Unit 3: Long term Debt finance

The term ‘ bonds ’is a general term used to describe a variety of forms of long-term debt an
entity may issue. These include debentures, loan stock, loan notes, zero coupon bonds and
convertible bonds.

A bond is a long-term contract under which a borrower agrees to make payments of interest
and principal on specific dates to the holders of the bond. Bonds are issued by corporations
and government agencies that are looking for long-term debt capital.

A debenture is a document issued by a profit-making entity containing an

acknowledgement of indebtedness. It need not give, although it usually does, a charge on
the assets of the entity.

Types of bonds

1. Secured and unsecured:

 It is usual, however, to use the expression ‘ debenture ’ when referring to the
more secure form of issue and the term ‘ loan stock ’ for less secure issues.
 The terms of a secured bond are set out in a trust deed. The deed usually
charges, in favour of the trustees, the whole or part of the property of the
entity.( The trust deed gives the trustees (representatives of the bondholders)
a legal claim on the company's property or assets.)
 The advantages of a trust deed are that a prior charge cannot be obtained on
the property without the consent of the bond or debenture holders, the events
on which the principal is to be repaid are specified and power is given for the
trustees to appoint a receiver and in certain events to carry on the business
and enforce contracts.
2. Deep-discounted bonds
 Deep-discounted bonds are debt instruments that are issued at a price well
below their nominal value. At the eventual redemption date they will be
redeemed at their nominal (par) value.
 For example an entity might raise £5,000,000 by issuing deep-discounted
bonds in 2004 at a price of £60 per £100 nominal that will be redeemed at par
in 2015.
 The deep discounting means that the interest rate on the bond will be much
lower than current market rates.
 This will give a cash flow benefit it to the issuing entity as interest payments
will be low throughout the life of the bond. Investors will be prepared to
sacrifice interest for the capital gain on redemption they can lock into.
 This may be appealing to investors who would prefer capital gains to income.
, buying a bond for £60 and getting £100 at redemption means a capital gain
of £40.
3. Zero-coupon bonds
 The lower the issue price of a bond in relation to its nominal value, the
greater the potential for a capital gain on redemption.
 The interest rate can therefore be reduced until we reach a stage where no
interest is paid on the bond at all during its life.
 This is referred to as a zero-coupon bond. With a zero-coupon bond, all of the
investor’s return is wrapped up in a capital gain on redemption.
4. Convertible Bond
 These are bonds that give the bondholder the option to exchange them for a
certain number of the issuing company's common stock (shares).
 Convertible bonds are hybrids between equity and debt finance.
 They offer investors a fixed return but also give the investor the right to
convert into the underlying ordinary shares of the entity at fixed terms.
 There are various types of convertible bond including convertible debentures
and convertible loan stock.
 All carry the right to convert into the underlying ordinary shares, and
represent less risk to the investor than ordinary shares because they have
greater priority for repayment should the entity be liquidated.
 The most secure is the convertible debenture which is secured upon the
tangible assets of the entity.
5. Warrant
 A long-term option to buy a stated number of shares of common stock at a
specified price.
 These bonds are similar to convertible bonds but with a key difference:
 Convertible Bonds: Allow the bondholder to exchange the bond for shares.
 Bonds with Warrants: Allow the bondholder to buy additional shares at a
specified price (using the warrant), without having to give up the bond itself.
If the stock price rises above the specified price in the warrant, the holder can
buy the stock at the lower price and potentially sell it at the higher market
price, making a profit (capital gain).
 Because of this factor, bonds issued with warrants, like convertibles, carry
lower coupon rates than otherwise similar nonconvertible bonds
6. Putable Bond
A bond with a provision that allows its investors to sell it back to the company prior
to maturity at a prearranged price.
Eg: A ltd $100 per bonds 10000 bonds mature 10 years at 8% p.a 2020.
In 2024, market interest 7% p.a, new bond
Clause: Call option, after 5 years-call option(A call option allows the issuing company to
"call" the bond, or buy it back, before it matures.)
In 2024, investors have the option to "put" the bond, meaning they can sell it back to A Ltd at
a predetermined price before the bond's maturity date in 2030.

7. Income Bond
A bond that pays interest only if it is earned enough profit to cover the interest
payments.
8. Indexed (Purchasing Power) Bond :
An indexed bond, also known as a purchasing power bond, is a type of bond where the
interest payments and sometimes the principal are adjusted based on an inflation index. This
protects the bondholder from the eroding effects of inflation.
djustment: If inflation is 3%, the interest payment increases to reflect this, ensuring
the bondholder's return keeps pace with inflation.
Key terms

 Par Value The face value of a bond.

 Coupon Payment The specified number of dollars of interest paid each year.
 Fixed-Rate Bond A bond whose interest rate is fixed for its entire life.
 Floating-Rate Bond A bond whose interest rate fluctuates with shifts in the general
level of interest rates.
 Zero Coupon Bond A bond that pays no annual interest but is sold at a discount
below par, thus compensating investors in the form of capital appreciation.
 Original Issue Discount (OID) Bond Any bond originally offered at a price below
its par value.
 Maturity Date A specified date on which the par value of a bond must be repaid

NASDAQ DUBAI- CONVENTIONAL BONDS

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Bond Valuation
Interest yield

Interest yield is also referred to as running yield or flat yield and is calculated by dividing
the gross interest by the current market value of the bond as follows:

Interest yield= gross interest/ market value *100%

Yield=interest+capt appp

Example: A 6% debenture with a current market value of £90 per £100 nominal would have
an interest yield of?

Market value=90

Face value=100

Interest= 6% 0f 100=6

IY=6.66%

Yield to maturity

The yield to maturity (or redemption) is the effective yield on a redeemable bond, taking
into account any gain or loss due to the fact that it was purchased at a price different from
the redemption value.

Coupon rate

 relationship of face value to market value and coupon rate (on debt) to rate of return.
 When a bond or any fixed-interest debt is issued, it carries a ‘ coupon ’rate.
 This is the interest rate that is payable on the face, or nominal, value of the debt.
  Unlike shares, which are rarely issued at their nominal value, debt is frequently
issued at par, usually £100 payable for £100 nominal of the bond.
 At the time of issue the interest rate will be fixed according to interest rates available
in the market at that time for bonds of similar maturity.
 The credit rating of the entity will also have an impact on the rate of interest
demanded by the market.

Yield to maturity

Yield to Maturity (YTM) The rate of return earned on a bond if it is held to maturity.

Suppose you were offered a 14-year, 10% annual coupon, $1,000 par value bond at a price of
$1,494.93. What rate of interest would you earn on your investment if you bought the bond,
held it to maturity, and received the promised interest and maturity payments? This rate is
called the bond’s yield to maturity (YTM).

C=1000*10%=100

FV=1000

PV=1494.93

N=14

YTM=0.0518 or 5.18%

Interest yield= 100/1494.93*100=6.68%

Question 2: A firm’s bonds have a maturity of 10 years with a $1,000 face value, have an 8%
pa are callable in 5 years at $1,050, and currently sell at a price of $1,100. What are their
nominal yield to maturity? What return should investors expect to earn on these bonds?

PV is 1100
FV is 1000
Coupon rate is 8%
N is 10 years
Ytm=6.66%
Interest yield=7.27%

What Is a Private Placement?

A private placement is a sale of stock shares or bonds to pre-selected
investors and institutions rather than publicly on the open market. It is
an alternative to an initial public offering (IPO) for a company seeking
to raise capital for expansion. Private placements are regulated by the
U.S. Securities and Exchange Commission under Regulation D.

The factors that the lender will consider before extending finance will
include:

● the purpose of the loan;

● the amount of the loan;

● the duration of the loan;

● if there are assets available to offer as security for the loan;

● the credit rating of the borrower;

● how the borrower is proposing to repay the loan;

● the level of borrowings currently outstanding.

What are Debt Covenants?

Debt covenants are restrictions that lenders (creditors, debt holders,
investors) put on lending agreements to limit the actions of the borrower
(debtor). In other words, debt covenants are agreements between a
company and its lenders that the company will operate within certain rules
set by the lenders. They are also called banking covenants or financial
covenants.

The Purpose of Debt Covenants

Debt covenants are not used to place a burden on the borrower. Rather,
they are used to align the interests of the principal and agent, as well as
solve agency problems between the management (borrower) and debt
holders (lenders).

Debt covenant implications for the lender and the borrower include the
following:

Lender

Debt restrictions protect the lender by prohibiting certain actions by the

borrowers. Debt covenants restrict borrowers from taking actions that can
result in a significant adverse impact or increased risk for the lender.
Borrower

Debt restrictions benefit the borrower by reducing the cost of borrowing.

For example, if lenders are able to impose restrictions, lenders will be
willing to impose a lower interest rate for the debt to compensate for
abiding by the restrictions.

Reasons Why Debt Covenants are Used

Note that in the scenarios below, it is in the best interest of both parties to
set debt covenants. Without such agreements, lenders may be reluctant to
lend money to a company.

Scenario 1

Lender A lends $1 million to a company. Based on the risk profile of the

company, the lender lends at an annual interest rate of 7%. If there are no
covenants, the company can immediately borrow $10 million from another
lender (Lender B).

In this scenario, Lender A would set a debt restriction. They’ve calculated

an interest rate of 7% based on the risk profile of the company. If the
company turns around and borrows more money from additional lenders,
the loan will be a riskier proposition. Therefore, there will be a higher
possibility of the company defaulting on its loan repayment to Lender A.

(Preventing Additional Borrowing (Debt Restriction): Imagine Lender A lends $1 million

to a company at a 7% interest rate. This rate reflects the risk Lender A sees in lending that
money. If there were no covenants, the company could quickly borrow $10 million from
another lender, making it riskier for Lender A because now the company has more debt to
manage. This increases the chance the company might struggle to pay back Lender A. So,
Lender A sets a covenant to limit how much more the company can borrow, keeping the risk
under control.

Scenario 2

Lender A lends $10 million to a company. In the following days, the

company declares a liquidating dividend to all shareholders.

In this scenario, Lender A will set a dividend restriction. Without the

restriction, the company can pay out all of its earnings or liquidate its
assets and pay a liquidating dividend to all shareholders. leaving less or
nothing to pay back Lender A. To protect against this risk, Lender A sets a covenant that
limits how much the company can pay out in dividends. his ensures there's enough money
left to repay the loan.

Bond ratings/ criteria to select a bond

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investment-grade-and-high-yield-bonds