A Bond is much more than a British spy.
It’s the IOU of the finance world.
Bonds are a security that are purchased by investors, where the investor, in essence becomes a creditor of the issuer. This is different to equities where the investor becomes a part ‘owner’ (a shareholder) of a company. Like any other loan, bonds are payable at a set date in the future, and the issuer is required to pay an agreed amount of interest on the debt, known as its coupon rate.
Not so long ago, a bond holder would receive a physical piece of paper stating the terms of the IOU. This piece of paper was worth money, and could be traded – purchased or sold to another investor.
It was therefore a security that had a face value (eg $100) with a number of attached coupons representing the interest owed to maturity.
The investor would cut off a coupon, take it to the issuer, and receive their interest. The purchase and sale of the security was based on a combination of current interest rates (yield), term to maturity, credit risk etc.
Nowadays, this security registration and trading is mostly electronic, with bonds held in “safe custody” for investors, and coupon payments made electronically to nominated bank accounts.
Given an investor knows the returns they will get from a bond and IOUs are settled before shareholders can receive a return, they are considered a ‘safer’ asset then shares. However there are also a number of other factors to consider when investing in bonds. Credit risk for one is the risk that the issuer is likely to default. The higher the credit risk, the greater the chance of default, therefore the more the investor demands as a return for the risk.
Companies and governments can issue bonds. By way of example, BHP may wish to expand production at a mine. They can borrow from existing short term credit facilities from their bank, issue some more shares, or issue debt (bonds); which they might match to the term of the estimated ramp up in production (eg 5 years).
What BHP chooses to do is usually based on what costs the least and what suits their balance sheet (eg levels of gearing). In most cases bond issuance is more attractive, especially since banks are more reluctant to fund from their own balance sheet and the tax treatment of debt may prove more favourable. Bond issuance also means BHP is sourcing cash directly from investors. In Australia, the bond market has been limited to the realm of sophisticated or wholesale investment, with initial minimum parcel sizes starting at $500,000.
Government and semi-government authorities make similar decisions, although they cannot issue equity, but may sell some equity in an infrastructure project if conditions are favourable.
This all sounds very straightforward but, like many good film scripts, there’s danger lurking below the surface. In finance world this danger is a default.
Default occurs when the issuer fails to meet their legal obligations of a bond. They commonly occur when an interest payment is missed – debt services default. A technical default can occur when a covenant is violated, eg gearing ratio breaches a certain level.
Defaults aren’t the same as bankruptcy. An organisation may have plenty of assets but may simply have a cash flow problem. Default is still serious business, and is usually a clear warning sign that the issuer is in financial trouble.
Bond holders are likely to force the company into bankruptcy so they can secure their monies owed through asset sales and the like in this situation.
If the Enron scandal were ever made into a spy movie, it would be hard to find a good guy. Enron was a monstrous US energy, commodities and services company worth around $60 billion. Enron managed to dominate US gas markets, and traded on a Price Earnings Ratio of 70x earnings. (Above 20 would be considered a high PE in Australia).
In 2001, the market became aware that Enron’s mind-blowing profits were the result of dodgy financial practices where the company hid its losses in offshore entities. Suddenly the investors realised that Enron owed billions and was unlikely to be ever able to pay off these debts. The company was declared bankrupt with $23 Billion in loans and bonds outstanding. Big losses caused chaos on the US markets. Enron bond holders ended up getting 53% of their initial money owed… and not until 7 years after the initial bankruptcy proceedings.
In 2001 a sequel of blockbuster proportions played on the streets of Argentina.
The Government, after years of mismanagement and debt to GDP levels of 166% defaulted in a payment to the IMF. This prevented the Government from accessing funds and the economic depression caused uprising on the streets. A new government successfully implemented a new debt management strategy and negotiated a debt restructuring.
Debt to GDP is now ¼ of 2001 levels, although 7% of the original debt holders (known as “holdouts”) refused to accept the new terms. More recently, these holdouts instigated court action, which was ruled in their favour and obliged Argentina to pay them in full. The catch is, the 93% that accepted the restructure had a clause in there to say any future deal needs to be extended to all bond holders. Rather than do this, they chose to default – again.
Greece is the latest country to be rocked by a default. Its failure to meets its obligations to the IMF last Tuesday means that it is now locked out of further IMF funds until the arrears is paid. However the consequences of Greece’s default are likely to be more far reaching because of its use of the Euro. If Greece fails to access funds in the short term, the European Central Bank will likely be forced to stop funding Greek Banks, forcing a collapse of Greece’s financial system. This increases the likelihood that Greece will leave the Euro Zone and start printing its own currency.
How the crisis will play out is hard to tell. Greece’s radical left Government is sending differing stories to its creditors.
This plot has plenty left in it.
