CoFi II

• Domestic Bonds

  • Bonds issued by a local entity and traded in a local market, but purchased by foreigners

  • They are denominated in the local currency

• Foreign Bonds

  • Bonds issued by foreign company in a local market and intended for local investors

  • They are denominated in the local currency

• Eurobonds

  • International Bonds that are not denominated in the local currency of the country in which they are issued

• Global Bonds

  • Bonds that are offered for sale in several different markets simultaneously

  • Global bonds can be offered for sale in the same currency as the country of issurance (unlike Eurobonds)

• Restrictive clauses in a bond contract that limit the issuers from undercutting their abillity to repay the bonds

• For example, covenants may:

  • Restrict the abillity of management to pay dividends

  • Restrict level of further indebtedness

  • Specify that issuer must mainatin a minimum amount of working capital

• Advantages:

  • By including more covenants, firms can reduce their costs of borrowing

  • The reduction in the firms borrowing cost can more than outwigh the cost of the loss of flexibility associated with covenants

• Restrictions on Issuing new debt

  • New debt must be subordinate to existing debt

  • No new debt unless firm maintains specific leverage or interest coverage ratios

• Restrictions on Dividends and share repurchases

  • Payouts can be made only from earnings generated after the bond issue

  • Payouts can be made only if earnings exceed some thresold

• Restrictions on Mergers and acquisitions

  • Mergers are allowed only if the combined firm has a minimum ratio of net tangible assets to debt

• Restrictions on Asset disposition

  • Maximum amount of assets that can be sold, and/or minimum amount of assets that must be maintained

  • Restrictions on making loans or any other provision of credit

• When a group of private investors purchases all the equity of a public corporation and finances the purchase primarily with debt

• Occurs when an investor, typically a financial sponsor acquires a controlling interest in a company's equity

• The debt raised (by issuing bonds or securing a loan) is ultimately secured upon the acquisition target and also looks to the cash flows of the acquisition target to make interest and principal payments

• Acquisition debt in an LBO is usually non-recourse to the financial sponsor and to the equity fund that the financial sponsor manages

Private debt:

• The private debt market is larger than the public debt market.

• Has the advantage that it avoids the cost of registration but has the disadvantage of being illiquid.

• There are two segments of the private debt market: term loans and private placements

Bond:

• Contractually entitled sequence of cash flows

• Priority in capital structure

• Therefore lower liquidity

• Yankee Bonds (Foreign Bonds in the US)

• Samurai Bonds (Foreign Bonds in Japan)

• Bulldogs (Foreign Bonds in the UK)

• Dim Sum (Foreign Bonds in CH)

• Seperate Trading of Registered Interest and Principal Securities

• They are Zero-coupon Treasury securities with maturities longer than one year that trade in the bond market.

• The Treasury itself does not issue STRIPS. Instead, investment banks purchase Treasury notes and bonds and then resell each coupon and principal payment separately as a zero-coupon bond.

• Treasury-Inflation-Protected Securities

• An inflation-indexed bond issued by the U.S. Treasury with maturities of 5, 10, and 30 years

• The principal is adjusted with respect to the Customer Price Index (CPI)

• They are standard fixed-rate coupon bonds with one difference: The outstanding principal is adjusted for inflation.

• Thus, although the coupon rate is fixed, the dollar coupon varies because the semiannual coupon payments are a fixed rate of the inflation-adjusted principal

• The final repayment of principal at maturity (but not the interest payments) is protected against deflation. That is, if the final inflation-adjusted principal amount is less than the original principal amount, the original principal amount is repaid.

• Default Spreads are als known as Credit Spread

• The difference between the yield on corporate bonds and treasury yields.

• To compensate default risk of basic assets to investors

Annahme: Face Value = 1000€

PV = 40/1,05 + 40/1,05^2 + 40/1,05^3 + 1000/1,05^3 = 972,77

The term structure of interest rates in the debt securities market shows the relation between the interest rates and maturities of zero coupon without a default risk.

• Discount

  • A bond is selling at a discount if the price is less than the face value.

• Par

  • A bond is selling at par if the price is equal to the face value.

• Premium

  • A bond is selling at a premium if the price is greater than the face value.

• Forward rates are interest rates on zero bonds where maturity starts in n periods from now and ends n+1 periods from now.

• According to the „Expectations Hypothesis“ of the yield curve forward rates equal market consensus expectations of future short term interest rates.

• An upward-sloping yield curve would then be evidence that investors anticipate increases in interest rates.

• The “Liquidity Preference Hypothesis” states that short-term investors dominate the market such that forward rates exceed expected interest rates by some liquidity premium.

• The discount rate that sets the present value of the promised bond payments equal to the current market price of the bond.

• The Yield to Maturity (YTM) is equivalent to the IRR of a bond, i.e., it is the discount rate at which the present value of coupon and face value payments equals the initial investment (bond price).

• The YTM is a promised yield. It will be realized only if the bond is held to maturity and the coupon payments are reinvested at the yield to maturity.

• Present Value (PV)

• Face Value (FV)

• C (Coupon)

• n (Duration)

Bond value = Present value of coupons + present value of par value

• Present value-weighted average maturity of the bond payoffs = economic time to maturity

• Can be applied to measure the bond‘s sensitivity to changes in interest rates (i.e. changes in the yield curve)

• And thus for immunization strategies

• Important feature: the duration of a portfolio of bonds is the weighted average of the durations of the bonds in the portfolio

• zero-coupon bond: r = YTM

• coupon bonds:

• A bond trades at a premium if its coupon rate exceeds the yield to maturity

• It trades at a discount if its coupon rate is less than its yield to maturity

• If the coupon rate of a bond is equal to its yield to maturity, it trades at par value

• If the bond's yield to maturity has not changed, the IRR of an investment in a bond is equal to its yield to maturity, even if you sell the bond early

• Bond prices change with interest rates. When interest rates (and bond yields) rise, bond prices fall, and vice versa (inverse relationship between interest rates and bond prices)

• Long-term zero-coupon bonds react more strongly to interest rate changes than short-term zero-coupon bonds

Bonds with low coupon rates react more sensitively to interest rate changes than bonds with high interest rates and similar maturities

The sensitivity of a bond’s price to changes in interest rates is measured by the bond’s duration.

• Bonds with high durations are highly sensitive to interest rate changes.

• Bonds with low durations are less sensitive to interest rate changes.

  
  

Using the law of one price and the yields of free zero-coupon bonds, one can determine the price and yield of any other default-free bond. The yield curve provides enough information to price all of these bonds

If the yield curve is not flat, bonds with the same maturity but different coupon rates will have different yields to maturity.

If a bond issuer does not pay out a bond in full, it is in default.

• The risk that a default will occur is known as default or credit risk.

• US government bonds are generally considered to be free of default risk.

The expected return on a corporate bond, i.e. the company's borrowing costs, corresponds to the risk-free interest rate plus a risk premium. The expected yield is lower than the yield to maturity of the bond, as the yield to maturity of a bond is calculated on the basis of the promised cash flows and not on the basis of the expected cash flows.

• Asset-Backed Security

  • An asset-backed security (ABS) is a security that is made up of other financial securities; that is, the security’s cash flows come from the cash flows of the underlying financial securities that “back” it.

• Mortgage-backed Security

  • By far, the largest sector of the asset-backed security market is the mortgage-backed security market. A mortgage-backed security (MBS) is an asset-backed security backed by home mortgages.

• “fallen angel”

  • Investment-grade bonds downgraded to a high- yield rating are referred to as fallen angels.

• “rising star”

  • High-yield bonds down- graded to an investment grade rating are referred to as rising stars.

• “potential fallen angel”

  • BBB-’ rated bonds with negative outlooks or CreditWatch placements.

• S&P (49%)

• Moodys (31%)

• Fitch (10%)

Rating Methodology:

• The methodology for creating a rating involves an analysis of all the factors affecting the creditworthiness of an issuer company.

• A detailed analysis of the past financial statements is made to assess the performance and to estimate the future earnings.

• The company‘s ability to service the debt obligations over the tenure of the instrument being rated is also evaluated.

• In fact, it is the relative comfort level of the issuer to service obligations that determinethe rating.

• Business risk analysis

  • Analyzing the industry risk, market position of the company, operating efficiency and legal position of the company.

• Financial analysis

  • Used to determine the financial strength of the issuer company through quantitative means such as ratio analysis, cash flow analysis or study of the existing capital structure.

  • As a rating is a forward-looking exercise, more emphasis is laid on the future rather than the past earning capacity of the issuer.

• Cash Flow analysis

  • Is undertaken in relation to debt and fixed and working capital requirements of the company.

• Geographic analysis

  • An issuer company having business spread over large geographical area enjoys the benefit of diversification and hence a better credit rating.

  • A company located in backward are may enjoy subsidies from government thus enjoying the benefit of lower cost of operation.

  • Credit rating agencies evaluate structure and regulatory framework of the financial system in which it works.

Benefits for companies:

• Market access (gate keeping)

• lower cost of borrowing

• Wider audience for borrowing

• Rating as marketing tool / improving their own image

• Reduction of cost in public issues

Benefits for investors:

• Due diligence efficiency

• Saving of resources

• Multiple independent perspectives

• Facilitates comparisons

• Tool in portfolio management

• Enhances secondary market liquidity

• Relatively stable over time

• Basis for performance benchmarks

• Reflection of temporary adverse conditions

• Rating is no guarantee for soundness of company

• Human bias

• Static study

• Difference in rating of two agencies

• Biased rating and misrepresentations

• Concealment of material information

Background to the fundamental differences in ESG-ratings:

• Between rating agencies:

  • Different weighting of the most important E-, S- and G-indicators

  • Variations of indicator definitions

  • Different methods and data sources for measuring the indicators

  • Different assessment of factors for which no information is available

• Between companies:

  • Company size (better ratings for larger companies)

  • Developed markets versus emerging markets (better ratings in developed markets)

• Maturity-free bond as a substitute for equity with characteristics similar to bonds and shares

  —> One-time cancellation option of the perpetual annuity for the issuer (usually terminated after ~10 years to ensure follow-up measures)

• Return of perpetuals is between respective equity and debt capital rates of return

• Primary objective is equity accountability for regulated industries (banks/insurances)

• Perpetual considered equity until issuer’s first termination option

• Contrary to equity issue no dilution in power or profits

• Interest payments are tax-deductible —> preferable over dividends

• Signal to capital markets: management targets for optimal capital structure

• Perpetual with higher rates of return than comparable debt types

  • unlimited maturity

  • dividend dependency

  • junior status

    —> risk premium

• Investment grade firms pay interest rates that equal non- investment grade investments

• Financial covenants can be used to protect creditors’ interests

Single termination option of perpetual for issuer

(commonly excised after ~10 years to ensure follow-ups)

• No rights on liquidation assets

• No participation in profits

• No decision or asset rights

• Fixed or variable interest payments

• CoCos are similar to traditional convertible bonds in that there is a strike price, which is the cost of the stock when the bond converts into stock.

• What differs is that there is another threshold in addition to the strike price, which triggers the conversion when certain capital conditions are met.

• Coco bonds are hybrid capital securities that absorb losses in accordance with their contractual terms when the capital of the issuing back fells below a certain level.

• The first CoCo bonds were offered by Lloyds in November 2009, which exchanged CoCos for its outstanding subordinated bonds.

• CoCo issuance volumes are rising and are expected to reach $1 trillion (S&P estimates).

• As a bail-in mechanism to infuse additional capital under adverse market conditions.

• Can be used as regulatory capital under Additional Tier 1 and Tier 2 of Basel guidelines.

• Transfer of risk from taxpayers to the private sector in times of distress.

• A firm may choose to call a bond issue if interest rates have fallen.

• The issuer can lower its borrowing costs by exercising the call on the callable bond and then immediately refinancing the issue at a lower rate.

• Note: If rates rise after a bond is originally issued, there is no need to refinance.

Generally, there are two different sustainable debt concepts:

• Use-of-proceeds:

  • Voluntary process guidelines list four key components for use-of-proceeds debt:

    1. Use of Proceeds

    2. Process for Project Evaluation and Selection

    3. Management of Proceeds

    4. Reporting

  • The guidelines list several green (for green bonds and loans) and social (for social bonds) project categories.

• Sustainability-Linked

  • Voluntary process guidelines list five key components for sustainability-linked debt:

    1. Selection of Key Performance Indicators (KPIs)

    2. Calibration of Sustainability Performance Targets (SPTs)

    3. Bond characteristics

    4. Reporting

    5. Verification

  • Typically, coupon payments vary depending on the achievement of sustainability targets.

Green bonds:

• Green bonds were the first sustainable bond type to be used on a larger scale.

• The Green Bond Principles (GBP) have been introduced in 2014 and are updated regularly by the International Capital Market Association (ICMA).

• Eligible green project categories listed in the GBP include:

  • Renewable energy

  • Energy efficiency

  • Pollution prevention and control

  • Sustainable water and waste management

  • Terrestrial and aquatic biodiversity

  • Green buildings

Green loans:

• Green loans are used for environmental projects which require smaller-scale investments.

• Similar to the GBP, the Loan Market Association (LMA) and the Asian Pacific Loan Market Association (APLMA) developed the Green Loan Principles (GLP) in 2018.

• The aim of the GLP is to create a framework of market standards for green loans while allowing the loan products its flexibilities.

• About 80 % of the issue volume is clustered in only three sectors.

• Relatively few issuers that are not from the Utility or Real Estate sector or large Industrials.

• Western European and Chinese issuers make up a large part of the global green bond market.

• The SL concept is also applicable to small companies without large investment volumes in sustainable projects.

• The possibility to use the bond proceeds without restrictions results in higher issuance volumes for SLB compared to green/social/sustainability bonds.

• SLB and SLL issuances are dominated by European issuers

• Pricing: Some studies find an advantage in financing costs for green bond issuers. However, the results of such an advantage are mixed (see last slides).

• Stock price: Various studies (e.g., Flammer (2021), Tang & Zhang (2021), Baulkaran (2019)) find a positive stock market reaction around green bond issue announcements.

• Ownership: The issuance of green bonds increases institutional ownership by 7,9% compared to the issuance of conventional bonds (Tang & Zhang, 2020). Especially, green bond issues attract long-term investors and green investors (Flammer, 2021).

• Environmental performance: Green bonds help their issuers to improve their environmental performance. Environmental ratings of green bond issuers increase significantly after green bond issues (Flammer, 2021).

—> Signalling: When using green bonds, “companies credibly siganal their commitment toward the environment” and help to enlarge a companies investment base by attracting impact investors, who satisfy their investment mandates by investing in green bond issuers