Bonds

Bonds or debentures are financial instruments. A bond is a certificate or evidence of a debt on which the issuing company or governmental body promises to pay the bondholders a specified amount of interest for a specified length of time and to repay the loan on the expiration date. A bond may be in bearer or registered form. At issuance, the par value of one bond represents a fraction of the total amount of the loan. The interest payments on bonds may be either fixed or variable. The duration of the loan, as well as the terms and conditions of repayment, are determined in advance. Certain structured products may take the form of a bond and, therefore, these products will be described under “structured products”.

The purchaser of a bond (the creditor) has a claim against the issuer (the debtor).

Characteristics

  • Yield: interest payments, possible increases in value (the difference between the purchase/issuance price and the sale/redemption price);
  • Duration: short-term (up to 4 years), medium-term (4-8 years) or long-term (more than 8 years);
  • Currency: the national currency of the investor or foreign currency. It can be provided that repayment of capital and interest payments can be made in different currencies. In such a case, an option can be associated to the bond in order to limit the exchange rate risk;
  • Form: individual documents with specific nominal values (which can be delivered to the investor) or collectively represented by a global certificate, which is deposited with a custodian bank;
  • Issue price: at par (100% of the nominal value), below par (the issue price is lower than the nominal value) or above par (the issue price is higher than the nominal value);
  • Place of issuance: it can be the domestic market of the investor or also a foreign market;
  • Repayment:
    • scheduled repayment: unless otherwise provided for or unless the issuer becomes insolvent, the loans are repaid either on the maturity date, or through annual installments (generally after a lock-in period), or at different dates determined by drawing lots (generally after a lock-in period);
    • unscheduled repayment: the issuer may reserve the right to repay at a date he will determine, at his own discretion, at a later stage;
  • Interests: interests depend on the terms and conditions of the loan; e.g. fixed interest for the entire duration or variable interest often linked to financial market rates (e.g. LIBOR or EURIBOR). In this latter case, a minimum and/or maximum rate can be provided;
  • Particular features (e.g. relations between the issuer and the investor): set out in the terms and conditions of issue of the relevant bond.

Advantages

Depending on market conditions, these products may provide a higher return than other fixed-income products. But higher returns >>>>> higher risks!!!!

Risks

Insolvency risk

The issuer risks to become temporarily or permanently insolvent, entailing his incapacity to pay back interests and/or the principal amount of the loan. The solvency of an issuer may change depending on the evolution of certain factors during the life of the bond. This may be due in particular to the general evolution of the economy, changes related to the company, the economic sector of the issuer and/or the relevant country as well as political changes entailing substantial economic consequences.

This risk is more or less important depending on whether the debentures are issued by a governmental body or a private institution. This risk is also related to the nationality of the issuing governmental body or the type or sector of activity of the private institution which issued the debentures (credit institution, industrial undertaking, etc…) as well as, more generally, the creditworthiness of the latter.

This risk is more limited if the debentures are collateralised. However, in such a case, the additional protection granted to the investor will have to be assessed on the basis of the status and creditworthiness of the guarantor.

From that point of view, it should be noted that, as a matter of principle, debentures issued by entities which are considered as safe generally offer lower returns. However, the risk of a total loss of the investment is correlatively lower.

The deterioration of the issuer’s creditworthiness does equally influence in a negative manner the price of the relevant financial instruments.

Interest rate risk

The uncertainty concerning the evolution of interest rates entails that the purchaser of a fixed-rate financial instrument bears the risk of a decrease in the price of such financial instrument in case of a rise in interest rates.

The sensitivity of the debentures to fluctuations in interest rates depends in particular on the period remaining until maturity of the bond and the level of nominal interest rates.

Anticipated refunding risk

The issuer of a bond may include a provision allowing him to repay earlier the bondholder in case for instance of a decrease in interest rates in the markets. Such an early repayment can have an impact on the yield expected by the investor.

Risks specific to debentures redeemable by drawing lots

The maturity date of debentures that are redeemable by lot is difficult to determine so that unexpected changes may take place in the yield of such debentures.

Risks related to the country of issue

If the bond is issued on a foreign market, it will in principle be governed by the law of the country of issue. The investor must thus inquire about the possible impact of the applicability of this foreign law on his rights.

Risks of specific kinds of debentures

Concerning some kinds of debentures, additional risks may exist: e.g. floating rate notes, reverse floating rate notes, zero coupon debentures, debentures in a foreign currency, convertible debentures, index or option-linked debentures, subordinated debentures, etc…

For those types of bonds, the investor should make inquiries about the risks described in the issuance prospectus and not purchase such financial instruments before being certain to master all risks.

The developments here only aim at providing a brief outline of the additional risks incurred by the investor in relation to specific bonds.

Types of debentures

Floating rate debentures

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Floating rate debentures can take several forms, such as for instance:

Floor floater debentures, which are variable-interest debentures which pay a minimum level of interest. Therefore, in the event that the sum of the reference rate and the spread falls below this level, the investor will receive payment of interests at least at the minimum rate determined in advance. Conversely, for cap floater bonds, the rate of interest paid to the investor is limited to a maximum amount determined in advance.

For these bonds, it is not possible to anticipate, as of their issue, the actual yield of the investment since the latter vary according to the fluctuations of market rates.

For certain variable-interest debentures, it can be provided that the interest rate moves in the opposite direction to market rates (i.e. reverse floating rate debentures). For these medium or long-term bonds, the interest rate payable to the investor is calculated according to the difference between a fixed rate of interest and a reference rate (e.g. 16% minus LIBOR). This means that the investor’s interest income rises when the reference rate falls.

The price of these bonds is usually subject to higher market fluctuations than the fixed-rate debentures having the same maturity.

There are also convertible floating rate debentures which give the investor or the issuer (depending on the terms and conditions of the bonds) the right to convert the note into a normal fixed-interest bond. If the issuer reserves this right, the actual yield of the bond may be lower than that contemplated by the investor.

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Zero debentures

Zero bonds do not have interest coupons attached. Instead of periodic payments of interests, the investor receives the difference between the redemption price and the issue price (in addition to the repayment of the principal amount). Such bonds are usually issued at a discount to their nominal value and redeemed on maturity at par. The size of the discount granted to the investor depends on the maturity of the bond, the borrower’s creditworthiness, and prevailing market interest rates.

Hence, such bonds offer investors a fixed lump-sum payment at a future date if the bond is held until maturity (which may have various tax implications depending on the countries). On the contrary, if the bond is sold before maturity, the investor will only receive payment of the sale price of the debentures.

Therefore, if market interest rates increase, the price of these debentures falls more sharply than for other debentures with the same maturity and credit rating. Moreover, in case of foreign currency denominated zero debentures, there is also an increased exchange rate risk because interest payments are not made on a regular basis over the life of the bond but there is only payment of a lump sum at a future date determined in advance.

Combined-interest debentures or step-up debentures

For combined-interest debentures or step-up debentures, the investor does not receive interest payments at a single, fixed rate over the entire life of the bond. However, such debentures are similar to fixed-rate debentures in so far as the interest rate is determined in advance and does not depend on fluctuations in market rates. Instead, the rate of interest only changes during the term of the bond, following a pattern agreed at the time of issue.

Indeed, with combined-interest debentures, it is agreed that there will be no coupon for the first years of the life of the bond but an above-average coupon will be paid to the investor for the remainingBonds years. These bonds are usually issued and redeemed at par.

With step-up bonds, a relatively low coupon is paid initially, and a very high one is paid to the investor for the following years. These bonds are usually issued and redeemed at par.

Phased interest rate debentures

These debentures are actually a hybrid of fixed and variable-interest notes. They usually have a maturity of 10 years, and pay a fixed coupon for the first years. Afterward, during a period of several years, the investor will receive interests calculated on the basis of a variable interest rate in line with market rates. For the last years of the life of the bond, the bond reverts to paying a fixed rate of interest to the investor.

Index-linked debentures

For these debentures, the redemption amount and/or interest payments are determined on the basis of the level of an index or of a managed account determined in advance – at redemption or on the interest payment date – and thus are not fixed. These bonds are often zero bonds.

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Such debentures are usually issued in two “tranches”: bull bonds (debentures which appreciate in value if the index rises) and bear bonds (debentures which appreciate in value if the index falls). The investor runs the risk of price losses if the value of the index falls (bull bonds) or if the value of the index rises (bear debentures).

BondsSubordinated debentures

For these debentures, investors ought to inquire about the ranking of the debenture compared to other debentures of the issuer since, in case of a bankruptcy of the issuer, those debentures will only be reimbursed after repayment of all higher ranked creditors (preferential and pari passu debentures).

However, generally, the better the position of the creditor in case of insolvency is, the lower the return of the bond will be.

Convertible/warrant debentures

In this case, the investor is granted the right to exchange the debentures, at a specific time or within a specific period, for shares in the issuer at a ratio determined in advance. There is usually a minimum lock-in period during which an investor cannot exercise his right of conversion. In case the right of conversion is not exercised, the debentures remain fixed-interest notes, repayable at par on maturity.

Because they offer a conversion right, such debentures usually offer a lower interest rate than ordinary debentures. The price of these debentures is essentially determined by the price of the underlying shares. Indeed, if the price of the shares drops, the price of the debentures falls as well. Therefore, the risk of price losses is higher than for debentures without conversion rights (but usually lower than the risk of price losses associated to a direct investment in the relevant shares).

There are also debentures which give the investor the right to subscribe for shares, in addition to the bond and not as an alternative. This subscription right is certificated by a warrant which is detachable from the bond. This warrant can be traded separately. The shares in the issuer can be purchased by the investor on surrender of the warrant, on terms agreed in advance. The investor continues, in addition hereto, to hold the bond until maturity. As for debentures with conversion rights, the periodic interest payments are usually relatively low. Moreover, the price of such bonds, with the warrant attached, will equally track the price of the underlying shares. If the bonds are without the warrant attached, they amount to traditional bonds and, therefore, their price is mainly determined by market rates.

Certain special forms of the bonds described in the preceding paragraph give the holder of the warrant the right to buy or sell another bond determined in advance at a fixed price.

Bonds

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