Chapter 9 – Long Term Finance - Bonds
7.1 Debt Financing
7.1.1 Term Loans
A term loan is a contract under which a borrower agrees to make a series of
interest and principal payments on specific dates to the lender. Term loans are
usually negotiated directly between the borrowing firm and a financial institution.
The maturity of term loan is more than 1 year. The interest rate can either be fixed
for the life of the loan or variable (floating).
7.1.2 Bonds
A bond is a long-term contract under which a borrower agrees to make payments
of interest and principal on specific dates to the holder of the bond.
Bonds are similar to term loans, but a bond issue is generally advertised, offered
to the public, and actually sold to many different investors. Indeed, thousands of
individual and institutional investors may purchase bonds when a firm sells a
bond issue, whereas there is generally only one lender and borrower in the case of
a term loan agreement.
Bonds are long term debt under which a borrower (issuer) agrees to make
payments on interest (coupon) and principal on specific dates to the bond
holders (lenders of fund).
Issuing organization(issuers) agrees to pay
i. a fixed amount of coupon (interest) periodically and
ii. to pay a fixed amount of principal upon maturity
Example: PLUS Bonds, Telekom Bonds, Malaysian Government Securities (MGS)
Bonds are similar to term loans, but a bond issue is generally advertised, offered to the
public, and actually sold to many different investors. Indeed, thousands of individual and
institutional investors may purchase bonds when a firm sells a bond issue, whereas there
is generally only one lender and borrower in the case of a term loan agreement.
Bonds are issued to finance a particular project or purpose.
Example:
PLUS bond were issued to finance the construction of the North – South Highway, and in
return the bond holder (lenders of the funds) will receive coupon payment every 6 months
and the bondholders will receive the principle amount upon maturity of the bond.
What are bonds?
Bonds are liabilities – traded IOU where bondholders are actually lending
money to the issuer
Are negotiable long term debt instrument representing the Issuer’s contractual
obligation(IOU)
Public Debt Instrument = Malaysian Government Securities (MGS) are issued
by the government.
Private Debt Instrument = Corporate Debt are issued by private Companies
e.g. PLUS Bonds, Maxis Bonds
Also known as Fixed income securities = coupon and principal payment are
specified over a period of time.
Failure to pay interest and/or principal = default.
Are long term debt under which a borrower agrees to make payments on
interest and principal on specific dates to the bond holders?
- Buying a company’s bonds is like making a loan to a company, except that
bonds may be traded in the market and their values fluctuate.
- It may also be pointed out that bondholders have claims that take priority
over the claims of the stockholders on the assets of the company.
4. CHARACTERISTICS OF BONDS
a. Nominal Value (Par Value)
The nominal value is the par or face value.
Also known as the principal value which is the amount that the issuer
agreed to repay the bondholder at the maturity date.
b. Coupon Rate
Is the nominal interest rate that determines the actual interest the bondholder
receives on owning the bond?
Payable annually, half yearly, or quarterly however, half yearly is most
popular
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c. Terms to maturity
Is the no. of years over which the issuer of the bond has promised to meet
the conditions and obligation of the bond issue.
During this time the bondholder is paid the promised coupon payment
It also indicates the remaining life of the bond.
Maturity of the bond is the date the bond will cease to exist, at which time
the issuer will pay back to the bondholders, the principal.
d. Yield-to-maturity
Is the indicated (promised) compounded rate of return an investor will
investor will receive from a bond purchase at the current market price and
held to maturity.
Is the effective interest rate earned on the bond investment.
Prices of bonds are quoted in relation to their yield.
e. Call Provision
Entitles the issuer to redeem or call the bonds from their holders.
Investors will receive some compensation for the risk that the bond will be
called away.
The investor will then be subjected to re-investment risk.
f. Sinking Fund
Money put aside by the issuer periodically for the eventual repayment of the
debt.
Ensures enough money to redeem the bond upon maturity.
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Advantages and disadvantages of Bonds
To Issuing Firm:
Advantages Disadvantages
a) Tax deduction of interest payment a) Debt must be paid.
Coupon payments to bondholders are The fixed interest charge must be
tax-deductible for the issuing firm paid whether the firm is having a
good or a bad year. Failure to meet
b) Increase in earnings per share these payments may lead to
Since a bond is a fixed-income bankruptcy suits by the bondholders.
security, the surplus earnings
available to shareholders after b) Increased risk due to financial
deducting interest payment to leverage
bondholders during good times would Bonds are categorized as long-term
be higher. debts and the issuance of such
security would increase the financial
c) Maintain control of the firm leverage of the firm.
Since bondholders are creditors of the
firm, they do not have controlling c) Restrictions on issuing firm
rights over the management of the To protect themselves, bondholders
firm as in the case of the may place certain restrictions or
shareholders. As such the covenants on the issuing firm to
shareholders of the firm still maintain prevent it from defaulting on its
control of the firm. obligations.
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To Investors:
Advantages Disadvantages
a) Fixed Returns 1) Fixed interest payment
Bonds are fixed-income security and If the issuing firm has good earnings,
investors who purchase bonds can bondholders do not get to enjoy the
expect a stable return since the additional earnings.
interest payment is fixed.
2) Decline in real interest payment
b) Lower Risk Since bondholders get a fixed interest
The bondholders would be able to payment, they may lose out during
have prior claims on the assets of the times of high inflation.
firm before the shareholders in the
event of liquidation of the firm. 3) Lower return
Because the risk is low, the returns
are too.
4) Reinvestment Risk on callable
bonds
Interest rate at which the money
received are reinvested may not be as
high as expected.
5. TYPES OF BONDS
i. Government Bond is a bond issued by a national government denominated
in the country's own currency. Government bonds are usually referred to as
risk-free bonds with maturity exceeding more than 3 years E.g. Malaysian,
Government Securities (MGS), Khazanah Bond, Bon Simpanan Merdeka
2009 issued to Malaysian citizens who are 56 years and above.
Malaysian Government Securities (MGS)
MGS are long-term bonds issued by the Government of Malaysia
for financing developmental expenditure.
MGS are fixed-rate coupon bearing bonds with bullet repayment of
principal upon maturity while coupon payments are made semi-
annually.
Beginning December 2006, BNM has also introduced Callable
MGS which provides the Government of Malaysia with the option
to redeem the issue at par by giving an advance notice of five
business days to the bond holders.
MGS are issued via competitive auction by Bank Negara Malaysia
on behalf of the Government.
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- The successful bidders are determined according to the lowest
yields offered and the coupon rate is fixed at the weighted average
yield of successful bids.
The actual issuance size is announced a week before the issuance
date. The typical issuance size ranges from RM1 billion to RM4.5
billion depending on Government financing requirement.
The Government is committed to continuously issue 3-year, 5-year,
7-year and 10-year MGS as benchmark securities as part of its
efforts to develop the benchmark yield curve.
In addition, 15-year and 20-year MGS were also issued to lengthen
the benchmark yield curve.
Secondary market for benchmark securities is liquid with average
daily transaction volume varying from RM100 million to RM500
million.
Standard transaction is RM10 million per lot.
Trades are settled in two business days (T+2) and are quoted on a
price basis to two decimal points.
- -For transactions via money brokers, brokerage fee is payable.
ii. Convertible Bonds:
A bond that is convertible into shares of common stock, at a fixed
price, at the option of the bondholder.
Convertible bonds carry a lower coupon rates, but they offer
investors a chance for capital gains.
iii. Zero Coupon Bonds:
A bond that pays no annual interest but is sold at a discount below
par, thus providing compensation to investors in the form of capital
appreciation.
a bond bought at a price lower than its face value, with the face
value repaid at the time of maturity
It does not make periodic interest payments, or have so-called
"coupons," hence the term zero-coupon bond.
When the bond reaches maturity, its investor receives its par (or
face) value. Examples of zero-coupon bonds include Treasury bills
iv. Floating Rate Bonds:
A bond whose interest rate fluctuates with shifts in the general level
of interest rates.
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v. Junk Bonds:
A bond rated 'BB' or lower because of its high default risk.
Also known as a "high-yield bond" or "speculative bond".
These are usually purchased for speculative purposes.
Junk bonds typically offer interest rates three to four percentage
points higher than safer government issues.
Corporate debt securities bearing credit ratings below investment
grade.
Are low-rated, high-yielding, speculative vehicles issued primarily
by corporations usually to finance restructuring, mergers and
takeovers.
2.0 BOND RATINGS
Bond ratings are grades that are assigned to bond issues on the basis of
extensive, professionally
conducted financial analysis to designate investment quality.
Ratings basically point to the default risk of an issue. Higher ratings mean that
issues are investment grade.
Lower ratings mean that issues are in the junk category and more speculative.
The higher the rating, the lower the default risk and, hence, the lower the yield of
an obligation.
A lower rating means that the investor must assume more of the default risk and
has to be compensated with a higher yield.
Rating Agencies in Malaysia
i. Rating Agency Malaysia(RAM)
ii. Malaysian Rating Corporation(MARC)
Bond Ratings
AAA
AA
A
BBB ----Investable Grade ---------
BB
B
C
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D
2.1 The use of bond ratings
Idividuals can depend on agency ratings as a viable measure of the
creditworthiness of the issuer and the issuer’s default risk.
These ratings are objective and reliable because they are done by an independent
party
Investors are able to make comparison among bonds in terms of risk and return.
2.2 Limitation of bond rating
Bond ratings are intended to only measure an issuer’s default risk, and as such,
ratings provide no indication of the amount of market risk imbedded in a bond
Even the highest quality issues will go down in price when interest rates increase,
subjecting investors to capital loss and market risk.
If bond ratings are done by unreliable rating agencies.
7.1.3 Key Factors When Deciding on the Appropriate Source of Long Term Loan
a) The purpose of the loan. The reason for seeking finance should be fully evaluated
to ensure that it is financially justified.
b) The amount of the loan. A cash budget should be prepared to check that the
amount of finance sought is sufficient for the required purpose.
c) Repayment of the loan. The detailed projections should identify repayment
schedules clearly.
d) The term of the loan. This should be appropriate to the type of asset being
acquired. As a general rule, long term assets should be financed from long term
finance sources.
e) The cost of finance. The relative costs of the different forms of finance available
should be compared.
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Tutorial: Chapter 9 Long Term Financing - Bonds
QUESTION 1
i. What are bonds?
ii. Discuss the characteristics of bonds.
QUESTION 2
i. Why bonds are also known as fixed income securities?
ii. Discuss the advantages of bonds to both the issuer and investor.
QUESTION 3
Discuss the disadvantages of bonds to both the issuer and investor.
QUESTION 4
Discuss the following types of bonds:
i. Government Bond
ii. Convertible Bonds:
iii. Zero Coupon Bonds:
iv. Junk Bonds
QUESTION 5
i. What are bond ratings
ii. Why are bond ratings important to investors
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QUESTION 1
1. i. What are bonds?
Bonds are long term debt under which a borrower (issuer) agrees to make
payments on interest (coupon) and principal on specific dates to the bond
holders (lenders of fund).
Bonds are issued to finance a particular project or purpose.
.ii. Discuss the characteristics of bonds.
CHARACTERISTICS OF BONDS
a. Nominal Value (Par Value)
The nominal value is the par or face value.
Also known as the principal value which is the amount that the issuer
agreed to repay the bondholder at the maturity date.
b. Coupon Rate
Is the nominal interest rate that determines the actual interest the bondholder
receives on owning the bond.
Payable annually, half yearly, or quarterly however, half yearly is most
popular
c. Terms to maturity
Is the no. of years over which the issuer of the bond has promised to meet
the conditions and obligation of the bond issue.
During this time the bondholder is paid the promised coupon payment
It also indicates the remaining life of the bond.
Maturity of the bond is the date the bond will cease to exist, at which time
the issuer will pay back to the bondholders, the principal.
d. Yield-to-maturity
Is the indicated(promised) compounded rate of return an investor will
investor will receive from a bond purchase at the current market price and
held to maturity.
Is the effective interest rate earned on the bond investment.
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Prices of bonds are quoted in relation to their yield.
e. Call Provision
Entitles the issuer to redeem or call the bonds from their holders.
Investors will receive some compensation for the risk that the bond will be
called away.
The investor will then be subjected to re-investment risk.
f. Sinking Fund
Money put aside by the issuer periodically for the eventual repayment of the
debt.
Ensures enough money to redeem the bond upon maturity.
QUESTION 2
i. Why bonds are also known as fixed income securities?
Because income received in the form of coupons are fixed.
ii. Discuss the advantages of bonds to both the issuer and investor
To Issuing Firm:
a) Tax deduction of interest payment
Coupon payments to bondholders are tax-deductible for the issuing firm
b) Increase in earnings per share
Since a bond is a fixed-income security, the surplus earnings available to shareholders
after deducting interest payment to bondholders during good times would be higher.
c) Maintain control of the firm
Since bondholders are creditors of the firm, they do not have controlling rights over
the management of the firm as in the case of the shareholders. As such the
shareholders of the firm still maintain control of the firm
To Investors:
a) Fixed Returns
Bonds are fixed-income security and investors who purchase bonds can expect a
stable return since the interest payment is fixed.
b) Lower Risk
The bondholders would be able to have prior claims on the assets of the firm before
the shareholders in the event of liquidation of the firm.
QUESTION 3
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Discuss the disadvantages of bonds to both the issuer and investor
To Issuing Firm:
a) Debt must be paid.
The fixed interest charge must be paid whether the firm is having a good or a bad
year. Failure to meet these payments may lead to bankruptcy suits by the
bondholders.
b) Increased risk due to financial leverage
Bonds are categorized as long-term debts and the issuance of such security would
increase the financial leverage of the firm.
c) Restrictions on issuing firm
To protect themselves, bondholders may place certain restrictions or covenants on the
issuing firm to prevent it from defaulting on its obligations.
To Investors:
1) Fixed interest payment
If the issuing firm has good earnings, bondholders do not get to enjoy the additional
earnings.
2) Decline in real interest payment
Since bondholders get a fixed interest payment, they may lose out during times of
high inflation.
3) Lower return
Because the risk is low, the returns are too.
4) Reinvestment Risk on callable bonds
Interest rate at which the money received are reinvested may not be as high as expected.
QUESTION 4
Discuss the following types of bonds:
i. Government Bond
Government Bond is a bond issued by a national government denominated in the
country's own currency. Government bonds are usually referred to as risk-free
bonds with maturity exceeding more than 3 years E.g. Malaysian, Government
Securities (MGS), Bon Simpanan Merdeka 2009 issued to Malaysian citizens who
are 56 years and above.
ii. Convertible Bonds
A bond that is convertible into shares of common stock, at a fixed price, at the
option of the bondholder. Convertible bonds carry a lower coupon rates, but they
offer investors a chance for capital gains.
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iii. Zero Coupon Bonds
A bond that pays no annual interest but is sold at a discount below par, thus
providing compensation to investors in the form of capital appreciation.
iv. Junk Bonds
Corporate debt securities bearing credit ratings below investment grade. Are low-
rated, high-yielding, speculative vehicles issued primarily by corporations usually
to finance mergers and takeovers.
QUESTION 5
i. What are bond ratings
ii. Why are bond ratings important to investors
BOND RATINGS
Bond ratings are grades that are assigned to bond issues on the basis of
extensive, professionally
conducted financial analysis to designate investment quality.
Ratings basically point to the default risk of an issue. Higher ratings mean that
issues are investment grade.
Lower ratings mean that issues are in the junk category and more speculative.
The higher the rating, the lower the default risk and, hence, the lower the yield of
an obligation.
A lower rating means that the investor must assume more of the default risk and
has to be compensated with a higher yield.
The use of bond ratings
Idividuals can depend on agency ratings as a viable measure of the
creditworthiness of the issuer and the issuer’s default risk.
These ratings are objective and reliable because they are done by an
independent party
Investors are able to make comparison among bonds in terms of risk and return.
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