There has been a lot of talk about bonds in the media. Bank bonds, Government bonds, Junk Bonds, Greek Bonds, Bond Default.
[Junk Bonds are sometimes called High Yielding Bonds, as the risk is the issuer, is a risky government, or new company or an un-creditworthy institution, so certain investors like pension funds are unable to hold such risky assets, and perhaps some cynical or risk adverse investors look at the Junk Bond see the relatively high interest rate, but look at the issuer and then simply draw the conclusion that the Junk Bond is just ‘Mutton Dressed As Lamb’]
I thought it was a good opportunity to explain these financial instruments. Sometimes known as fixed income securities or debentures, or debt securities or debt instruments or income bearing securities. Yes, lots of explanations for the same thing. A financial product that promises to pay a return to the holder of the product. It is an “I Owe You”
The bond market is by far the largest securities market in the world, providing investors with virtually limitless investment options. Many investors are familiar with aspects of the market, but as the number of new products grows, even a bond expert is challenged to keep pace. While we spend a great deal of time discussing economic forecasts and how those forecasts may affect unique sectors of the bond market. So to be clear, the Bond Market (Debt Market) is many many times larger than the Stockmarket. Yes, the value of companies listed (Market Capitalisation) is dwarfed by the Bond Market.
I will now explain the fundamentals of the bond market. (sometimes known as the debt market)
First and foremost, a bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments and companies issue bonds when they need capital. If you buy a government bond, you’re lending the government money. If you buy a corporate bond, you’re lending the corporation money. Like a loan, a bond pays interest periodically and repays the principal at a stated time.
Suppose a hypothetical world class company (Asad Karim PLC) that wants to build a new global telecommunications network for £1 million and decides to issue a bond to help pay for the network. Asad Karim PLC might decide to sell 1,000 bonds to investors for £1,000 each. In this case, the “face value” of each bond is £1,000. Asad Karim PLC—now referred to as the bond “issuer”—determines an annual interest rate, known as the “coupon,” and a timeframe within which it will repay the principal, or the £1 million. To set the coupon, the issuer takes into account the prevailing interest-rate environment to ensure that the coupon is competitive with those on comparable bonds and attractive to investors. Our hypothetical company (a world class operation of course…..) may decide to sell five-year bonds with an annual coupon (the yield or interest rate payable) of 5%. At the end of five years, the bond reaches “maturity” and Asad Karim PLC repays the £1,000 face value to each bondholder. (Asad Karim PLC honours its debts of course)
Vodafone has issued bonds:
You will see that Vodafone have 3 programmes of Bond Issuance (Debt Issuance) in the form of a European, US and Commercial Paper programme. The European programme has raised €30 Billion. Quoting Vodafone the reason for the Bond programme:
‘Our financing strategy is to provide timely, cost efficient and secure financial resources to the Group and to manage Vodafone’s capital structure in line with its targeted low single A credit rating. The Group’s policy is to borrow centrally using a mixture of long-term and short-term capital market issues and borrowing facilities to meet anticipated funding requirements. In respect of certain emerging markets we may elect to borrow on a non-recourse basis. Risk management is at the core of our financing policies. We use derivative instruments to manage our currency and interest rate risk and collateral support agreements to mitigate the credit risk of banking counterparts. Liquidity risk on long term borrowings is managed by maintaining a disciplined maturity profile. Our mid to long-term debt is primarily financed via corporate bonds programmes. Our short-term funding requirements are met through our commercial paper programme’
In essence, buyers of Vodafone bonds, are lenders to Vodafone, (Vodafone creditors) and lend cash to Vodafone, and and have to trust Vodafone to repay them. That is the risk.
How long it takes for a bond to reach maturity can play an important role in the amount of risk as well as the potential return an investor can expect. A £1 million bond repaid in five years is typically regarded as less risky than the same bond repaid over 30 years because many factors can have a negative impact on the issuer’s ability to pay bondholders over a 30-year period. The additional risk incurred by a longer maturity bond has a direct relation to the interest rate, or coupon, the issuer must pay on the bond. In other words, an issuer will pay a higher interest rate for a long-term bond. An investor therefore will potentially earn greater returns on longer-term bonds, but in exchange for that return, the investor incurs additional risk.
Every bond also carries some risk that the issuer will “default,” or fail to fully repay the loan. Independent credit rating services assess the default risk of most bond issuers and publish credit ratings in major financial newspapers. These ratings not only help investors evaluate risk but also help determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer.
It is an bond investor today, with a large appetite for risk who today buys Greek Government Bonds or Spanish Bonds for example.