Abstract
The role of the corporate and government debt market in the form of bonds in a country’s economic development can not be undermined, as it is an important channel that links the savings of the society into the investment opportunities. The importance of the corporate and government bonds can be seen from the benefits accruing to the issuer of the bonds as well as to the investor. This paper presents an overview of the corporate bonds and government bonds. While examining different types of bonds the paper also presents the key considerations that need to be taken in to account while investing in the bonds. The paper also presents a report on the growth of the bond market in the United States.
Glossary
A glossary is a list of abbreviations and technical terms used and their definitions. The following are the definitions of some of the key terms used in this study.
Accrued Interest – The interest earned on a bond since the last coupon payment date.
American Option – An option that can be exercised at any time during the life of the option
Bond Option – An option where a bond is the underlying asset
Bond Yield – Discount rate which when applied to all the cash flows of a bond causes the present value of the cash flows to equal the bond’s market price
Call Option – An option to buy an asset at a certain price at a certain date
Convertible Bond – A corporate bond that can be converted into a predetermined amount of the company’s equity at certain times during its life
Coupon – Interest payment made on a bond
Credit Rating – A measure of the creditworthiness of a bond issue
Credit Risk – The risk that a loss will be experienced because of a default by the counterparty in derivative transaction
Derivative – An instrument whose price depends on or the price is derived from the price of another asset
Forward Contract – A contract that obligates the holder to buy or sell an asset for a predetermined delivery price at a predetermined future time.
Hedge – A trade designed to reduce risk.
Maturity Date – The end of the life of a contract
Option – The right to sell or buy an asset
Par Value – The principal value of a bond
Par Yield – The coupon on a bond that makes its price equal the principal.
Treasury Bill – A short term non-coupon-bearing instrument issued by the government to finance its debt.
Treasury Bond – A long-term coupon-bearing instrument issued by the government to finance its debt.
Yield – A return provided by an instrument
Zero Coupon Bond – A bond that provides no coupon
Introduction
Just like people, organizations like corporations, federal and state governments need to borrow money occasionally to meet certain exigencies like capital investment in infrastructure projects. These organizations have to commit not only to repay the amount borrowed but also a little extra in the form of interest for the privilege of using the other peoples’ money for the time being. Deficit-laden governments often resort to the method of raising the required funds by issue of bonds of various types with different conditions attached to the bonds. Similarly the corporations issue debt securities for the purpose of financing their expansion plans or other financial commitments.
Thus bonds are considered to be a core element of any financial plan to invest and grow wealth. A bond represents a debt security much in similar to an I.O.U. When a bond is purchased by an investor the investor is considered to have lent money to the government, municipality, corporation or other government agency (known as the issuer) issuing the bonds. In return for the amount the lent the issuer guarantees to pay the lender a specified rate of interest during the tenure of the bond. In addition the issuer also guaranteed the repayment of the principal amount when the bond matures or its tenure comes to an end. A prospective investor has different types of bonds to choose from like the US Treasury bonds, corporate bonds, mortgage and asset backed securities, federal agency securities, and foreign government bonds.
The diversity of fixed income securities as the bonds are otherwise called offer to the investors, wide range of choice of investments to meet their investment needs. The individual financial objectives might vary depending on the disposable income possessed by the investor, his income bracket, and the tax advantage he/she is expecting from the investments they make. There are different considerations the investors have to weigh with their decision to go in for investment in bonds. These considerations may include among other things, the rate of interest, maturity of the bonds, conditions attached to the redemption, quality of credit and credit ratings. With this background this paper details the basic features of corporate and government bonds, the key considerations involved in making an investment in the bonds and a discussion on the dealings in the bond market.
Literature Review
This section of the paper presents a detailed review of the available literature on corporate bonds and government bonds. The information and data on the corporate, and government bonds have been gathered from secondary sources like books, journals, and websites of government departments for presenting this literature review. The objective of this review is to enable the reader to acquire a comprehensive knowledge on the general and specific issues concerning the corporate bonds and government bonds apart from providing a basic knowledge on these debt securities.
Bonds – an Overview
Industrial, financial, and service companies in order to meet their requirements of capital investment and operating cash flow issue debt securities which are generally known as corporate bonds. The corporate bonds offer a wide range of choice to the investors in terms of structure of bonds, coupon rates representing the return on the bonds, maturity dates, quality of credit and exposure to the industry.
Bonds are also issued by government and government agencies to finance various projects. The debt securities issued by the US Treasury, US government agencies and by US sponsored enterprises comprise of debt securities which is one of the largest and most liquid bond market in the world. The US treasury securities which are issued to finance the debt needs of the federal government are considered to have a least risk of the bonds associated with them as the bonds are backed by the US government’s ‘full faith and credit’. The government bonds become more secured because the government is the taxing authority.
According to Hakansson (1999) the existence of a corporate bond market “is associated with greater accounting transparency, a large community of financial analysts, respected rating agencies, a wide range of corporate debt securities and derivatives demanding sophisticated credit analysis and efficient procedures for corporate reorganization and liquidation.” The author also points out the need for several factors that have to be present in the market in order to have a well-developed bond market. Some of the factors are; a financial reporting system for companies that has the ability to present relevant, reliable, and timely financial statements showing the true financial position of the company. The reporting system should be supported by a community of knowledgeable financial analysts and reliable credit rating agencies. There should also present a mechanism which enables an efficient reorganization whenever there are cases of default or bankruptcy.
Herring and Chatusripitak (2000) observe that the absence of a bond market in a country would render the economy of the country less efficient. The absence of such market also makes the country prone to sever financial crisis. However the authors opine that the investors should have the means and right of collecting their promised repayments well defined and legally enforceable.
Domowitz, Glen and Madhavan (2000) have documented the use of the institution factors in the development of different sources of financing including debt securities. The institutions may play a major role in defining the accounting standards, the levels of investor protection, the provisions on the restrictions for entry into the market and the level of concentration in the banking system.
La Porta, Lopez de Silanes, Schleifer and Vishny (1998) argue that the extent and scope of legal protection in a country is an important determinant in deciding the growth of the financial markets in a country. Martinez Trigueros (2000) supports this view by pointing out that the existence of a proper and well defined legal environment which ensures the maximum protection to the minority shareholders and bondholders would contribute more to the development of the financial sector. She further adds that this would automatically lead to the acceleration in the rate of growth of the economy.
Types of Bonds
Bonds are known as ‘fixed income securities’ as the amount of income being generated from the bonds is fixed every year and irrespective of the ownership of the bonds the bonds will yield the same income year or year until they are redeemed. The bonds can take four different forms depending on the agency selling the debt covered by the bonds. They are:
Federal Government
The federal government issues bonds which are called ‘Treasuries’. It is named as treasuries since they are sold by the treasury department. The ‘treasury’ bonds come in a variety of different maturities having different periods of maturity. The length of maturity varies from 3 months to 30 years. Different types of treasury bonds include Treasury notes, Treasury bills, Treasury bonds, and inflation-indexed notes. These bonds differ depending on the maturity and the amount of interest payable on the bonds. Savings bonds and other treasury bonds are being sold through Bureau of the Public Debt. The ‘Treasuries’ are backed by the US government and are eligible for exemption from state and local taxes on the amount of interest being paid on the bonds (Robert Brokamp).
Other Government Agencies
There are other government agencies and quasi-government agencies Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Government National Mortgage Association (Ginnie Mae) which also issues bonds guaranteed by the full faith and credit of the US government for some specified purposes like funding for owning homes (Robert Brokamp).
Corporate Bonds
Just in the way companies sell shares they also sell their bonds through the public securities market. A company has a large leverage in the amount of debt it wants to raise, the period of maturity, the rate of interest it wants to pay on the bonds and other conditions attached to the bond. However it is for the company to make the bonds saleable in the market for attracting the investors. Otherwise the bonds will not be taken up by the investors. The corporate bonds normally pays higher rates of interest as there is the risk of the company going bankrupt and the amount of debt not being repaid by the company. This risk is not there in the case of government bonds as the government can support the repayment of the bond from its own resources. High-yield bonds which are otherwise known as junk bonds are corporate bonds issued by companies whose credit worthiness is much lower then the normal investment grade. The companies also issue convertible bonds which imply that part of the bond can be converted into stock subject to the fulfillment of certain conditions (Robert Brokamp).
State and Local Governments
The state and local governments can also debt securities in the form of bonds. Since there are chances that the state and local governments may be in a situation that they may not be able to repay the bond amount, it becomes imperative that these governments make the bonds attractive for the investors. Unlike the corporate entities the state and local governments have the only source of income as taxation which has its own limitations. Hence the federal government allows the state and local governments to issue bonds the interest on which is exempt from federal income tax. The state and local governments are also authorized to waive the local income taxes on the interest on the bonds issued by them to make them more attractive for the people who are in higher income bracket. Such people can get a high after-tax yield from the fixed income securities like the government bonds (Robert Brokamp).
Characteristics of Bonds
There are three major elements involved in the issue and dealing with the bonds, be they are corporate or government bonds. They are the par value, the coupon rate and the maturity date. A detailed knowledge on these three elements provides a better understanding about the bonds and makes it easier to compare the investment in bond with any other investments.
Par Value
Par Value is the amount of money that the investor is likely to get back once the maturity period of the bond is completed. This amount basically represents the principal amount lent by the lender to the issuer of the bond. The par value of the corporate bond is normally fixed at $ 1000 and it may vary for the government bonds to any other amounts (Robert Brokamp).
Coupon Rate
The coupon rate represents the interest that the bondholder may be able to realize on the investment in the bonds in the form of interest. Normally the coupon rate is expressed as a percentage of the par value. The bond will also normally provide for the periodicity of the payment of interest whether monthly, quarterly, or in any other intervals (Robert Brokamp).
Maturity Date
The maturity date is the date on which the issuer has to repay the amount borrowed on the bond to the bondholder. Sometimes a company may decide to ‘call’ the bond meaning that the company would like to repay the bond amount even before the maturity date. It is the practice in the case of corporate bonds to specify whether they can be called and if so how soon they can be called. Normally the federal government bonds are not called while the state and local bonds may be called for settlement at an early date than the maturity date of the bond (Robert Brokamp).
Considerations for Investing in the Bonds
There are a number of factors that need to be considered while making investments in the bonds. Factors like the maturity, redemption conditions, price, yield and tax status are some of the important considerations with regard to the investments in bonds. A thorough consideration of these factors enables the investor to determine the value of the investment and also the extent to which the investments in bonds would be able to meet the investment objectives of the investor in terms of risks and rewards. The following is a discussion on some of the key factors:
Interest Rate
The interest rates on the bonds may be fixed. The rates may also be arrived at as floating rates or rates payable at maturity. Most of the bonds carry interest rates that remain fixed during the tenure of the bonds. The interest rate is expressed as a percentage of the face value of the principal amount. Generally the interest payments are made on a half-yearly basis.
However some of the buyers and sellers of bonds may agree that the interest rate may be worked out as a floating rate implying that the interest rate would be adjusted periodically in tune with the change in the rate index like the rate in treasury bills. In some cases there may be only one time payment of interest on the date of maturity along with the principal. These bonds are known as zero coupon bonds. These bonds are sold at heavily discounted prices in the bond market. If the bond is subjected to income tax, the interest due there on is also taxable on accrual irrespective of the fact whether the interest is paid or not (SIFMA).
Redemption Features
The maturity period specified in respect of each bond specifies the time period for which the bond will be outstanding. However certain bonds are structured in such a way that such structures significantly change the validity period of the bonds.
Call Provisions
There are call provisions attached to the bonds which either allows or requires the issuer of the bonds to repay the principal amount to the investors at a specified period even before the maturity of the bonds. The ‘calls’ on the bonds are made when the interest rates have fallen significantly since the time the bonds are issued. The bonds with a redemption provision of calling them early will provide for a higher return in order to compensate the risk involved in the bonds being called off earlier (SIFMA).
Puts
In the case of some bonds the investor has the option to require the issuer to repurchase the bonds at specified times prior to maturity. The investor normally exercises the option when there is the need for cash for some emergent purposes or there is increase in the interest rates since the investments were made in the bonds. The realizing the proceeds before the maturity date would allow the investor to reinvest the money in more profitable avenues (SIFMA).
Credit Quality of the Bonds
There are different kinds of bonds available with credit quality ranging from the highest as in the case of US Treasury bonds and securities to bonds that are below the investment grade. The US treasury securities are considered having highest credit quality as they have the backing from the US government. On the other hand the bonds which are of lower credit quality are considered speculative. Since the life of a bond will extend for more number of years the credit quality is an important consideration for evaluating a fixed income security.
When a bond is issued it is mandatory for the issuer to provide details as to the credit worthiness of the firm and this is contained in a document accompanying the issue known as offering document. Alternatively the prospectus or an official statement in lieu of the prospectus may also contain information about the financial soundness of the firm. There are specialized rating agencies who assign ratings to different bonds when they are getting issued. These agencies also monitor the performance of the bonds during the bonds’ life time. Apart from these credit rating agencies securities firms, and investment and commercial bankers also monitor the actions of the corporations, governments, and other issuers in honoring their commitments for the interest payment and the repayment of the principal amount (SIFMA).
Credit Ratings
Some of the major specialized credit rating agencies in the United States include Moody’s Investors Service, Standard & Poor’s Corporation, and Fitch Ratings. The credit ratings are assigned by these rating agencies after a careful consideration and analysis of the financial strength and management, economic characteristics of the issuer, and the strength of the revenue sources that secures the payments of interest and principal repayments of the bonds. A schedule of credit ratings assigned by these agencies is shown as Appendix 1. Since the bonds have a long tenure of life there are bound to be changes in the credit ratings. These changes are signaled by the rating agencies by denoting the security on ‘Credit watch’ – by Standard & Poor; ‘Under review’ – by Moody’s; or ‘Rating watch – by Fitch Ratings. There are exclusive rating information desks which make the ratings available to the public. The ratings of different issuers can be found through accessing the internet (SIFMA).
Bond Insurance
The credit quality can be increased by adopting ‘bond insurance’. There are specialized insurance firms that underwrite the payment of the interest and principal on the due dates by the issuing firms. Most of the bond insurance companies have been assigned best credit ratings by the agencies with some of them being assigned lesser credit ratings. In any case, the insured bonds are rated according to the respective ratings given to the insurance companies, which is judged on the basis of the capital base and claim settling capabilities of the bond insurance companies. Traditionally the underwriting activities have been focused around covering the municipal bonds while recently the activities of these companies are being extended to other kinds of bonds like mortgage and asset based securities, in addition to covering other types of bonds and securities (SIFMA).
Price
Price is another key consideration that needs to be taken into account while deciding to make any investment in bonds. The prices of bonds depend on a host of factors like interest rates, supply and demand, credit quality, maturity date and tax status. It is the case with the newly issued bonds that they will sell at or close to the face value of the bonds. The prices of bonds being traded in the secondary market will largely be determined by the changes in the interest rates. When the bond is selling at a price above its par value it is said be selling at a premium. On the contrary if the bond is selling at a price below the par value the bond is said to be selling at a discount (SIFMA).
Yield
The yield is the return that can be earned out of the interest payable on the bond. The yield is relative to the amount of interest on the bond and the price of the bond. The yields normally are of two kinds, namely current yield and yield to maturity or yield to call. Current yield is the annual return earned on the bond represented by the percentage arrived at by dividing the interest payment by the purchase price of the bond. Yield to maturity or yield to call reflects the amount of earning on the bond till the time the bond is held either up to maturity or up to the period of call (SIFMA).
Bonds as Derivative Instruments
Derivatives are financial instruments the value of which changes along with the changes in the value of underlying assets covered by the derivatives. The main forms of derivative instruments are futures, forwards, options and swaps. The main objective of derivatives is to reduce the risk for one part. Hybrid instruments such as convertible corporate bonds can be listed on the stock or bond exchanges and traded upon. A ‘bond future’ is a derivative instrument which is traded in an exchange. The price of a bond future changes according to the changes in the value of the underlying basket of bonds. Bond futures normally include medium term to long term government bonds. Given the limited number of bonds this kind of derivative instruments are not very popular as that of interest derivatives (Fidelity.com).
Research Methodology
The study undertakes the qualitative research method to collect information and data for the completion of the study. The qualitative method is ‘one of the two major approaches to research methodology in social science’, which involves ‘investigating participant’s opinions, behaviours and experiences from the informants’ points of view’.
In contrast with the quantitative research method, the qualitative research method ‘does not rely on quantitative measurement and mathematical models, but instead uses logical deductions to decipher gathered data dealing with the human element’. The difficulty in using this research method is ‘that it is more expensive, has smaller sample sizes and is hard to measure’. In qualitative research method non-quantitative’ methods of data collection and analysis are being used (Lofland & Lofland; 1984). Qualitative research method been defined as ‘focuses on “quality” rather than quantity. While some other researchers say Qualitative method involves a subjective methodology and making the researcher as the research instrument (Adler and Adler; 1987)
Research Design, Approach and Process
The research approach usually takes the form of either a deductive or inductive approach. Saunders et al (2003) point out that under deductive technique the researcher develops different hypothesis and adopt a research strategy to study the hypothesis. The inductive approach uses the method of collecting the data by the researcher and after the collection of the data a theory is designed on the basis of the analysis of the data. According to Creswell (1994) the inductive approach explores research themes which are relatively interesting and exciting as well as controversial.
Content Analysis Research Approach
The method of content research analysis enables the researcher to analyse a large volume of data and systematically evaluate them to find out the relevance and suitability of the various information and data collected during the process of exploratory study. While conducting a detailed research by adopting qualitative method, the researcher is usually provided with a large volume of data which needs to be evaluated by the researcher using his expertise and knowledge in the topic under study. The researcher has to take a clear stand on the research material he is going to use and categorize the information and data according to the degree of importance. While doing this the authenticity and importance of the source need to be considered by the researcher. In fact content analysis is an important step in completing any research.
Data Collection
Marshall and Rossman (1995) points out that the qualitative studies are based on the gathering of data and the findings and recommendations are purely based on the data already collected. Yin (1989) identified several sources that are being used in the qualitative research like archival records, direct observations, interviews, and observation of the participants. Due to the nature of the research the study has been based only on secondary sources of information.
The study relied on the internet search engine of ‘Google’. This search engine gives the researcher the option to use subject matter, phrases, and keywords as an option to find the topic and data that is required to be explored. Other sources used were numerous journals and publications from various sources provided details in explaining and defining different viewpoints on the development of corporate and government bond market in he United Stares.
Discussion and Reflection
As a part of the research, the growth in the United States Bond market was studied. In general, according to Financing Growth, “bond financing has become a significant part of countries’ and firms’ financing, especially for emerging market economies”. In the case of developed countries like United States also the contribution of bonds as a major source of financing can not be undermined. Globally the size of the bond market has grown from $36 trillion in 1995 to $61 trillion in 2005. The current situation is that the international bond financing is considered as volatile in many of the countries and the domestic bond markets are yet to be developed to its full strength in many countries. Therefore, it becomes important that the information and data on this form of financing is particularly important to assess the rate of growth in the respective countries.
The following table illustrates the growth of the bond market over the period from the year 2001 till 2005.
Table: Growth of Bond Market in the United States. Source: Financial Indicators – Bond Markets – World Bank Group.
The bond market size index is given by the calculation of the average of the private bond to GDP ratio, public bond to GDP ratio and international bond to GDP ratio. It may be observed that though there is an overall growth in the total value of domestic debt the bond market index has come down in the year 2005. This is due to the reason that the value of the corporate bond newly issued to GDP percentage has come down from 10.982 percent in the year 2004 to 9.4 percent in the year 2005. The growth in the GDP of United States in the year 2005 may be the reason for this trend.
The total domestic debt in the country has increased from $ 15.06 billion in the year 2001 to 20.55 billion in the year 2005. The domestic debt has thus registered a growth of 36.45 percent over the 2001 levels. The private sector bond issue has also shown an increase of 6.86 percent over the years. The above data can be graphically represented as below:
Therefore from the analysis it becomes clear that the private sector bonds contribute much to the growth of the debt financing in the United States
Conclusions and Recommendations
The use and value of debt financing especially through bonds has been found to be increasing with the advent of globalization and increased economic activities of the industrially advanced nations as well as emerging economies all over the world. In the United States the contribution of the corporate bonds to the development of the economy has been commendable in the recent decades. The confidence level available in the Treasury bonds of the United States government
has made them the bench mark securities for the calculation of the values of other securities in the capital markets of the world. This paper observed the characteristic features of the bonds in general and also the key considerations that need to be taken into account while any investment is proposed to be made in the bonds.
The investor in order to maximize the returns on his/her investments with a minimum of risk has to adopt the following principles while making the investments in the bonds. The investor:
- has to go through the prospectus or other offering document carefully to assess the financial strength of the issuer of the bonds
- has to carefully watch the movements in the interest rates as well as the changes in the credit ratings of the issuers to shuffle the investment portfolio so that he can maximize his returns
- has to study the redemption options carefully and switch the investments from corporate bonds to government bonds and vice versa as and when necessary.
References
Domowitz, Glen and Madhavan, (2000) ‘International Evidence on Aggregate Corporate Financing Decisions’, unpublished manuscript Fidelity.com ‘Interest rate futures’. Web.
Hakansson, Nils H. (1999) ’The Role of a Corporate Bond Market in an Economy – and in avoiding crises’, draft, University of California, Berkley.
Herring, Richard and N. Chatusripitak, (2000) ‘The Case of the Missing Bond Market and Why it Matters for Financial Development’, ADB Institute Working Paper 11.
La Porta, Lopez de Silanes, Schleifer and Vishny, (1998) ‘Law and Finance’ JPE 106.
Robert Brokamp ‘Types of Bonds’. Web.
SIFMA ‘Bond Basics’. Web.
Appendix 1 Bond Credit Quality Ratings
- The ratings from Aa to Ca by Moody’s may be modified by the addition of a 1, 2 or 3 to show relative standing within the category.
- The ratings from AA to CC by Standard & Poor’s and Fitch Ratings may be modified by the addition of a plus or minus sign to show relative standing within the category.