A fixed income instrument (bond) is a financial instrument which, at inception, involves the exchange of monies between two parties to a transaction in exchange for claims on the underlying features and characteristics of the bond.
Simply put, a bond is a type of loan whereby investors (one party to the transaction) lend/loan out money to governments or corporations (other party to the transaction) at a pre-determined set of conditions.
Generally, it is the issuer of the bond who approaches the investor (via the bond market) informing them of their intentions to issue a new bond and borrow monies.
Most governments and corporations are highly dependent on the availability of financing in terms of loans for their short and long term longevity requirements. Bank loans are amongst the cheapest forms of financing around.
After having exhausted all their borrowing facilities at banks, governments and corporations resort to the bond market for alternative means of raising cash, whereby the large quantity of small investors makes it easy for bond issuers to tap in the form of a wide array and pool of investors.
After deciding to resort to the bond market to raise finance in the form of a bond issue, bond issuers (mainly corporations) embark on a marketing campaign aimed at creating visibility and improving the corporate profile of the company with the public via the media. This is usually the case in Malta.
In the international bond market, bond issuers organise what are known as roadshows targeted for the large international banks within the most popular financial hubs such as London and New York. This gives prospective bond issuers access to such banks via their multi-billion dollar network of retail and institutional clients.
Inevitably, bond issuers need to get prospective investors on their side, so it is in their interest to project their company in the best possible way, whilst providing clarity on the future prospects of the company.
However, investors ought to know what their money is going to be used for, so bond issuers should clearly state this whilst also giving prominence to the medium to longer term viability, liquidity and profitability of the company.
Bond issuers need to intricately highlight the salient points, not only of their bond issue but also the pros and cons for investors willing to lend them money as well as the underlying risks inherent within the bond issue.
Bond issuers therefore have the obligation of 'coming clean' with investors whilst investors have the responsibility of taking informed decisions prior to 'trusting' bond issuers with their money.
There are a number of characteristics which define a bond and make it unique, such as the financial/credit viability of an issuer, the tenure of the bond, the currency, the price at which it is issued and whether there are any sorts of covenants assigned to a bond issue.
However, the coupon at which the bond is issued (the rate of interest) I'd by far the most important feature of a bond, other than the prevalent underlying market conditions.
To us investment managers, we are particularly concerned at the way a bond is priced on the primary market, and by this we mean at what yield a bond is priced. To simplify matters (bonds are generally issued at a price of 100) the coupon of a bond at inception defines the yield to maturity at which the initial bond investor lends money to the bond issuer.
Clearly for investors, the coupon/yield of a bond needs to be commensurate with the underlying risk of lending money to the bond issuer. There are thus a series of trade-offs and forces of demand and supply at play between the bond issuer and bond investor in the issue of the level of the coupon.
A bond issuer would want to entice as many investors by pricing the bond at a premium to similarly comparable bonds, but would not want to be over-generous as this could ultimately be costly for the company throughout the lifetime of a bond.
On the other hand, if an investor deems that the price (or coupon) of a bond is inadequate, s/he would simply not participate in the bond issue and the bond issuer would run the risk of not raising the planned amount of capital. This further accentuates the sensitivity around the pricing of a bond, both for the bond investor and well as for the bond issuer.
Most bond markets are efficient, which means that yields at which bonds trade on the secondary market are a fair representation of the underlying risks of being a bond holder of particular bond issues.
This follows that as soon as a newly issued bond begins trading in the efficient secondary bond market, the price/yield will immediately adjust accordingly and reflect all risks. If the market deems that the coupon of a bond was too low (and investors were not adequately compensated for the risk), then that bond's price is expected to drop (and yield subsequently rises).
If on the other hand the coupon was deemed to be too excessive, the bond is said to be cheap on the secondary market, demand for that bond will increase, the price of the bond will rise and the yield on that bond will likewise adjust lower to reflect fair value.
Among many other factors, the price and yield of a bond on the secondary market are pretty much dictated by the economic forces of demand and supply.
Disclaimer: This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt . The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.
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