2.2.3. Bonds and their valuation
Bonds as securities
Definition of a bond. Bonds are securities, registered or bearer, issued by any enterprises, regardless of their organizational and legal form, confirming the fact of the loan of money by the investor (holder, bondholder) to the issuer and entitling to participate in the profit issuer in a specially stipulated way (usually in the form of a fixed percentage of the bond's nominal value).
These are & quot; older & quot; in relation to shares of paper: since their holder is a creditor, and not a co-owner of the enterprise, claims for them in the event of bankruptcy of the issuer are satisfied earlier than claims of shareholders of the company. Accordingly, the funds accumulated by the enterprise through the placement of a loan (bond issue) are not their own, but borrowed (mainly long-term loans).
Properties of bonds. According to the laws of the Russian Federation, bonds can be issued:
o as registered or as bearer securities. The appeal of bearer bonds is simplified in comparison with the nominal ones: the transfer of rights to bearer securities is effected by simply handing it over to the new owner;
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o with collateral (pledge, guarantees of third parties) and without additional collateral;
o with the right of conversion, i.e. exchange of bonds for a certain number of shares of the issuing corporation, and without it;
o with different repayment opportunities - in cash or in kind, at a time or in series (in separate series), just in time or with the right of early recall by the issuer. All this should be provided for in the release terms.
Issue of bonds. The possibility of issuing bonds in the Russian Federation without additional guarantees arises in enterprises that exist for at least three years. If no additional collateral is provided, the issue size is limited to the amount of the authorized capital, which, according to the legislation, must be fully paid by the time the prospectus is registered.
Issue of bonds is organized by decision of the issuer's board of directors. The timing of these securities can vary significantly: short-term bonds can be issued (they must be repaid in a year or less) and long-term bonds with maturities of more than one year. The procedure of issuance is the same as for the issue of shares.
For long-term bonds, the percentage of income may vary, but in general it is higher than for short-term bonds, due to the fact that such securities are more risky and more risk-compensated by a high rate of return.
The figure below (Figure 2.2) illustrates the process of investing in corporate bonds in a graphic way.
Fig. 2.2. Investing in bonds (using the scheme from Guide to Understanding Money & Investing. - N-Y, Lightbulb Press, 2007)
The main characteristics of bonds. The main characteristics of bonds as an investment object are:
o Coupon (its availability, type, method of accrual);
o repayment (term and mode of payment of income);
o the terms of the issuance of the rating support (negative and certifying obligations of the issuer);
o Embedded options (additional capabilities of the issuer and the bondholder);
o price (clean and dirty price, quotation). Consider these characteristics in more detail.
Coupon - is the current yield on the bond, determined in percent per annum from the nominal price of the bond and charged once a year, half year or quarter. In addition, bonds may not have a coupon at all and then they are called zero-coupon. Taxes on coupon income are held by the issuer, therefore in world practice such taxes are classified as withholding taxes.
Example . A corporate bond with a face value of $ 1,000 is quoted at a price of 99% of the nominal value. The coupon at a rate of 10% per annum is paid semi-annually. What is the amount of one semiannual coupon payment? How much will the corporation own a single bond to its account (coupon income tax is 9%)?
Solution. The coupon added for half a year: 1000 dollars х 10%: 2 = = 50 dollars.
The transferred amount minus the withheld tax: $ 50 x (1 -0.09) = $ 45.5
According to the method of charging coupons, debt securities are divided into fixed income bonds (the sequence and amount of payments for which is determined by the terms of issue) and bonds with floating coupons, their value is not known in advance.
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The types of cash flows for bonds with a fixed coupon are shown in Fig. 2.3. Apparently, zero-coupon bonds (b) do not have a coupon and are redeemed at face value. Bonds with accumulated coupon (c) differ in that the coupon is charged for them within the period until maturity, but its amount is paid at maturity. For bonds with increasing coupons (g), different coupons are paid in time, but their value is known in advance. Finally, the payment of deferred coupon payments does not begin immediately, but after some time after the bond issue (d, e). At the same time, coupons can be charged from the very beginning of the bond's existence, and then the accumulated coupon will be paid after a certain time (and then regular coupon payments will continue). In another case, coupons are accrued and paid at a certain time after the issue date.
Fig. 2.3. Varieties of fixed-coupon bonds
The coupon on floating rate bonds is usually divided into two parts - floater (variable part) and margin (constant part). The constant part remains unchanged throughout the life of the bond. Floater varies depending on the state of the market. The following modifications are possible:
o interest base rate for interbank loans, for example LIBOR, FIBOR, MIBOR, etc .;
o non-interest indexation of the coupon (for example, depending on the oil price index, inflation index);
o Periodical review of the coupon depending on the yield on another sector of the debt market (for example, a quarterly coupe on long-term federal loan obligations may be re-established depending on yield to maturity on the Treasury bills market quarterly).
Example . Suppose, on the eurobonds of a Russian corporation is paid a coupon at a rate of LIBOR + 2.5%. Coupon payment occurs every six months. What will be one coupon payment if the LIBOR rate at the moment of fixation is 4.5%?
Solution: (LIBOR + 2.5%): 2 = (4.5% + 2.5%): 2 = 3.5% of the nominal value.
Repayment of bonds. Repayment of bonds can also be organized in various ways. Bonds can be repaid in a single payment or in series (in this case the issue is divided into series, each of which has its maturity dates). Amortized bonds are repaid in more than one amount; their redemption is distributed over time. Finally, bonds with selective redemption can be repaid from a specially formed fund according to the lottery principle in a random way.
Terms of the release terms. To maintain the rating of bonds in the conditions of their issuance, various provisions are introduced that limit credit risk. As already mentioned, bonds can be secured with corporate assets or with guarantees of third parties. In addition, contractual restrictions may apply to the issuer, which are divided into negative (negative) and affirmative. The first prohibits the issuer to perform certain actions that reduce the rating of these bonds (eg, you can not sell the collateral to issue new loans with the same or higher priority conditions, practice leaseback, etc.) The second pas impose certain obligations of the issuer, such as compliance with the restrictions the level of financial leverage, maintaining certain coverage ratios, the formation of a fund for loan repayment and interest in a certain amount, etc.
Embedded options. The ordinary bond is a certain way issued by the issuer's obligation to pay within a certain time the amount of the principal and the interest (coupon). However, some types of bonds also imply certain contingent liabilities and rights that can be granted to either the issuer or the owner of the bond. These rights are called embedded options.
So, the options for the issuer can be:
o the right to early payment of the principal at par (ie, the possibility of early repayment at the request of the issuer);
o right of early recall, realized at a price higher than the nominal value (that is, with a premium for withdrawal);
o Cap on a floating interest rate (i.e., a floating rate bond is issued, but it is set & quot; cap & quot; - the growth rate of the coupon rate).
The options for a bondholder are:
o the right of early redemption of the bond at the request of its owner;
o warrant, i.e. the right of the bondholder to buy a certain number of shares in the future at a fixed strike price;
o the right to convert a bond into a certain fixed number of shares in the future;
o flor to a floating interest rate (i.e., a floating rate bond is issued, and the "flor" is set to the lowest minimum coupon rate).
The issuer's options usually reduce the price of a bond in comparison with its usual counterpart without an option; the holder's options, on the contrary, increase the price of the bond, all other things being equal.
Secondary bond market and investor activities on it. The largest bond market is the global euromarket. The investor's activities are as follows: the investor instructs his broker to contact several market makers of the market, on which the eurobonds of interest (ie eurobonds) are quoted, to obtain information on the prices of supply and demand. Then the transaction is carried out at the best prices. If, for example, the maximum purchase chain and the minimum bid price for bonds are 93-93.5, and the Eurobond value is $ 1,000, it means that they are sold at a price of $ 935, and they are bought at $ 930.
Eurobonds are sold and bought in the secondary market using the coupon method ("cum coupon"). This means that the quotation reflects only the & quot; pure & quot; the price cleared from the effect of the current coupon. And when the transaction is carried out, the buyer not only pays the seller a net price, but also compensates the coupon yield for the period that has elapsed since the last payment of the coupon in proportion to the time of holding the bond. The payment date for a Eurobond is usually seven days after the transaction is confirmed.
Example . The investor buys 100 eurobonds with a nominal value of $ 1,000. The coupon is 12% per annum, the offer price at which the purchase is made is 93.5 (bonds are usually quoted as a percentage of the nominal value). Payment for the purchased bond takes place 175 days (a year - 360 days) after the payment of the last coupon. It is required to calculate the total amount paid by the buyer.
Payment of the net price of Eurobonds: $ 1000 x 100 pcs. x 93.5: 100 = = $ 93,500
Payment of the accumulated coupon: 100 х 1000 dollars х 0.12 х 175: 360 = = 5833,33 dollars
Total payment amount: 93,500 + 5833,33 = 99,333.33 dollars.
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