TABLE OF CONTENT
TABLE OF CONTENT A. INTRODUCTION 2 I. OVERVIEW OF BOND 3 1. Definition 3 2. Features of bond .3 2.1. Par value/ Face Value/ Principal .3 2.2. Coupon 3 2.3. Maturity date .3 2.4. Bond pricing 4 2.5. Credit rating 5 (Source: Fundamentals of Investments, Charles J. Corrado, Chapter 11, page 33) 8 2.6. Callability 8 2.7. Putability .8 3. How are bonds different from stocks? .8 II. INSTITUTION ISSUING BONDS .9 1. Government bonds 9 2. Municipal bonds .10 3. Corporate bonds .10 3.1. Definition .10 3.2. Advantages of bond financing over a bank loan 10 3.2.1 Fixed Interest Rate 10 3.2.2 Long-term Loan, Fully Amortized .11 3.2.3. Open-ended Mortgage .11 3.2.4. Liberal Prepayment Provisions .11 3.3. Type of corporate bond 12 3.3.1. Secured bond .12 3.3.3. Convertible bond .12 3.3.4. Junk bond 13 3.3.5. Zero coupon bond .13 3.4. Requirements .13 III. RISK OF INVESTING IN BONDS 14 1. Interest Rate Risk 14 2. Inflation Risk .14 3. Default Risk 15 4. Rating Downgrades 15 5. Liquidity Risk 15 IV. WHY BUYING BOND? .16 1. Income predictability 16 2. Safety 16 3. Choice .16 B. CONCLUSION: 16 C. REFERENCES .17 1 A. Introduction Nowadays, in whatever economic types, the capital always plays an extremely important role. It is not only important in day-by-day needs but also in many aspects of the real life. With business organizations, they need capital to buy or lease real estate for placing the factory, the office, the inventory goods…; to purchase materials for producing merchandise; to distribute the merchandise from producers to consumers, to pay for employees, etc. So how they can obtain the needed capital for their business? There are many ways to raise capital such as: mortgage assets, borrowing from the financial institutions or banks, issuing stocks or bonds, etc. With government, they need capital to do the government projects, to do profit or non- profit activities, etc. So how they can do it? Increasing any types of taxes? Increasing the price of products which are under the management of the government? Borrowing from other countries? Selling the real materials abroad with the low price? Issuing stocks or bonds? etc. With many people who have free-cash and want to use it usefully without doing business, how they can do with their money? Lending? Saving in banks? Buying stocks or bonds? etc. They have many ways to choose. They can find the best way which is suitable for their own situation. However, there are many organizations choose issuing bonds, and many people choose buying bonds instead of stocks. Why they choose this way? How they can do it? What are the bonds? Today, we will introduce about BONDS, a way to raise capital for business organization, for government and to invest carefully for the investors. 2 I. Overview of bond 1. Definition Bond is a debt instrument issued for a period of time with the purpose of raising capital by borrowing. The issuer is the borrower (debtor), the holder is the lender (creditor). Institutions that sell bond are governments, cities, corporations. Coupon interest, capital gains and interest on interest (if a bond pays no coupon interest, the only yield will be capital gains) are the three factors affecting the yield of bond. 2. Features of bond 2.1. Par value/ Face Value/ Principal The face value (also known as the par value or principal) is the amount of money printed on the bond, on which the issuer pays interest and the holder will get back when bond matures. 2.2. Coupon The interest rate printed on bond expressed as a percentage of the par. It can be paid monthly, quarterly, semi-annually or annually. The risk and the maturity date will affect the coupon. The more risk the bond is and the longer the maturity date the bond has, the higher interest rate is. 2.3. Maturity date The date when bond comes due and the issuer has to repay principal to the holders. 3 Municipal bonds issued in 2005 in Ho Chi Minh city 2.4. Bond pricing The real price that investor pay for the bond. It can be higher, equal or lower than the nominal value. However, whatever the buying price is, the coupon is still determined by nominal value and the issuer still pay the principal when bond matures. 4 The buying price of bond is opposite with interest rate on the secondary market. When interest rate increases, the bond price will decrease and when interest rate decreases, bond price will go up. Example: a company issues a bond with par value $1000, coupon 8%. After a period of time: Case 1: Interest rate on secondary market is 10%. New bond (a bond with similar characteristics such as credit quality and maturity) coupon is 10% Instead of holding old bond, investors will use their money to buy new bond. Therefore, they will sell old bond at price lower than its nominal value to make it competitive. The 8% bond’s interest payments would have a current yield of 10 % only if that bond could be bought for $800. Now, the price falls from $1000 to $800 (-20%). The bond is said to be selling at a discount Case 2: Interest rate on secondary market is 6%. New bond coupon is 6% Instead of buying new bond, investors will keep old bond. Therefore, the price of old bond in the secondary market will increase. The 8% bond’s interest payments would have a current yield of 6% only if that bond could be bought for $1333. Now the price goes up from $1000 to $1333 (+30%). The bond is said to be selling at a premium. 2.5. Credit rating A credit rating evaluates the credit worthiness of a corporation, or a country. Therefore, a credit rating let a lender or investor know whether the issuer can pay back a loan. If the issuers have a poor credit rating, they also have a high risk of default or bankrupt, that leads to high interest rates, or the refusal of a loan by the creditor. The evaluation is necessary for the investors will be protected. 5 When a corporation sells a new bond issue to investors, it usually subscribes to several bond rating agencies for a credit evaluation of the bond issue. Each contracted rating agency then provides a credit rating - an assessment of the credit quality of the bond issue based on the issuer's financial condition. Rating agencies will normally provide a credit rating only if it is requested by an issuer and will charge a fee for this service. As part of the contractual arrangement between the bond issuer and the rating agency, the issuer agrees to allow a continuing review of its credit rating even if the rating deteriorates. Without a credit rating a new bond issue would be very difficult to sell to the public, which is why almost all bond issues originally sold to the general public have a credit rating assigned at the time of issuance. Also, most public bond issues have ratings assigned by several rating agencies. Some rating agencies in the United States are Duff and Phelps, Inc. (D&P), Fitch Investors Service (Fitch), McCarthy, Crisanti and Maffei (MCM), Moody's Investors Service (Moody's), and Standard and Poor's Corporation (S&P). Moody's and Standard and Poor's is considered the two best rating companies. These companies publish regularly updated credit ratings for thousands of domestic and international bond issues. Rating agency Credit Rating Description Moody’s Duff & Phelps Standard & Poor’s Investment Grade Bond Ratings Aaa Aa1 1 2 AAA AA+ Highest credit rating, maximum safety. 6 Aa2 Aa3 A1 3 4 5 AA AA- A+ High credit quality, investment-grade bonds. A2 A3 Baa1 6 7 8 A A- BBB+ Upper-medium quality, investment-grade bonds. Baa2 Baa3 9 10 BBB BBB- Lower-medium quality, investment-grade bonds. Speculative Grade Bond Ratings Ba1 Ba2 Ba3 11 12 13 BB+ BB BB- Low credit quality, speculative-grade bonds. B1 B2 B3 14 15 16 B+ B B- Very low credit quality, speculative-grade bonds. Extremely Speculative Grade Bond Ratings. Caa 17 CCC+ CCC CCC- Extremely low credit standing, high-risk bonds. 7 Ca C CC C D Extremely speculative Bonds in default. (Source: Fundamentals of Investments, Charles J. Corrado, Chapter 11, page 33) 2.6. Callability The characteristic of a bond gives the issuer the right to take back or redeem bonds before they mature under certain conditions. The sooner the bond is called, the higher is the price which issuer has to pay to the bond holders. The issuers use this right to make sure that they don’t pay the higher interest on the debt in case the interest on the market is lower than interest of the bond. When they redeem all the bonds, they will reissue them at a lower interest rate than that of the previous bonds. 2.7. Putability The characteristic of bond gives the holder the right to sell the bonds to the issuer before they mature under certain condition. When the interest rate in the market increase (causing bond value to decrease), the bond holder can sell bonds back to the issuer to recover the loss. 3. How are bonds different from stocks? Bonds are considered debt investments, the bond holder become the creditor of the company. On the contrary, a stock is considered an equity investment because the investor (stockholder) becomes a part owner of the corporation. 8 The bond holders don’t have the right to participate in corporation’s operations because they are just creditors. Whereas the stockholder may have the right in voting in the company. The issuer of bond is government, corporation or city. However, only corporations issue stock. Bond holders earn fixed income from interest of the bonds. On the other hand, stockholder receive dividend - a proportion on the corporation’s profits and it’s not fixed Bonds have maturity date but stocks don’t. Because bondholders are creditors rather than part owners, if a corporation goes bankrupt, bondholders have a higher claim on assets than stockholders. This makes bond investor safer. II. Institution issuing bonds 1. Government bonds A government bond is a bond issued by a national government denominated in the country's own currency. Government bonds are considered no risk, because the government can raise taxes to buy back the bond at maturity. However, there still exist other risks. First, it is currency risk for foreign investors. For example Foreign investors buying US Treasury bond received lower returns in 2004 because of the decline in value of US dollar comparing with other currencies. 9 Second, there is inflation risk, which is the principal repaid at maturity will have less purchasing power than anticipated if the inflation outturn is higher than expected. 2. Municipal bonds Municipal bonds are debt securities that states, cities, counties, and other governmental issue to raise money for public purposes—such as building schools, highways, hospitals, and other special projects. A feature of many municipal securities is that the interest you receive is free tax from federal income tax. The interest may also be free tax from state and local if you live in the state where the bond is issued. 3. Corporate bonds 3.1. Definition A corporate bond is a bond issued by a company. That is a bond that a corporation issues to raise money in order to expand its business. Unlike government bond, corporate bond is exposed to default risk. Different corporate bonds have different levels of default risk, depending on the issuer company’s characteristics. The larger the default risk, the higher the interest the issuers have to pay. 3.2. Advantages of bond financing over a bank loan 3.2.1Fixed Interest Rate Most banks offer loans with adjustable interest rate in case it rise, so your organization have to pay higher interest when having an increasing in interest rate. 10 [...]... purchasing power of a bond investor’s future interest payments and principal It also leads to higher interest rates, causing bond price to fall 14 When that happens, investors will receive a lower rate of return For example: an investor earns interest rate of 7% on a bond If inflation grows to 4%, the investor's true rate of return (because of the decrease in purchasing power) is 3% (instead of 7% if inflation... centre, or that already has at least 100 shareholders, excluding professional investors If the SSC's proposal is accepted, it seems that it will be difficult for a company to list its bonds III Risk of investing in bonds 1 Interest Rate Risk The price of bond usually changes oppositely of interest rates When interest rates rise, the price of bonds trading in the marketplace generally fall Conversely, if... stock ones 3 Choice In the bond market, there are a wide range of bond issuers, coupon rates and maturity dates are available for you to choose from This makes you easier in finding what kind of bond suitable to your income B Conclusion: Now you have some basic understanding of bond With the overview, you have some general definition of bond, then you know what institution issuing bond You can decide... non-investment-grade bond with a low credit rating, usually BB or lower; as a consequence, it usually has a high yield opposite of investment-grade bond 3.3.5 Zero coupon bond This is a kind of bond that does not pay any amount of coupon but is sold at a discount price It means that the investor will have profit when bond matures For Example : A zero coupon bond with face value $1000 will be traded at $600 When it matures,... follow the conditions: a) Have capital of at least VND 10 billion b) Have been profitable for the two preceding years c) Have a good financial condition and no debts that have been overdue for more than one year d) Have fulfilled all financial obligations to the government e) Have at least 50 existing bond holders who have acquired the bonds through a public offering 13 However, there changes in these... term of the loan Budgeting is simplified by knowing interest and principal payments are fixed for the entire term of the loan Your concern about rising interest rates is eliminated 3.2.2Long-term Loan, Fully Amortized Many bank loans are only in three to five years, with a large payment due at the end of the term This means you must refinance your loan at a later date If the financial position of your... the bond program, prepayment of any amount of principal with unborrowed funds is allowed without penalty You can lower the effective interest rate on your loan by specifying prepayment of the longer-term bonds, which pay higher interest rates than the shorter-term bonds Then, you may also lower your normal loan payments accordingly They do have some limitations on prepayment of bonds with funds borrowed... funds borrowed specifically for refinancing during the first three years of the loan This gives some assurance to the bondholders that they will have their investment for a reasonable duration 3.3 Type of corporate bond 3.3.1 Secured bond A secured bond is a type of bond that is guaranteed by the specific assets as collateral of the company, such as a mortgage, revenue, equipment which would be paid... risk than secured bond Therefore, it offers higher interest rates than do secured bonds 3.3.3 Convertible bond Convertible bond is a kind of bond which is able to convert to shares The issuers allow the bond holders the right to change bond into shares The holders have the right not to convert into shares if the company ‘s business is not good Generally, this type of bond 12 has lower interest rate than... 3) ‘Bonds: An introduction to bond basics’ 2008, Investment Industry Association of Canada, 4) ‘Diversification With Bonds: The Potential Benefits And Risks’, AXA Equitable Life Insurance Company, viewed 20 November 2010, 5) Eugene F . government projects, to do profit or non- profit activities, etc. So how they can do it? Increasing any types of taxes? Increasing the price of products which are. of return. For example: an investor earns interest rate of 7% on a bond. If inflation grows to 4%, the investor's true rate of return (because of