financial market report
rockshan19977
Topic-5DebtCapitalMarket-2020.pptxThe Debt-Capital Market Fixed Income Securities
FINANCIAL MARKETS
Topic 5
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Overview: Debt Capital Market
Operation of the debt-capital market
The features and characteristics of the main form of debt instruments traded.
Fixed Interest Bond Market
Government
Corporate
Bond Pricing
Features of the International Bond Markets
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Financing Choices
Corporate debt market
Bonds
Sources of long term debt finance
Government debt market
International bonds
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Financial market at a glance
Last week was about Money Market Instruments.
Debt instruments <=1 year of maturity.
They are Discounted Securities
This week we focus on the Debt market for the securities with longer term to maturity.
Government and Corporate are the DEUs here which borrow funds heavily from these markets.
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Financial markets
Capital market
Debt market
Equity market
Money market
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Financing choices: Corporate Internal vs External
Choice No. 1:
Internally-generated funds or External funds?
Criterion for decision
Are internally-generated funds sufficient for asset acquisition?
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Corporate funding decisions
Internal
External
LT
ST
Debt finance
Equity finance
Debt finance
Direct finance
Indirect finance
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Financing choices: Corporate External funds
Choice No. 2
Short-term finance or Long-term finance?
Criterion for decision
Matching principle
i.e. matching short-term assets with short-term finance and long-term assets with long-term finance
The firm needs to examine carefully the need for finance and apply the matching principle.ie the matching of :
short term assets with short term liabilities and
long term assets with long term liabilities.
Firms should match the maturity structure of their assets, that are funded through debts, with the maturity structure of their liabilities including the alignment of debt repayments with the expected cash flows from their assets.
Draw a time line of Incoming and Outgoing Cashflows
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Short term debt (liabilities) such as trade credit, overdraft or commercial bills, should be acquired to fund short term assets like cash, working capital, inventories or projects where there is only a short period of time between commencement and cash flows.
Longer term assets like factories, machinery, plant and equipment should be funded through long term debt.
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Corporate funding decisions
Internal
External
LT
ST
Debt finance
Equity finance
Debt finance
Direct finance
Indirect finance
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Financing choices: Corporate Long-term finance
Choice No. 3
Debt or Equity?
Criterion for decision
Debt to Equity ratio
Advantages and Disadvantages of both
Debt Cheaper, Tax Advantage but bankruptcy risk
Equity is expensive no Tax benefit - but Ownership – risk sharing.
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Corporate funding decisions
Internal
External
LT
ST
Debt finance
Equity finance
Debt finance
Direct finance
Indirect finance
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Criteria used for choosing D/E ratio
What other firms in the industry do
Tradition within the firm
Capacity to service debt
Restrictions imposed by lenders
There is a wealth of literature on capital structures and appropriate debt/equity ratios but there is no generally agreed standard. In practice, there are four criteria that are usually used by companies.
What other firms in the industry do: Significant deviations from norms in the industry may concern the investors.
Tradition within the firm: If the firm has been earning a good return on assets then it may be deemed appropriate to continue with the same ration. Deviations from the ratio may results in dissatisfaction from the share holders.
Capacity to service debt: Firm would compare the forecasted cash flows with the interest and principal payments. Firm wants to see whether they have enough cash flows left over to pay shareholders.
Restrictions imposed by lenders: There might be loan covenants that prohibit firm from talking additional debt. A common covenant is the ration of total debt liabilities to total assets.
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Financing choices - Long-term Debt
Choice No. 4
Direct finance or Indirect (intermediated) finance?
Criterion for decision
Advantages and disadvantages of indirect finance (Topic 1)
Refinancing of ST loans
Overdrafts
Term loans
Mortgage finance
Lease finance
Corporate bonds / non-govt bonds
For a corporation, in direct finance is that they can generally acquire funds more cheaply than borrowing from a financial intermediary.
In direct financing, corporations generally sell financial assets that are securitised: ie. they can be sold in a secondary market.
Advantages of Indirect Financing:
Asset value transformation
Maturity transformation
Credit risk reduction and diversification
Liquidity provision
Increased quantity of national savings
Disadvantages of Indirect Financing:
Increased cost of funds for borrowers
Reduced return from lending for savers
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Corporate funding decisions
Internal
External
LT
ST
Debt finance
Equity finance
Debt finance
Direct finance
Indirect finance
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Financing choices: Corporate Long-term direct finance
This is obtained by issuing bonds
“Bonds” is the most general term. Debentures and notes are types of bonds.
Fixed Income securities
Interest payment fixed by contract
There are two components of the bond market in Australia
Corporate bond market
Government bond market
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Corporate Bond Market
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Australian domestic market has been heavily used by mining firms.
Australian firms issue offshore is comparable if not greater than onshore
Corporate bond market issuance
Offshore borrowing is high
Mining sector borrows a lot.
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Corporate bonds aka non-government bonds
Traditional corporate Bonds – initially dominated by Financials corporations
Authorised Deposit taking institutions issue medium term floating rate securities to raise funds that have a longer-term to maturity than deposits
Kangaroo bonds issued by non-residents
Non-financial companies who issue long-term bonds for large amounts
Some lower rated issuers have their credit standing improved by credit wrapping such as guarantees by a third party
Foreign Bonds issued in other country in its local currency. They are subject to the local regulations.
USA – Yankee
Japan – Samurai
Australia – Kangaroo
Euro bonds issued in other countries but not in its local currency. Australian company issuing USD denominated bonds but not in USA.
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Non-government bonds
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Dominated by Financials in the recent years
Second are non resident issue – Kangaroo bonds
Financing choices: Government
Government bond market
85% of government debt is raised through the issue of long-term fixed-interest securities (Treasury bonds)
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Over 85% of funds raised by governments in Australia result from the sale of long term debt securities.
The Australian debt-capital market is dominated by the Australian Treasury (fixedinterest) bonds which are referred to as treasury bonds.
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Financing choices: Government
Treasury bonds
Issued by tender to finance budget deficits and long-term government expenditure
Very liquid market - especially 3 and 10-year bonds
Main holders are the RBA, banks, life offices, superannuation funds
Traded in parcels of $5 - $10m.
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Financing choices: Government
Semis
Government bonds issued by State governments and semi-government authorities are referred to as “semis”
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Financing choices: Government
Trading and settlement
A wholesale, OTC market where dealers are market makers under Australian Financial Market Association protocols
Treasury bonds:
Actively traded
Trade by telephone or electronic systems
Dealers quote bid-offer yields
Standard parcel size is $10 million
Each treasury bond has a face value of $1000
Settlement is through Austraclear
Many non-government bonds are not actively traded
A retail market is growing for corporate bond (notes)
Trade trough the ASX
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Recent developments….
Trading of retail corporate bonds on the exchange
Australian Stock Exchange
Medium term notes convertible (hybrid) or callable
Quarterly coupons
15-20 years maturity
Regulation
Enabling trading on exchange
Retail treasury bonds
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Sources of medium to long-term corporate debt
Direct finance
Corporate bonds
Intermediated finance
Refinancing of short-term debt (ST loans, bank bills)
Overdraft
Term loan
Mortgage finance
Lease finance
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Direct finance
In order to issue long-term debt securities (bonds) companies need:
a high credit rating,
credit enhancement (bank guarantee, loan security, etc), or
a high interest rate to compensate for high risk
(“junk” bonds)
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Key features of a standard bond
Face value
The amount to be repaid on maturity
Coupon rate
The annual rate of interest. Annual Interest Amount = Face Value x Coupon rate
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Key features of a standard bond
Maturity Date
The date on which the bond matures
Term to maturity
The period of time between now and the maturity date
Price
The present value of the cash flows to be received by the bond-holder
Yield
The rate of return if the bond is held to maturity
“Market yield”
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Bond pricing
For example, a bond that has a face value of $1000, with semi-annual coupon payments, a coupon rate of 8% and 3 years to maturity, will have the following cash flows:
Years
$40
$40
$40
$40
$40
$1040
0
1
2
3
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Bond pricing
The general formula for the present value (price) of a bond is:
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Bond pricing
This formula can be disaggregated (broken down) so that the price is the present value of interest payments plus the present value of the face value
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Bond pricing
Face value = $1000, 3 years to maturity, annual coupon distribution, coupon rate = 8% pa, market yield = 6%.
The present value of these cash flows is given by:
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Bond pricing
If the coupon payments are fixed, the present value can be calculated by treating the flow of coupon payments as an annuity:
Annuities = series of cash flows of similar amount and distributed at regular intervals. E.g $80 every year
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Bond pricing
Face value = $1000, 3 years to maturity,
Semi annual coupon distribution
Coupon rate = 8% pa, market yield = 6%.
What is the present value/price of this bond?
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Bond pricing
Face value = $1000, 2 years to maturity, annual coupon distribution of 4% pa and a yield of 6%.
What is the present value/price of this bond?
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Bond pricing
The price is inversely related to the market yield
If yield > coupon rate, price < face value. Bond trades at a discount.
If yield < coupon rate, price > face value. Bond trades at a premium.
If yield = coupon rate, price = face value. Bond trades at par.
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Variations to a standard bond
Floating rate (notes) bonds
The coupon rate varies periodically, and is based on an marker rate such as LIBOR, BBSW
Zero-coupon bonds
The only cash flow is the face value on maturity. These bonds are sold at a steep discount
Deferred coupon bonds
There are no coupon payments for a fixed period after the bond issue
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Variations to a standard bond
Convertible (notes) bonds
The bond holder has the option to convert to equity at or prior to maturity of the bond
Bonds with embedded options
The bond-holder may have the option to sell the bond back to the issuer (puttable) or the bond-issuer may have the option to buy it back from the holder (callable)
Often used in combination with each other and with convertible bonds
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International bonds
Foreign bonds
Issued in a country, other than that of the borrower, in the currency of the country in which they are issued
Sold in Japan “Samurai”, in the USA “Yankee”, in Australia “Kangaroo” bonds.
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International bonds
Eurobonds
Issued in a currency other than that of the country in which they are issued
Medium to long-term fixed interest securities paying coupon payments
Bearer securities
Sold directly to public
Listed on exchanges although most trading is between dealers
Underwritten by a syndicate of banks
The Euromarkets
The Euromarket is considered a major finance source for international trade/transaction.
A debt transaction denominated in a currency other than the currency of the country in which the transaction occurs
USD is the dominant currency, while all major currencies are issued
Why?
The Euromarkets do not deal in small retail market transactions, and so the administrative cost is lower
Loans to governments, financial institutions, and multinational corporations tend to be in large amounts
Creditability of borrowers is important
Euromarket funds are not subject to reserve requirements and other controls
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Variations to standard Eurobond
Floating rate notes (FRNs)
Exotics
Eurobonds with special features
E.g. optional conversion to equity
Dual currency bonds
Funds are raised in one currency and coupon payments and/or face value paid in another
THE END
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