Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1  Corporate bonds  Commercial paper  Role of the credit rating agencies  Investment and non-investment grade 31cis Lesson 31:

Other risks associated with holding bonds  Early redemption  The risk that the issuer might invoke a call provision (if the bond is callable) o A call provision is the right to “call in” or redeem the bonds early, if, for instance, the issuer has been able to refinance the borrowing at a cheaper interest rate The other main risks associated with holdings bonds as an investment are:  Seniority risk  The issuer might issue new, additional bonds, which rank higher in seniority o In the event of the issuer’s liquidation, debt with the highest seniority is repaid first  Liquidity risk  Some bonds are more easily sold at a fair market price o Liquidity: the ease with which a security can be converted into cash  Exchange rate risk  The bonds might be denominated in a currency different to that of the investor o The value of the issuer’s currency might have declined relative to the investor’s

Corporate bonds Corporate bonds are bonds issued by companies The term corporate bond is usually applied to longer-term debt instruments  Corporate bonds have a maturity date of more than 12 months  It is unusual for a company to issue a bond with a maturity of more than 10 years  Only companies with a very high credit rating can do so without having to offer very high interest rate  A corporate bond with a maturity of less than 12 months is called “commercial paper”  Only the largest and most credit-worthy companies can issue commercial paper  Most corporate bonds are listed on stock exchanges  But the majority of corporate bond trading in most developed markets is transacted Over-The-Counter (OTC)  There is no real secondary market for commercial papers

Features of corporate bonds Bond security  The risk of a default is much greater for a corporate bond than for a government bond  However, since 2008, the risk of a government bond default has increased substantially  Corporate bond issuers often have to offer security  This is a form of guarantee to the investor that the bond will be repaid  The security is usually in the form of a charge over assets of the issuer, such as:  Issuer’s property  Issuer’s trade assets  If the corporate bond issuer defaults, the investor has a claim on those assets before other creditors  Sometimes the security takes the form of a third-party guarantee  Such as a bank guarantee that if the issuer defaults, the bank will repay the bond-holders Cumulative historic default rates (in %) Issuance of bonds secured by aircraft

Bond security (cont.) Bond security can be fixed or floating  Fixed security  Specific assets (e.g. a building) are charged as security for the loan  Floating security  General assets are offered as security, such as: o Cash at the bank o Trade debtors o Stock  The greater the security offered, the lower the cost of borrowing should be

Redemption provisions Sometimes a corporate bond will have a call provision  The corporate bond with a call provision gives the option to buy back the bond before maturity  The call provision can apply to all or part of the bond issue  Issuers of corporate bond like call provisions  If interest rates move lower, they can refinance the bond, i.e. o Issue a new bond with a lower coupon and use the proceeds to repay the old bond  Investors in corporate bonds do not like the call provision feature  Many bond investors – especially pension funds – want their income to be predictable for the long term  Investors usually require a higher yield as compensation for this reduced predictability  Call provisions can take various forms  There may be a requirement for the issuer to redeem a specified amount at regular intervals o This is known as a “sinking fund” requirement

Redemption provisions (cont.) Sometimes a corporate bond will have a “put” provision  A “puttable” bond is one which gives the investor (the bond-holder) the right to require the issuer to redeem the bond early  The “put” provision may set a specific date for this potential early redemption  Or it might specify two dates between which the put provision may be exercised  Investors in corporate bonds like put provisions  A corporate bond with a put provision is more easy to sell to investors o However, the issuing company faces the risk of having to refinance the bond at an inconvenient time – perhaps at a more expensive interest rate

Other risks associated with holding bonds  Early redemption  The risk that the issuer might invoke a call provision (if the bond is callable) o A call provision is the right to “call in” or redeem the bonds early, if, for instance, the issuer has been able to refinance the borrowing at a cheaper interest rate The other main risks associated with holdings bonds as an investment are:  Seniority risk  The issuer might issue new, additional bonds, which rank higher in seniority o In the event of the issuer’s liquidation, debt with the highest seniority is repaid first  Liquidity risk  Some bonds are more easily sold at a fair market price o Liquidity: the ease with which a security can be converted into cash  Exchange rate risk  The bonds might be denominated in a currency different to that of the investor o The value of the issuer’s currency might have declined relative to the investor’s

Role of credit rating agencies How can an investor assess the likelihood of a bond issuer defaulting? Independent credit rating agencies monitor the financial health of companies that have issued, or are seeking to issue, bonds or other debt securities The three most prominent credit rating agencies are: The credit rating agencies will give a rating to each bond, indicating the likelihood that the interest and capital will be paid in full.  Standard & Poor’s  Moody’s  Fitch Ratings

Credit ratings Credit rating agencies assess a bond when it is first issued and then re- assessed if circumstances change.  Investment grade  Expected to give a steady return over the life of the bond  Expected to repay the capital sum at maturity  Non-investment, or speculative grade  Not suitable for pension funds, etc  Also known as: o High yield o Junk A bond’s credit rating can be upgraded or downgraded. A change to the credit rating will have an immediate impact on the price of the bond in the resale market Credit ratings can be divided into two main categories: Yield spread between High-Yield (Junk) bonds and investment grade bonds (percentage points)