Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1 Lesson 7:  Bonds  Impact of economic environment on investments 7cis

Where to put your money? UK investors are likely to place their money in the following order: 1. Cash deposits 2. Property 3. Equities (shares in companies) 4. Bonds These are four different classes of assets Because bonds are normally issued in very large minimum sizes, it is quite rare for a retail investor to buy bonds directly. Usually they are bought through a collective investment scheme, such as a unit trust Although you read a lot more about the equities markets than the bond markets in the newspapers and on the Internet, the bond market is the larger of the two, in terms of global investment value. This is because governments can (and do) issue bonds but they cannot really issue shares.  A government’s shareholders are its citizens

What is a Bond? A bond is a loan  A company that wishes to borrow money could:  Take out a bank loan, or  Issue shares, or  Issue a bond Characteristics of bonds  Investor lends money to the company, company issues certificate to the investor  Certificate states that the money will be repaid on a certain date in the future  Certificate states that interest will be paid on the bond a certain number of times over the life of the bond (usually semi-annually)  The certificate is tradable: the investor can sell the bond to another investor without needing the permission of the borrower

Bond jargon Bonds can also be called  Debt securities  Loan stock  Fixed interest securities Bond jargon  The regular interest payment on a bond is often referred to as the “coupon”  This dates back to the time when bond certificates had coupons attached, entitling the holder to redeem them at the bond issuer’s bank for the interest payment  The amount of money for which the bond is originally issued is called the “nominal” amount  A bond is listed according to the following convention:  Interest payable  Name of issuer (i.e. the borrower)  Date of redemption (i.e. repayment)

1888 US railway company 30-year bond certificate: Title: “4.4% Pennsylvania Railroad Company 1918” This US$1,000 bond certificate has coupons attached. These coupons would be redeemed for an interest payment of 4.4% (i.e. US$44) each year for 30 years. At the end of 30 years, the certificate would be presented to the issuer’s bank and the original US$1,000 would be repaid and the interest payments would finish.

A “bearer” certificate: physical possession was proof of ownership. The investor holding this bond certificate clipped out the coupon each year for eight years. The investor may have stopped claiming interest because the certificate was lost; or maybe the investor died and the certificate was mislaid with his other papers. Sometimes, coupons would go unredeemed because the issuing company defaulted on the annual interest. In those instances, the original loan (the nominal sum) would not have been repaid either. Not in this case: PRR lasted until the 1970s.

Primary market and secondary market Primary market  Sale of bonds by the issuer (i.e. the borrower) to investors  Pennsylvania Railroad Company in 1888 borrows US$20m for 30 years o sells to investors 20,000 bond certificates of nominal value US$1,000 each  each certificate bears 30 coupons, entitling holder to annual interest payment of 4.4% nominal (i.e. US$44) This is attractive because cash deposits only paid 3.5% at the time  each certificate is repayable with US$1,000 in 1918 (maturity) Secondary market  Sale of bonds by the original investor to different, second, investor  Or by the third successive holder of the certificate to another investor, who becomes the fourth successive holder etc o Each successive holder of the certificate is entitled to their portion of that year’s interest payment and  Whoever is holding the certificate on redemption date is entitled to the final repayment of US$1,000

The value of a bond The value of the bond consists of two elements  The accumulated interest payment (coupon) over the life of the bond  Interest payments are normally paid every six months but can be annual  The principal sum (par value) which will be repaid at maturity  In the UK, most bonds are issued in amounts of £10,000  The life of bonds can vary from one year to 30 years Accumulated income stream over the 30-year life of the 4.4% Pennsylvania Railroad Company 1918 bond is US$44 x 30 + US$1,000 = US$2,320

Bond defaults Do investors in defaulted corporate bonds ever get their money back?  Depends on whether the bond was secured, e.g.  By a charge over the assets of the issuing company  By a third-party guarantee from a bank, or the company’s parent  Depends on whether the company was liquidated  Any proceeds from the liquidation of the company’s assets would be paid out in order of “seniority” o Taxman first, then banks, then bond-holders, and shareholders last!  Depends on whether he / she had sold on the bond to another investor before the issuer defaulted  Because a bond certificate is a tradable instrument, the investors might have sold it to someone else for a higher (or lower) price

Why buy a bond? Because the size of the interest payment is predictable for many years this can make the bond very attractive to long-term investors A pension fund manager might calculate that he / she needs a return of 4% on the fund’s invested capital to meet annual payments to its retirees With cash deposits only yielding 3.5%, the income would be insufficient to meet the annual pension pay-out obligation A bond paying 4.4% would enhance the overall yield of the pension fund over a 30-year period. The bond has a yield advantage over cash deposits of 0.9% (4.4% minus 3.5%) A well run pension fund will always try to have a wide mix of investment assets to avoid excessive exposure to unforeseen events, such as the BP disaster in It will always keep some of the fund in cash for unforeseen payments

If cash deposit interest rates rose by 0.23% then in order to maintain its yield advantage compared to the cash market, the price of a newly issued US$1,000 bond bearing a 4.4% coupon would need to fall by US$50. If demand for long-term bonds pushed up the price of this bond up from US$725 to US$750, the yield would fall by 0.20%

Bonds and interest rates Bond investors are very vulnerable to changes in interest rates US interest rates since 1950 UK interest rates have been even more volatile Between 1965 and 1982, US interest rates increased from 4.5% to 14.5% UK interest rates since 1950 Because of this price sensitivity, the bond markets will try to anticipate any change in interest rate. Analysts monitor the economy and the Bank of England very carefully  If they expect interest rates to come down, bond traders will buy bonds in anticipation of their value rising  If they expect interest rates to rise, they will sell bonds

Other factors affecting bond prices It is not just interest rates which affect the prices of bonds If there is a scarcity in the market of bonds with a particular feature – perhaps those a very long maturity period – the price will get pushed up as investors bid to buy them  Pension-fund managers need long-term bonds  Too many pension-fund managers chasing too few long-term bonds means higher prices The higher the bond price the lower the yield

How interest rate movement affect investments Interest rates rise Cash deposits:  Interest paid on cash deposits rise  Asset class becomes more attractive to all investors Interest rates fall Cash deposits:  Interest paid on cash deposits fall  Asset class becomes more attractive to all investors Equities:  Company borrowing becomes more expensive, thus reducing profitability  Share price may fall in anticipation  Asset class becomes less attractive to existing investors  Dividends yield less versus cash deposits (unless share price falls sharply)  Asset class becomes less attractive to existing investors Bonds:  Bond yield becomes less attractive versus cash deposits  Bond price falls  Yield advantage re-established Bonds:  Bond yield becomes even more attractive versus cash deposits  Bond price rises  Yield advantage shrinks to former levels Equities:  Company borrowing becomes less expensive, thus increasing profitability  Share price may rise in anticipation  Asset class becomes more attractive to existing investors  Dividends yield more versus cash deposits (unless shares price rises sharply)  Asset class becomes more attractive to existing investors