BONDSBONDS

(DEBT FINANCE)(DEBT FINANCE)

CORPORATE FINANCECORPORATE FINANCE(sources of funds)(sources of funds)

COMPANIES:COMPANIES:

1. generate internal cash flows / undistributed profits1. generate internal cash flows / undistributed profits

2. issue shares (2. issue shares (equity finance) equity finance) / issue bonds (/ issue bonds (debt finance)debt finance)

3. 3. borrowborrow from financial institutions - from financial institutions - loansloans from: from: - commercial banks - commercial banks

- building societies (S&L - building societies (S&L associations)associations)

- insurance companies- insurance companies

Bondholders/investorsBondholders/investors

principalprincipal = sum of money invested to earn = sum of money invested to earn interestinterest

(received back on a fixed (received back on a fixed mamaturity turity datedate))

coupon coupon = interest payments at regular = interest payments at regular intervals intervals

(six-monthly, annually)(six-monthly, annually)

BONDSBONDS

lenderlender less riskyless risky (get their money back)(get their money back) pay fixed rate of pay fixed rate of

interestinterest (regular intervals)(regular intervals) maturity datematurity date (principal) (principal) tax deductible (interest tax deductible (interest payments before payments before

paying tax)paying tax)

SHARESSHARES (STOCKS) (STOCKS)

ownerowner uncertain investmentuncertain investment (depends on profit)(depends on profit) pay dividends on a pay dividends on a

profitprofit (may be higher (may be higher

return)return) no maturity dateno maturity date dividends paid out of dividends paid out of

already taxed profitsalready taxed profits

GovernmentsGovernments

If tax revenue insufficient If tax revenue insufficient

raise money raise money

issue bonds - risk-free investmentissue bonds - risk-free investment

Government bondsGovernment bonds The US:The US:

a) a) Treasury notes Treasury notes – – a maturity of 2 to 10a maturity of 2 to 10 years years (short-term)(short-term)

b) b) Treasury bondsTreasury bonds – a maturity of 10 to 30 years – a maturity of 10 to 30 years (long-term)(long-term)

The UKThe UK Gilt-edged stock (gilts)Gilt-edged stock (gilts)

Market makers Market makers (banks & brokerage companies) (banks & brokerage companies)

Quote bid and offer prices for bondsQuote bid and offer prices for bonds

The The yieldyield of a bond ( of a bond (how much income it giveshow much income it gives) ) depends on its purchase price and its depends on its purchase price and its couponcoupon (the (the amount of interest a bond paysamount of interest a bond pays):):

Interest rates Interest rates rise rise existing bonds existing bonds lose lose valuevalue

Interest rates Interest rates fall fall existing bonds existing bonds increase increase in value in value

Debt increases financial Debt increases financial riskriskBond Bond interestinterest has to be paid has to be paid

The The principalprincipal has to be paid (maturity has to be paid (maturity date)date)

Dividends do not have to be paidDividends do not have to be paid

Bond investmentsBond investments

a) very low risk – a) very low risk – government securities / government securities / blue chip blue chip

companiescompanies

b) moderate degree of risk – b) moderate degree of risk – other other companiescompanies

c) very high risk - c) very high risk - junk bonds junk bonds – risky – risky companiescompanies

Types of investorsTypes of investors

1. Institutional investors1. Institutional investors (banks, mutual funds, pension funds, insurance (banks, mutual funds, pension funds, insurance

companies)companies)

2. Companies2. Companies

3. Individuals3. Individuals

4. Government4. Government

CreditworthinessCreditworthiness (financial health of the company)(financial health of the company)

investment grade – AAA, ABB, BBB, CCCinvestment grade – AAA, ABB, BBB, CCC

higher rating – lower interest of borrowinghigher rating – lower interest of borrowing

price fluctuates according to interest ratesprice fluctuates according to interest rates

BOND BOND RISKSRISKS

1. Financial health of the company1. Financial health of the company

2. Selling prior to maturity – less gains2. Selling prior to maturity – less gains

3. Changes in interest rates3. Changes in interest rates

4. Inflation – the principal is smaller4. Inflation – the principal is smaller

MATCH UP THE VERBS WITH THE NOUNS TO MATCH UP THE VERBS WITH THE NOUNS TO MAKE COMMON VERB-NOUN COMBINATIONS:MAKE COMMON VERB-NOUN COMBINATIONS:

1.1. borrow ___________borrow ___________ a) activitiesa) activities

2.2. deduct ___________deduct ___________ b) assets/bondsb) assets/bonds

3.3. finance ___________finance ___________ c) c) interest/dividends/taxinterest/dividends/tax

4.4. issue _______________issue _______________ d) principald) principal

5.5. pay _________________pay _________________ e) moneye) money

6.6. raise ________________raise ________________ f) shares/bondsf) shares/bonds

7.7. repay _______________repay _______________ g) moneyg) money

8.8. sell _________________sell _________________ h) interest payment/taxh) interest payment/tax

ANSWER THE QUESTIONS:ANSWER THE QUESTIONS:

1. Which gives the highest potential return to an investor?1. Which gives the highest potential return to an investor?

a) a corporate bonda) a corporate bond b) a junk bondb) a junk bond c) a government c) a government bondbond

22. Which is the safest for an investor?. Which is the safest for an investor?

a) a junk bonda) a junk bond b) a corporate bondb) a corporate bond c) a government bondc) a government bond

33. Bondholders are guaranteed to get:. Bondholders are guaranteed to get:

a) nothinga) nothing b) some of their moneyb) some of their money c) all their money backc) all their money back

if a company goes bankrupt.if a company goes bankrupt.

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

What is a bond?What is a bond?

What is the bond’s coupon?What is the bond’s coupon?

What happens when the bond matures?What happens when the bond matures?

When does a bond carry more risk?When does a bond carry more risk?

http://www.investopedia.com/video/play/stocks-versus-bonds

What is a portfolio?What is a portfolio?

How often do bonds pay interest?How often do bonds pay interest?

What helps to maximize profits and minimize risks?What helps to maximize profits and minimize risks?