EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETS Dr Helen Weeds 2013-14, Spring Term

1. EC247 FINANCIAL INSTRUMENTS AND CAPITAL MARKETSDr Helen Weeds2013-14, Spring Term Lecture 4: Bond markets

2. LEARNING OUTCOMES At the end of the topic the student should understand: • The nature and main types of bonds • Why bonds are used • The main issuers of bonds • Bond pricing and yield • The term structure of interest rates

3. WHAT ARE BONDS? • Long-termloan contract (> 1 year) • C.f. money markets: short-term debt of < 1 year • Bond holder lends money to a company, government etc. • The issuer promises to make predetermined paymentsin the future • Payments are usually regular, during life of the bond • These may consist of interest and a capital sum at the end of the bond’s life (at maturity) • Time to maturity for bonds is typically between 5 and 30 years, at time of issue • ‘Shorts’: <5 years remaining until maturity • Medium-dated: maturities of 5-15 years • ‘Longs’: maturities of >15 years • $91 trillion in issue at end-2009 (Bank of International Settlements)

4. Bonds and equity compared • Bond promises a return • Less risk • Bondholders have the right to receive interest before the equity holders receive any dividend • Rights to seize company assets if bond payments not met • Less upside gain • Bondholders do not (usually) share in the increase in value created by an extraordinarily successful business • Less control over company decisions • No voting power over the management of the company • Referred to collectively as fixed-interest securities

5. Why use bonds? • Finance expansion • Leverage (using borrowed money) enables a business to expand beyond what can be financed from shareholders’ funds • Without diluting voting control (c.f. new equity issue) • Long duration helps match revenue and expenses • Capital investments take years to complete then generate revenues over a lengthy period • Bonds can match repayments to anticipated revenue period • Cheaper than bank loans • Control risk: repayment can be tied to a particular project or government agency; insulates parent company / government • For governments • Inter-generational equity: long-term investments which benefit future generations are paid for by them, not current taxpayers • Deficit smoothing: avoid tax increases / spending cuts in a recession

6. Issuers of bonds Four main types of entities issue bonds • National governments (‘sovereigns’) • Lower levels of government (‘semi-sovereigns’) • E.g. municipal bonds issued by US states and cities; German Länder; Japanese prefectures & cities • Repayment may be from general (tax) revenues or from revenues of a particular project (e.g. a toll bridge) • Riskier than national government bonds • Corporations • Securitisation vehicles • Asset-backed security: the payments required on the bond are made from income generated by specific assets • E.g. mortgage loans

7. GOVERNMENT BONDS • Governments issue long-term debt to finance investment and to meet budget deficits • Sovereign bonds issued by reputable governments are very secure • Governments are aware of the need to maintain a reputation for paying their debts on time • Governments can raise taxes or print more money to pay debts • Secondary trading • Although government bonds are very secure, investors can lose money buying and selling gilts in the secondary market before they mature • Changes in bond prices generate capital gains / losses

8. UK gilts • UK government bonds are called gilt-edged securities or gilts • Issued by the UK Debt Management Office • March 2011: total amount of gilts in issue was £1032.91 billion • Features of gilts • Nominal(face or par or maturity) value of £100: amount paid to holder at maturity • Coupon (or dividend): annual payment, stated as rate of return on the nominal value • E.g. ‘Treasury 4.5pc ’42’ pays out £4.50 each year for every £100 nominal, then in the year 2042 the nominal value of £100 is paid • Coupons are paid twice yearly in two equal instalments (of £2.25) • Types of gilts • Dated gilts: fixed date for redemption (may be a range of dates) • Undated gilts: no redemption date, may never be redeemed • Conversion gilts: the gilt may be converted to another one

9. Index-linked gilts • Long-term bonds carry risk from (unexpected) inflation • Governments may issue index-linked bonds that protect investors from this • Nominal value and coupon amount are adjusted (uplifted) according to the Retail Price Index (RPI) • Consider a 10-year index-linked bond with a coupon of 2% • Inflation of 4% over the first year of the bond’s life: raises its payouton maturity to £104 • Over the ten years, RPI rises by 60%: the payout on maturity is £160 • Coupon rate also rises if inflation is positive • First year inflation of 4%: coupon rises to 2% x 1.04 = 2.08%, i.e. for every £100 bond, the coupon is now £2.08 • Last coupon will be 60% higher than that paid in the first year

10. Other governments’ bonds • US Treasury notes and bonds • Maturity of two, three, five, seven or ten years • Treasury inflation-protected securities (TIPS) • French bonds • OATS (Obligations assimilables du Trésor): 7–50-year bonds, mostly fixed rate • BTANS (Bons du Trésor à intérètsannuels): 2–5-year bonds with a fixed rate • German bonds • Two-year Federal Treasury Notes – Bundesschatzanweisungen (Schätze) • Five-year Federal Notes – Bundesobligationen (Bobls) • 10- and 30-year Federal Bonds – Bundesanleihen (Bunds) • Japanese bonds • Japanese government bonds (JGBs), maturity of 2, 5, 10 and 20 years • Chinese bonds • In 2009 China issued its first bonds denominated in renminbi

11. CORPORATE BONDS • Issued by corporations (private or public) • Secured bonds (‘debentures’ in the UK) • Company pledges specific assets to bondholders, e.g. factory financed from the bonds • If company defaults, bondholders can seize these assets (only) • General-purpose debt • Has first claim on company’s revenues and assets, other than those pledged to secured bondholders • Subordinated debt • No claim on revenues or assets until all other bondholders paid • Mezzanine debt • Has less security than other bonds, but more than shares • Secondary trading: many corporate bonds are listed on stock exchanges

12. Many forms of corporate bond • ‘Vanilla’ bonds • Regular (annual or 6-monthly) fixed coupon • Specified redemption date • Floating rate or variable-rate bonds • Interest rates linked to the rate of inflation • Also index-linked bonds • Payments may be linked to a wide variety of economic events • Commodities prices • Other events: e.g. Sampdoria (Italian football club) issued a €3.5 million bond that paid a higher rate of return if the club won promotion to the ‘Serie A’ division • 2.5% if it stayed in Serie B, 7% if it moved to SerieA, and if the club rose to the top four in Serie A the coupon would rise to 14%

13. Repayments • For many bonds, principal is paid entirely at maturity • Bond may have a range of dates for redemption, e.g. 2018-2022 • Some bonds are ‘irredeemable’ (or ‘perpetual’) • Other means of redeeming bonds • Issuing firm can buy the outstanding bonds from bondholders • Purchase bonds on the open market • Deep discounted bond • Sold at well below the face value; may pay zero coupon • E.g. bond issued at a price of £60, redeemable at £100 in eight years • Investor makes capital gain by holding the bond • Floating-rate note (FRN) • Variable interest rate offers investor greater protection against inflation than a fixed rate • Linked to a benchmark rate, e.g. 70 basis points over LIBOR

14. Trust deeds and covenants • Restrictions placed on issuer to reduce bondholder’s risk • Trust deed (or bond indenture) • Sets out terms of contract between issuer and bondholder • Trustee may be appointed to ensure compliance, including to liquidate the company • Otherwise each bondholder has right to take legal action to ensure payment • Affirmative covenants • Requirements to supply financial statements and make payments • Negative (restrictive) covenants, e.g. • Limits on further debt issuance • Dividend level • Limits on the disposal of assets (e.g. property & land) • Financial ratios e.g. interest cover (ratio of annual profit to annual interest payments)

15. Credit rating • Issuers often pay to have their bonds rated by credit rating agencies • How rigorous is this system? • Rating depends on • Likelihood of default on interest and/or capital payments • Extent to which lender is protected in a default (recoverability) • Assessed using a range of quantitative and qualitative factors • Competitive position of the company, quality of management, vulnerability to the economic cycle • Ratings: see table in Lecture 3 • Investment grade: AAA to BBB- (Baa3 for Moody’s) • High-yield (or junk) bonds: BB+ (Ba1) and below • The same company can issue bonds with different ratings, depending on the bond’s ranking in the capital structure

16. Bond default rates Table 6.1 Fitch global corporate finance average cumulative default rates 1990–2010Source:Fitch Ratings Global Corporate Finance 2010 Transition and Default Study http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id = 606665

17. High-yield (junk) bonds • Debt instruments offering a high return with high risk • May be either unsecured or secured • Interest rates 2–9 percentage points above that on senior debt • Ranks below straight debt but above equity • ‘Hybrid’ finance - subordinated, intermediate, or low grade • May have equity warrants or share options attached (‘equity kicker’) • Offers possibility of larger upside gain • Issuers • May be safe investments which have become risky (fallen angels) • Or issued when bank borrowing limits are reached • Firm cannot /does not want to issue more equity • Means of increasing leverage or financial gearing (debt:equity ratio) • E.g. to finance merger activity • Leveraged recapitalisations: use in capital restructuring • Market prices of junk bonds are volatile, closer to equity values

18. OTHER TYPES OF BONDS • Convertible bonds (or convertible loan stock) • Pay interest, • Also give the right to exchange for equity at some future date according to a specified formula • STRIP bonds • Turns bond into separate securities, one for each payment • E.g. 10-year bond with semi-annual coupon becomes 21 different securities, 20 representing each coupon and 1 for the principal • Each is effectively a zero-coupon bond • Foreign bonds • Bonds issued in the domestic market by a foreign issuer • International bonds (‘Eurobonds’) • Bonds sold outside the jurisdiction of the country whose currency the bond is denominated in (see Lecture 3)

19. PROPERTIES OF BONDS • Maturity (or term) • Date on which issuer will have repaid all of the principal and will redeem the bond • Duration • An ‘average’ maturity time of the bond’s payments • The time to each payment (e.g. 1 yr, 2 yrs, 3 yrs) is weighted by the discounted PV of the payment (as % of total PV) • Typically duration < term, except for a zero coupon bond • A measure of the bond’s riskiness • Coupon • Annual interest rate, as percentage of price at issuance • Does not change over bond’s lifetime • Yield • Return made by the investor: this typically varies over the bond’s lifetime

20. Bond prices and current yield • Coupons on outstanding bonds (e.g. gilts) differ considerably • Reflect prevailing interest rates at time of issue • Secondary trading • Gilts may trade above or below the nominal value of £100 • Prices adjust to reflect current interest rates, given the coupon • Consider an undated gilt offering a coupon of 2.5% • Coupon is £100 x 2.5% = £2.50 • Suppose current price of the gilt is £50 • Then its current (or interest or simple or annual) yield is 5% • Note: higher market price implies lower current yield

21. Yield to maturity (redemption yield) • Annual rate of return to bondholder if the bond is held to maturity • Includes capital gain/loss between amount invested and maturity value • E.g. Treasury 10 pc with five years to maturity • Coupon is £100 x 10% = £10 • Suppose this sells in the secondary market at £120 • Current yield is • Also a capital loss: invest £120, nominal of £100 repaid in 5 years • Capital loss: per year • Percentage capital loss per year: • Yield to maturity (YTM): 8.33% - 3.33% = 5% (approx.) • Note: higher market price lowers YTM relative to current yield • Current gilt price > £100 implies YTM < current yield • Current gilt price < £100 implies YTM > current yield

22. Cum-dividend and ex-dividend • Gilts usually pay coupons twice a year • Between payments the interest accrues on a daily basis • Investor buys the gilt cum-dividend • I.e. receives the interest accrued since the last coupon, when the next coupon is paid • Gilts (and other bonds) are quoted at ‘clean’ prices • Does not include interest accrued since the last coupon • Buyer pays the clean price plus accrued interest value • ‘Dirty’ price or full price or invoice price • Ex-dividend • A few days before the coupon is paid, gilt switches to ‘ex-dividend’ • Coupon will be paid to holder on this date; • If gilt is traded during the ex-dividend period, the price is adjusted (in the opposite direction to above) to reflect this

23. BOND DEMAND AND SUPPLY • Bond prices (& yields) are determined by demand and supply

24. Factors affecting bond demand • Expected inflation • Higher inflation reduces real return on bonds: ↓ • Relative riskiness • Higher risk relative to other assets: ↓ • Wealth • People have more to invest: ↑ • Liquidity of bonds • Easier/cheaper/quicker to sell bonds: ↑

25. Factors affecting bond supply • Expected inflation • Higher inflation lowers real cost of borrowing: ↑ • Availability of profitable investment opportunities • More companies look to raise funds by selling bonds: ↑ • Government borrowing • Large government deficit increases supply of govt bonds: ↑

26. Term structure of interest rates • Yield to maturity varies with the maturity of the bond • Typically slightly upward-sloping: longer-dated bonds are riskier • Default risk, inflation, lower liquidity • Now: steeper upward slope (short-term interest rates very low) • Inverted yield curve: slopes downward (tight monetary policy)

27. ISSUINGBONDS • Issuing bonds: offer document (prospectus) sets out • Financial condition of the issuer • Purpose for which bond is issued • Schedule of interest and principal payments • Security offered to bondholders • Underwriters and dealers (investment banks) • Arrange the issue and market it to investors, for a fee • Or may purchase bonds at a discount and resell to the public • Setting the interest rate • May be set by the underwriter, based on market rates on the day • Or set by auction, e.g. competitive bids in which investors offer a price for bonds issued at a given interest rate • Selling direct to (institutional) investors over the internet

28. Secondary trading • Now much secondary trading in bonds • Trading on stock exchanges • Many corporate bonds are now quoted on stock exchanges • Trade takes place between brokers acting for buyer & seller • Over-the-counter (OTC) trading • Majority of bond trading occurs directly between an investor and a bond dealer • Investor wanting to buy or sell calls dealers to check prices • Actively traded bonds (e.g. government bonds) are traded by many dealers and bid-ask spreads are very thin • Smaller issues (by corporations and sub-sovereigns) harder to trade • Electronic trading • Now widely used for trading in government bonds • Relatively small number of different securities • High liquidity: investor wanting to buy or sell is likely to find a taker