BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds

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Financial Management MGT201

Lesson 13

BONDS AND CLASSIFICATION OF BONDS

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following topic

· Bonds

· Classifications of bonds

Up to lecture no 12, we have discussed the investment decisions and capital budgeting as it relates

to real assets and properties.

Now, we discuss about the securities.

Difference between Real Assets & Securities

Real assets are physical property such as Land, Machinery, equipments and Building etc. Where

as securities basically, are legal contractual piece of paper.

Kinds of securities:

We have discussed about two types of securities.

Direct claim securities:

Stocks (Shares):

It is defined as equity paper representing ownership, shareholding. Appears on Liabilities side

of Balance Sheet

Bonds:

It is a debt paper representing loan or borrowing. These are long term debt instruments.

Classification of bonds on Balance sheet:

One should be very careful regarding the classifications of bonds on the balance sheet. Because,

when you are Issuing Bonds (i.e. borrowing money) then the Value of Bonds appears under Liabilities

side (as Long Term Debt) of Balance Sheet. If you are Investing (or buying) Bonds of other companies

then their Value appears under Assets side (as Marketable Securities) of Balance Sheet.

The Important thing to remember is that the stocks represent the ownership and bonds represent the debt.

Both are the direct claim securities.

When a company or investor rising funds he have two possible options available to him.

1) Equity

2) Debt

One form of the debt is bonds. Value of Direct Claim Security is directly will be determined by

the value of the underlying Real Asset. This concept explained with the help of the following example:

Textile Weaving Factory Case Study:

A Textile Weaving Factory uses thread to make cotton fabric and then sells cotton fabric to earn

cash receipts. It needs Rs.1 million to make a Capital Investment in looms and machinery. It has two

options he can raise money through

1. Equity, OR

2. Debt

Lets suppose that company decide to take Rs. 1 million in the form of debt It can raise money for a

period of 1 year by Debt Financing by Issuing a 1 year Mortgage Bond whereby it pays the Lender (i.e.

Investor or Bondholder) 15% p.a Coupon Interest Rate. You decided to divide 1 million in to 1 thousand

parts and each one of these parts in the form of paper that has a face or par value of Rs 1,000.Each Bond

paper worth Rs 1,000 and the total number of bonds is 1,000.Each bond paper carries the face value

which is printed on it and also carries coupon interest rate. Suppose that coupon interest rate on this

bond is 15% it means that this company would pay 15% of the face value to the lender. It is income for

the lender (Bond holder). The Bond also has the limited life. In this case we suppose that management

need money for the period of two years. The company pays the coupon rate to the bond holder for two

years and also returns the principle to the lender after two years at maturity date.

The Lender's (or Bond Holder's or Investor's) money is protected because the Mortgage Bond is

Backed (or Secured) by Real Property such as the land, factory building, and machinery. Upon

Maturity, after 1 year, the Bond Issuer will return the Par or Face Value (or Principal Amount of Rs 1

million) to the Lender.

Now, we discuss different concepts which are common in different bonds. There are certain

advantages and disadvantages of raising money either through equity or through bonds.

Financial Management MGT201

Why to raise money through a Debt (ie. Bond) rather than through Equity (i.e. Shares or Stocks)?

If the Company raises money using Bonds, then it will have to pay a fixed amount of interest

(or mark-up) regularly for a limited amount of time. You do not share the profits of the company. But

there as legal risk attached to the failure to pay interest can force company to close down.

If the Company raises money using Equity, then it is forced to bring in new shareholders who

can interfere in the management and will get a share of the net profits (or dividends) for as long as the

company is in operation! The amount of dividends can vary.

Value of the Bond:

The Value of the Bond can be calculated from the Cash Flows attached to the Bond. Bonds are

direct claim securities. The bond holder will receive the coupon interest rate and he will also receive his

principle amount at the time of maturity. Where are these cash flows come from? How the company is

able to pay interest to the bond holder. The company is making cash from operations. Those Cash Flows

depend on the Cash Flows from the Real Business i.e. the textile factory's cash flows from sale of fabric.

Bond value is coming from the fabric sale. This is why the Bond is called a Direct Claim Security

whose value depends on the value of some underlying real asset.

Characteristics of bonds:

In Pakistan, the bonds take on the form of Term Finance Certificates (TFC's).These are traded

on three stock exchanges of Pakistan. It is quite common to trade bonds in the stock markets. In

Pakistan, the Par Value (or Face Value) of each TFC is generally Rs 1,000 but it can be different. The

Life of a Bond is generally limited (or finite) i.e. 6 months, 1 year, 3 years, 5 years..... The bonds can be

issued by any one (Public, Private) who is in need of money. Even individuals can issue bonds. For

example, Defense saving certificates, Treasury bills, T Bills (short term bonds) & FIB (Long term

bonds) are also classifieds as the bonds

Face value is the amount which is mentioned on the bond paper. Par value is fixed but the bonds are

traded in the markets. As the financial health (cash flows and income) of the company changes with

time, the Market Value (or Price) of the Bond changes (even though it's Par Value is fixed). Market

Prices also change depending on the Supply-Demand for the Bond (or TFC) and Investors' Perception.

Major reason is the change in interest rate effect the bond price we will discuss it in detail in upcoming

lectures. In case of Textile Company this company issued a bond at the fixed coupon interest rate is

15 % of par value. This rate is fixed and should be paid by the company. Non payment of this would

defult and result in the closing of the company.

However, the market interest rate keeps moving and it changes on daily basis. We have discussed the

factors that caused the changes in interest rate in the previous lectures.

Bonds: Definition

Bond is a type of Direct Claim Security (a legal contractual paper) whose value is secured by Real

Assets owned by the Issuer. Bond is issued by the Issuer (or Borrower) to the Bondholder (or Lender or

Investor or Financier) in exchange for the cash. Borrowers and lenders can be individual persons or

companies or governments.

Examples: Term Finance Certificate (TFC issued by Public Listed Industrial Companies), Defense

Saving Certificate (DSC issued by Government), T-Bill (issued by Government)Bond is a Legal

Contractual Paper Certificate that represents Long Term Debt (or Long-term Promissory Note).Bond

paper contains legal & numerical points

Bonds: Numerical Features

· Maturity or Tenure or Life: Measured in years. On the Maturity Date when the bond expires,

the Issuer returns all the money (Principal/par and Interest/coupon) to the Investor (thereby

terminating or Redeeming the bond) ie. 6 months, 1 year, 3 years, 5 years, 10 years, ...

· Par Value or Face Value: Principal Amount (generally printed on the bond paper) returned at

maturity ie. Rs 1,000 or Rs. 10,000. Contrast this to Market Value (or Actual Price based on

Supply/Demand) and Intrinsic or Fair Value (estimated using Bond Pricing or Present Value

Formula)

· Coupon Interest Rate: percentage of Par Value paid out as interest irrespective of changes in

Market Value ie. 5 % pa, 10 % pa, 15% pa, ... etc. Coupon Receipt = Coupon Rate x Par

Value. Coupon Receipts can be paid out monthly, quarterly, six-monthly, annually...etc.

Contrast to Market Interest Rate (macro-economic).

Financial Management MGT201

Bonds: Characteristics & Legal Points

Indenture": Long Legal Agreement between the Issuer (or Borrower) and the Bond Trustee

(generally a bank of financial institution that acts as the representative for all Bondholders).

Basically protects Bondholders from mis-management by the bond issuer, default, other security

holders, etc.

Claims on Assets & Income:

Bondholders have the First Claim on Assets in case the company closes down (Before

Shareholders). The Financial Charges due to Bond Holders must be paid out from the Income before

any Net Income can be distributed to Stockholders in the form of Dividends (see P/L Statement). If

Issuer (or Borrower) does not pay the interest to the Bondholder (i.e. Default), then the firm can be

legally declared Insolvent, Bankrupt, and forced to close down.

Security:

Mortgage Bonds are backed by real property (ie. Land, building,, machinery, inventory) whose

value is generally higher than that of the value of the bonds issued. Debentures and Subordinated Bonds

are not secured by real property but they are backed by personal and corporate guarantees and their

security and value is tied to the anticipated future cash in-flows of the business.

Call Provision:

The right (or option) of the Issuer to call back (redeem) or retire the bond by paying-off the

Bondholders before the Maturity Date. When market interest rates drop, Issuers (or Borrowers) often

call back the old bonds and issue new ones at lower interest rates.

Bond Ratings & Risk

Bonds are rated by various Rating Agencies:

Internationally: Moody's, S&P.

In Pakistan: Pacra, VIS.

Based on future Risk Potential of the company that is the Issuer of the bond.

Bond risk increases with:

Operating losses (check Cash Flow Statement and P/L)

Excessive borrowings or debt (check Balance Sheet)

Large variations in income

Small size of business

Country and foreign exchange rate risk

International Bond Rating Scale (starting from the best or least risky): AAA, AA, A, BBB, BB, B, CCC,

CC, C, D. Also + is better and - is worse. So A+ is better than A. A- is worse than A.

Types of Bonds:

Mortgage Bonds: backed & secured by real assets

Subordinated Debt and General Credit: lower rank and claim than Mortgage Bonds.

Debentures:

These are not secured by real property, risky

Floating Rate Bond:

It is defined as a type of bond bearing a yield that may rise and fall within a specified range

according to fluctuations in the market. The bond has been used in the housing bond market

Eurobonds: it issued from a foreign country

Zero Bonds & Low Coupon Bonds: no regular interest payments (+ for lender), not callable (+ for

investor)

Junk Bonds & High Yield Bonds: Corporations that are small in size, or lack an established operating

track record are also likely to be considered speculative grade. Junk bonds are most commonly

associated with corporate issuers. They are high-risk debt with rating below BB by S&P

Financial Management MGT201

Convertible Bonds:

A convertible bond is a bond which can be converted into the company's common stock. You

can exercise the convertible bond and exchange the bond into a predetermined amount of shares in the

company. The conversion ratio can vary from bond to bond. You can find the terms of the convertible,

such as the exact number of shares or the method of determining how many shares the bond is converted

into, in the indenture. For example a conversion ratio of 40:1 means that for every bond (with Rs.1,000

par value) you hold you can exchange for 40 shares of stock. Occasionally, the indenture might have a

provision that states the conversion ratio will change through the years, but this is rare. Convertibles

typically offer a lower yield than a regular bond because there is the option to convert the shares into

stock and collect the capital gain. But, should the company go bankrupt, convertibles are ranked the

same as regular bonds so you have a better chance of getting some of your money back

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