Fundamentals of Financial Services

Fundamentals of Financial Services

Bonds
 Key Topic Areas
1. Introduction to Bonds
2. Bond Issuers
3. Features of Bonds
4. Bond Terminology
5. Advantages/Disadvantages of investing in
Bonds
6. Credit Rating Agencies
7. Bonds or Equities?
 Lesson Objectives
By the end of the lesson:

• Everyone MUST be able to:

– Define what a bond is
– Explain the reasons for issuing bonds.
– Explain the key terms associated with bonds: nominal, coupon, redemption/maturity; yield

• Most SHOULD be able to:

– Explain the advantages/disadvantages of investing in bonds.
– Explain the role of credit rating agencies

• Some COULD be able to:

– Understand and explain the benefits and risks of leverage in a company’s financing structure
 What is a BOND?

A debt instrument whereby an investor lends money to an

entity (such as a company or a government) that borrows the
funds for a defined period of time at a fixed interest rate.
 What is a BOND?

Watch the video clip which provides

a quick introduction to BONDS.
Jot down your understanding
 What’s in a Bond?
Company Name
Name of
company/individual
the bond has been
Face value issued to
of the bond

Repayment
The interest or maturity
rate to be date of the
charged bond
 Who can issue bonds?
The Two Major Issuers of Bonds

Companies Governments
Issuing corporate bonds Issuing government bonds
 Examples
Microsoft Bond Issue: Nov 2012
Sold $2.25bn of corporate
Microsoft were vague about how
bonds in Nov 2012.
the money would be spent:
It chose to sell three individual
• To purchase other companies
groups of bonds, repaying the
• To pay off other more
money at different dates and
expensive loans
paying different interest rates.

Why do you think the interest rate INCREASES as the repayment term increases?

Quantity Repayment Interest

Issued Payment RISK & REWARD
$600m 5 years 0.875% pa Longer dated bonds are more risky and hence
investors want greater returns…MS is probably
$750 10 years 2.125% pa more likely to have problems in the next 30 years
$900m 30 years 3.5% pa rather than the next 5 years!
Total $2,250
 Examples:
Government Bond Issues
Why do you think that
governments such as the
US and the UK issue
bonds?
UK Govt. Bond Issue: Jan 2015
When Total Receipts (taxes)
The UK government sold £1.75 are less than
billion of bonds called Total Expenditure…
Treasury Gilts in January 2015.
…the difference needs to be funded
The bonds will repay the through the issue of bonds
borrowed money in 2034 and
will pay interest of 4.5% each
year.
 Bond Features
Nominal Value
Also known as the face value. It is the
amount that is written on the face of the
bond certificate.

Repayment
Date Tradeable
When the money will be Interest Rate & Bonds can be sold before they
returned. Also known as reach their repayment date
the redemption or Frequency
maturity date. This is Percentage paid as interest
when the bond will be and how often it is paid.
redeemed. More typically termed as
the COUPON on a bond.
 Bonds Terminology
FLAT YIELD
• When the calculation of YIELD = COUPON/PRICE

YIELD TO MATURITY
• When the calculation includes the capital gain/or loss if the bond is held until its
maturity date.

NOMINAL VALUE
• This is the FACE value of the bond. It is the amount owed by the bond issuer, that will
be repaid on repayment date.

REPAYMENT/REDEMPTION/MATURITY DATE
• Is the date when the bond will be paid back to the investor.

TRADEABLE INSTRUMENT
• A bond is a tradable instrument which means it can be bought and sold.
 Bond Yields
YIELD: This is just another work for “return” and it is expressed as an ANNUAL PERCENTAGE

COUPON: This is the INTEREST RATE paid on the FACE/NOMINAL value of the bond

YIELD and COUPON are not the same thing.

They are only the same when the bond is bought/sold at its
FACE/NOMINAL value.

Otherwise, generally they are different.

Their relationship can be explained as follows:

 Bond Prices
Bond prices respond to changes in INTEREST RATES.

• This is because, for their yield (return) to be attractive to investors it

must remain competitive (when compared to the return available on
alternative investment instruments).

• If the bank increases the rate of interest, then alternative investments

may appear to have a more competitive return.

• In response to this the bond price decreases to make the bond

appear cheaper to purchase, and the yield offered needs to increase.
 Case Study: John
John purchases a bond which has a face value of £1000 with a yield of 5% per annum,
to be matured in 5 years time.

• One year later, the interest rate offered by banks INCREASES from 5% to 7% thus
making alternative investments more attractive.
• John is considering selling his bond, however he cannot sell it at £1000 and offer
just the 5% yield when there are better investment opportunities available.
• Therefore, to make the bond seem more attractive to customers, the price of the
bond is dropped from £1000 to £800.
• As the price has dropped the yield now appears to be more attractive too.
• This is because they are still getting the original yield of 5% of £1000 i.e. £50. This
is a bigger percentage of the amount paid (50/800 x 100 = 6.25%)
• If the new investor keeps the bond until maturity date, they will also make a gain
on their investment as they only paid £800 for the bond but will be redeemed with
£1000 (the face value of the bond)
 Bond Prices: Quick Questions
1. A 30 year bond is paying a 7% coupon and is
currently priced at face value. What is the
current yield on the bond?

– If the price is at nominal/face value then the

yield is the same as the coupon rate.
– In this case 7%.
 Bond Prices: Quick Questions
2. If the above bond’s price falls to $980, what happens to the
yield? Does it increase or decrease?

– When price decreases, then required yield increases beyond the

coupon rate, i.e. beyond 7%.
– The fall in price results in an increase to the percentage the investor
receives each year.
– The purchase will receive 7% of $1000 having paid only $980. This
means the purchaser receives around 7.14% of his investment each
year (based on 70/980 expressed as a percentage).
– If he holds on to the bond for the 30 years, the purchaser will also
benefit from a windfall gain of a further $20 on redemption, having
paid$980 and receiving back $1000.
 Bond Prices: Quick Questions
3. If the bond’s price now increases to $1,100, what
happens to the yield? Does it increase or decrease?

– When price increases, then required yield decreases because

an increase in a bond’s price results in a fall in the bond’s
yield.
– For a buyer paying $1100, the annual yield generated by the
bond will fall to 6.36% each year (based on 70/1100 expressed
as a percentage).
– The purchaser will also suffer a further loss at redemption
when the bond will only pay back $1000 even though the
purchaser paid $1100 to buy the bond.
 Bond Yields
There is an INVERSE RELATIONSHIP between BOND
PRICE and BOND YIELD

Bond Price
Bond Yield

If the required yield INCREASES, price DECREASES

If the required yield DECREASES, price INCREASES
 Interest Rates & Bond Prices
• Bond prices are susceptible to movements in general interest rates.

• For the yield offered to be attractive to investors it needs to remain

competitive with the return available on alternative instruments.

Bank Rate of Interest DECREASES Other products may appear to

Bond Price INCREASES have a more competitive
return.
Bond Yield DECREASES

Bank Rate of Interest INCREASES Bondholders are willing to

Bond Price DECREASES accept a lower return when they
buy bonds.
Bond Yield INCREASES
What will happen to the Bond Price?

Look at the following two scenarios.

Think about whether the bonds will go up or down in value or
stay the same?

The European Central Bank

The central bank in the UK (Bank
decreases interest rates in the
of England) increases interest
Eurozone. What is likely to
rates.
happen to the bond prices of
What will happen to the price of
German and French Government
UK government bonds?
Bonds?
 What will happen to the Bond Price?

Look at the following two scenarios.

Think about whether bonds will go up or down in value or stay
the same?

The PRICE will go UP.

When interest rates go down

The European Central Bank
decreases interest rates in the
Eurozone. What is likely to
happen to the bond prices of
German and French Government
Bonds?
then shareholders are willing to
accept a lower return when they
buy bonds, so the price of the
bonds will go up. This brings
about a fall in yield
What will happen to the Bond Price?

Look at the following two scenarios.

Think about whether the bonds will go up or down in value or
stay the same?

The PRICE will go DOWN.

An increase in interest rates

means that bond yields need to
increase too, to keep them
attractive to investors. The
increase in bond yields is
generated by the prices of those
bonds falling.
The central bank in the UK (Bank
of England) increases interest
rates.
What will happen to the price of
UK government bonds?
 Summary
An inverse relationship exists between interest
rates and bond prices.
An inverse relation exists between yield and
bond prices.

Interest
Bond Price Rates
Bond Yield
 Advantages/Disadvantages
of investing in bonds
ADVANTAGES DISADVANTAGES
Predictable income Actual default – the failure of the issuer
to be able to pay the coupons and/or the
Most bonds pay a stated amount of income redemption amount.,
every year or half-year in the form of coupons.
– In contrast to dividends which are unpredictable
and may not be paid regularly. An increased risk of default resulting in a
fall in the bond’s value
Investors know exactly how much they will be
getting back. Less substantial issuers are more likely to
default than more substantial issuers.
Investors know the exact date when the bond
will be redeemed.
If such risk exists, the investor may look
to sell their bond before its maturity date
This provides greater security and less risk for and pass on the risk to someone else.
the investor.
– In contrast to equities where the price at which the
shares can be sold is unknown as share price can go
up or down.
 What will happen to the Bond Price?

Look at the following three scenarios.

Think about whether the bonds will go up or down in value or
stay the same?
Buddy Inc is an oil exploration company that has just announced a significant discovery of
easily accessible oil. What happens to the price of Buddy’s 5% coupon-paying bonds?

Anemone PLC’s sales have suffered due to a recession in its main market. Anemone has a
number of 7% coupon-paying bonds in issue – what is likely to happen in their price.

Lakeground Inc announces a substantial equity issue aimed at reducing its debt burden.
What is likely to happen to the price of Lakegound’s bonds?
 What will happen to the Bond Price?

Look at the following three scenarios.

Think about whether the bonds will go up or down in value or
stay the same?
Buddy Inc is an oil exploration company that has just announced a significant discovery of
easily accessible oil. What happens to the price of Buddy’s 5% coupon-paying bonds?

The PRICE will go UP.

The increased likelihood of Buddy being able to pay the

coupons and repay the bonds should result in the yield
required by investors falling and the price of the bonds
rising.
 What will happen to the Bond Price?

Look at the following three scenarios.

Think about whether the bonds will go up or down in value or
stay the same?

Anemone PLC’s sales have suffered due to a recession in its main market. Anemone has a
number of 7% coupon-paying bonds in issue – what is likely to happen in their price.

The PRICE will go DOWN.

Anemone’s credit risk has increased as its main

market is in recession.
The result is likely to be that Anemone’s bonds
will fall in price, resulting in an increase in the
yield to reflect the additional risk.
 What will happen to the Bond Price?

Look at the following three scenarios.

Think about whether the bonds will go up or down in value or
stay the same?

Lakeground Inc announces a substantial equity issue aimed at reducing its debt burden.
What is likely to happen to the price of Lakegound’s bonds?

The PRICE will go UP.

A reduced amount of debt relative to the size of the issuing company will
mean there is less risk that Lakeground may fail to pay the coupons and
repay the debt.

The lower the credit risk should mean the bond’s price increase, with the
investors willing to accept a lower yield.
 Credit Rating Agencies
Credit Rating Agencies will look at bond issuers and assess the risk involved.

• There are three dominant credit rating agencies:

• Moody’s
• Standard & Poor’s
• Fitch Ratings

• All three have an alphabetical system where issuers with the LEAST credit
risk are termed “Triple A”
• SP and F use an identical scale
• M uses their own scale

• These have been depicted on the next slide…

“Triple A” means….
Standard & Poor’s / Moody’s Ratings
Fitch Ratings

AAA Aaa
AA Aa
A A
BBB Baa
Increasing
BB Ba
levels of
B B credit risk
CCC Caa
CC Ca
C C
D
 “Triple A” means….
Standard & Poor’s / Moody’s Ratings
Fitch Ratings
S&P: “extremely high AAA Aaa
“highest quality
capacity to meet their
AA Aa with minimal
financial
credit risk”
commitments” A A
BBB Baa
FR: “exceptionally
BB Ba
strong capacity for
payment of financial B B
commitments”
CCC Caa
CC Ca
C C
D
There is a dividing line between…

The bonds that are rated by agencies as having

less credit risk therefore suitable for prudent
investors

The bonds that are more risky and therefore less

appropriate for prudent investors.
 The dividing line…
Standard & Poor’s / Moody’s Ratings
Fitch Ratings

AAA Aaa Investment

Grade
AA Aa (BONDS)
A A
BBB Baa
BB Ba
B B
Non-
CCC Caa
Investment
CC Ca Grade
Already in (BONDS)
C C
default and
failing to pay D
the bond
coupons
 What’s the Credit Rating?
TASK
Complete the following table. You must identify which credit rating agency the score
is relevant to as well as whether the score suggests suitability for prudent investors or
not.
Credit Rating Standard & Poor’s/ Fitch Investment grade or non-
Ratings, Moody’s or all investment grade?
three?

Aaa
AA
Ba
BBB
B
Why is it better for your business to
issue bonds rather than equity?
• Issuing equity means that the influence of the
original shareholders will become diluted.

E.g. A company doubles its shares by selling new

shares to new shareholders . This means the
original shareholders’ original 100% ownership
will be diluted to just 50% after the new issue.

• Hence, this is not a popular choice for existing

shareholders.
WHAT ARE THE BENEFITS AND RISKS OF LEVERAGE
IN A COMPANY’S FINANCING STRUCTURE?
 Leverage
Leverage is the proportion of debt finance compared to equity finance in a company.

A business will either raise finance through debt or equity.

Scenario 1: The value of a company is £100mn at the start of the year and this goes up to
£120mn by the end of the year.

The outcomes would depend on how the business is financed.

If the company is financed

PURELY by equity, then this
means ALL of the 20% gain will
be for the shareholders.

The share value will increase by

20%
 Leverage
Leverage is the proportion of debt finance compared to equity finance in a company.

A business will either raise finance through debt or equity.

Scenario 1: The value of a company is £100mn at the start of the year and this goes up to
£120mn by the end of the year.

The outcomes would depend on how the business is financed.

If the company is financed by $50mn debt and

$50mn equity then:

The value of the equity would go up from $50mn to

$70mn.

The debt amount would stay the same at $50mn.

Overall there is a 40% increase in equity.

(20/50 *100 = 40%)

The GAIN has been MAGNIFIED

 Leverage: Activity
What if the borrowing had been even bigger?

Assume that the Starting Value is still $100m and the

Ending Value is $120mn.

Assess the impact on the shareholders but this time with:

a) 60% debt
b) 90% debt
 Leverage
Leverage is the proportion of debt finance compared to equity finance in a company.

A business will either raise finance through debt or equity.

Scenario 2: The value of a company is $100mn at the start of the year and this goes down to
$90mn by the end of the year. The company was financed through $50mn Equity and $50
Debt.
The outcomes could be:

If the company is financed

PURELY by equity, then this
means ALL of the 10% loss will
be felt by the shareholders.

The share value will decrease by

10%
 Leverage
Leverage is the proportion of debt finance compared to equity finance in a company.

A business will either raise finance through debt or equity.

Scenario 2: The value of a company is $100mn at the start of the year and this goes down to
$90mn by the end of the year. The company was financed through $50mn Equity and $50
Debt.
The outcomes could be:

If the company is financed by £50mn debt and

£50mn equity then:

The value of the equity would go down from £50mn

to £40mn.

The debt amount would stay the same at £50mn.

Overall there is a 20% decrease in equity.

(10/50 *100 = 20%)

The LOSS has been MAGNIFIED

 Leverage: Activity
What if the borrowing had been even bigger?

Assume that the Starting Value is still $100m and the

Ending Value is $90mn.

Assess the impact on the shareholders but this time with:

a) 60% debt
b) 90% debt
 Plenary
Assess your learning:
Have you met the
learning objectives for
this Chapter?
Assess your learning
using the sheet
provided.
 Check your learning: EXIT PASS
Complete a 1:2:1 EXIT CARD

• Identify 1 area that you already knew about

• Identify 2 new things you have learnt today
• Identify 1 area you would like to know more about
 Links: Video Clips
• What are bonds and how do they work?
– http://www.learningmarkets.com/what-are-bonds-and-how-do-they-
work/

• Investopedia – Understanding Bonds

– http://www.investopedia.com/video/play/understanding-bonds/

• Zions Capital Markets

• https://www.youtube.com/playlist?list=PLVqSsfU_wIKK-Smo7R7uD_bT
fI1fx6hlK

• Corporate Bonds
– https://www.youtube.com/watch?v=jeRxswiPJBs