Fundamentals of Financial Services Bonds Key Topic Areas

Fundamentals of Financial Services Bonds

Key Topic Areas 1. 2. 3. 4. 5. 6. 7. Introduction to Bonds Bond Issuers Features of Bonds Bond Terminology Advantages/Disadvantages of investing in Bonds Credit Rating Agencies 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 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 Face value of the bond The interest rate to be charged Name of company/individual the bond has been issued to Repayment or maturity date of the bond

Who can issue bonds? Companies Issuing corporate bonds Governments Issuing government bonds

Examples Microsoft Bond Issue: Nov 2012 Sold $2. 25 bn of corporate bonds in Nov 2012. It chose to sell three individual groups of bonds, repaying the money at different dates and paying different interest rates. Microsoft were vague about how the money would be spent: • To purchase other companies • To pay off other more expensive loans Why do you think the interest rate INCREASES as the repayment term increases? Quantity Issued Repayment Interest Payment $600 m 5 years 0. 875% pa $750 10 years 2. 125% pa $900 m 30 years 3. 5% pa Total $2, 250 Longer dated bonds are more risky and hence investors want greater returns…MS is probably more likely to have problems in the next 30 years rather than the next 5 years!

Examples: Government Bond Issues UK Govt. Bond Issue: Jan 2015 The UK government sold £ 1. 75 billion of bonds called Treasury Gilts in January 2015. The bonds will repay the borrowed money in 2034 and will pay interest of 4. 5% each year. When Total Receipts (taxes) are less than Total Expenditure… …the difference needs to be funded through the issue of bonds

Bond Features Also known as the face value. It is the amount that is written on the face of the bond certificate. When the money will be returned. Also known as the redemption or maturity date. This is when the bond will be redeemed. Bonds can be sold before they reach their repayment date Percentage paid as interest and how often it is paid. 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 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 Bond Price INCREASES Bond Yield DECREASES Other products may appear to have a more competitive return. Bank Rate of Interest INCREASES Bond Price DECREASES Bond Yield INCREASES Bondholders are willing to accept a lower return when they buy bonds.

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

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

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 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 / Fitch Ratings Moody’s Ratings AAA Aaa AA Aa A A BBB Baa BB Ba B B CCC Caa CC Ca C C D Increasing levels of credit risk

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

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 / Fitch Ratings Already in default and failing to pay the bond coupons Moody’s Ratings AAA Aaa AA Aa A A BBB Baa BB Ba B B CCC Caa CC Ca C C D Investment Grade (BONDS) Non. Investment Grade (BONDS)

What’s the Credit Rating? 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 Aaa AA Ba BBB B Standard & Poor’s/ Fitch Ratings, Moody’s or all three? Investment grade or noninvestment grade?

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 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 £ 100 mn at the start of the year and this goes up to £ 120 mn 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 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 £ 100 mn at the start of the year and this goes up to £ 120 mn by the end of the year. The outcomes would depend on how the business is financed. If the company is financed by $50 mn debt and $50 mn equity then: The value of the equity would go up from $50 mn to $70 mn. The debt amount would stay the same at $50 mn. 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 $100 m and the Ending Value is $120 mn. Assess the impact on the shareholders but this time with: a) 60% debt b) 90% debt

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 $100 mn at the start of the year and this goes down to $90 mn by the end of the year. The company was financed through $50 mn 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 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 $100 mn at the start of the year and this goes down to $90 mn by the end of the year. The company was financed through $50 mn Equity and $50 Debt. The outcomes could be: If the company is financed by £ 50 mn debt and £ 50 mn equity then: The value of the equity would go down from £ 50 mn to £ 40 mn. The debt amount would stay the same at £ 50 mn. 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 $100 m and the Ending Value is $90 mn. 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-theywork/ • Investopedia – Understanding Bonds – http: //www. investopedia. com/video/play/understanding-bonds/ • Zions Capital Markets • https: //www. youtube. com/playlist? list=PLVq. Ssf. U_w. IKKSmo 7 R 7 u. D_b. Tf. I 1 fx 6 hl. K • Corporate Bonds – https: //www. youtube. com/watch? v=je. Rxswi. PJBs