Th e most common yield measures are “running yield” which measures the return on a bond measure by the relationship between the coupon and the current bond price, and the yield to maturi
Trang 2Information Disclaimer
Th e contents of this booklet are believed to be accurate at
the date of issue Th ey are intended for general purposes only
and not considered as providing recommendations or advice
Th e CMDA does not give warranty or accept any liability
(whether arising from negligence or otherwise) for any error
or omission or any loss arising from acting on the information
in this publication, except where under law, liability cannot be
excluded
Trang 3Issuer - Th e business that issues a bond Th e issuer borrows money from investors (bondholders) Recent issuers in Fiji include Government and large institutions and companies such
as Fijian Holdings Ltd, Housing Authority, Fiji Electricity Authority and Fiji Development Bank
Bondholder- An investor in bonds A bondholder may be an individual person, a company or an institution By investing in bonds, the bondholder lends money to the issuer
Price - Th e amount a bondholder pays for a bond In our example, the price is $100
Face Value (also Par Value or Principal) - Th e amount the issuer pays the bondholder at the end of the lending period
Bonds can be issued at diff erent face values In our example the face value is $100, which is the same as bonds recently issued
in Fiji
Note that the face value and price can be diff erent We will discuss why this could be the case in Understanding Bond Price.
Coupon and Coupon Rate - Th e coupon rate is the rate of interest paid on a bond Interest is usually paid in equal amounts
at regular intervals (e.g every three, six or twelve months)
Th ese are called coupons In our example, the coupon rate is 6% payable annually Th is means that each year the issuer pays
a $6 coupon (6% x $100 face value)
Coupon rates may be fi xed or fl oating Fixed rates do not change during the life of the bond3 Floating rates allow periodic adjustments to refl ect prevailing market conditions
In Fiji, fi xed rate bonds generally have six-monthly coupon payments while fl oating rate bonds often pay interest quarterly
Most bonds have fi xed interest rates Th e alternatives are normally called Floating Rate Notes (FRNs)
Term (also Maturity) – Th is is the life of a bond At the end
of the term, the last coupon and the face value of the bond is paid to the bondholder Th e bond is said to have matured Th e term for bonds in Fiji generally ranges from one year to around
15 years
Embedded Options- Some bonds give either the issuer and/
or the bondholder the option to take some action against the other party under certain circumstances Th e general term for these is embedded options Examples include call features and conversion rights
Yield– Th is is a measure of the return that a bondholder makes
on a bond Th e most common yield measures are “running yield” which measures the return on a bond measure by the relationship between the coupon and the current bond price, and the yield to maturity4 which measures the rate of return on
a bond assuming it is held to maturity including the premium
or discount to the face value Th e term yield in this booklet refers to yield to maturity Th e higher the yield, the higher the
3 It is more normal for bonds to carry fi xed coupons (hence the term “fi xed income securities”) In this guide we generally refer to bonds with fi xed coupons.
4 Yield to maturity is basically the interest rate that equates the bond’s future cashfl ows to its price.
How are Bond Prices Quoted?
By convention, price is stated as a percentage of the bond’s face value For example if a bond’s face value is
$100, a price of 100 means that the bond price is 100% of the face value i.e $100 A price of 98.5 is 1.5% lower than the face value ($98.50) while a price of 102 is 2% higher than the face value ($102)
Floating Rate Example
A bond’s coupons are linked to the bank bill rate, the interest rate paid by banks on bills of exchange The coupon rate is set at “3% + the bank bill rate” If the bank bill rate is 2%, the coupon rate will be adjusted to 5%
Examples of Embedded Options
n Call feature – This allows the issuer to pay back (“call”) the bond early For example, a bond may mature on 31 December 2008 but allow the issuer to “call” the bond at any time after 31 December 2006 Generally the issuer must advise investors and gazette the call date three months in advance Call features are an advantage for the issuer because when interest rates fall, the issuer can call bonds and refi nance by issuing new bonds at a lower interest rate (i.e coupon rate)
n Conversion rights – This gives a bondholder the option of converting his / her bondholding into shares of the issuer The time at which conversion can take place depends on the terms of the particular bond For example, say you own $2,000 worth of bonds issued by Company X and the terms of conversion say you can convert to ordinary shares at $2 a share You can either convert your $2,000 into 1,000 ordinary shares of Company X or withdraw your $2,000 when the bond matures Conversion rights are an advantage to the bondholder In our example, the bondholder can choose to convert to ordinary shares at
$2 if he/she thinks the shares are really worth say $2.10
Introduction
Raising capital is one of the most important challenges for any
business, be it a company, a statutory authority, town council,
Government or other institution A business needs money
to expand or to pay for its day-to-day operations It can get
money in various ways - by earning revenue from its goods and
services, by raising capital from shareholders or by borrowing
I n
Fiji,
Businesses have traditionally relied on capital from shareholders
and bank loans Th is booklet introduces an alternative way
of raising capital – issuing bonds We hope to answer the
following questions:
n What are bonds and how do they work?
n Why might bonds be a good method of raising capital?
n What are the risks of issuing bonds?
n How do you go about issuing bonds?
What are Bonds?
A bond is a type of investment where the investor (the
bondholder) lends money to a company1 (the issuer) which
issues the bond As proof that the issuer owes money to the
bondholder, the bondholder gets a bond certifi cate from the issuer Th is certifi cate can be sold to another investor much like shares
In some ways, a bond is similar to a bank loan Th e issuer pays the bondholder an agreed interest rate Usually interest
is paid in equal amounts (called coupons) throughout the life
of the bond Th e bond is for an agreed term which is always more than one year2 At the end of the term, the issuer pays the amount borrowed back to the bondholder
Key Features of Bonds Let’s take a look at some of the key features of bonds To help you understand the basic terms, a diagram of a bond which shows the diff erent cash outfl ows and infl ows for the issuer is presented below
Why Does a Business Borrow?
Businesses need to raise money from time to time to
expand or to fi nance their day-to-day operations Issuing
bonds is one way to do this Other options include
borrowing from a bank or raising capital by issuing shares
to investors The latter is called equity
1 For simplicity, we refer to “businesses” issuing bonds
These businesses could be companies, institutions (including statutory authorities and town councils) and Government Recent examples of issuers in Fiji are Fijian Holdings Ltd, Fiji Pine Ltd, the Housing Authority and the Fiji Development Bank.
2 A bill is an example of a fi xed income security with a term
of 1 year or less Apart from the term, bonds and bills are very similar
Receive $100
(Price) Pay $6
Coupon
Pay $6 Coupon
Pay $6 Coupon Pay $6 Coupon CouponPay $6
Pay $100 (Face Value
Today Year 1 Year 2
Year 3
Year 4
Year 5
Bondholder
Issuer
Pay regular coupons Repay amount borrowed at expiry
of bond
Lend money
by buying
bonds
E.g company, institution, Government
Bond Example
In this example, the price of the bond is $100 Th e bondholder
is lending $100 to the issuer
Th e bond has a term of 5 years Th is is the life of the bond
Th e face value is $100 Th is is the amount the investor receives
at the end of 5 years
Th e coupon rate is 6% paid each year Th is is the interest rate
Th e bondholder receives a $6 coupon at the end of each year
Bonds
Bonds belong to a class of investments called fi xed income
securities Other examples are bills and notes
Fixed income securities are like contracts where
the investor lends money to a business for an agreed
interest rate and period Interest is usually paid in regular
installments
Trang 4principal repayments to hundreds of bondholders as well
as maintaining all records
n Disclosure requirements– Where bonds are issued to the public, detailed disclosure requirements are set by the CMDA and other regulatory authorities Th is compares with a bank loan where details can be kept confi dential
n Tax implications – Bond coupons are generally taxed
as income to the shareholder In contrast, for example, dividends on listed shares are tax-free In this case, the issuer may have to increase the yield on the bond to compensate bondholders for tax and ensure its bonds remain attractive
Understanding Bond Price
What drives the price of a bond? Understanding this will help you structure a successful bond issue that meets investors’
expectations As a fi rst step, we look at the concept of “time value of money”
As mentioned earlier, a bond’s price can be higher or lower than its par value So after a bond is issued, how much will it buy or sell for? Unfortunately, valuing a bond is not easy and
is beyond the scope of this introductory booklet However, this section tries to give you a basic understanding of what determines the value of a bond Further information can be found in the appendix Please consult your investment adviser for specifi c advice
Basic Concepts
n Why do you buy a car? For most people, it is because they get the benefi t of having their own means of transport
Similarly, people invest in a bond because of what they will get out of it, namely income and capital growth
n It follows that the value of a bond should refl ect the income and growth it is expected to give the bondholder in future
In other words, a bond can be viewed as simply a stream
of cashfl ows which includes the initial price paid by the
bondholder and the coupons and payment of face value received by the bondholder
Time Value of Money5
However, valuing a bond does not simply mean forecasting and adding up all future income and capital growth because
Are Bonds Suitable for your Organisation?
Bonds are just one of several funding options that you can consider But are they suitable for your business? Here are some general characteristics of businesses that might be suited
to issuing bonds:
a Good credit quality – Poor credit quality means higher returns are needed to compensate the investor for higher risk and therefore issuing bonds will be more expensive
In addition, because issuers with poor credit are likely to
be struggling with cashfl ows, debt may not be a good idea because the issuer is legally required to make regular payments regardless of how well or poorly it is performing
a Relatively large size – Investors are likely to be more comfortable with large businesses that have extensive resources
a Good fi nancial record – A profi table business is more attractive for investors
a Public profi le – An established business with a good public profi le will probably fi nd it easier to attract investors than
a new, less-known business
a Relatively stable earnings – Bonds involve legally-enforceable payment obligations, regardless of whether the issuer is profi table or not Issuers with unstable earnings risk defaulting on payments in bad earnings years which could lead to legal proceedings against it by the bondholders
a Relatively low debt – Remember that debt increases
fi nancial risk As a general rule, a business should choose
a level of debt versus equity that (a) takes advantage of leverage but (b) does not blow out its risk
a Large borrowing requirement – The fi xed cost of issuing bonds (e.g prospectus, trust deed, legal and accounting advice, etc) is signifi cant Therefore small issues may not
be cost effective
a Receptive to public scrutiny – Under the law, an issuer making a public offer of bonds, shares or other securities must regularly report material information to the public
Benefi ts Source of capital Leverage Delayed Interest Delayed Principal Fixed Interest Rate Flexibility
Risks Financial risk Refi nancing risk Bullet payment Admin cost Disclosure Tax
5 See the appendix for a more detailed discussion of time value of money and bond values.
rate of return We will discuss this further in Understanding
Bond Price.
Security – An issuer may “secure” the bond on some of its
assets, like property or shares that it owns Th us if the issuer
defaults in paying bondholders, the bondholders will have the
rights to the proceeds from the sale of the assets Security for a
bond reduces the risk to the bondholders and therefore makes
the bond more attractive to investors Generally however bonds
rank behind loans from banks in priority for payment, but
ahead of ordinary trade creditors
Why Issue Bonds?
Bonds off er a business a number of benefi ts Some of them are
listed below:
n An alternative source of capital – In Fiji, businesses have
traditionally relied on shareholders’ equity and bank loans
Alternative sources of funds like bonds mean that businesses
have a wider choice and more fl exibility in funding
n Leverage – Borrowing can increase shareholder returns
Let’s say you build a new factory and fi nance this through
a mix of borrowing and equity If you can borrow at an
interest rate that is lower than the return from the factory,
the return to shareholders will increase Th is is called
leverage Bonds can be one method of leverage
n Less frequent payments – Coupons are typically paid
every three, six or twelve months, depending on the bond
Th is may be more fl exible and convenient for the issuer
compared to a bank loan which requires monthly interest
payments A bullet bond goes even further by paying all
coupons and principal at maturity
n Delayed principal repayment – Compared to the typical bank loan which requires that the principal is repaid in installments, the bond principal is paid as a lump sum
on maturity A zero coupon goes even further Th is type
of bond is issued at a discount to its face value and pays
no coupons Th e net present value of the diff erence between the face and the issue price is the internal rate of return which compensates investors for not getting coupons during the life
of the bond with a big capital gain at maturity
n Fixed interest rate – Th e interest rates can be fi xed by issuing a fi xed rate bond In this way, if interest rates increased, the issuer has locked in its interest rate
n Flexibility – Bonds can be structured in many ways, to suit the needs of the issuer For example, the issuer can choose how often coupons are paid, the term, whether the coupon rate is fi xed or fl oating and the type of embedded options
Risks and Challenges of Issuing Bonds
n Financial risk – Because bonds are a debt, the issuer has payment obligations that are enforceable under law Even if the issuer runs into fi nancial diffi culty, coupons and principal payments must still be made Compare this with ordinary shares – a company can decide not to pay dividends in years where it makes a loss
n Refi nancing risk – When bonds mature the issuer still needs capital, it may have to refi nance i.e pay off the bonds and fi nd new capital to replace the funds paid out However, refi nancing could be a problem if interest rates have been rising – the issuer might end up refi nancing at a higher interest rate
n Large bullet payment– Th e principal is paid when bonds mature While delaying this payment may be convenient initially, it means the issuer will have to make a large “bullet”
payment when the bonds mature Th e issuer needs to plan its cashfl ows carefully so it isn’t caught unprepared
n Administration cost – Administration of a large pool of investors would be more work compared to say borrowing from a bank Imagine sending out coupon cheques and
Leverage Example
Crash Co needs $100,000 for a manufacturing operation
that will generate a 10% rate of return after a year (i.e
$10,000)
If shareholders provide all the funds, they get a 10% rate of
return ($10,000) However if 50% of the funds is borrowed
at a 5% interest rate (i.e interest = 5% x $50,000 = $2,500),
the shareholders get the remaining return of $7,500 on
their equity of $50,000 Their return in this case is 15%
($7,500/$50,000)
With leverage, the shareholders’ return is now higher
because the interest on debt is lower than the return on
the project
Leverage vs Financial Risk
Note that fi nancial risk should be weighed against the benefi ts
of leverage More debt increases the benefi ts of leverage but also increases fi nancial risk Therefore businesses usually look for a balance between the two i.e take on some debt but not too much!
Trang 5How to Value a Bond?
So what does all of this jargon mean? How do you actually go about valuing a bond? Unfortunately, valuing a bond can be
quite complex and is beyond the scope of this booklet However,
here are a few pointers:
n Government bonds- the Reserve Bank regularly publishes information on yields and prices for diff erent maturities and coupon rates Th is information refl ects recent bond issues and therefore provides an indication of the current value of
a Government bond
n Non-Government bonds - Corporate and other non-Government bonds are generally riskier than non-Government bonds so should really be giving you a higher yield than that
of a similar Government bond Th e yield can be estimated
by adding a premium on the equivalent Government bond yield to refl ect the extra incremental risk Th e resulting yield can then be used to calculate the bond’s value i.e the present value of the bond’s future cashfl ows
Estimating the amount of premium to add is not straightforward and is best left to your investment adviser Th is premium will vary from issuer to issuer Th e higher the overall risk of a bond compared to a similar Government bond, the larger this premium
Structuring Bonds – Practical Issues
Structuring a bond issue normally requires specialist investment
advice and is outside the scope of this introductory booklet
However, in this section we discuss some practical issues that will help you when working with your investment adviser
Leverage Remember, debt can increase the return on equity through
leverage However, with more debt, a business’s fi nancial risk
increases because regardless of whether the business is making profi ts or losses, it is locked into legally-enforceable payment obligations It is therefore important to strike a balance Usually a business will have a target capital structure, e.g “50% equity/50% debt” Th is will determine how much capital should be raised through a bond issue
Determining an ideal capital structure depends on the individual
business, its industry and other factors, beyond the scope of this
booklet As a rough guide, a business with stable earnings from
its operations will be better able to meet its debt obligations Term
Th e term of a bond depends on the reasons for raising capital and the expected cashfl ows that will be available to meet payments For example, a large project might be funded with a ten-year bond issue to allow enough cashfl ows to be generated to pay
off the bonds Alternatively the issuer may choose to fund this through a 5-year bond issue and refi nance with a second 5-year issue when the fi rst lot of bonds mature Various combinations are possible Please consult your investment adviser
Credit Spread, Yield and the Coupon Rate
We have seen how government bonds are often regarded as low risk or risk free, because government is seen as unlikely to default on its payments
Th erefore, the yield on government bonds will normally be the lowest in the market Remember the lower/higher the risk, the lower/higher the return (yield) has to be in order to compensate investors
Risk Premium and the Coupon Rate
In theory, as the required yield increases, the issuer will have
to increase the coupon rate or else the price investors are willing to pay will fall Issuers normally don’t want the latter because this could mean that they raise less money than planned i.e investors are paying less for the same number
of bonds
Therefore in practice, issuers will aim to keep the bond price
at the face value They do this by setting the coupon rate at the required yield In MRC’s example, the coupon rate is 8%
Determining the appropriate yield can be done through an auction process
Example
Max Risk Co (MRC) wants to issue a 10 year bond with a
$100 face value and a callable option MRC is a medium-sized public company which has been profi table except for the last 2 years when it made a small loss It expects to return to profi tability this year
MRC’s bonds are riskier than government bonds because MRC has less resources, has earnings which have fl uctuated
in recent years and has a callable option
10-year government bonds have a yield of 6% In this case, MRC’s bonds might end up with an 8% yield
you need to take into account what is called the “time value” of
money
Consider the following: Which would you rather have: $100
today or $100 in a year’s time? Th e logical choice is $100 today
because you can invest this to earn interest so that in a year’s
time, your initial investment will be worth more than $100
For example, if you could invest to yield 10% for the year, a
$100 investment today would be worth $110 after one year
Reversing this process, $110 in a year’s time would be worth
$100 today6 To use the technical jargon, at an interest rate or
yield of 10%, present value of $100 is equal to future value of
$110
Th is concept has some important implications for bond value:
n Because you can invest at some interest rate, $100 today
should be worth more than $100 in one year’s time (this
is true of any amount and interest rate for that matter)
Similarly, $100 in one year’s time should be worth less than
$100 today7
n Th e higher the interest rate the greater the diff erence
between present value and future value Say you invest for
a year at a 20% interest rate A present value of $100 would
be equal to a future value of $120 and vice versa
n So what is the value of a bond? It is basically the present
value of the future cashfl ows (income and growth) that the
bondholder will receive
How Interest Rates Aff ect a Bond’s Value?
As we have seen, interest rates aff ect a bond’s value Th e bond
price may be higher or lower than its face value depending on
how its interest rate (the coupon rate) compares with interest
rates available on other investments
Take a bond with a fi xed coupon rate8 of 6% Th e coupon rate
never changes even though interest rates may Let’s say when
the bond is fi rst issued, similar bonds and other investments
were also paying 6% Th erefore the bond’s coupon rate is in
line with the market and its price will be equal to its face value
Th is bond is said to be trading at par
What happens if the market interest rate dropped to 4%?
Now the bond is still paying 6% so is more attractive than
other investments paying only 4% Investors will be willing
to pay more for this bond Th is is why a bond’s price can be
higher than its face value Th is bond is said to be trading at a
premium
What happens if market interest rates increased to 8%? Th e bond is still paying 6% so is now less attractive than other investments paying 8% Investors will want to pay less for this bond Th is is why a bond’s price can be lower than its face value Th is bond is said to be trading at a discount
To summarise, a bond’s value (i.e its price) and the interest rates in the market are like a see-saw As one goes up, the other goes down An increase in interest rate leads to a fall in bond price and vice-versa
Which Interest Rate?
In our simple example below, we used a 10% interest rate What
is the relevant interest rate for analysing a bond? Basically this should be the interest rate available on other investments that are similar to the bond (this is referred to as the market yield) Why is this so? Because if an investor didn’t choose the bond, he/she could get this yield (interest rate) from similar investments anyway
Th erefore the market yield is like the benchmark to measure
a bond against If the bond’s coupon rate isn’t as high as the market yield, investors will pay less than the face value
If the coupon rate is above the market yield, the bond is more attractive and investors will be prepared to pay more than the face value
6 Future Value = $100 x 1.10 = $110 i.e $100 today is worth $110 in a year Present value of $110 to be received
in a year = $110/1.10 = $100 i.e $110 in a year is worth
$100 today It follows that $100 to be received in a year is worth less than $100 today!
7 With a 10% interest rate, this is worth $100/1.1 =
$90.90.
8 When the bond is fi rst issued, the issuer tries to set a coupon rate that is competitive with similar bonds Too high and the issuer ends up paying too much interest, too low and investors might not be attracted.
General Interest Rates
Bond value
General interest rates increase but bond coupon rate stays the same the bond is now LESS attractive relative to
other investments
Investors are prepared to pay LESS for the same
bond
Trang 6n Managing coupon and face value payments, including mailing out cheques or depositing payments into bondholder accounts
n Keeping track of sales of bonds in the secondary market
n Ensuring all records are up to date
Th e Reserve Bank of Fiji currently carries out administration
of Government bond issues For other bond issues, the issuer may prefer to do this in-house or enter into an agreement for
a third party, such as the RBF, to carry out these tasks on the issuer’s behalf
Tax Implications
Th e taxation of bonds diff ers from shares because bonds are generally treated as debt
Th e following diagram summarises the general tax treatment
of bonds compared with shares
A key implication is that bondholders pay tax on coupons while shareholders can be tax-exempt Th e issuer may have to increase the yield on the bond to compensate bondholders for tax and ensure bonds remain attractive
Sinking Fund
One of the risks of bonds is that the issuer will have to make a large payment of face value when the bond matures Planning for this is important to avoid a cash crisis Companies with strong cashfl ows and large cash reserves may not have to worry For others, a sinking fund, where money is set aside
in installments to meet principal repayments, may be a wise move
A sinking fund is basically like amortising a bank loan over time Th is reduces credit risk and therefore, may reduce the
yield demanded by bondholders However, a sinking fund ties
up cashfl ow over the bond’s term
The Bond Issue Process Basic Requirements
Th is section deals mainly with issues of bonds to the public, as opposed to private placements In general, private placements
to selected institutions and other investors (without a general
off er to the public) are treated as a private transaction, subject
to what is agreed between the parties In contrast, issues to the public must meet strict requirements set by the CMDA Public issues must be approved beforehand by the CMDA
Th is requires that a proposal be made to the CMDA Once the proposal is approved, key steps in the bond issue are:
n Preparation of a prospectus, which provides detailed information for the benefi t of investors
n Appointment of a trustee to represent the interests of the bondholders Th e relationship between the trustee and issuer is governed by a document called the trust deed
A trustee is required by law and is usually a company specialising in providing trustee services
n Appointment of a registrar to handle the administration of the bond issue Th e registry function may be carried out by the issuer or outsourced to a third party
n Conversion to a non-private company where applicable – By defi nition in the Companies Act, a private company cannot off er shares or bonds to the public Th erefore to carry out a public off er, a private company must convert to a non-private (“public”) company
n Application for stock exchange quotation – If it is decided
to quote the bonds on the stock exchange, application needs
to be made to the stock exchange
n Appointment of underwriters and sub-underwriters
n Roadshow to key institutions and other investors to build demand for bonds
n Running of the off er period
n Auction process and allotment of bonds (see below)
As a very basic guide, a typical bond issue could take around 12 weeks to complete A conceptual timeline for a public issue of bonds is presented In practice this will depend on the particular issue
Bonds
n Coupons are paid out of income
n Coupons are tax-deductible
n Coupons = interest income
to bondholder
n Bondholder is taxed regardless of whether tax is paid at company level
Shares
n Dividends are paid out of profi ts
n Listed company dividends are tax free
n Inter-company dividends are tax free
n Shareholder is not taxed to the extent that tax is paid at company level
Th e yield on non-government bond issues will depend on the
risk of those bonds compared to the equivalent government
bond Th e diff erence between a bond’s yield and the yield on
a similar government bond is called the credit spread or risk
premium Factors that determine the risk premium include:
n Management quality and performance record of the issuer;
n Financial, operating and competitive position of the issuer;
n Structure and ownership of the issuer;
n Th e value and quality of assets off ered as security;
n Constraints imposed on the borrower (e.g maximum debt
levels, which reduce risk for the bond-holder); and
n Embedded options Note that some embedded options
(e.g a convertible option) are valuable to a bondholder while
others (e.g a callable option) increases a bondholder’s risk
Th is callable option may also be seen by the bondholders as
a sign of confi dence in the issuer’s operations
Security and Other Enhancements
Providing security reduces the risk for investors and the cost
to the issuer through a lower required yield Th is is especially
important where the issuer might have a poor credit rating
Examples of security include:
n Real property - fi xed assets, land; and
n Collateral – shares, and bonds owned by the issuer
Bonds can be made less risky in other ways, for example:
n A guarantee provided by a third party; and
n A bank letter of credit
Underwriting
A bond issuer may consider having the issue underwritten
In an underwriting, the underwriter, usually a company,
institution or wealthy individual, promises to take part or all
of the shortfall bonds that are not demanded by investors Th e
issue may also be sub-underwritten by other parties Th is helps
spread underwriting risk and is especially important when an
issue is too large for the underwriters
Th e advantages of underwriting include the following:
n Reduces risk for the issuer by ensuring that a minimum
amount of capital will be raised;
n Ensures that the bond issue is seen as a success by the markets;
n Helps to stimulate demand in the secondary market; and
n Th e underwriter typically helps the issuer in pricing and marketing the issue
Registration Just like shares issued to the public, a bond issue requires careful administration to ensure that the issuer meets all its payment and other obligations on time
Some of the common administrative tasks include:
n Receipt of applications and payment when bonds are issued
n Running the auction process to determine the appropriate yields and allotting bonds to successful applicants
Other Special Features
Bonds provide the issuer with considerable fl exibility in designing the features of the bond We have discussed some
of the main options above Here are just some of the other features that could be considered:
n Floating coupon rate – This allows the coupon rate to increase or decrease depending on how interest rates
in the markets move In this way, bondholders can be protected against interest rate movements that could devalue their bonds
n Bullet payment – Some bonds can be structured to delay payment of interest until maturity
n Call provision – This allows the issuer to repay bonds early if this is advantageous to the issuer For example, when interest rates are falling, the issuer could repay bonds and refi nance at a lower interest rate
This list is not exhaustive Talk to your investment adviser about other bond features that might be suitable for your business
Administration is sometimes referred to as the registry function and the party carrying out this function is called the registrar
Trang 7Th e prospectuses must be approved by the CMDA and registered with the Companies Offi ce.Th e purpose of the prospectus is to help investors make informed investment decisions before they decide to invest.Th e prospectus will have attached the application form and instructions for completing
an application
Tender and Allocation Process Bonds are generally issued through an auction process In such a process, investors submit tenders for the bonds and this allows the issuer to determine what the appropriate yield and coupon rate should be Some of the common methods of issuing bonds are shown in the diagram below
The South Pacifi c Stock Exchange
The SPSE is currently the only stock exchange in Fiji
Trading sessions are held on weekdays at 10:30am where matching buy and sell orders are transacted Trades are settled within T + 3 working days At this time, the buyer receives the bond certifi cate(s) and the seller receives payment
Having an auction process provides a number of advantages For example, the bond issue more accurately refl ects market demand and is more transparent Competition can also result
in more competitive terms for the issuer
Once tenders are received, successful bidders are chosen according to set criteria, typically based on yield Common approaches include the following:
n Single Price (“Dutch auction”) – Here, competitive bids are ranked from the lowest to the highest yield (note that higher yield means lower price) Starting with the lowest yield and working up, the yield at which the quantity
off ered for sale equals the quantity demanded is identifi ed
Th is yield is called the “stop yield”) All competitive and noncompetitive bids are fi lled at the price implied by the stop yield Sometimes there may be more quantity demanded than is available In this case, bonds may have to
be pro-rated
n Multiple Price – Here, quantity is allocated at the yield demanded, starting from lowest to highest until the supply of bonds is fully allocated In other words, each group of bidders is paid a diff erent price Where both non-competitive bids are accepted, they typically receive a weighted average of the competitive yields accepted
Successful tenderers are then issued with a bond certifi cate(s)
as proof of ownership
Listing and Trading Bonds on the SPSE
Bonds can be bought and sold in the secondary market either directly between buyer and seller or using a broker as a “go-between”
One of the options for trading bonds is the stock exchange, where bonds can be traded just like shares To trade bonds
on the stock exchange, the issuer must quote its bonds on the
Non-Competitive Auction
Under this method, investors apply for quantity or dollar amount of the bonds they want to purchase
The price is assigned based on the outcome of the competitive bids
Competitive Auction
Under this method, investors specify both the quantity of the bonds demanded and the price they are willing to pay
Dual Auction
Here both competitive (price and quantity) and non-competitive (quantity only) bids are allowed
Primary Market vs Secondary Market
The bond market can be viewed as two markets:
Primary Market - Created when a company fi rst offers bonds to the public A company seeking to raise funds by issuing bonds must publish a prospectus offering investors the opportunity to buy Investors would fi rst evaluate the prospectus before subscribing for bonds
Secondary Market – Where existing bonds are traded
Bonds in Fiji may be traded in the secondary market directly between bondholders or through an intermediary, called a broker Brokers must be licensed by the CMDA
Your investment adviser will be able to help you plan and
implement a bond issue in a timely and cost eff ective manner
Other legislation and regulations that need to be considered
1 Companies Act
Certain sections of the Companies Act 1985 need to be
complied with prior to issuing bonds to the public Th ese
sections outline basic requirements for prospectuses,
allotment and special provisions, etc Th e key sections to
keep in mind fall under Part III of the Companies Act i.e.,
Share Capital and Debentures
2 Income Tax Act
Specifi c binding tax rulings may need to be obtained by
issuers for their specifi c circumstances Specifi cally, treatment
of income from interest payments to bondholders, whether
it is taxable in their hands or the interest withholding tax
needs to be deducted at source as a statutory obligation from
the interest paid to the non-resident bondholders (if any)
needs to be clearly documented If an organisation intends
to raise capital outside of Fiji, risks such as foreign exchange
risk needs to be addressed together with any impacts on the
resultant tax situation arising from any realised or unrealised
gains/losses
3 South Pacifi c Stock Exchange Listing Rules
If the issuer intends to quote the bonds on the South Pacifi c
Stock Exchange (“SPSE”) for day-to-day trading then
the SPSE Listing Rules (“LR”) has to be complied with
including the payment of SPSE fees and charges Th e LR
impose strict obligations on companies and non-compliance
could result in being disqualifi ed from the offi cial list and
loss of offi cial quotations for their bonds
4 Trustee Act
Similar to unit trusts, a trustee has to be appointed to
represent the interests of the bondholders Th ere must be
a trust deed which sets out the relationship between the
issuer and the trustee holding the principles outlined in the
Trustee Act 1966
5 Company’s Articles of Association
Th e Articles of Association has to be checked to ascertain
whether the directors of the company are empowered to
issue bonds and raise money from the public If this is
not possible, amendments may be required to the Articles
of Association to allow for the capital raising through the
bond instrument
6 Foreign Investment Act
Off shore investors have to obtain approval from the Fiji Islands Trade and Investment Bureau (“FTIB”) to invest
in Fiji Bond issuers have to bear in mind the Foreign Investment Regulations 2005 that states the minimum percentage ownership that needs to be retained for certain industries by local residents Th e remaining percentage could then be off ered to off shore investors buying bonds which have provisions of conversion to equity or other embedded options that could deem the instruments as equity or quasi-equity
7 Reserve Bank of Fiji Act Reserve Bank of Fiji exchange control approval has to be obtained for any off shore investors interested in investing
in bonds issued in Fiji
Please note that the above key legislation are in no way an exhaustive list Professional advice needs to be considered on
a case by case basis
Primary and Secondary Markets
When bonds are fi rst issued, this is done in the primary market
Bonds can be issued just to a selected group of investors, usually large institutions and companies (this is called a private placement) Where bonds are off ered to the public (a public off er), various laws apply, including the Capital Markets Development Authority Act and associated rules and regulations
One of the most important requirements is that the issuer must prepare and make available to investors a document called a prospectus Th e prospectus sets out detailed information on the issuer, including its history, operations, resources, fi nancial performance, how the funds being raised will be used, how to apply for bonds and whether there is any minimum amount that must be applied for
Phase 1
1 2 3 4 5 6 7 8 9 10 11 12
Week
Plan, budget, structure
Prospectus and other regulatory requirements
Registration, book building, auction and allotment
Conceptual Timeline
Trang 8Valuing a Bond Conceptually, the value of a bond is the net present value of its cashfl ows:
Price = C1 +C2 + + P + Cn
(1+r)1 (1+r)2 (1+r)n
Where:
C1 = Annual coupon in year 1 C2 = Annual coupon in year 2
Cn = Annual coupon in year n
P = Principal repaid in year n
r = market interest rate for bond with term of n years
In reality valuing a bond is a little more complicated because of several special factors For example, accrued dividends mean that the basic bond price will fl uctuate over time Th e pricing formula used by the Reserve Bank of Fiji for valuing bonds is
as follows:
P = C/2 x A + FV - (n + k)
Where:
P = price per $100 face value
C = coupon (assumes coupons are paid semi-annually)
A = 1 - (1 + i/2) - (n + k)
i/2
F = face value
V = (1 + i/2)
n = number of whole half years to maturity
k = f/d where: f = actual number of days from
settlement date to next coupon date
d = actual number of days in that half year coupon period
i = current yield to maturity or rate of return
Appendix Bond Valuation Mathematics Future Value (FV) – this is the value which an amount today will grow to if it earns interest
= Present Value x (1+r)n, where n = number of periods in which interest is earned
Present Value (PV) – this is the value today of a future amount assuming an interest rate PV is the reverse of FV
= Future Value ÷ (1+r)n where n = number of periods in which interest is earned
Net Present Value (NPV) - NPV is the value today of all current and future cashfl ows It refl ects time value of money using the basic PV formula above Obviously, a dollar today has a present value of $1 However, future cashfl ows are
discounted by a market interest rate (or what is often called
a discount factor) to take into account the fact that future
amounts are worth less today Th e formula for calculating a stream of cashfl ows is:
NPV = -C0 + C1 + C2 + + Cn
(1+r)1 (1+r)2 (1+r)n Where:
-C0 = cashfl ow in year 0 (now)
C1 = cashfl ow in year 1
C2 = cashfl ow in year 2
Cn = cashfl ow in year n
r = market interest rate
n = last year of cashfl ow stream
NPV Example
Consider the following cashfl ows from an investment:
What is the Net Present Value if the market interest rate
is 5%?
NPV
= -100 + 10 + 10 + 110
(1+0.05)1 (1+0.05)2 (1+0.05)3
= -100 + 10 + 10 + 110 1.05 1.1025 1.157625
= -100 + 9.5238 + 9.0703 + 95.0221
= $13.62
Future Value Example
Calculate FV of $300 invested for 10 years if it earns 8% a year
FV = 300 X (1+ 0.08)10 = $647.68
Present Value Example
Calculate PV of $1000 to be received in 5 years assuming
a discount rate (interest rate) of 9%
PV = 1000/ (1+ 0.09)5 = $649.93
Year 0 = -$100 (i.e invest $100);
Year 1 = $10;
Year 2 = $10; Year 3 = $110
Exchange Th is requires an application for quotation to be
made by the issuer and may be subject to quotation fees
Listing bonds on the stock exchange off ers several benefi ts
including:
n Liquidity and marketability of bonds
n A mechanism for shareholders to sell their shares
n Enhanced prestige and corporate profi le
n Enhanced value
Under the Capital Markets Development Authority Act, investors must use a broker licensed by the CMDA when buying or selling bonds on a stock exchange Th e broker follows the client’s instructions in taking the order to the stock exchange, including the quantity to be traded, price, or range of prices, to trade at, and the length of time for which the order
is valid In return for its services, the broker may charge a small fee which includes the broker’s commission and SPSE and CMDA levies
Trang 9How Interest Rates Aff ect Bond Prices – Examples Say you buy a $1,000 bond when it is issued in the primary market Th e bond has a coupon rate of 10% and a maturity of
10 years Th erefore, each year for the next ten years, you will receive an annual coupon of $100 (i.e 10% x $1,000) At the end of 10 years, the $1,000 you lent is repaid to you
To see how interest rates aff ect the price of bonds, say you decide
to sell the bonds after 4 years Let’s look at two scenarios: (1) interest rates have risen and (2) interest rates have fallen
Scenario 1 - Interest rates rise Interest rates have risen and investors are now looking for a 12% coupon rate on similar bonds
Th is means the market value of your bonds must be at a level where a buyer earns at least 12% Th e bond will continue to pay $100 annual coupons But since the buyer requires a return
of 12%, he will pay you less than the par value of $1,000
Using the bond price formula, the price of the bond is $917
Th e buyer will receive $100 coupons each year plus a principal repayment of $1,000 in the sixth year when the bond matures
Th e $100 per year plus the gain of $83 (1,000 face value – 917) equals a 12% per annum yield on the initial $917 invested by the new investor
As the original bondholder, you will incur a capital loss on your investment
Scenario 2 - Interest rates fall Now assume that interest rates have fallen and investors are now seeking a coupon rate of 8% on similar bonds
You would require the buyer to pay a price that yields a return equal to the current market rate of 8% Because the bond pays
an annual coupon of 10% (higher than the current market rate
of 8%), the bond price should be higher than the original price you paid
Using the bond formula, the buyer will have to pay you $1,092 for the bond, which would yield him a return of 8% Th is is equivalent to the current market rate You therefore make a capital gain of $92
Th e examples illustrate that during the life of a bond, its capital value can change at any time in line with changes in the overall level of market interest rates Th is is the risk that investors trading in the secondary market face In contrast, investors who hold the bonds to maturity are guaranteed that they will
be repaid the par value of the bonds when the bond matures
A Bond Valuation Example
A bondholder wishes to sell the following bond in the
secondary market:
Coupon = 9% = $9 (paid in semi-annual
amounts of $4.50) Face Value = $100.00
Maturity date = 14 February 2006
Settlement date = 30 September 2003
Last coupon date = 14 August 2003
Next coupon date = 14 February 2004
f = 30/09/03 to 14/02/04 = 137 days
d = 14/08/03 to 14/02/04 = 184 days
Price = 9/2 x 1 - (1+0.0675/2)- (4+0.74457)
0.0675/2 + 100 x (1 + 0.0675/2) - (4+0.74457)
= 4.5 x 0.14571/0.033750 +100(0.85429)
= 4.5 x 4.31737 + 85.42900
= $104.86
* Please consult your investment adviser or broker for
specifi c advice on valuing a bond
Clean vs Dirty Price
The RBF formula given above does not take into account the
interest accrued on the bond since the last coupon payment
date For example, say you have a semi-annual coupon bond
and the last coupon payment was three months ago If you
sold the bond today you should be entitled to half of the next
coupon (3 months out of the 6 months) Where the price
includes this accrued interest, it is called the dirty price
Normally bonds are quoted without accrued interest This is
called the clean price To calculate the dirty price, the accrued
interest is added to the clean price The formula for accrued
interest (A1) is:
number of days in coupon period
Dirty Price
Continuing with our bond example, the calculation of the
clean price is as follows:
A1 period = 47 days/184 days = 0.25543
A1 = 0.25543 x $4.50 = $1.15
Dirty price = Clean price + A1
= $104.86 + $1.15
= $106.01
Glossary
Accrued Interest an amount of interest accumulated, but not yet paid, between semi-annual payment dates
Auction usual method of issuing bonds where investors submit bids
Bondholder an investor in bonds
Call option type of embedded option which allows the issuer to pay back the bond early
Call provision some bonds notably perpetual securities have a call provision attached Th is gives the issuer
the right, but not the obligation, to buy back the bonds from investors at a particular point in time at a certain price
Clean price Price that does not include the interest accrued since the last coupon payment
Competitive auction Auction method where investors apply for both the yield and the quantity they wish to purchase
Competitive bid a bid for bonds submitted under auction specifying both yield and quantity
Conversion rights type of embedded option, which gives a bondholder the option of converting his/her bondholding
into shares of the issuer
Coupon regular interest payments made to the bondholder
Coupon rate percentage of interest paid on a bond
Credit risk risk that the issuer may be unable to pay bondholders
Dirty price price that includes interest accrued since the last coupon payment
Distribution return Th e return an investor gets from the dividends or realized capital gains from his investment
Diversifi cation spreading your money over diff erent investments to reduce overall risk
Dual auction combination of competitive and non-competitive auction methods
Embedded option option given to the issuer and/or the bondholder to take some action against the other party
under certain circumstances
Face value amount paid to the bondholder at the end of the lending period
Fixed coupon rate coupon rate, which does not change over the life of the bond
Fixed income securities class of investments which includes bonds issued by the government, statutory authorities
and companies A typical feature is these securities make regular interest payments and repay the principal on maturity
Floating coupon coupon rate that may be periodically adjusted to take into account prevailing market conditions
Future value value which an amount today will grow to in future if it earns interest
Growth return the return an investor gets from selling his investment at a
profi t i.e for a higher price that he bought them
Income return a bondholder’s return from receiving regular coupons
Infl ation when the cost of a product or service rises and quality Remains the same; also when spending
increases relative to supply – think of it as too much chasing too few goods
Trang 10CMDA Educational Booklets
n Investing in Shares
n Investing in Unit Trusts
n Investing in Bonds
n Rewarding Employees
n Using Employee Share Schemes - FAQ
n Why You Should Invest - FAQ
n Investing in Shares - FAQ
n Choosing the Right Shares - FAQ
n How to Use a Broker or Investment Adviser - FAQ
n Investing Wisely - FAQ
n How to List Your Company on the Local Stock Exchange
n Vakatubu I Lavo e na Voli Sea
n Vakatabu I Lavo ena “Unit Trusts”
If you wish to receive these free educational booklets, please contact us:
Level 5, FNPF Place, 343-359 Victoria Parade, Suva,
P.O Box 2441, Government Buildings, Suva
Tel: (679) 3304 944 Fax: (679) 3312 021 Email: cmda@connect.com.fj Website: www.cmda.com.fj
Interest rate risk risk that rising interest rates cause bond prices to fall
Issuer company or institution that issues a bond Th e issuer borrows money from bondholders
Liquidity risk risk that a bond cannot be easily sold at or close to its market value
Maturity see “Term”
Multiple price method of allocating bonds where successful competitive bids receive the tendered yield
Allocation while non-competitive bids receive a weighted average of competitive yields accepted
Net present value value today of all current and future cash fl ows
Non-competitive auction method where the yield of bonds is fi xed and investors only apply for the number
of bonds they want to purchase
Non-competitive bid a bid submitted under auction specifying only the quantity
Par value the face value of an investment set at the time of issue
Political risk risk that unexpected events adversely aff ect the value of a bond
Present value value today of a future amount assuming a specifi c rate of return
Price amount an investor pays for an investment
Primary market where an issuer fi rst off ers bonds to the public
Principal amount paid to the bondholder at the end of the lending period
Prospectus a formal off er document required by law which sets out detailed information on
the company that will help potential investors to analyze the investment
Re-investment risk risk that if interest rates fall, coupons would have to be re-invested at a lower interest rate
Secondary market trading in bonds or shares that have already been issued
Security assets of the issuer that may be sold to reimburse bondholders if the
issuer fails to meet its obligations
Single price method of allocating bonds where all bonds are issued at the highest
(“dutch auction”) accepted yield allocation tendered by investors
Term the life of a bond
Yield the return on investment usually expressed as a percentage of the initial investment
Yield to maturity type of “yield” which measures the rate of return on a bond assuming it is held to maturity