Perpetual Bonds &Bond Rating

Perpetual Bonds &Bond Rating Hana Lee & Maggy Sharobeem

Last Time: Perpetual Bonds • A bond with no maturity date • It is treated as an equity not a debt • Pay coupons forever • The issuer does not have to redeem the bond • Most of these bonds are callable (after 5 years) meaning that the issuer of the bond can redeem the bond on call dates at a defined call price

Past & Present • British Treasury - Napoleonic Wars (1814) • UK government- consul • Government bond with no maturity • Financial analysts believe it would be more efficient if US government also issued perpetual bonds

Callable Bond • Issuer retains the privilege of redeeming the bond at some point • Guidelines indicate which conditions must exist for callable bond to be considered eligible for redemption • Terms specify a call date

Call Date • Earliest possible date that the bond issuer can exercise demand for payment • For perpetual bonds usually 5 years after issued • Call dates may be extended to bond holders when rates fall • Unless there is a sound financial reason for call date, likely bond will remain in effect and continue to earn interest

Callable Bond • Provisions to ensure investor will receive all interest due up to call date • Issuer honors a rate that is slightly above the par and applies it to the interest due • Callable bonds have a higher coupon than non- callable bonds • May result in higher return than other bonds even if call date is exercised

Perpetual Bond • Attractive to conservative investors • Downside: bond will never yield a huge profit for a short period of time • Investor cannot decide to hold bond until maturity to receive a lump sum payment • Treated as equity not debt • Similar to low volatility stock that pays dividends

Valuing a Perpetual Bond • Fixed interest payment, or coupon amount, divided by constant discount rate • Discount rate= speed at which money loses value over time partly due to inflation • Discount rate denominator reduces the real value of nominally fixed coupon over time, eventually making value equal zero • Even though they pay interest forever, can be assigned a finite value, which represents their price • Helps cap the value of the bond overtime

The Equation • INT – fixed annual payment (fixed interest/ coupon payment) • V – present value • Kd– investor’s required rate of return for debt issue (Discount Rate)

Example • Calculate present value given: • Bond pays $75/ year forever • Required rate of return is 10% • V=? • V= $75/ 0.10 • V= $750.00

Bond Rating • Grade on bond indicates credit quality • Affects interest rate applied to bond • Credit rating for an issuer based on issuer’s credit worthiness (ability to pay back loan) • Major bond categories: • supranational agencies • national governments • provincial or state governments • municipal governments • corporate bonds

Bond Rating *http://en.wikipedia.org/wiki/Credit_rating

Bond Rating • Similar to individual credit score • Based on issuer’s: • Assets • Debts • Income • Expenses • Broad financial history • Trustworthiness to pay on time, in full

Bond Rating • Usually reviewed every 6 – 12 months • Missed/delayed payment to investor • Issuance of new bonds • Changes to an issuer’s underlying financial fundamentals • The acquisition or divestiture of a line of business • A change of policy by a government • Erosion in the credit markets that was not foreseen • Other broad economic developments

Bond Rating • Credit ratings are opinions about relative credit risk • Express opinions about: • ability and willingness to meet financial obligations in accordance with the terms of those obligations • credit quality of an issue and the relative likelihood that it may default • Default does not necessarily mean failing to pay full interest on debt, but rather the potential for delays in payment

Bond Rating • Comparable credit opinions are likely to result in reasonably similar average default rates • As demonstrated in historical studies, default rates in each rating category can fluctuate and such fluctuations are to be expected in the future • Example: • if the annual average default rate of 'BBB' issues was 0.30% historically, this does not mean that a 'BBB' rating is a mathematical prediction of a 0.30% default probability • if a particular set of 'BBB' rated issues suffer a 0.60% default rate, it does not mean those ratings were somehow wrong or inaccurate

Bond Rating • Credit ratings do not measure performance factors, such as market value or price fluctuations • Do not address, explicitly or implicitly, whether: • Investors should buy, sell, or hold rated securities • A particular rated security is suitable for a particular investor or group of investors • A security is appropriate for an investor’s risk tolerance • The expected return of a particular investment is adequate compensation for the risk it poses • The price of a security is appropriate given its credit quality • There is, or will be, a ready liquid market in which the security may be bought or sold • The market value of the security will remain stable over time

Bond Rating • Credit quality: important consideration in evaluating an investment - cannot serve as the sole indicator of investment merit • May affect price an investor is willing to pay for debt issue • In evaluating an investment purchase, investors should consider more factors, i.e.: • the current make-up of their portfolios • their investment strategy and time horizon • their tolerance for risk • an estimation of the security’s relative value in comparison to other securities they might choose

Bond Rating • Investors : use to help assess credit risk and to compare different issuers and debt issues when making investment decisions and managing their portfolios • Issuers: use credit ratings to provide independent views of their creditworthiness and the credit quality of their debt issues • Issuers may also use credit ratings to help communicate the relative credit quality of debt issues, thereby expanding the universe of investors • Typically Unrated bonds: • U.S. treasury bonds • Agency (or Government Sponsored Enterprises) bonds • Insured bonds

Bond Rating

In Summary • Why should companies care about how their credit is rated? • There are two disadvantages of lowered ratings: • lower the rating, the higher the cost of borrowing, the lower the company’s value • bonds less liquid in the secondary market, increase the bond’s YTM (i.e., the required return on the bonds), increasing the cost of borrowing for the firm • Should individuals who have no intention of buying any of these companies’ bonds care about the ratings? • Banks and insurance companies try to maintain a high quality rating, otherwise they would have a tough time competing for customers (rated at the request of the lender) • Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan

Sources • http://www.investopedia.com/terms/p/perpetualbond.asp • http://www.wisegeek.com/what-is-a-callable-bond.htm • http://www.wisegeek.com/what-is-a-call-date.htm • http://www.wisegeek.com/what-is-a-perpetual-bond.htm • http://www.finweb.com/investing/definition-of-a-perpetual-bond.html • http://financial-dictionary.thefreedictionary.com/consol • http://finance.thinkanddone.com/valuation-of-perpetual-bonds.html • http://personal.fidelity.com/products/fixedincome/bondratings.shtml • http://beginnersinvest.about.com/gi/o.htm?zi=1/XJ&zTi=1&sdn=beginnersinvest&cdn=money&tm=79&f=00&tt=14&bt=1&bts=1&zu=http://www.morevalue.com/glossary/restrict/Cost%2520of%2520Borrowing-Bond%2520Rating.html • http://www.usatoday.com/money/companies/regulation/2010-08-31-sec-credit-rating-agency-warning_N.htm • http://www2.standardandpoors.com/aboutcreditratings/ • http://www.investopedia.com/ask/answers/09/moodys-bond-ratings.asp • http://en.wikipedia.org/wiki/Credit_rating • http://www.finpipe.com/bndiss.htm • http://thismatter.com/money/bonds/bond_ratings_and_credit_risk.htm

Perpetual Bonds &Bond Rating