Question

1)    What advantages does financing with bonds provide over equity?

2)    What disadvantages does financing with bonds have vs equity?

3)    What is "leverage"?

4)    What types of debt are available to finance a business?

5)    What conditions must exist for a company to issue bonds at a "premium"?.

6)    What conditions must exist for a company to issue bonds at a "discount"?

Answer 1

1) Advantages of financing with bonds provide over equity.

Bonds have a clear advantage over other securities. The volatility of bonds (especially short and medium dated bonds) is lower than that of equities (stocks). Thus bonds are generally viewed as safer investments than stocks. In addition, bonds do suffer from less day-to-day volatility than stocks, and the interest payments of bonds are sometimes higher than the general level of dividend payments.

Bonds are often liquid. It is often fairly easy for an institution to sell a large quantity of bonds without affecting the price much, which may be more difficult for equities. In effect, bonds are attractive because of the comparative certainty of a fixed interest payment twice a year and a fixed lump sum at maturity.

Key Points

• Bonds are a debt security under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and or repay the principal at a later date, which is termed the maturity.
• The volatility of bonds (especially short and medium dated bonds) is lower than that of equities ( stocks ). Thus bonds are generally viewed as safer investments than stocks.
• Bonds are often liquid – it is often fairly easy for an institution to sell a large quantity of bonds without affecting the price much.
• Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt, its bondholders will often receive some money back (the recovery amount).
• There are also a variety of bonds to fit different needs of investors.

2) Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk, and yield curve risk.

Price changes in a bond will immediately affect mutual funds that hold these bonds. If the value of the bonds in a trading portfolio falls, the value of the portfolio also falls. This can be damaging for professional investors such as banks, insurance companies, pension funds, and asset managers (irrespective of whether the value is immediately “marked to market” or not). If there is any chance a holder of individual bonds may need to sell his bonds and “cash out”, the interest rate risk could become a real problem.

Key Points

• A bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest and possibly repay the principal at a later date, which is termed the maturity.
• Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise.
• Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk, and yield curve risk.
• A company’s bondholders may lose much or all their money if the company goes bankrupt. There is no guarantee of how much money will remain to repay bondholders.
• Some bonds are callable. This creates reinvestment risk, meaning the investor is forced to find a new place for his money. As a consequence, the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

3) Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets. When one refers to a company, property or investment as "highly leveraged," it means that item has more debt than equity.

4) There are many types of debt finance

Financial Institution Loans : If you wish to finance a major purchase such as a home or car, you'll probably need to borrow from a bank or the credit union where you work. To qualify for the loan, you need to meet rather stringent underwriting requirements, including having a solid credit history. If your goal is to finance a new business enterprise, many financial institutions offer small business loans. However, these loans may be more difficult to qualify for, as banks are reluctant to lend money unless it is to an existing business with a proven track record of success.

Friends and Family : If a bank gives you the old heave-ho, or if you just don't want to deal with bankers, you can turn to friends and family for your financing needs. This frees you from the hassle of going through the bank loan application process, and people you know are more likely to provide more favorable terms, such as lower interest rates and a more flexible repayment schedule. On the downside, you run the risk of straining your relationship with someone you care about if you are unable to repay the loan.

Peer-to-Peer Lending : Peer-to-peer lending offers a small-business debt financing alternative to bank loans or borrowing from people you know.

Home Equity Loans and Lines of Credit :If you already have a home that you've owned for several years, you can borrow against the accumulated equity in the form of a home equity loan or line of credit for your financing needs.

Credit Cards : A quick and easy way to get the funds you need is to take a cash advance on your credit cards. While you may like to think of your credit card as a cookie jar full of ready cash, convenience can be costly, as you will incur a relatively high interest rate as well as any additional cash advance fees assessed by the card issuer. Consequently, you may want to avoid using your credit card for your financing.

5) Premium bonds

A bond that is trading above its par value in the secondary market is a premium bond. A bond will trade at a premium when it offers a coupon (interest) rate that is higher than the current prevailing interest rates being offered for new bonds. This is because investors want a higher yield and will pay for it. In a sense they are paying it forward to get the higher coupon payment.

Said another way, if a bond that is trading on the market is currently priced higher than its original price (its par value), it is called a premium bond. Conversely, if a bond that is trading on the market is currently priced lower than its original price (its par value), it is called a discount bond.

So, a premium bond has a coupon rate higher than the prevailing interest rate for that particular bond maturity and credit quality. A discount bond by contrast, has a coupon rate lower than the prevailing interest rate for that particular bond maturity and credit quality.

6) Discount bonds

A bond currently trading for less than its par value in the secondary market is a discount bond. A bond will trade at a discount when it offers a coupon rate that is lower than prevailing interest rates. Since investors always want a higher yield, they will pay less for a bond with a coupon rate lower than the prevailing rates. So they are buying it at a discount to make up for the lower coupon rate.

Said another way, if a bond that is trading on the market is currently priced higher than its original price (its par value), it is called a premium bond. Conversely, if a bond that is trading on the market is currently priced lower than its original price (its par value), it is called a discount bond.

So, a premium bond has a coupon rate higher than the prevailing interest rate for that particular bond maturity and credit quality. A discount bond by contrast, has a coupon rate lower than the prevailing interest rate for that particular bond maturity and credit quality.