International Business Finance - Literature review Example

Sub Department Bonds A bond, in finance, can be described as a debt instrument issued by a company or government whose key objective is raising money. Typically, a bond is a contract between a company or a government –acting like the borrower-and investors (ordinary citizens like us) acting like the lenders. Basically, when a person purchases a bond, s/he is lending money to the company or government that issued the bond for some return agreed upon by the company or the government to be paid back with some interest sometimes in the future. A bond therefore is actually a debt security whereby the company or the government owes the bond holders a debt which depending on the bond terms should be paid interest or coupon with the principal being paid at a later date, popularly known as maturity date (Parameswaran, 2011). Normally, interest is payable at intervals (annual, semiannual and at times monthly) that are fixed. Most of the times the terms of the bond are negotiable, implying that the instrument ownership can be transferred to another individual in the secondary market. Thus, the moment the bond is stamped by the transfer agents it becomes extremely liquid on the secondary market. A bond is therefore a type of IOU or a loan with the bond holder being the lender (creditor) and the bond issuer being the borrower (debtor) as well as the coupon which basically is the interest. Consequently, bonds offer the borrowers external capital to fund long-term investments and with the government bonds financing of current expenditure (Richelson, 2011). Stocks and bonds are all securities with the key difference being that stakeholders (investors) usually have a share in the company while bondholders normally are entitled to a creditor stake within the company, implying they are taken as lenders. The other key difference is that stocks are normally outstanding for ever whereas bonds have a defined maturity or term, after which the redemption of the bond is done. However there are some irredeemable bonds, for instance Consols or also known as perpetuity (Brandes, 2011). Credit institutions, public authorities together with companies are the main issuers of bonds in the primary market. Underwriting is the most common procedure of issuing bond. After underwriting of bond issue, a syndicate (which is one or more banks or securities firms) purchases the whole bond issue from the issuing institution/government-re-selling them to other investors. Consequently, the security firm assumes the risk of not being able to resell the bond issue to the end investors (Brandes, 2011). Bookrunners are charged with primary issuance of the bond and arranges the bond issue having one on one contact with investors in addition to acting as bond issuer advisors in terms of pricing and timing of the issue. Thus, the bookrunners are as a matter of practice listed being the first amongst all underwriters taking part in the bond issue especially in the tombstone adverts regularly utilized in announcing bonds to the general public. The willingness of the bookrunners to underwrite should be discussed before any decision regarding bond issue since there may be inadequate bond demand. There are various types of bonds, nevertheless, the main ones include; corporate bond which represent a bond issued by an institution or corporation. The second type is municipal bond which issued by a county, state, city as well as local government authority. Lastly is the US Government Securities that are normally issued to fund federal government operations and are usually backed by the full credit and faith of the government (Brandes, 2011). In most instances, government bonds are generally issued through an auction. Consequently, in some instances, both banks and the general public may bid for these bonds. However, in some other instances, its only market makers who may be allowed to bid for these bonds. In addition, the overall return rate of the bond is dependent on the price paid and bond terms. Bond terms such as the coupon are usually determined in advance with the market determining the price of the bond. Underwriters usually charge an underwriting fee for the underwritten bonds. Private placement of a bond is an alternative method of issuing bonds and is frequently used for bond issues that are small so as to avoid the underwriting cost.The following are features of bonds; Maturity-this is the length or duration of time till the maturity term and is frequently known as the tenure, maturity or a term of the bond. The issuer usually has to pay back the nominal amount once the maturity date has been reached. As far as every due payment has been made, the bond issuer has no more requirements to the holders of the bond after date of maturity. Usually the maturity of the bond can be of any period of time, even though debt securities having a term of less than a year are usually selected money market instruments instead of bonds. A lot of bonds have 30 years as their term. Other bonds having terms of fifty years or even more and traditionally bonds without maturity dates (irredeemable) have been known to have issues. There are 3 classes of bond maturities in the US market for treasury securities; short term maturities which range between 1 to 5 years with instruments having maturities of less than 12 months are known as Money Market Instruments. The second category is known as medium term or notes which has maturities ranging from 6 to 12 years and the final category is that of long term or bonds having maturities of more than 12 years (Parameswaran, 2011). Coupon-this can be described as the interest rate which is paid by the issuer to the bond holder. This rate is normally fixed through the entire life or period of the bond and can also differ according to the money market index for example LIBOR or can be sometimes more foreign. The term “coupon” arose since in the past certificates of paper bonds were issued with coupons attached to each one of them, one for every interest payment. The bondholder on the due date gives the coupon to a banking institution effectively exchanging it interest payment. Normally, interest can be compensated at various frequencies; mostly semi-annual (6 months) or annual. Principal-this is also known as face amount, nominal, par , principal and is the amount on which interest is paid by issuer and which frequently has to be paid back when the term ends. Some bonds such as structured ones may be having a redemption amount differing from the principal amount and may be connected with performance of specific assets (Brandes, 2011). Yield-this is the return rate gotten when someone invests in a bond .In other words yield is the return on a bond and denotes the interest gotten from a bond and is generally expressed yearly as a percentage on the basis of the cost of the investment ,its face value or present value in the market (Parameswaran, 2011). Credit quality-this refers to the likelihood that the holders of the bond will get the promised amounts at the appropriate dates depending on a broad range of factors. For instance, high-yield bonds also known as junk bonds are normally rated lower than investment grade and are bonds that are riskier compared to grade bonds and which bondholders anticipate that they will receive a yield that is high(Parameswaran, 2011). Market price-thus, the market price of a bond that is tradable can be influenced by the timing, currency and amounts of the interest payments as well as capital repayments due, bond quality in addition to the obtainable redemption yield especially of similar bonds tradable in the market (Parameswaran, 2011). Bond market being the biggest securities market globally plays not only a crucial but also a big role in the world economy. For instance, the value of outstanding US debt issues had risen from 12 trillion dollars in 1996 to over 35.9 trillion dollars by 2010.Thus the bond market offers federal, state and local governments as well as private enterprises the much needed funds to facilitate development together with long-term infrastructural projects to get started. Thus, prior to hiring personnel, moving earth, pouring concrete or rolling products to the floor of the factory, capital is required to set up the work in motion. Thus, bond issues assist in raising the capital needed to get such projects off the ground and help in maintaining the quality of living, well-being as well as global competitiveness (Richelson, 2011).Consequently, the issuing and purchasing of bonds assist in lowering the costs associated with infrastructural renovation as well as replacement especially for public works, and for new together with expanding businesses. Thus, bonds for example, assist in the building of bridges, transportation systems, roads, reservoirs together with pipes that deliver water to industries and homes, power plants that heat and light industries and homes in addition to factories that manufacture essential products for our daily use. Without issuance of bonds to fund these projects in record time there would be erosion and breakdown of these systems (Brandes, 2011). Apart from long-term infrastructural projects financing, bonds assist governments in management of the receding of its cash flow thus passing savings to the taxpayers who normally assist the government in paying for the much required services such as those offered by police, the military, teachers, medics as well as others. Clearly then, bonds are one of the ways in which both private and public institutions borrow trillions of dollars so as to finance key infrastructural projects (Richelson, 2011).A wide range of individuals and institutions buy bonds. Bonds as investments, can offer a way of safeguarding capital as well as earning a return that is predictable. Investment in bonds usually builds a stable income stream emanating from investments payments before maturity. In addition, bonds can also offer a downside investment fortification against the volatility experienced by the stock market (Richelson, 2011).The main buyers of bonds comprise of banks, insurance companies, pension funds, hedge funds as well as other corporations that buy bonds to ensure steady sources of income flows to meet recurrent obligations. Thus for instance, insurance companies make use of the frequent interest payments in meeting obligations arising from the policies that they sell. Additionally, businesses and governments having huge pension funds purchase bonds to make sure that capital sufficient to meet such obligations as those of beneficiaries and retired employees. The other big investors in bonds comprise of mutual funds as well as international investors like central banks. Thus in conclusion, the following are the biggest investors in bonds; pension funds, mutual funds, insurance companies, financial institutions, international institutions and individual investors (Parameswaran, 2011). All bonds are not similar. Basically, there are two primary factors that affect a bond’s worth after issuance. Thus the prices of bonds go up as well as down depending on changes in the interest rates together with credit quality fluctuations. A bond’s safety is dependent on the relative ability of the issuer to pay both the interest as well as returning of the principal as agreed. Consequently, the better the stability and reputation of the issuer, the more certain and less risk that investors will get what they have lend out. As a result, low interest is paid on highly rated bonds such as those backed by federal agencies or US Treasury. This implies that quality debt is dependent on the issuer’s reliability (Owen, 2015). However, despite all of the above, investors are willing to buy bonds with negative yields. There are a number of reasons why investors would purchase negative yielding bond. Some of them include the fact that risk-averse investors may invest in a negative yield bond as a form of insurance premium so as to have their money in a moderately liquid and safe debt instrument in comparison to keeping it in a shaky bank. Secondly, in an environment that is deflationary, the inflation-adjusted or the real bond return with negative yield might still be positive. Consequently, if a bond has a yield of negative 1%, however the consumer price index goes down by 2%, then the purchasing power of the investor would still rise (Shaffer, 2015). Thirdly if yields further fall into negative region, investors may make a capital gain since the bond price-that moves opposite to the yield direction-will rise. Thus investors can also buy negative yield bonds so as to receive a negative-yield that is less negative. In addition, the investor could be thinking that the currency will rise which the bond is denominated in. The investor in the bond could be a pension fund or an insurance company that is needed to buy specific kinds of comparatively safe assets, despite their yield (Heinzl, 2015).The other reason that investors would buy negative yielding bonds is due to the fact that the largest tendency in the market is that currently investors are no longer interested in bond yields. As an alternative, most investors are seeking to hold bonds especially for their duration, whereby short-term bonds are seen as especially attractive due to the possible price growth (Shmuel, 2015). Europe offers cases in economic theory for buying bonds with negative yields. Thus, interest rates for government bonds from such countries as Switzerland, Denmark as well as Germany in addition to corporate bonds for companies such as Shell, Nestle have all gone negative. Though the ordinary person may not be happy about this, nevertheless, amongst economic and finance types, it is a big deal. Consequently, this phenomenon occurring in Europe is a strange one and had been until recently though to be completely impossible. Thus, a lot of economic theory was built around the issue of the Zero Lower Bound which is the impracticality of continued negative interest rates with some economists wanting to do away with paper money so as to get rid of the lower bound issue. A lot of columns have been written about this issue, especially by Professor Paul Krugman, an economist at Princeton University and actually in one of his articles says that “the zero lower bound is not a theory, it’s a fact that we’ve been facing for five years now” Nevertheless, it is obvious that the impossible has now occurred. Initially economists thought that a negative yielding bond was not possible since it is guaranteed to lose money and thought it would be wise holding cash instead of buying one. Nevertheless, the conservative view has popularly been that there is no one who would. Economists reasoned that bond interest rates cannot fall below zero since at that juncture; people would prefer to hold onto their cash. Widely speaking, the European continent is experiencing lending at negative interest rate especially within the Eurozone with Switzerland being the most severely hit. Thus, countries such as Sweden, Switzerland, Denmark, Austria and the Netherlands have all seen bonds trading at negative rates. Nestle (Switzerland based) saw its 4 year euro-denominated bond trade negatively early February with Finland becoming the first European country to have its initial bond sales trade negatively in the same month (Yglesias, 2015). Germany also sold its 5 year term bonds at negative interest rates on February 28 confirming that this negative trend is not a coincidence trend-a large typical nation is actually getting paid so that it can borrow money. The big question remains what is causing interest rates to plummet. Literally, the case for negative interest rates simply lies on demand and supply and with a bond being a tradable loan, anyone selling it is seeking to pay the investor interest in exchange for the principal invested. Thus, if the demand is not high for purchasing bonds, the interest rate will have to rise so as to entice customers to buy. On the other hand, if the demand is high, there will be a corresponding fall in the interest rate. Mathematically reasoning, there is nothing special that occurs to this process even when if the interest rate reaches zero. Thus if demand continues to rise, then it is obvious that the rate will tend towards negative (Yglesias, 2015).All the same bonds are some of the safest investment instruments and are preferred by most investors due to their security as compared to stocks. List of References Brandes, M. 2010 Naked Guide to Bonds: What You Need to Know - Stripped Down to the Bare Essentials. New York: John Wiley & Sons,Inc. Heinzl, J. 2015 "Who Would Buy a Bond with a Negative Yield." The Globe and Mail: np. Owen, A. 2015 "Why Investors buy Bonds at Negative Yields." Cuffelinks : np. Parameswaran,S.2011 Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds,Foreign Exchange and Derivatives. New York: John Wiley & Sons,Inc. Richelson, R.2011 Bonds: The Unbeaten Path to Secure Investment Growth. New York: John Wiley & Sons Ltd. Shaffer, L.2015 "Negative yield Bonds;Heres who s buying?" CNBC: np. Shmuel, J.2015 "Why investors keep buying bonds despite negative yields." Financial Post : np. Yglesias, M.2015 "Something economists thought was impossible is happening in Europe." Vox: np. Read More