Corporate bonds Essay
I am deeply indebted to my teacher, Mrs Le Thi Hai, MA, for her useful instructions and valuable recommendations during the initial preparation of this paper. Her advice has been important in making this thesis well-organized and coherent. I also gratefully acknowledge her grammar corrections as well as all of her suggestions. I would like to express my thanks to my friends: Duong Thanh Nga, at the Bank Institue; Tran Hong Nhung, at the Economics University; who have given time and attention to my preparation.
I am also grateful to my classmates: Luong Thi Ngoc Tu, Vu Huong Lan, Le Hoang Long and Dao Nguyen Vinh Yen in class A3-K42-KTNT for their kind encouragement and assistance during the development of my thesis. Finally, I wish to express my special thanks to my family for their care, understanding during the preparation. The 21st century witnesses the growth of the world’s economy accompanied by the development of monetary and financial markets. People seem more involved in investing their money, at the same time, enterprises/ also try to seek more efficient capital channels to finance their performance.
The first thing that comes to most people’s minds when they think of investing is the stock market.
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However, contrary to accepted wisdom, bonds, the core part of which is corporate bond, play a very important role in economies. Corporate bonds are the inevitable portion of smart investors’ portfolios, as well as a necessary vehicle for most companies to raise capital. They help balance the world’s financial market which has been always excited by stocks. For example, the 1997 Asian financial crisis came as a shock to the region’s economies. In the post-crisis period, efforts are under way in several areas to address the structural weaknesses that contributed to the crisis.
The lack of a strong corporate bond market is one of main causes. Bonds are negotiable promissory notes that can be issued by individuals, business firms, governments, or governmental agencies. These documents promise to repay their investors the principal amount plus a predetermined amount of interest. The principal and interest may be repaid as a single payoff or through a series of payments. Corporate bonds are bonds issued by corporations, as the name suggests, to finance capital investment and operating cash flow.
The term is usually applied to longer term debt instruments, generally with a maturity date falling at least 12 months after their issue date and semiannual payments. In the world, they are typically issued in multiples of $1,000 and/or $5,000. Companies use the funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding the business. They are different, for example, from stocks, which have an uncertain future pay-off, depending on a company’s performance, and no final maturity date, so long as the company remains active and solvent.
When you buy a bond, you are lending money to the corporation that issued it. The corporation promises to return your money, or principal, on a specified maturity date. Until that time, it also pays you a stated rate of interest, usually semiannually. The interest payments you receive from corporate bonds are taxable. Unlike stocks, bonds do not give you an ownership interest in the issuing corporation. These are the normal types of bonds. It is unsecured debt, backed only by the name and goodwill of the corporation and have no lien against any property.
They may be seen as a claim on earnings, not on assets. This is not to say that debenture investors are not protected incase of default. In the event of the liquidation of the corporation, holders of debentures are repaid before stockholders, but after holders of mortgage bonds. These investors are classified as general creditors by law, since they have no collateral pledged. All assets that are no specially pledged and any balance from pledged assets remaining after payment of secured debts are available to pay the legal claims of general creditors.
The issuers are usually large companies having good reputations and investors’ confidence. A bond is a promise. In return for money lent to a corporate or governmental borrower, the borrower pledges to make periodic payments of interest at a fixed rate and to repay the original loan after a set period of time. Both the date at which the principal is scheduled for return and the time remaining to that date are known as the bond’s “maturity. ” When a person buys a bond at its issue, holds it to maturity, and the issuer keeps its promises, there is no risk.
Most of bonds, however are not treated that way. Bonds are issued by all kinds of companies and agencies, held in large portfolios-including thousands of mutual funds and traded in markets around the world. Bond risk arises from the workings of these markets. Default risk: corporate executives face tough financial realities. Business executives are supposed to borrow money only to invest in ventures that will generate sufficient profits to pay off the debt. Since developing profitable undertakings in which to invest is not easy, corporate bonds involve some risk of default.
A bond issue is un default if any investor does not receive money of interest and if the bond’s face value is not repaid as schedule. A corporate bond issuer that defaults on its debt obligations will be sued. A bankruptcy court can reorganize the defaulted company or declare it bankrupt and liquidate the firm. To avoid this happening to their investment, bond investor study different bond issues to assess the default risk of each one. Interest rate risk: the risk that the relative value of a security, especially a bond, will worsen due to an interest rate increase. This risk is commonly measured by the bond’s duration.
A bond is a part of a loan to an entity. Someone buying a bond when it is first issued can be compared to someone putting money in a certificate of deposit (CD). It is locked away and every quarter a check is sent to the lender for the interest paid, at a certain interest rate (for example 5 %). If the lender holds the bond until it matures (for example after a year), then the lender gets his money back plus 5 % interest and there is no interest rate risk. Unlike a CD however, a person can’t terminate their bond early if they need their money (with a CD one can do this with a penalty).
The only thing a person can do is sell the bond to someone else. Assuming interest rates on comparable bonds have remained the same, a person is likely to buy the bond at a discounted price which reflects the interest payments already given to the seller (so that the seller does not lose any money). If the interest rates on other similar bonds are now being issued at 7 %, there would be no reason to buy a bond that only makes 5 %, so the seller must sell the bond at a discount (and lose money) which roughly means the buyer who buys it earns 7 % if he holds it until it matures.
The possibility of a loss due to a scenario like this is called interest rate risk. The other side of the coin is that when interest rates are lower, the owner of the bond can sell it to someone at a premium because that will be just as good if not a better return than what the other person can get new. The price differences in the values of bonds caused by these interest rate changes are thought to be at present more volatile as a class than stock price changes. This was especially true after Paul Volker let interest rates float freely in the early 1980’s.