Bonds - Business Finance - ثاني ثانوي

7.5 Bonds Key Terms Principal Maturity date Mortgage bonds Asset-backed securities Current yield/Yield to maturity Convertible bonds Variable interest rate bonds Coupon Indenture Defaults Credit ratings Zero coupon bonds Debentures High-yield securities (junk bonds) A bond is a fixed-income promise to pay, issued by a company or government representing a loan made by an investor to a borrower. Fahd has considered raising capital by issuing bonds since the cost of funds raised through the issue of equity is higher than the cost of funds from bond issues. Link to digital lesson OXO www.den.edu 7.5a Characteristics of All Debt Instruments All bonds and other long-term debt instruments share several characteristics. They are liabilities of their issuers for a specified amount, called the principal (face value). Virtually all debt has a maturity date; it must be paid off by a specified date. If maturity occurs after a year, it is long-term debt. When this debt is issued, the length of time to maturity can range from a few years to 20 years or more. The owners of debt instruments receive payments (interest); this is sometimes called yield and may be expressed as current yield or yield to maturity. The payments are usually fixed and are often referred to as the coupon. Interest paid should not be confused with other forms of cash outlays for a company, such as cash dividends paid by common and preferred stock. Dividends come from the company's earnings, while interest is an expense to a company. Each debt agreement has terms that the debtor must meet, and these are stated in a legal document called the indenture. One of the most frequent requirements is the pledging of collateral that the borrower must Principal The amount that a borrowerowes Maturity ate The date by which the debt must be repaid The rate of return on a pond investment бирон The interest rate received by the bondholder Indenture Legal document specifying the terms of 4 delat issue وزارة التعليدر CHAPTER 7 Stocks and Bonds 291

Default When the borrower Talk to meer the terms specified in the indenture of a debt issue put up to secure the loan. For example, the collateral for a mortgage loan is a building and land. Other assets, such as securities or inventory owned by the borrower, may also be pledged to secure the loan. If the borrower defaults on the loan (fails to pay the interest or fails to meet other terms of the indenture), the creditor may seize the collateral and sell it to recoup the principal. Other examples of common loan restrictions are limits on dividend payments, limits on the issue of additional debt, and the requirement to periodically retire a proportion of the debt. These examples do not exhaust all the possible conditions of a given loan. Since each loan is separately negotiated, there is ample opportunity for subtle differences among loan. agreements. The important point, however, is that if any part of the loan agreement is violated, the creditor may declare that the debt is in default and the entire loan is due. Default is not just the failure to pay the interest. Failure to meet any of the indenture provisions places the loan in default, even though the interest is still being paid. 203-10 Why might a limit be set on dividend payments?

There are two influences on the expected return on debt instruments. This includes the expected market return and the perceived risk of a company's ability to pay interest and principal on debt. Fixed-income securities, such as preferred stock and fixed-rate bonds, offer no protection from inflation. If the rate of inflation increases, the real purchasing power of the dividend or coupon yield is diminished. In addition, increased inflation will probably lead to higher interest rate payments by new securities, which will drive down the market value of all current lower interest rate fixed-income securities, including preferred stock and bonds. Higher rates of inflation impact fixed Income, long-term securities through both decreased purchasing power of the dividend or yield, and the market value of the stock or bond will be diminished. EXAMPLE Assume a SAR 1,000 fixed rate bond pays 4% when the inflation rate is 2%. Investors are willing to pay SAR 1,000 to receive a yield, after considering inflation, of 2%. If inflation rose to 3%, what discount (less than the face value) would an investor be willing to pay for the fixed rate bond to maintain a 2% post-inflation return? At 4%, the investor receives SAR 40 (SAR 1000 x 4%) per year. Whereas inflation = SAR 1,000 x 2% = SAR 20. Therefore, the investor receives SAR 20 above inflation (SAR 40-SAR 20). With inflation at 3%, the investment would need to earn a return of 5% (Required Investment Return is: Inflation 3% + Return above inflation 20 above inflation. 2%) to maintain the 2% 1000 So, the annual payment is still at SAR 40. Thus the new price will be SAR New Bond Price x Required Investment Return %= Annual Payment SAR New Bond Price x 5% = SAR 40 SAR New Bond Price SAR- 40 0.05 =SAR 800 The above formulas showed that the bond price could drop to SAR 800 for an investor to maintain their 2% above inflation return. وزارة التعليم 2922-1884 CHAPTER 7 Stocks and Bands 293

N You Try It Assume a SAR 1,000 fixed-rate bond pays 5% when the Inflation rate is 3%. Investors are willing to pay SAR 1,000 to receive a yield, after considering inflation of 2%. If inflation drops to 2%, what premium (above the face value) would an investor be willing to pay for the fixed rate bond to maintain a 2% post-inflation return? Classification schemes designed to indicate the risks associated with a particular debt instrument Another characteristic of all debt is risk. This includes the risk that the interest will not be paid, the risk that the principal will not be repaid, the risk that the price of the debt instrument may decline, and the risk that inflation will erode the purchasing power of the interest payments and principal repayment. The riskier a company's ability to pay interest and principal on the debt, the higher the expected return for that debt. Credit ratings Measures of the perceived riskiness of a company are determined by credit rating agencies. In Saudi Arabia, credit ratings must be assigned by an authorized credit rating agency, which includes agencies incorporated in Saudi Arabia and foreign credit rating agencies. Rating agencies may use different rating systems: 294Business Finance

Lowest risk Typically, these start with high A ratings, such as a triple AAA for high-quality debt, followed by AA+, AA, AA-, etc. Lower medium grade risk Debt would start with SBB- followed by BBB, etc. to highly speculative debt at B- Substantial risk This would start with CCC+ and run to C with default imminent Defaudr Companies in default would have Dratings. Since the risk of default may be substantial for poor-quality debt, some financial institutions and investors will not purchase debt with a low credit rating. Fahd knows that if his company issues bonds, and the lenders anticipate inflation, they will demand a higher rate of interest to help protect their purchasing power. In addition, Fahd's company has never issued securities and does not yet have a credit rating. Fahd also knows that if his company sells bonds they could be resold in the open market at a premium or discount. For his bond investors, one feature of the bond debt that partially compensates for the risk of price fluctuations is that when debt ultimately matures, the principal must be repaid. If the price falls and the debt instrument sells for a discount, the price of the bond must appreciate as it approaches maturity. For on the day it matures, his company must pay the full amount of the principal. Figure 7.4 shows a bond purchased in an open market at a discount (at SAR 90 as an example), and the bond price begins to converge on the face value (SAR 100) as it approaches maturity. وزارة التعليم CHAPTER 7 Stocks and Bonds 295

FIGURE 7.4 A discounted bond approaching maturity Nichas in the Open marker (discount d ور السما TOWARDS MATURITY SAR As maturity arches in bond will bey to converge on the fam value SAR IDU 7.5b Types of Corporate Bonds All bonds have some level of risk. Secured bonds are tied to a specific asset that is used as collateral to secure the loan and therefore have less risk for an investor than unsecured bonds. Figure 7.5 outlines types of corporate bonds, their features, and the riskiness for investors. Types of Carpurate Sunds FIGURE 7.5 Types of Bond Features Investor Rick Mortgage Bond Secured to a specific real estate asset, such as a building. Less risky Marabouds A form of iban that is secured by a claim on real estate -backed contes Bonds issued to -fmance activities, that generate income Asset-Backed Securities Sub Issued to finance activities that generate Income For example, issued to finance the construction of a parking garage secured by the parking fees If the issuer fails to make the required payments on these secured bonds, the investors can take possession of the specified asset or assets and use them to recoup the money due. Shariah compliant financial certificates like asset-backed securities. The investor gains partial ownership of an issuer's assets providing a yield based on the annual rate of retum for the security until the sukuk maturity date Less risky Less risky Contbonda A form of loan that may be converted into fexchanged for stock at the option of the person who has taken | QUI 206Business Finance " UTS Convertible bonds Allows the holder the option to exchange the bond for a predetermined number of shares of common stock based on a conversion ratio. Less risky CONTINUED

FIGURE 7.5 continued Variable Intercede Long-term debt instruments whose interest payments vary with changes in short-term interest rates of the Consumer Price Index Types of Band Variable Features Investor Risk Types of Corporate Bonds Intrus! Re Bonds Band payments vary with changes in the rate of inflation or changes in market interest rates. Also called floating rate notes. Less risky Z Coupon Lands Sells for a discount from face value. The discount on the bond is determined by the length of time maturity and the specified Less risky interest to be accrued. At maturity, the investor receives the bond's face value. Debenturay Unsecured bonds are supported by the general credit of the company. Riskier High-Yield SHEWIGUS Name given to debt of low-quality bonds rated High Risk below mple B typically subordinated to the company's other debt. Also called junk bonds. Zero coupon boods A form of loan that is mitially sold at a discount and on which interest accrues and is pand at maturity Dub Unsecured bands supported by the general credi of the company Blight-y (junk bunds) Poor quality debt with high returns and high probalellity of default What does a bond with a floating rate protect against? وزارة التعليم BONDS 297

2018 Business Finance Exercises Choose the correct answer. 1. Credit ratings for companies are assigned by the Saudi government. True/False 2. If interest rates increase due to inflation: a. the prices of bonds and preferred stock increase b. the price of bonds Increases but the price of preferred stock decreases c. the prices of bonds and preferred stock decline d. the price of bonds decreases but the price of preferred stock increases 3. Convertible bonds allow the holder the option to exchange the bond with a predetermined number of shares of common stocks. True/False 4. Which of the following bonds is supported by collateral? a. unsecured bonds b. income bonds c. mortgage bonds d. debentures