When a company borrows funds, it creates a creditor rather than a shareholder. Debt capital occurs in a variety of forms. The simplest option is a fixed-rate, fixed-term, unsecured bank loan. Alternatively, a company can sell loan stock, either unsecured or in the form of debentures. Mortgage debentures are secured against specified assets of the company (usually land and buildings), while other debentures are secured against the current and future assets of the company in general. The advantage from the viewpoint of the company is that, unlike the case of mortgage debentures, it remains free to dispose of its assets so long as the debts are properly serviced.
In choosing between secured and unsecured borrowing, a company must weigh up conflicting factors. Unsecured borrowing will be more costly than funds secured against assets. Bond issues are likely to entail greater public scrutiny of the company compared to a straightforward bank loan. Unsecured loans are in many cases conditional on meeting performance targets. In addition, borrowing sometimes requires that the company agree to restrictive covenants regarding its business plans, use of assets, payment of dividends, etc. Finally, and crucially, a company’s borrowing practices will be of great interest to its shareholders. The implications of this fact, and the other factors just mentioned, will be an important focus of analysis in the forthcoming weeks of the unit.
The Packaging of Debt Instruments
The basic form of loan stock offers fixed, regular interest payments until a specified maturity date, whereupon the debt is repaid. However, there are many variations on this basic form. Loan stock is often issued on a variable rate or index-linked basis. This means that the interest payments vary from one period to the next, depending on what happens to rates in general and to inflation. Typically, loan stock of this kind would offer to pay interest at a fixed premium above a reference rate such as the London Inter-Bank Offer Rate (LIBOR) or above a specified index of inflation. Hence, if LIBOR or the index changes so does the interest payable on the loan.
Aside from variable interest rates, loan stock may exhibit variable redemption dates. The issuer may have scope to redeem the bond prior to the stated date (callable bonds). In contrast the loan agreement may give the purchaser the right to stipulate the redemption date (puttable bonds). Furthermore, bonds can be issued in the form of convertibles offering holders the right to convert the debt to equity (or another type of debt) under specified conditions. Another possibility is to issue bonds with warrants attached. Warrants entitle the holder to purchase equity in the company at a specified price up to a particular date.
Corporations can issue bonds in one of three markets:
- Domestic Market
- Foreign Market
- Eurobond Market
Thedomestic market embraces bond issues by agencies domiciled in a particular country that are denominated in the country’s currency. Central government bond issues generally form the most important component of the domestic bond market. The foreign market consists of bond issues in a particular country, that are denominated in the country’s currency, but which are undertaken by non-domiciled agencies.
References to the eurobond market can be confusing as it requires neither that bonds are issued in Europe, nor that they are denominated in a European currency. It could more accurately be termed an international bond market in that it is a self-regulated market not subject to the financial regulatory laws and practices of any particular country. The reference to eurobonds is a legacy of the market’s origins in efforts by US corporations to avoid the payment of withholding tax on borrowing within the United States in the 1960s. Nowadays eurobonds refer to any issue that takes place in one country that is denominated in the currency of another country. For instance, Britain is an important centre for trading bonds denominated in US dollars, European euros, Japanese yen, Swiss francs and Canadian dollars etc.
Most eurobond issues are made by government bodies, international organisations and low risk companies. In terms of Standard & Poor’s credit ratings system this would include bodies with AAA to A ratings. However, in recent years, there have been a number of eurobond issues by institutions with lower credit ratings, namely, by the central governments of what are perceived as the more dynamic among the emerging economies of the world. Prominent examples include many of the former command economies of Eastern Europe, the larger Latin American states such as Brazil and Mexico, Asian countries such as China and Thailand, and South Africa on the African continent. Poorer nations find it difficult to access the eurobond market due to lack of interest among investors. These emerging market eurobonds involve more risk to investors. In the late-1990s economic turmoil in Russia resulted in a CCC- rating on its debt securities. In effect, Russia was perceived as close to bankruptcy.
Most eurobonds are straights, though floating rate notes(FRN) are fairly common. Most issues are of medium-term maturities – meaning that they are due to be redeemed in 10 years or less. Many will have a callable facility attached to them.
One of the most appealing features of eurobonds for investors is that they are bearer securities. Ownership of domestic bonds must be publicly registered. With eurobonds, ownership is not recorded by a state regulatory agency. (Of course, the sale of eurobonds by one party to another is a documented commercial transaction. But knowledge of the transaction will be restricted to the investor’s broker and solicitor, and the issuing company for coupon payment purposes). The anonymity enjoyed by investors is an attractive feature. It means that interest is paid gross and that tax payments can be delayed or avoided.
An issue of eurobonds starts with the prospective borrower approaching an investment bank for advice on the prospects of a successful issue, the most appropriate terms of any issue, timing of the issue and so on. Once there is a commitment to proceed, the investment bank will appoint a lead manager whose responsibility is to co-ordinate the issue in all its facets. A primary task will be to organise a syndicate of institutions (in the main, other banks) prepared to underwrite the issue. The underwriting agreement involves the syndicate committing itself to purchasing the entire issue of bonds at an agreed discount to the offer price. Thus the borrower is certain to receive the funds. The underwriters, meanwhile, seek to sell the bonds on the open market at the offer price.
For borrowers, an attractive feature of the eurobond market is that it is possible to raise large amounts of capital quickly. The procedures outlined above may take only a few weeks from start to finish. The regulatory requirements associated with domestic bond issues mean that the process is more expensive and time consuming.
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