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Bonds can variously be described as IOUs, loans or debts. They are similar to bank loans, but generally last longer (from 1 year to over 30 years).
When institutions, companies, governments and other entities want to raise long term finance but do not want to dilute their share holdings (or, indeed, cannot issue share capital ─ like the UK Government), they turn to the bond markets. Here they can raise money without having to pay it back for possibly decades.
On the other side of the deal are the investors. The biggest investors in the UK are the insurance companies and pension funds. They buy bonds to generate return, offset their liabilities, generate income or diversify their portfolios.
Before electronic ownership of bonds became common in the latter part of the twentieth century, when an institution issued bonds, the lender received a certificate. This was often a very elaborate and large document with pictures of whatever the bond was financing (trains, factories, airplanes etc). Amongst other information it also showed how much the certificate was worth (i.e. how much had been borrowed), the rate of interest, the currency and the borrower.
At the bottom of the certificate were a number of “coupons” attached to the main body by perforations (like stamps). Periodically, the lender would go to the paying agent (the company employed by the borrower to facilitate payments to bonds holders) with the certificate; the paying agent would tear off the relevant coupon and hand over the interest payment. At maturity, the whole certificate would be presented, the “principal” (or nominal amount) of the loan and final coupon paid and the certificate cancelled. We still use this slightly archaic terminology today, referring to “coupons” and “principal” even though virtually all bonds are now held electronically.
When an investor thinks about purchasing a bond, there are four key risk attributes that they will assess to determine whether the bond is a good fit with their portfolio, how likely it is that the expected returns will be achieved and whether the price is fair. These attributes are:
- its issuer
- its currency
- its coupon
- its maturity
Issuer − The issuer of the bond (i.e. borrower of the money) defines the credit risk of the bond. That is, the likelihood that the investor will be repaid their initial loan. For example, governments are generally considered to have a low credit risk.
Currency − A key difference between equity and debt is that, unlike equity, institutions can issue bonds in many currencies. Indeed bond markets talk about the currency of issuance and not the country of issuance. For instance, Vodafone, with its equity listed in London, issues debt in six currencies including the Australian dollar and Czech Koruna. The currency of the bond defines the second key risk characteristic of the bond.
Coupon − The coupon or interest rate defines the rate of interest paid on the bond. This interest can be paid annually, semi‐annually or even every 3 months, depending on the way the bond is structured. The stated rate of interest relates to the original amount of money lent or the “face value” of the bond and is more often than not a notional value of 100 or “par”. This is often not the same as the price paid for the bond. The size of the coupon gives an indication of the credit risk of the bond. The higher the coupon, the greater the riskiness of the issuer as an investor will require a higher interest rate to compensate them for the greater likelihood of the issuer defaulting.
Maturity − The maturity date is the date the investor gets their money back. There are a number of subtleties around the maturity date, but most bonds have a single fixed date. The further in the future the maturity date (the “longer” the bond), the more risky the debt as there is more time for the issuer to get into trouble. Indeed, some bonds (including the famous war loan from the UK Government) are “undated”, which means that the issuer never has to repay the debt. Undated, or perpetual, bonds often have features that allow the issuer to pay back the debt under certain circumstances: these are called “call options” and give the issuer the right, but not the obligation, to pay back the lender. The UK War Loan is undated and has a 3.5% coupon rate that is paid semi‐annually. However, since 1952 the Treasury has been able to “call” the bond and pay back investors at a price greater than 100 (or Par). Unfortunately, even during the deflationary hiatus of January 2006 the price of the bond only rose to about 94 with a yield of 3.7% so the bond was not called. War loan investors are therefore very unlikely to get their money back (ever)!
Legal Status and Growth Participation
There are three broad ways in which a company or institution can raise money: through the equity markets, the banks or the bond markets. Each of these has their own merits as shown in Table 1.
In terms of legal status and growth participation, bank loans and bonds are very similar. The main two differences are the length of the borrowing and what rights the lender has if the company goes into bankruptcy. Banks loans are often much shorter in maturity than bonds and banks usually get their money back before bond holders.
The key differences between bonds and equity is that most equity has voting rights and participates in the growth of the company (i.e. shares in the upside), whereas debt has neither voting rights nor the ability to participate in the company’s growth. However, debtors do have the ability to call in the administrators if the company defaults on a payment or breaks a covenant – a legally binding promise made by the issuer to the investor in the prospectus -and possibly close down the company.
They also have an earlier call on the company’s assets. So if the company does default, the bond holders often get something back whilst the equity holders get nothing. Indeed in this scenario the bond holders usually end up owning the company. In bond market language this means that the debt holders rank “above”, are “higher” or “senior” to the equity holders.
|BROAD CHARACTRISTICS||Equity||Bond||Bank Loan|
|Usual Term||Perpetual||Medium to Long term||Short term|
|Participation in growth||Yes||No||No|
|Legal recourse||Company law||Instigate bankruptcy||Instigate bankruptcy|
Credit Ratings are fundamental to good bond fund management. Not all bonds have a rating but, those that do not, suffer for not having one, having to pay more for the money they borrow.
There are three major rating agencies, Moody’s, Standard and Poor’s (S&P) and Fitch. They all have similar rating categories, which reflect the likelihood of a bond defaulting or the rating changing.
From the coarsest perspective, bonds are either investment grade or high yield. High yield can also be termed “junk”, “speculative”, “non‐investment” or “sub‐investment” grade. The arbitrary divide between the two categories was created by Moody’s in the early part of the twentieth century but has remained important − some funds cannot invest in sub‐investment grade bonds.
Underneath that categorisation there are ratings bands: AAA, AA, A and BBB are called “investment grade”, BB, B, CCC, CC and C are called “high yield” (a.k.a. “junk bonds”), and D are in default. The average 5 year default rate for investment grade bonds runs (based on Moody’s dataset going back to 1920) from 16% to 3.13%. The average 5 year default rate for high yield bonds runs from 9.9% to 41.8%.
As the ratings fall so does the likelihood of a default and also that the greater the time horizon the greater the probability of default. No bond with a rating of AAA has defaulted over a 1 year horizon. Over 5 years there have been AAA defaults, but these bonds would have been downgraded to other categories over that 5‐year period.
Primary and Secondary Markets
The life of a bond has two phases, primary and secondary. The primary phase is the gestation period of a bond before it is priced and launched into the markets. After its initial pricing, it enters its secondary phase.
The primary phase encompasses all the work leading up to the pricing and launching of a bond. This includes:
- Creating the prospectus (This is a document possibly several hundred pages long written by lawyers to specify in great detail what rights an investor has and what the issuer can do and has to do while the bond us still in issuance)
- Writing research to support the issue
- Talking with investors to see at what price they would buy the bond
- Building a “book” (gathering a list of investors who have committed to buying the bond)
- Working on selling other bonds to facilitate the purchase of the new bond
- The final pricing.
There are often several brokers working together (mainly!) on the primary issuance of a bond. These are called lead and co‐lead managers. Having a number rather than one lead manager gives the bond the greatest possible exposure to potential buyers as each broker will have some non‐overlapping clients. The key objective for the brokers is to get the best (i.e. highest) price for the bond to raise the most amount of money for the client whilst also ensuring that all the bonds are sold. Indeed, it is good practice to ensure that there is more demand than supply. If the bond is priced too high and the entire bond is not sold to end investors, the bond becomes tarnished and perform not only badly to start with (i.e. the price will fall) but in the long term the bond may also not perform well (investors have memories!). This impacts the ability of the issuer to sell more bonds in the future.
The primary phase finishes when bonds have been allocated by the brokers to clients, “switches” – where a broker agrees to buy an existing secondary market bond in exchange for sale of the new primary market bond on fixed terms – have been completed and the price set. The secondary phase then starts.
When a bond enters its secondary phase it is open to be traded by all. Generally, the brokers, or lead managers, that brought the bond to market commit to making a two way price (they commit to both offering to buy or sell the bond or “make a market”) in the bond for its life.
In reality, this is not always the case especially in difficult market conditions where there is a lot of volatility (e.g. caused by emerging economic data, loans crises, political unrest or defaults) or if the bond is of a small size and/or has a complex structure (too many bells and whistles, including call options, put options, odd coupon payments; all of which can be complex to understand and can therefore be a disincentive to ownership. Demand for these types of bonds tends to be lower, because of these time, cost and demand overheads).
This is important as it impacts the liquidity of the bond, its price and the willingness of investors to own it. (Liquidity is essential, as it allows the fund manager to change the structure of their portfolio in the event of difficult market conditions.)
From “The Sterling Bond Markets and Low Carbon or Green Bonds”, a report to E3G by Climate Bonds Advisory Panel member Alex Veys.