Economics and Finance: The Corporate Bond Market - Term Paper Example

?Introduction The Corporate Bond market is a market in which debt securities are issued and traded. The capital bond markets contain such debt securities which are issued by companies and sold to investors to raise operating capital funds. The corporate bond market is helpful in providing competition in the private sector as well as improving the financial well-being of an economy. Stability in the financial sector is crucial for any economy. The bond market plays a vital role in stabilizing the sector by mitigating risks such as the interest-rate risk. A prominent feature of an efficient bond market is that it allows fair allocation of fund investment while also encouraging investors to diversify their portfolio by investing in assets deemed riskier. Another important feature of a developed bond market is that this corporate bond market provides an alternative source for funds used for operational purposes by the private sector other than borrowing from banks or from the equity markets. Debentures, Unsecured Notes and subordinated debts are those securities which are traded and issued on the corporate bond market. Those firms which are running efficiently and successfully can also decide to spread out their activities and start-up new projects. To start new projects the firms need to raise capital. Hence the firm can decide on raising those funds from the bond market as it can be advantageous for the firm in the long run. Understanding the corporate bond market is critical for any company. The following sections give an outlook of the market, on how it functions(the securities which can be issued in the market), the advantages of issuing bonds over other sources such as equity markets and other sources of finance, the types of firms that can issue the corporate bonds, the providers of debt and their requirements. The information of the corporate bond markets will help the Board in making informed decision regarding the use of corporate bonds for raising capital to finance the new project which is worth 800 million. Types of securities that can be issued in the corporate bond market The following are the three types of securities that a firm can issue. 1. Debentures A debenture is a type of a document which is not secured by any collateral. Below are the two types of debentures explained? a. Fixed-Charge debenture:. In this type of debenture, a charge is fixed over those assets which are permanent for example fixed assets like buildings. In case the company defaults, these assets are not allowed to be sold until the bondholder has been satisfied in the event of default. The first claim on the assets is of these bondholders b. Floating-charge debenture: In this type of debenture, the charge is floating, that is a charge is issued over assets such as finished goods. Since, these assets are meant to be sold the firm issues a floating charge over these assets. When the firm defaults the floating charge is converted into fixed charge. The bondholders can then take control of the assets. When the claims of the fixed charge bondholders are satisfied, they can claim the remaining assets of the firm. 2. Unsecured Notes It is a corporate bond with no underlying security attached to it. The bondholders cannot claim the assets until the fixed-charge and floating-charge bondholders are satisfied. In the event of default, the unsecured notes holders will be paid last. 3. Subordinated Debt Subordinated debt is that type of a debt which is issued for the long-term and in the event of a default, subordinated debt holders receive after all other creditors. Subordinated debt is closer to equity than debt. It is shown as shareholders’ funds on the balance sheet. It improves the credit rating of the firm. As a result the firm can borrow more easily. Types of firms that qualify for raising direct debt Direct debt can be raised by public limited companies, who can do this by issuing financial securities such as stock and bonds.. These shares can be issued to the general public by means of an Initial Public Offering (IPO) and subsequent trading through the stock exchange. Public limited firms also have the freedom to keep more than 50 non-employed shareholders. Four types of Public limited firms exist. These are: 1. Public companies limited by shares 2. Public companies limited by guarantee 3. Companies unlimited with shares and 4. No liability firms. 1. Public firm limited by shares Public limited firms are those in which shareholders purchase shares. The debts of the shareholders then becomes restricted only to the amount they have invested in the purchase of shares (plus any outstanding amount due on unpaid shares) is called a public limited firm limited by shares. The liability of each member of the firm is restricted to amount they have invested in the firm meaning that the personal assets of the members remain safe and in the event that the firm faces bankruptcy or lawsuits against its activities, the shareholders only stand to lose the invested amount. Public firm limited by guarantee Some public firms do not have share capital but rather its members place a guarantee on the firm which can be enforced in the event of winding up the firm. The guarantee is not to be shown on the firm’s statements because it cannot be considered an asset that has any monetary value. Such firms are called public firms limited by shares and usually include small businesses and charities. Unlimited liability firms Unlimited liability firms have no limit as to what each individual’s liability is towards the firm. Partnerships are an example of unlimited liability firms. The members of unlimited liability firms raise capital by means of personal investment. No liability firm No liability firms have ‘NL’ or ‘no liability’ in their name. These usually include mining firms and do not have any statutory or contractual right to recover unpaid calls. Reasons why corporate bond market debt raising may be beneficial Financial intermediaries usually tend to charge a small profit margin when providing loans. With the issuance of bonds, firms can essentially eliminate the use of this intermediary and avoid paying intermediary costs therefore raising debt at lower costs. Bonds provide a unique feature by having a call option on them. These callable bonds can be redeemed by the issuer before maturity hence it allows the company to redeem the bonds in the event that interest rates drop, thereby allowing the firm to generate capital at lower costs An important reason for developing a corporate bond market is that these the corporate bond market is a provider of an alternative source of operational funds for the private sector other than borrowing from the banks and the equity market. Another benefit is that there is diversity in the source of funds which allows the firms to adjust their borrowing banks, financial institutions and the bond market. Established corporate debts markets help create competition for local banks, aiding in reducing the spread between advances rates and deposit rates in the banking network. This way, commercial banks can be restricted in their attempts to exploit investors by charging exorbitant rates and helps generate investment for even the more risky projects Corporate bond markets and banks tend to complement each other in the sense that if any one of these institutions comes under financial stress, it will not spill over into the entire economy hence preventing the economy from becoming unstable The corporate bond market also provides benefits to those firms who are looking for long-term financing. For example if a firm is thinking of investing in a certain project which may take fifteen year to come to completion ,then raising funds through issuing corporate bonds can be beneficial for the firm. Issuance of corporate bonds by the firm itself would mean that it can choose the terms, conditions and the date to maturity of the Bond. When a firm issues the bond to the general public the firm is able to borrow on its own terms which it states in its prospectus and this creates an advantage for the firm. The reason being that if the firm would have borrowed from a bank then the bank would have determined the repayment terms and the time period of the loan. Issuing bonds rather than further stocks is also beneficial because it helps avoid any changes in the ownership structure of the firm by affecting the majority ownership of the firm. Raising further shares will only cause the stock to devalue and become less valuable than it was when the new shares were being issued thereby making it much beneficial for the firm to raise funds through bonds than through issuance of additional stock A bond issue also provides the firm with significant tax advantages. As the bondholders are essentially debt holders, the company shall be required to pay interest on its debt i.e. on the bonds. These interest payments count as tax-deductible expenses and leads to tax-savings for the firm. Had the company raised funds by means of issuing stocks, the dividend payments made to shareholders would not have been tax-deductible. Firms tend to issue bonds to institutional investors. However, small household investors also tend to invest in these bonds and command significant purchasing power. This exposes the firm to a significant capital pool and access to generate greater amount of capital. Main providers of direct debt finance The providers can be categorized according to the method the firm chooses to raise funds. The methods are explained below. 1. Family issues Parties who already hold the firm’s security such as stockholders, holders of convertible notes and bond holders. 2. Public issues The general public is the main target in this method. The general public is expected to contribute. 3. Private placements A few chosen investors are offered to contribute. However, these investors are large institutions and include insurance firms, pension funds and mutual funds. Requirements of direct debt providers The requirements for raising direct debt differ across countries. In most countries there are some common requirements, while some requirements may be customized according to the laws of each particular country. Firstly, the prospectus should be registered with the regulator. Prospectus is a type of document which states the conditions and terms set by a company when it issues the debt security. The prospectus confirms the invitation sent to the public. It protects the investors’ interests. It presents a complete picture of the firm and the business. It helps investors in making informed decisions. It includes information on the company such as the following: ? Details about the firm’s Executive managers and directors The company’s books of accounts and notes to these accounts ? Special reports pertaining to the company’s accounting procedures, taxation details and legal reports ? All material concerns that affect the operations of the firm ? The Company’s long-term strategic plans, how it plans to function and how the funds generated from the issue of shares shall be put to use Private placements are another preferred option than other methods for firms. It is because they find it hard and lengthy to write and register the prospectus. Private placements do not require the firm to write and register a prospectus, which is quite a lengthy and painstaking process. Instead the firms must only have an information memorandum which will suffice for private placements. An information memorandum provides limited information about the firm. The assumption is that institutional investors are already present in the market and have full awareness and market knowledge. Therefore they have more knowledge about a firm than the general public would be assumed to possess and can make decisions even if presented with limited information such as that made available by the information memorandum. Hence it is not deemed necessary to give complete details in the said memorandum and proceedings for private placements can begin. The information memorandum includes changes that will or may influence the firm, the most recent financial statements published by the company and the purpose of raising debt. References Asquith, Paul, Andrea S. Au, Thomas Covert, and Parag A. Pathak. "The Market for Borrowing Corporate Bonds." 2010. Brigham, Eugene F., and Joel F. Houston. Fundamentals of Financial Management. Edited by Jack W. Calhoun. South-Western Thomson, 2004. Brealey, Richard A., Stewart C. Myers, and Franklin Allen. Principles of Corporate Finance. 8th. McGraw-Hill, 2006. Viney, Christopher. Fiannacial Institutions, Instruments and Markets. McGraw-Hill Australia, 2009. Brigham, Eugene F., and Michael C. Ehrhardt. Financial Management: Theory and Practice. South-Western Cengage Learning, 2005. Lynch, David. Asian Bond Markets. International Banks and Securities Association of Australia, n.d. Read More