as movie rights or music rights, areaccepted. The bond agreement gives control of the assets to a third party who,if the company defaults on the bond, can sell the assets and use the proceeds to

repay the bond.

Offering security is a simple way of giving bondholders confidence that they will be

repaid. And this confidence will enable the company to pay a lower coupon rate.

But there are several problems with security.

1. Asset suitability - The asset used as security must be valuable to other




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1.7. Bond default 15

businesses. A city centre office building is good security. A football stadium

is not so good. If the football club is a financial failure, who will want to pay a

high price for its stadium?

The most popular aeroplane around the world for short-haul commercialflights is the Boeing 737. It is used by dozens of different airlines. So a

Boeing 737 is good security for a loan or a bond. Another aircraft might be

just as good from an engineering point of view, but if few airlines use it, it willnot be acceptable as security and airlines will find it hard to borrow money to

buy it.

2. Flexibility - A company may pledge its head office building as security for a

bond. What if the company expands and wants to move to a new, bigger

head office? What if a company decides on a new strategy and wants to sellcertain movie rights that are used as security? Bond agreements will often

have provision for one set of pledged assets to be replaced by another set of

at least equal value and suitability. But renegotiating the security for a bondis a complex business which most finance directors would prefer to avoid.

3. Enforceability- If an airline goes into default on a bond secured by its aircraft,the bondholders will want the planes to be sold to redeem their bond. But

selling the aircraft will immediately close the airline down and put all the

employees out of work. It might leave some cities without air services.

In most countries, the legal system will prevent bondholders from suddenly

removing key assets from the business. Companies can apply to the courts

for protection from their creditors (including bondholders). While they are

protected, the company can try and develop a new and credible businessplan. This may involve negotiating with bondholders over changes in the

bond agreement. If the law courts are preventing the bondholders from

getting hold of the assets pledged as security, the bondholders may have little

choice but to accept new and less favourable terms. The legal system varies

from country to country. Some legal systems are much more favourable tobondholders than others.

Seniority - Large companies will often have several different bond issues

outstanding. They will have been issued at times in the past when the company

needed to raise money and decided to use bond finance. All the bond issues (as

well as the companys various bank loans) will be ranked in terms of seniority. Ifthe company goes bankrupt and its assets are sold off, the most senior debt is

paid off first, the second most senior next, and so on. The shareholders are last

in the queue. Only after all the debt-holders have been paid in full would any

remaining money be divided among the shareholders. In the US and the UK, thelegal system works on the basis of absolute priority. Senior bondholders must get

100% of the money due to them before junior bondholders get anything at all. Bond

agreements are likely to specify for example, No bond issues made subsequent to

this one can have priority over this bond in the event of liquidation. Senior bondsmay also have security associated with them. Bondholders will require a highercoupon rate, other factors equal, on a junior bond compared to a senior bond.




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16 Chapter 1. Bonds

Example : Ill lend you money as long as you are bankrupt!

Imagine the following conversation between a banker and the finance director of a

company.

Finance Director Lend us some money, quickly. Our company is running out

of cash.

Banker How is business going?

Finance Director Badly. If things go on the way they are, we shall be in real

financial difficulty.

Banker That doesnt sound good. But never mind. Id be happy to

lend you money. Theres just one condition.

Finance Director Whats that.

Banker Go bankrupt first.

Does that sound CRAZY? It isnt. If a company goes into administration (UK) or

Chapter 11 of the Bankruptcy Code (US), the company, with the agreement of the law-court, can borrow fresh money on terms that have priority over all the existing debts

of the company. In the US, these new loans are called debtor-in-possession financing.

From the bankers point of view, it is obviously attractive to make loans on terms that

have priority over every other loan to the company. These rules are designed to try and

help rescue companies that have got into financial difficulty. In bankruptcy, they canborrow money and keep operating (temporarily) while plans are made to restructure the

company.

If a company is liquidated (i.e. if all its assets are sold off to the highest bidder) then

absolute priority will operate. Only when the more senior debt has been paid in fullwill the more junior debt-holders qualify for any repayment at all. However, sometimes

companies will seek a voluntary restructuring. The company tells its debt-holders, We

are not breaching any of our covenants at the moment but, look, business conditionsare very bad and there is a risk that we may default in the future. The risk of default

is creating problems for the company. Customers wont buy from us because they see

that we are a heavily indebted company with a risk of going bankrupt. If we default and

our assets are sold off, there will be very little money for any debt-holders. It is in your

interest to agree to give up some of your rights and to support a financial restructuring.

Restructuring may involve exchanging bonds which are likely to default for a new bond

with a lower nominal value - but a much higher chance of actually being paid. It may

involve a debt-for-equity swap, where bondholders agree to exchange bonds for shares.

In a voluntary restructuring, absolute priority may not apply. The bondholders may be

told that they must all make sacrifices if the company is to be rescued. The junior

bondholders may be asked to make a large sacrifice; the senior bondholders may beasked to make a smaller one. Such an arrangement violates the principle of absolutepriority, but under some circumstances it may be in the interest of all bondholders to

agree.




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1.8. Bond rating agencies 17

1.7.1 Declaring default

When does a bond go into default? The bond agreement may specify a set of defaultevents, but there are a number of alternative ways in which default can be declared and

the bond agreement will generally specify which one is to be used.

Bond trustees - Some bond agreements will set up a trustee who has the rightand the obligation to act if a default event occurs. If, for example, a bond is secured

by a property asset, then a trustee company may hold the deeds to that asset. If

the bond defaults, the Trustee Company will have the job of selling the property and

distributing the proceeds to bondholders. In these cases, individual bondholders

cannot take possession of the security; they must wait for the Trustee Company toact.

Bondholder vote - For some bonds, the bondholders must vote to declare an

issuer in default. If the bondholders are private investors who are not very activein protecting their rights, the need for a vote may be a substantial barrier to a

declaration of default. It is even possible that some of the bonds could be bought

up, cheaply, by allies of the bond issuer. These allies would then vote against adefault being declared.

Individual bondholder rights - The bond agreement may give every individual

bondholder the right to call default and to take legal action to secure repayment.

For a large bondholder, this can be a useful right. Small bondholders will not want

to incur the cost of legal action. If bonds are held by a large number of small,

isolated bondholders, there may be no one willing to take action. This, of course,

would be to the benefit of the bond issuer.

1.8 Bond rating agencies

Some bond issuers are in a much stronger financial position than others. Some bond

agreements protect bondholders better than others. Analysing a bond and identifying itslevel of risk is a skilled and time-consuming business. It doesnt make sense for every

potential bond-buyer to do the analysis himself. Bond rating agencies analyse almost

all new bond issues and allocate each of them into a risk category (called a rating).

The bond-rating agency will continue to monitor a bond during its life. If circumstanceschange, it will change the rating of the bond to reflect the new level of risk.

The two largest rating agencies are Moodys and Standard and Poors (S & P) which

operate internationally although they are based in the US. Their rating symbols are as

follows:




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18 Chapter 1. Bonds

Both Moodys and S & P make further refinements to their ratings. Moodys add 1, 2 or 3

to a rating, with 1 being the highest. S & P will add a+ or a- to modify a rating (+ meansless risk; - means more risk).

A rating of Baa (Moodys) or BBB (S & P) and above is called Investment Grade. The

other B-graded bonds (Ba, B for Moodys ; BB, B for S & P) are classed as speculative.

The C ratings are given to bonds which have a substantial risk of default. The D (S & P)rating refers to bonds which are actually in default.

Often a bond will be rated, independently, by both Moodys and S & P. Generally, they

will agree on the rating, but sometimes a bond will hold a higher rating from one agency

than the other.

How is the rating of a bond determined? Partly, the rating agency will look at the bond

issuers accounting ratios. Five key ratios which are important to assessing the risk-level

of a bond are

Gearing Ratio - the ratio of debt to equity. The higher the proportion of debt in thecompanys capital structure the greater the risk of default.

Current Ratio - current assets divided by current liabilities. The higher the current

ratio the safer the bond.

Profitability ratio - the rate of return on the companys assets (or equity). Higher

profitability reduces the risk of a bond.

Cash flow ratio - the ratio of cash flow to company debt. The more the cash flow,

the lower the probability of default.

Times Interest Earned - is the companys earnings (before interest and tax)

divided by the total amount of interest payable. A higher TIE ratio is associatedwith a lower risk of default and hence a higher bond rating.

The information given by these ratios tends to overlap. Companies with a strong financialposition measured by one ratio are likely to have strong values measured by other ratios

too.

The ratios alone are not enough to determine a rating.

In addition

1. The rating agency will consider the industry within which a company operates.A real-estate company can safely take on more debt than a toy manufacturingcompany. A real estate company has solid assets with long-term earning power.




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1.8. Bond rating agencies 19

Toys are often fads which rise and fall quickly in popularity. Toy making companies

rise and fall with their products.

2. The rating agency will consider all aspects of the bond agreement. If good security

is offered, a bond might qualify for a high rating even if the issuers financial ratioswere weak. Companies may often have several different bonds outstanding. The

bonds will not all have the same rating. Senior or secured bonds can qualify for ahigher rating than junior unsecured bonds from the same company.

3. Rating agencies offer issuing companies the opportunity of a meeting to discuss

company policy. A company can argue its case that its bonds are low risk and

should be rated accordingly. For example, a company might make a take-overand take out bank loans to fund the acquisition. More debt could have a negative

effect on the ratings of its outstanding bonds. But if the company assures the ratingagency that the high debt level will be temporary, and that it plans to act quickly to

sell assets and get the debt level down - then the rating agency might not lowerthe ratings.

How significant are bond ratings? The obvious relationship is between the rating given toa bond and the coupon rate that a company will have to offer. For example, the average

coupon rates at which a 10-year US $ bond could be issued might vary as follows

AAA 5.4%

AA 5.7%

A 6.0%

BBB 6.6%

etc.

These would be promised returns. In fact, some bonds will default, so that the actual

returns will be lower. The evidence shows that lower rated bonds do, in practice, default

more often. The difference between the actual returns from BBB and AAA bonds will besmaller than the difference in the promised returns listed in the table. But the evidence

is that lower rated bonds generally give higher actual returns than high-rated ones andthis, of course, is what we should expect since they carry more risk. Note that even an

AAA corporate bond is not perfectly safe, and it will have to offer a higher coupon than

a US Treasury bond.

The second significant feature of bond ratings is that they can determine whether a

company can make a bond issue or not. Many institutions will not buy bonds unless

they are rated investment grade, Baa/BBB or above. In the US, insurance companies

which are major purchasers of bonds, can be restricted by law from investing in less-

than-investment grade bonds. For many companies, if they cannot get an investmentgrade rating, they wont even try to issue bonds. Bond ratings play a very important

part in the financial policy of major corporations. If, for example, the board of directors

decides that company policy is to maintain an A credit rating, then this will largelydetermine the financial structure of the business. Bond rating agencies are very powerful

organisations. For many companies, they effectively determine the amount of debt that

the company can issue.




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20 Chapter 1. Bonds

A third significant feature of bond ratings is that they may affect the coupon rate after

the bond has been issued. Some bonds have a step-up clause which specifies that the

bond must stay at or close to its original rating. If the bond falls to, say, a B rating, then

the coupon rate must rise by a specified amount to compensate the bondholders.

Most bonds, when they are issued, have an investment grade rating. If the valuing later

falls to Ba/BB or below, they are called fallen angels. Bonds which are originally

issued with a below-investment grade rating are called high-yield bonds by thecompanies that issue them and junk bonds by everyone else. Junk bonds are

particularly purchased by private investors who are attracted by the high coupon rates.

Example : Who pays for bond ratings?

For many decades, Moodys and Standard & Poors issued huge books with details, and

ratings, of outstanding bond issues. Their income came from selling these books tosubscribers, especially banks and insurance companies. The books were expensive,

and users were tempted to save the subscription and get the information they needed

by phoning their broker (who would, of course, have a copy). They could ask fora photocopy of the pages they wanted. One of the problems in the economics of

information is that it is difficult to sell information. Once you have sold the information

to one customer, that customer may decide to pass the information on for free - or at aprice that undercuts the original information producer.

So the rating agencies switched. Now if they are invited to rate a bond, they will charge

the issuer for doing so (although some bonds are still rated in the original way, with no

invitation from the issuer). One advantage of working with issuers is that the bond ratingcan be informed by a direct discussion with corporate management about companyplans and policies (as discussed above). A possible disadvantage is that, if the issuers

are paying, they might have an inappropriate influence over the ratings they get. But, so

far, there have been no scandals of this sort.

1.9 Bond ratings and efficient markets

Bond ratings are related to bond prices. All other factors equal (including the coupon

rate) a bond with a higher rating will have a higher price.

So when a rating agency downgrades a bond, should we expect the price of the bond to

fall? It seems logical, but the evidence suggests that this effect is not very large. Why?

Remember the Efficient Markets Hypothesis covered in 2nd level finance. According tothe semi-strong form, new publicly available information is immediately incorporated into

securities prices. Immediately! Rating Agencies dont act as quickly as that. They use,generally, publicly available information, and they take time to review a bonds rating.

So, in most cases, the change in a bonds rating will lag behind the change in the bonds

market price.Sometimes rating agencies are criticised for lagging behind the market and being slow




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1.10. Conclusions 21

to regrade bonds when circumstances change. Investors, of course, would like to be told

in advance of circumstances in which a bond price is likely to fall. Then they could sell

without suffering a loss. But could rating agencies ever hope to provide such a service?

The Efficient Markets Hypothesis says no.

1.10 Conclusions

This chapter has provided an introduction to bonds as marketable securities. It has

described

the basic characteristics of a bond;

the categories of bond issuers and bond purchasers;

the different types of bond that can be issued;

bond default and the effect of various features that may be found in bondagreements;

the rle of ratings agencies.

1.11 Review Questions

Q1:

a) What is the difference between the principal amount of a bond and the price of a

bond?

b) What is the difference between the amount of a bond issue and the principal

amount of a bond?

c) What is the difference between the coupon of a bond and the coupon rate of abond?

Q2:

Explain how the holder of a corporate bond is protected against irresponsible decisionsby corporate management that might put the value of the bond at risk.

Is the protection system for bondholders the same as the protection system for

shareholders?

Q3:

Identify and distinguish between five different types of bond issuer.

Q4:

Briefly explain the character of each of the following types of bond.

a) Zero-coupon bond

b) Exchangeable bond




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22 Chapter 1. Bonds

c) Floating rate note

d) Puttable bonds

Q5:What does a rating agency do? Who pays the fees of the rating agency? What effect

does a rating have on bond issuers? What is a junk bond? What is a fallen angel?




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23

Chapter 2

Bond Yields, Prices and BondSwaps

Contents

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

2.2 Bond yields with annual coupon payments . . . . . . . . . . . . . . . . . . 242.3 Bond yields with semi-annual coupon payments . . . . . . . . . . . . . . . 25

2.4 Interest yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2.5 Real yields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2.6 Bond price quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

2.7 Bond issuance and bond trading . . . . . . . . . . . . . . . . . . . . . . . 30

2.8 Bond swaps (Interest rate swaps) . . . . . . . . . . . . . . . . . . . . . . . 31

2.8.1 Risk in interest-rate swap . . . . . . . . . . . . . . . . . . . . . . 34

2.8.2 Banks and swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . 352.9 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36


Learning Objectives

On completion of this chapter students should be able to understand:

the definition and calculation of bond yields-to-maturity;

the definition and calculation of interest yield and real yield;

the way in which bond prices are quoted;

some basic aspects of bond issuance and bond trading;

the nature and logic of bond swaps, with associated calculations.


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24 Chapter 2. Bond Yields, Prices and Bond Swaps

2.1 Introduction

This chapter is concerned with the basic operations of the bond market. It will explain

how yield-to-maturity (YTM) is calculated, and also the calculation of interest yield and

real yield. Some of this material will review material already covered at levels 1 and 2.

The chapter will also explain how bonds are quoted and the division of the price actually

paid by investors in the secondary market into two parts - the clean price and accruedinterest. It will briefly discuss the operation of the primary market for UK gilts and for

Eurobonds.

Finally, this chapter will cover interest-rate swaps and will demonstrate how borrowerscan gain from using swaps compared to direct bond finance.

2.2 Bond yields with annual coupon payments

The concept of a bond yield has been introduced in level 1 and level 2 modules but is

reviewed here. A bond yield is the internal rate of return (IRR) of the cash flowsgained by purchasing a bond at the market price and holding it to maturity .

Consider a bond with the following characteristics

Coupon of 7 per cent, paid annually, next payment due in 1 year.

Redemption date 5 years hence.

Current market price 105.33.

What is the yield of the bond?

Note, first, that we can assume that the bond has a nominal or par value of 100. The

coupon is based on this nominal value, so the interest paid by this bond is 7 per year.

For an investor who buys the bond today and holds to maturity, the annual cash flowsare

Now(105.33)

1 yr7

2 yr7

3 yr7

4 yr7

5 yr7

The IRR is the interest rate (r) at which these cash flows have zero present value

+ 71 + r +

7

1 + r

+ 7

1 + r

+ 7

1 + r

+ 107

1 + r

The bond is selling at a premium. The market price is above the nominal price. A higherprice reduces the yield of the bond. So the yield will be below the coupon rate of 7 percent.

In the real world, yields are calculated by computer. In university examinations, they are

calculated by trial-and-error. Try 6 per cent. The NPV of the cash flows is

+

7

1.06+

7

1.06+

7

1.06+

7

1.06+

107

1.06

The lower the interest rate we use, the greater will be the discounted value of the futurecash flows. We want to increase the present value, so we try a lower interest rate. Try 5




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2.3. Bond yields with semi-annual coupon payments 25

per cent.

+

7

1.05+

7

1.05+

7

1.05+

7

1.05+

107

1.05

We now have a positive NPV, so 5 per cent is too low. The yield lies between 5 per centand 6 per cent. Clearly it is closer to 6 per cent than to 5 per cent, because the NPV is

closer to zero at 6 per cent.

We find the solution by interpolation. From 5 per cent to 6 per cent, the difference in

NPV is

3.33 - (-1.12) = 4.45

From 5 per cent to the point where NPV is zero, the difference is 3.33. So the yield is

5 +

3.33

4.45

2.3 Bond yields with semi-annual coupon payments

For most UK government bonds, and most corporate bonds (including Eurobonds),coupon payments are made at half-yearly intervals.

This makes the calculation more complex. If the calculation is carried out using half-a-

year as the interval of time, then the calculated yield is a yield per half-year. Consider

a bond with the following characteristics

Coupon 9 per cent, payable semi-annually, next coupon due in 6 months.

Redemption in 3 years time.

Current market price 106.45.

For an investor who buys the bond today, the cash flows are

Now- 106.45

6 mths4.5

12 mths4.5

18 mths4.5

24 mths4.5

30 mths4.5

36 mths104.5

At a discount rate of 4 per cent per half-year, the present value is -3.83. At 3 per cent

per half-year the present value is +1.68. So, by interpolation, the yield per half-yearon this bond is

1.68(1.68 + 3.83) per half - year

Interest rates are usually measured per year. If the rate is 3.30 per cent per half-year

then the compounded rate for a whole year is

(1.0330)2 - 1 = 0.0671 or 6.71%

But this is not how bond yields are quoted. Generally, a bond yield is quoted as twice

the half-yearly rate. This is called the US/UK convention. For our example, the bond

yield would be quoted as3.30%

2 = 6.60%




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26 Chapter 2. Bond Yields, Prices and Bond Swaps

This conventional method quotes a bond yield that is less than the true rate of 6.71%.

So quoted bond yields in the UK/US are not true rates and are misleading unless you

understand the curious convention by which they are measured. Conventions differ in

different national markets. Most Continental European markets do not follow the US/UK

convention, and will quote true yields.

2.4 Interest yield

The interest yield on a bond, which is also known as the current yield or the running

yield, is the annual coupon payment as a percentage of the current market price of the

bond. If the annual coupon amount is C and the bond price is P, then

Interest yield = CP

In our example, this is

9106.45

or 8.45%

When a bond is priced above par, then

Coupon rate

Interest yield

Yield to maturity

The yield to maturity has to take into account the capital loss when the bond is redeemed

for less than the current market price. The interest yield ignores this factor. Hence

interest yield yield to maturity.

When a bond is selling below its nominal value

Coupon rate Interest yield Yield to maturity

Most investors look at yield-to-maturity and ignore the interest yield. But institutions that

want to obtain interest income to match expected cash outflows will watch the interest

yield. Interest yield can also be significant if investors pay a different tax rate on interest

than on capital gains.

2.5 Real yields

The general relationship between the nominal (or money) interest rate (N) and the real

(a purchasing power) interest rate (R) depends on inflation (I). If inflation is zero, then

the nominal and real rates are equal. If inflation is non-zero, the relationship is

1 + N = (1 + I)(1 + R)

= 1 + I + R + IR

Both inflation and real rates are generally small numbers far below 1 (i.e. far below

100%). So IR the product of two small numbers, will be a minor element in the equation.

So investors sometimes use the approx

(c89sm) securities markets 1.pdf

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