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The new electronic orderbook for retail bonds
T R A D I N G B O N D S O N T H E L O N D O N S T O C K E X C H
A N G EA G U I D E F O R P R I VA T E I N V E S T O R S
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ContentsIntroduction 3What are bonds? 3Bond basics 4Types of
bond issuer 5Bond structures 6Bond pricing 7Yield 8Risk 8Order book
for Retail Bonds 9Key features 10Accessing the order book 11
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IntroductionIn the current economic climate, investors
areincreasingly looking beyond traditional equity toother asset
classes as they search for higheryield. And with continued
uncertainty across thefinancial markets, the security of fixed
incomeinstruments, with their regular coupon paymentsproviding a
steady income stream, are provinghighly attractive to private
investors.
With the launch of our new trading service forbonds we aim to
respond to private investordemand for an electronic bond market by
providingthe liquidity and transparency needed to trade inand out
of fixed income securities. Our aim is tooffer greater access to
trading in individualbonds for private investors as they manage
anddevelop their own investment strategies.
An initial offering of gilts and corporate bonds,tradable in
small, more easily manageabledenominations, from our existing range
of listedbonds are now available for trading on the newelectronic
Order book for Retail Bonds (ORB).
This guide provides an introduction to the mainfeatures of bonds
and considers the benefits andrisks associated with them. It also
gives anoverview of the London Stock Exchange's newelectronic order
book for bonds to help youdecide whether trading bonds on this new
marketmay help you meet your investment needs.
What are bonds?A bond is a tradeable security, issued by
aborrower (the bond issuer) and representing aformal agreement
between the issuer and thelender (the bondholder) that the issuer
willrepay to the lender the full amount borrowedplus interest over
the lifetime of the bond.
Bonds are therefore debt instruments whichrepresent a series of
cash flows payable duringa specified period of time. These cash
flows arethe principal amount, borrowed by the issuer atthe time of
the bond’s issue and repaid to theinvestor at the time of the
bond’s redemption,in addition to the interest payments made
atregular intervals until the bond’s maturity.
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Example: Government bondThe following listing tells us that
thisparticular security is a gilt, a UK governmentbond, because the
issuer is HM Treasury. It has an annual coupon of 4% payable
untilmaturity in 2016.
TREASURY 4% Gilt 2016Because UK gilts have a semi-annualcoupon
cycle, the interest on these bondswould be paid in two installments
each year.If the bondholder has a total nominal valueof £5,000
invested, this would generatetwo coupon payments each of £100 to
bepaid at six monthly intervals until the giltwas redeemed in
2016.
The issuer is the organisation raising capitalthrough the issue
of bonds and which isborrowing money from the bond investors.
The principal, also known as the ‘nominal value’or 'par value'
of a bond, is the amount that theborrower, the bond issuer, will
pay back to thebondholder on maturity. The principal amount isthe
amount on which interest is paid. Theprincipal can also be referred
to as the ‘faceamount’, ‘redemption value’ or ‘maturity value’.
The maturity or ‘redemption date’, of a bond isthe date on which
the issuer (borrower) agreesto pay back the principal amount the
bond.
The coupon rate is the annual interest rate paidon the bonds and
is the rate used to determinethe amount of interest the borrower
pays to thebondholder at regular intervals throughout thelifetime
of the bond. The coupon is the amount ofinterest paid and is
expressed as a percentage ofthe principal.
Example: Corporate bondFrom the following bond listing, we
cansee that the issuer is Marks & Spencerand that the coupon
rate is 5.625%. Thematurity date is 24 March 2014. Thismeans that
until the bond is redeemed in2014, the issuer will pay the
bondholderinterest of 5.625% on the total nominalamount invested by
the bondholder.
Marks & SpencerPLC 5.625% NTS 24/03/14As is commonly the
case with corporatebonds, this particular security has anannual
coupon cycle. If the bondholder has£10,000 nominal held in these
particularMarks & Spencer notes, he wouldtherefore receive a
single interestpayment of £562.50 each year.
Bond basics
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There are four main types of entities issuingbonds: sovereign
governments and theiragencies, supranational bodies,
localgovernment authorities, and corporations.
Sovereign governments
Government bonds are issued by centralgovernments. In the UK,
these government bondsare known as ‘gilts’. Gilts are issued by the
UKGovernment through the Debt ManagementOffice (DMO), an agency of
the HM Treasury.
Governments issue bonds to borrow money tocover their net cash
requirements, i.e., to meetthe gap between the amount received in
taxesand the amount required for governmentspending. Governments
also issue bonds torefinance existing debt or to raise new
capital.Government bonds are generally considered tobe of the
highest credit quality because they arebacked by central
governments which are ableto print money to meet their obligations.
Manyinvestors concentrate their trading activity onbuying and
selling government bonds and thesesecurities are the most liquid
and heavily tradedof all fixed income instruments.
Supranational entities
Supranational bonds are issued by internationalbodies comprising
a number of sovereignmember states. Supranational entities
issuebonds to raise funds to invest in developmentprojects and
include organisations such as theEuropean Investment Bank (EIB) and
the Bankof International Reconstruction andDevelopment (IBRD).
Supranational bonds aregenerally backed by a group of
sovereigngovernments, therefore they are considered tobe of very
high credit quality.
Local government authorities
Local authority bonds are issued by localgovernments such as
borough councils.Because these bonds are not issued by thecentral
government, they cannot beclassified as sovereign government
bonds.They are generally of a slightly lower creditrating than
sovereign debt, because they arenot backed by the central
government. Localauthority bonds are not as liquid asgovernment
bonds and are not so easilytraded in the secondary markets.
Corporate bonds
Corporate bonds are those issued by privateand public companies.
Investing in thecorporate bond of a particular company isgenerally
considered to be lower risk thaninvesting in the same company’s
sharesbecause, in the event of the company goinginto bankruptcy,
the bondholders will beclassed as creditors and will take priority
overequity shareholders in terms of repayment.Unlike shares
however, bonds do not give theholder an ownership interest in the
issuingcorporation and bondholders typically have no,or very
limited, voting rights in the company.
The ability of the company issuing the bond torepay the money to
its investors holding thebond, depends on the success of
thatcompany’s business. Because of this higherrisk, investors
usually demand a higher rate ofinterest on their holdings in
corporate bondsthan the equivalent government bond.
In general, there are two main categories ofcorporate bonds:
investment-grade andspeculative-grade (also known as high-yield
oreven ‘junk’ bonds). Investment-grade bonds areconsidered to be of
higher credit quality thanspeculative-grade, therefore they will
typicallygenerate lower rates of interest than higher-yielding
speculative-grade bonds. Investors inhigh-yield bonds demand a
greater rate ofreturn due to the perceived higher risk that
theissuer will not be able to pay back the money ithas borrowed
from it bondholders.
Types of bond issuer
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Bond structures
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Bonds are typically referred to as ‘fixedincome’ securities.
This is because, in theirsimplest form, bonds pay a fixed coupon
atregular intervals throughout their lifetime untilmaturity. As the
bond markets have developedhowever, this is no longer always the
case andother more complex structures, which gobeyond ‘fixed’
returns, are now common.
The main types of bond structure and their keyfeatures are as
follows:
Fixed-rate bonds, also known as‘conventional’ or ‘plain vanilla’
bonds, arebonds which pay a fixed rate of interest atregular
intervals over the lifetime of the bonduntil maturity, when the
entire principal amountborrowed is repaid.
Floating-rate bonds, which may alsosometimes be known as
floating rate notes(FRNs), are securities whose interest ratevaries
(is ‘floating’ as opposed to ‘fixed’). Herethe coupon is reset
periodically according to aparticular reference rate. The
referencebenchmark rate is typically Libor (the Londoninterbank
offered rate) or Euribor (the Eurointerbank offered rate). Usually,
a ‘spread’comprising fractional percentage points isadded to the
Libor or Euribor rate. This spreadwill vary depending on the credit
quality of theissuer, with a larger spread being added forhigher
risk instruments.
Index-linked bonds, often known simply as‘linkers’ are bonds
whose principal amount andcoupon payments are linked to an index.
Themost common are Inflation-linked bonds, wherethe principal and
interest payments are linkedto a consumer retail price index (RPI).
Inflation-linked bonds have their principal and coupon‘uplifted’ to
reflect inflation in line with the RPI.The investor’s return is
therefore protectedagainst being eroded by the effects of
inflation.
Zero coupon bonds, also known as‘discount’ bonds, do not
generate any interestpayments. As the name suggests, they haveno
coupon. Instead, the return on the bondcomes from the significantly
discounted valueat which they are initially sold compared to
theeventual redemption value. A zero couponbond will be issued at a
price well below parvalue but on maturity, the issuer will pay
theholder the full par value amount.
Convertible bonds are bonds which givethe investor an option to
exchange the bond fora preset number of shares in the issuer at
apredetermined price and time. Convertiblebonds allow the
bondholder to ‘convert’ hisholding into equity of the issuing
company.
Bond trading denominationUnder the Prospectus Directive, the
EUregulation which governs the documentationpublished when a bond
is listed and brought toa market such as the London Stock
Exchange,the regulatory regime distinguishes between‘wholesale’ and
‘retail’ bonds. ‘Wholesale’bonds are tradeable in units of £50,000
orgreater, whereas ‘retail’ bonds are tradeable insmaller size,
often in denominations of £1,000for example.
At the moment, most of bonds issued in theUK are ‘wholesale’
bonds and are therefore notaccessible to many private investors
becauseof the large size of the denominations in whichthey must be
traded. In developing the Orderbook for Retail Bonds we selected an
initialpool of 'retail’ securities from the existing rangeof listed
bonds on our markets.
We expect that the benefits of extendingtransparency and
liquidity in fixed incomesecurities will increase distribution
forbonds by opening up these markets toprivate investors who may
havepreviously felt excluded from this market- facilitating new
flow for private clientbrokers and opening up new pools ofcapital
for issuers seeking access to largepools of retail liquidity.Pietro
Poletto, Head of Fixed IncomeLondon Stock Exchange Group
The development of a liquid, transparentsecondary market for
retail bonds brings intofocus the benefits of retail
issuanceprogrammes as an additional source of fundingfor companies
wishing to raise capital from awider pool of investors. Indications
are that thiscould stimulate increased retail-size issuanceof
corporate bonds thus widening the range ofbonds available for
private investors to choose.
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Bond prices are expressed per 100 nominal, i.e.,as a percentage
of the bond’s nominal value. Forsterling-denominated bonds, a price
of 101.25 forexample, would mean that for every £100 nominalof that
bond, the buyer would pay £101.25.
The present value of a bond
The price of a bond today can be determined bycalculating the
present value of the cash flowsassociated with that particular
bond.
Money deposited in an interest-bearing accountwill attract a
rate of interest over the term it isinvested. For example, £100
invested today atan annual rate of interest of 5% will become£105
in one year’s time. This interest reflectswhat is known as the time
value of money.
If, as in the example above, the future value ofa sum of money
can be calculated based on itsvalue today, then conversely, the
time value ofmoney can also be expressed by calculatingthe present
value of a sum based on its knownfuture value. Again this valuation
will reflect theprevailing rate of interest. So, given an
interestrate of 5%, a nominal amount of £100receivable in one
year’s time, would be worth£100 divided by 1.05. Its present value
wouldtherefore be £95.24.
This process of establishing present values isknown as
discounting. The prevailing interestrate used in the calculation is
the discount rate.The present value of a future sum of
money,receivable after n years, based on a prevailingrate of
interest of r, is calculated as follows:
Present value of sum of money = future value of sum x 1 / (l +
r)n
Using this approach, the present valuecalculations can be used
to derive the price of abond, given the appropriate rate of
interest andcash flows. The fair value of a bond is the sumof the
present values of all of its cash flows,including both the coupon
payments and thefinal redemption payment.
Accrued interest
Bond prices are quoted on a ‘clean’ basis.This means that the
price showing does notinclude any accrued interest. When aninvestor
buys a bond however, they pay thebond’s ‘dirty’ price which is the
clean priceplus the accrued interest.
When a bond is traded between couponpayment dates, accrued
interest is paid tocompensate the seller for the period duringwhich
the seller has held the bond, but forwhich they receive no interest
from the bond’sissuer as they will not be holding the bondwhen the
next coupon payment date arrives.Because the seller has only held
the bond forpart of the interest-earning period, they willreceive a
pro-rate share of the next couponfrom the buyer.
There are a variety of day count conventionsused when
calculating the accrued interestpayable on a bond. These
conventionsdetermine the number of days assumed to be inthe coupon
period and the number of days onwhich accrued interest is payable
to the seller.
For gilts, the day count convention isACT/ACT, meaning that the
calculation takesthe actual number of days to the next coupondate
and divides this by the actually number ofdays in the interest
period to determine whichproportion of the coupon amount should
accrueto the bond seller.
Many corporate bonds use a 30/360 day countconvention which
means that rather than usingthe actual number of days in the
relevantperiods, there are assumed to be 30 days inthe month and
360 days in the year.
Bond pricing
Interest rates
The most important factor influencing theprice of a bond is the
prevailing interestrate. If the interest rate on cash (thedeposit
rate) falls to below the couponrate paid by a particular bond, that
bondwill become more attractive and its pricewill rise. Conversely,
rising interest rateswill cause the bond’s fixed couponpayments to
become less attractive (theinvestor can gain a higher return
simplyby putting his cash on deposit) and so themarket price of
that bond will fall.
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Yield is the rate of return generated by aninvestment in a
particular bond. The followingtypes of yield calculations may be
used toexpress the return on a bond:
Flat yield
This calculation takes into account only thereturn generated by
the coupon and does notfactor in any capital gain or loss on the
bondthroughout its lifetime. Flat yield thereforeexpresses the
return generated only by theinterest paid on the bond and not by
any profitor loss that the bondholder may incur byholding the bond
until its maturity.
Flat yield = (annual coupon / price) x 100
For example, the flat yield on a 4% gilt,currently priced at
102.50 would be 3.9%. Ifthe bond’s price were to rise to 105.75,
the flatyield on that bond would fall to 3.78%. Thisdemonstrates
the inverse relationship betweenbond yield and price. As a bond’s
priceincreases, its yield falls. As a bond’s price falls,its yield
increases.
Gross Redemption Yield
The Gross Redemption Yield calculation offersa more complete
measure of yield than thatprovided by the flat yield as it takes
bothcoupon payments and capital gain or loss intoaccount. It
involves a more complex calculationbased on the present value cash
flows of thebond. The Gross Redemption Yield reflects the‘'internal
rate of return' of the bond, i.e., thediscount rate that, when
applied to the futurecash flows of the bond, produces the
currentprice of that bond.
Gross Redemption Yield reflects the totalreturn that a bond will
generate over itsremaining lifetime and expresses this as
apercentage of the bond’s price on anannualised basis. Because of
this, the GrossRedemption Yield allows investors to makecomparisons
between bonds with differentmaturities and coupons.
Net Redemption Yield
Like the Gross Redemption Yield, the NetRedemption Yield also
takes into account boththe coupon and the capital gain or loss
madeon the bond if held to maturity. However, theNet Redemption
Yield also considers the cashflows after tax rather than the gross
pre-tax
cash flows used in the calculation of GrossRedemption Yield.
RisksSome of the risks associated with investing inbonds can be
broadly defined as follows:
Credit risk, also known as ‘default risk’ or‘issuer risk’, is
the risk that the issuer maynot be able to meet its obligations in
terms ofcoupon payments or may not be able to pay theprincipal
amount back to the bondholder atmaturity. Government bonds are
deemed to beof very low credit risk because they are backedby the
central government which is able to raisetaxes or print money to
meets its obligations.The default risk of corporate bonds will
varydepending on the credit quality of the issuer.
Market risk is simply the risk that the priceof the bond will
fluctuate away from the price atwhich the investor bought it. These
pricefluctuations may simply relate to the marketforces of supply
and demand and if the investormaintains his holding, the variation
in the valueof his bond position will be a paper profit orloss. If
the investor is forced to sell his bond toraised funds however,
there is a real risk ofcapital loss.
Interest rate risk is a particular form ofmarket risk comprising
the risk that thevalue of the bond may be adversely affected bythe
prevailing direction of interest rates. Ifinterest rates rise, the
price of bond willgenerally fall, since bond investors will demanda
higher yield in keeping with the higher ratesavailable on
deposits.
Issue-specific risk relates to specialfeatures that a particular
bond may haveembedded within its structure. Some bonds,for example,
have a derivative element such asa ‘call’ which, if exercised,
would allow theissuer to repay the bond early. The risk is thatthe
bond will be ‘called’ by the issuer and thatthis will be
disadvantageous for thebondholders. Investors should take care
toread the prospectus documentation and makethemselves familiar
with any particularcharacteristics of the bond structure which
mayincur additional risk.
Yield
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The Order book for Retail Bonds (ORB) offerselectronic trading
in gilts and retail-size corporatebonds, i.e. those which are
tradable in smaller,more manageable denominations of £1,000
orsimilar. These include some of the UK’s mostwell-known companies
such as Vodafone,GlaxoSmithKline, BT and Marks & Spencer.
It also provides corporate issuers with anefficient mechanism
for distributing bonds toprivate investors – helping to stimulate
newissues of bonds that are tradable in smallerdenominations and
providing private investorswith wider investment opportunities.
Open and transparent: the new orderbook brings transparency to
the bond marketin three ways: all participants simultaneouslyaccess
executable prices and have equalopportunity to trade at the best
available price;can see the price discovery process throughour and
third-party data feeds; and all trading is
monitored by our experienced marketsurveillance team and
authorities such as theFinancial Services Authority.
Regulation: All securities admitted to tradingon the new
electronic Order book for RetailBonds are London-listed securities
admitted tothe EU-Regulated Main Market. This ensures ahigh level
of regulatory oversight and offers thebenefits of the transparency
afforded by theFinancial Services Authority’s disclosure
andcontinuing obligations regimes.
Improved liquidity: the centralised tradingmechanism
concentrates liquidity whilededicated market makers provide
two-wayprices throughout the trading day. All otherregistered
member participants are also able toenter orders into the order
book, giving privateinvestors the opportunity to take or make
aprice in a security.
Order book for Retail Bonds
Currency risk is relevant where an investorholds a bond which is
denominated in acurrency other than his or her own domesticcurrency
since the value of this investment maybe adversely affected by
fluctuations in theforeign currency exchange rate.
Inflation risk is the risk that the value of abondholder’s
investment will be eroded by theeffects of inflation. A fixed rate
coupon andprincipal amount will end up being worth lessin real
terms if inflation is high during thebond’s lifetime. This risk is
removed forinflation-linked bonds.
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Many investors currently gain exposure to fixedincome markets by
buying units in managedbond funds, but a growing number of
privateinvestors are becoming increasinglyknowledgable about debt
securities and areseeking to take a more active role in
managingtheir assets.
Acknowledging this trend we were inspired tocreate a bond market
for private investors usingthe wide range of debt securities
alreadyadmitted to our markets. In fact there are over10,000 listed
bonds available on our systemsbut up until the introduction of the
ORB nonewere traded on our electronic order books.Instead,
transactions in bonds were typicallyagreed in the over-the-counter
(OTC) marketbetween counterparties and the details of thetrade then
reported. This means that thesecondary market for retail bonds
wasfragmented and private investors found itdifficult to access the
bonds they would like toinclude in their investment portfolios.
Key features of the order bookThe ORB offers an open and
transparent marketstructure for trading in retail-size bonds and is
anelectronic order-driven model like that alreadyestablished for
share trading.
Dedicated market makers quote two-way bidand offer prices in a
range of bonds throughout
the trading day. Additionally, all other registeredmember
participants are able to enter ordersinto the book.
The trading day starts with an initial openingauction phase
running from 8.00 to 8.45followed by continuous trading until
marketclose at 16.30.
The minimum price movement, also known asthe ‘tick size’, for
all order book bonds isstandardised at 0.01 (one penny). This
meansthat the bonds can be quoted and traded to thenearest
penny.
The unit in which each corporate bond istradeable follows the
trading denominationspecified in the particular bond’s
prospectusdocumentation. For ‘retail’ bonds this istypically £1,000
although some retail bondsmay be tradeable in multiples of £5,000
or£10,000. For gilts, the standard lot size on theORB is £1,
meaning that gilts can be traded inmultiples of whole pounds.
All order book trades are trade reportedautomatically and
published immediately.
Settlement
All trades on the ORB are executed on a ‘clean’basis, i.e.,
excluding accrued interest.
The standard settlement timetable for corporatebonds on the
order book is T+3. In keeping withthe market standard, the
settlement timetablefor all gilt securities is T+1.
At
fingertips
Creating an electronic bond market in the UK
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Types of broker
Execution Only brokers will only buy or sellbonds according to
your instructions, providingno investment or trading advice. This
allows youto select the bonds in which you wish to tradeand simply
direct your broker to execute thetrade for you.
Advisory brokers provide advice and alsoexecute the trading
decisions you make.
Discretionary brokers will buy and sell bondson your behalf and
may also have theauthority to make investment decisionswithout your
prior approval.
Direct Market Access
You may also wish to choose a broker whooffers Direct Market
Access (DMA), a servicewhereby London Stock Exchange Members
areable to directly submit customer orders to theorder book via
their own systems.
DMA allows sophisticated private investors totake greater
control of their trades by enablingthem to place buy and sell
orders directly on theLondon Stock Exchange’s order books
andexecute with other market participants.
Accessing the electronic Order book for Retail Bonds
Further Information
Full details of the new electronic Order bookfor Retail Bonds
are available on the LondonStock Exchange web site
at:www.londonstockexchange.com/bondsmadeeasy
If you would like to know more about tradingbonds on the London
Stock Exchange pleasecontact your broker or email the ORB teamat:
[email protected]
DISCLAIMER: The publication of this document does not represent
solicitation by the London Stock Exchange plc of public saving and
is notto be considered as a recommendation as to the suitability of
the investment, if any, herein described. This document is not to
be consideredcomplete and it is meant for information and
discussion purposes only. Information in this brochure is not
offered as advice on any particularmatter and must not be treated
as a substitute for specific advice. In particular the information
provided does not constitute professional,financial or investment
advice and must not be used as a basis for making investment
decisions and is in no way intended, directly orindirectly, as an
attempt to market or sell any type of financial instrument. Advice
from a suitably qualified professional should always besought in
relation to any particular matter or circumstances. The contents of
this brochure do not constitute an invitation to invest in sharesor
bonds of the London Stock Exchange, constitute or form a part of
any offer for the sale or subscription of, or any invitation to
offer to buyor subscribe for any securities or other financial
instruments, nor should it or any part of it form the basis of, or
be relied upon in anyconnection with any contract or commitment
whatsoever. The London Stock Exchange does not conduct investment
business in the UnitedKingdom with private customers and
accordingly services and products mentioned or referred to in this
brochure are not available to suchpersons directly via the London
Stock Exchange.The London Stock Exchange accepts no liability,
arising, without limitation to the generalityof the foregoing, from
inaccuracies and/or mistakes, for decisions and/or actions taken by
any party based on this documents.
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To support this new market, a number ofspecialist broker
partners will be working with us to provide access to the retail
bond market’snew electronic order book. Look out for thededicated
partner logo indicating that a broker isoffering access to this
service. Details of thesepartners are also available on our web
site.
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Copyright © January 2010 London Stock Exchange plc. Registered
in England and Wales No. 2075721.
London Stock Exchange plc has used all reasonable efforts to
ensure that the information contained in this publication is
correct at the time of going to press, but shall not be liable for
decisions made in reliance on it.
London Stock Exchange and the coat of arms device are registered
trademarks of London Stock Exchange plc.
London Stock Exchange plc10 Paternoster SquareLondon EC4M
7LSTelephone: +44 (0)20 7797 1000www.londonstockexchange.com
003/LMA/ORB
