Introduction
When a company wishes to grow and expand its commercial activities, it needs funds to finance any new project or acquisition (e.g., a plant or machinery). The company’s management can look into two types of financing: equity and debt. Firms can raise long-term debt via the banking system, e.g., by taking out a loan or overdraft, or via the money and bond markets where short-term (money markets) and medium-to-long-term (bond markets) financial instruments are issued and can be traded rather than held to maturity [1]. Corporate bonds, similar to gilts (in the UK) or bonds issued by central or local governments, as the name suggests, are issued by companies.
Pike et. al. (2015) describe a corporate bond as [1]:
‘... a general term used to describe a variety of longer-term loans to companies. In some markets, they are described as ‘loan stock’, or, especially where the interest payable is variable, as ‘notes’. A bond is simply a receipt or promise to repay money on loan, usually with interest, i.e. binds the borrower to commitment that can range between one and 30 years.’
Arnold and Lewis (2019) provide a similar definition [2]:
‘A corporate bond is a long-term contract in which the bondholders lend money to a company. In return the company (usually) promises to pay the bond owners predetermined payments (usually a series of coupons) until the bond matures. At maturity the bondholder receives a specified principal sum called the par (face or nominal) value of the bond.’
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An essential feature of a bond is its structure and the type of interest rate that a borrower agrees to pay to the lender. Interest is paid gross at specific intervals set out in the bond’s terms [3]. For UK companies, this is usually semi-annual. The most common three types of interest rates are [4]:
Fixed-rate. This is the most common type of corporate bond where the interest rate is fixed until the bond matures (the redemption date). Fixed coupon bonds pay interest at regular intervals (usually semi-annually or annually).
Floating-rate. Some bonds pay interest rates that vary and are usually periodically adjusted against a benchmark rate, such as LIBOR. Floating rate notes (FRN) are explained later in this article.
Zero-coupon. When the bond pays no interest, it is commonly referred to as zero-coupon bonds. Those debt instruments are issued at a discount, i.e., well below the eventual redemption price. For example, an ‘XYZ’ bond might be issued at £55 per £100 nominal, with an eventual redemption price at £100 per £100 nominal [2]. As a result, the capital appreciation reflects the return on holding the bond.
Debentures
Bonds secured either by a fixed or floating charge against the firm’s assets are called debentures. Generally, bonds backed by a security, e.g., land or buildings, are more secure, resulting in lower yield (that is, the rate of return on the bond investment) [1] as a consequence. If the borrower defaults on interest payments or the capital repayment, the investor can apply for a court ruling to force the sale of either pre-specified assets (called a fixed charge) or any of the firm’s assets (a floating charge). If a company issues debentures subject to a fixed charge, it cannot dispose of a specified asset unless the creditors permit it to do so [1].
Credit Rating on Corporate Bonds
One of the most fundamental concepts in finance is the relationship between risk and return. In essence, the more risk investors are willing to take, the greater return they can expect. Conversely, the smaller risk usually yields lower returns. Credit rating agencies (Standard & Poor's, Moody's, or Fitch Ratings) are essential in assessing the quality of corporate bonds with their ratings, suggesting how likely a company is to default. Bond ratings are based on various financial parameters of the company that issues the bond [6]. As a result, the evaluation of the bonds' creditworthiness indicates the issuer's financial ability to make interest payments and repay the loan in full at maturity [7].
Securities Industry and Financial Markets Association (SIFMA) suggests that:
‘Each agency assigns its ratings based on analysis of issuer’s financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody’s).’
Investors typically classify the rated bonds into two separate categories [7]:
· Investment-grade refers to the bonds rated Baa3/BBB- or better. Companies with corporate bonds rated AAA or Aaa are the least likely to default and therefore offer a coupon with a lower interest rate.
· High-yield (also referred to as non-investment-grade or junk bond) refers to the bonds rated Ba1/BB+ and lower. Those companies issue bonds with a higher coupon to compensate investors for taking the additional risk. High-yield bonds are discussed in more detail in the next paragraph.
Nonetheless, it is essential to remember that credit ratings are an indication and not a guarantee of whether a company will default or not. Therefore, investors should not solely rely on credit ratings as a measure of credit risk.
Table 1. Credit ratings scale of the three leading companies. Source: The Chartered Institute for Securities & Investment (2020).
High-Yield Bonds
The term of high-yield bonds refers both to sovereign and corporate bonds. In this article, we shall focus on the latter. High-yield bonds, also known as ‘junk’ or speculative bonds, are regarded as below investment grade. That is, their issuer has a credit rating of BBB+/Ba1 or below [3]. Speculative bonds have a greater probability of defaulting, thus offering a higher return rate to compensate the investors for taking the additional risk- and in some cases, additional investor-friendly structural features, e.g., higher default premiums [8]. Although junk bonds are not classified as investment grade (IG), they offer some considerable benefits and advantages to investors. According to PIMCO, a global investment management firm, high yield bond investments have historically offered similar returns to equity markets but with lower volatility [9].
High-yield bonds tend to have shorter maturities than investment-grade bonds. That is one of the reasons why speculative bonds generally have less sensitivity to interest rate risks. According to Lindquist (2016), the longer a bond’s maturity date, or duration, the more sensitive it is to rate moves [10]. In addition, junk bonds have a low correlation with other fixed income securities sectors, e.g., government or high-grade bonds. That means the lower-quality bonds might be the better-performing fixed-income assets when the Bank Rate surges. Thus, high-yield bonds are often used in investment portfolios for diversification purposes.
The idea of capital appreciation can be another factor for investors willing to accept a higher risk when acquiring high-yield bonds. For example, their price can rise if an economic outlook or the financial health of an issuing company improves. Other events that are likely to push up the price of high-yield bonds include rating upgrades (non-investment-grade à investment grade), improved firm’s profitability, mergers or acquisitions, product developments, or market-related changes [9].
Convertible Loan Stocks / Convertible Bonds
There is another type of instrument available in a company's financing arsenal called a convertible bond or convertible loan stock. It is a type of bond that can be converted into equity on predetermined conditions. This type of debt instrument is more prevalent in the US than in Europe. In fact, the first convertible bonds were issued by US railroad companies in the 19th century.
Arnold (2015) describes convertible bonds with the following passage [11]:
‘… like other hybrids [convertible loan stocks] combine a debt security element and an equity element. Convertible bonds carry a rate of interest in the same way as ordinary bonds, but they also give the holder the right to exchange the bonds at some stage in the future into ordinary shares according to some prearranged formula.’
It is vital to remember that bondholders are not obliged to exercise their right to convert their bonds into equity shares. In such a case, the investor will continue to receive agreed interest payments until the redemption date when the principal will be paid back to the investor by the bond issuer.
The structure of a convertible bond can be complex, including the features of callability, putability, or contingent conversion. For example, the latter suggests that an investor cannot convert the bond into shares unless the equity price is higher than a contingent conversion threshold [12]. In simple terms, the prospectus for a convertible issue specifies the conversion ratio – the number of shares for which each bond may be exchanged [13]. The conversion ratio can be calculated by dividing the bond’s principal with a predetermined conversion price.
In 2006, Temenos Group AG (a company incorporated in Switzerland) issued convertible bonds with a redemption date in 2013. The aggregate principal amount was CHF 132 250,000 with a coupon of 1.5% payable in arrears on 21 March each year, commencing on 21 March 2007. The par value of one bond was CHF 5,000. The conversion price was established at CHF 18.06 per share with a par value of CHF 5.00 each. The company intended to use the net proceeds from the offering for acquisitions outside Switzerland and general corporate purposes. As a result, the conversion ratio can be calculated as follows:
Each convertible bond issued by Temenos Group AG carries the right to convert to 276.9 shares, equivalent to paying CHF 18.06 for each share at the CHF 5,000 par value of the bond. Therefore, with a closing price of CHF 12.45 per share on 10 March 2006, we can calculate the conversion premium using the following formula:
An investor willing to subscribe for convertible bonds will have an intention to exchange those bonds for equity when the conversion value is at the highest possible point within the conversion period, in the case of Temenos Group AG, that is, from May 2006 to 21 February 2013 inclusive, subject to excluded periods. Conversion value refers to the value of a convertible bond if it were converted into ordinary shares at the current share price [11]:
Conversion value = Current share price x Conversion ratio
Floating Rate Notes (FRNs)
A bond issue where interest rate is paid at a variable rate (often a Eurobond) is called a floating rate note (FRN) [1]. The interest rate is adjusted regularly by a margin against a benchmark rate, such as LIBOR [3]. It happens at one-to six-monthly intervals as preferred by the issuer. The Chartered Institute for Securities & Investment provides the example of bonds’ adjustable interest rates in the following passage:
‘… the issuer might agree that their FRN will pay 50 basis points (0.5%) over the rate of LIBOR. So if LIBOR is 6% per annum over a six-month period (it is usually worked out as an average), the FRN will pay 6% per annum plus the 0.5% spread, or 6.5% per annum in total over the six-month period’.
Floating rate notes are popular when interest rates are volatile. In this case, lenders (i.e., investors) may be hesitant to lend money cheaply, at a fixed rate. As a result, FRNs are in high demand among investors who expect interest rates to rise. According to RBC Capital Markets, floating-rate notes can benefit investors as they offer an opportunity to earn higher coupon payments should the benchmark rate rise. In addition, FRNs are also typically issued with shorter redemption dates (that is, notes with a lower duration) than bonds with fixed rates. This allows investors to protect the investment value in a rising rate environment [14].
Corporate Bond Market in the United Kingdom
Corporate bonds, in principle, are sufficiently liquid, with the vast majority of trading occurring in the over-the-counter market (OTC) directly between a bondholder and the dealer [2]. Like in equity trading, corporate bonds are first sold in primary markets to be then traded in a secondary market on the respective stock exchange, i.e., London Stock Exchange (LSE) in the UK. Watson (2019) explains the process of new issues in his book Corporate Finance 8th edition:
‘Debt finance is raised in the new issues market (the primary market) through lead banks which will seek to place blocks of new bonds with clients through advance orders prior to the issue date. This process is referred to as book building. Several banks may join forces in a syndicate in order to spread the risk associated with providing debt finance.’
Access to a secondary market means that an investor does not wait until the bond’s redemption date to receive the principal (initial investment). In addition, given that the price of a corporate bond will fluctuate depending on the demand and supply influenced by changing interest rates and other macroeconomic factors, an investor may also sell his holdings at a price higher than initially invested should the trading price increase.
As of August 2020, ICMA estimates that the overall size of the global corporate bond markets in USD equivalent notional outstanding is approximately $40.9tn. The UK corporate bond market plays a significant role in the real economy. Wright & Hamre (2020) suggest that more than a fifth of large UK companies (excluding financials) used the corporate bond market to raise £270bn, and these 230 companies employ around 2.3 million people in the UK [15]. Those companies include Vodafone, BP, Astra Zeneca, BT, or Diageo – all having a significant global outreach. In the UK, corporate bonds are equivalent to 46% of the total corporate debt, according to the report published by New Financial in May 2020. This number is significantly higher compared with the member countries of the EU (corporate bond sector: 23%), where bank lending (77%) is still a preferred method for companies to raise funds in the debt capital markets [15].
References
[1] Pike, R., Neale, B., Linsley, P. (2015). Corporate Finance and Investment: Decisions and Strategies. 8th ed. Pearson: London
[2] Arnold, G. and Lewis, D. (2019). Corporate Financial Management 6th Edition. 6th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/871263/
[3] Chartered Institute for Securities & Investment (2020). Investment, Risk and Taxation. 11th ed. CISI: London
[4] Securities Industry and Financial Markets Association (2010). Investors’ guide. Corporate Bonds [online]. Available at: https://hjsims.com/assets/Corporate-Bonds.pdf
[5] Barclays (n.d.). Introduction to Investment Bonds and Gilts [online]. Available at: https://www.barclays.co.uk/smart-investor/investments-explained/cash-and-bonds/introduction-to-investment-bonds-and-gilts/
[6] Fidelity (n.d.). Bond Ratings [online]. Available at: https://www.fidelity.com/learning-center/investment-products/fixed-income-bonds/bond-ratings
[7] Kumar, R. (2014). Strategies of Banks and Other Financial Institutions [eBook]. Available at https://www.sciencedirect.com/topics/economics-econometrics-and-finance/corporate-bond
[8] Standard & Poor’s (2007). High-Yield Bond Market Primer [online]. Available at: https://www.lcdcomps.com/d/pdf/hyprimer.pdf
[9] PIMCO (2017). Understanding Investing. High Yield Bonds [online]. Available at https://www.global.pimco.com
[10] Lindquist, R. (2016). Morgan Stanley. High-Yield Bonds in Rising Rates [online]. Available at: https://www.morganstanley.com/im/publication/insights/investment-insights/ii_highyieldbondsinrisingrates_en.pdf
[11] Arnold, G. (2015). FT Guide to Bond and Money Markets. 1st ed. Pearson: London
[12] Solvency Analytics (2015). Working Paper. Convertible Bond Pricing [online]. Available at: https://solvencyanalytics.com/pdfs/solvencyanalytics_convertible_bond_pricing_2015_10.pdf
[13] Levinson, M. (2018). The Economist Guide to Financial Markets. 11th ed. The Economist: London
[14] RBC Capital Markets (2017). Floating Rate Notes: An Overview of Floating Rate Notes [online]. Available at: https://www.rbccm.com/assets/rbccm/docs/expertise/fixed-income/us/rbc-floating-rate-notes-fact-sheet.pdf
[15] Wright, W., Hamre, E.F. (2020). The Value of Capital Markets to the UK Economy [online]. Available at: https://newfinancial.org/wp-content/uploads/2020/05/2020.05-The-value-of-capital-markets-to-the-UK-economy-New-Financial-FINAL-EXTERNAL.pdf