Debt Markets and Analysis

R. Stafford Johnson

• Publisher: Bloomberg Press
• Year: 2013
• ISBN:
  9781118235430
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

An accessible guide to the essential elements of debt markets and their analysis

Debt Markets and Analysis provides professionals and finance students alike with an exposition on debt that will take them from the basic concepts, strategies, and fundamentals to a more detailed understanding of advanced approaches and models.

• Strong visual attributes include consistent elements that function as additional learning aids, such as: Key Points, Definitions, Step-by-Step, Do It Yourself, and Bloomberg functionality
• Offers a solid foundation in understanding the complexities and subtleties involved in the evaluation, selection, and management of debt
• Provides insights on taking the ideas covered and applying them to real-world investment decisions

Engaging and informative, Debt Markets and Analysis provides practical guidance to excelling at this difficult endeavor.

PART I

Bond Evaluation and Selection

CHAPTER 1

Overview of the Financial System

Real and Financial Assets

Most new businesses begin when an individual or a group of individuals come up with an idea: manufacturing a new type of cell phone, developing land for a future housing subdivision, launching a new Internet company, or exploring for crude oil. To make the idea a commercial reality, though, requires funds that the individual or group generally lacks or personally does not want to commit. Consequently, the fledgling business sells financial claims or instruments to raise the funds necessary to buy the capital goods (equipment, land, etc.), as well as the human capital (architects, engineers, lawyers, etc.), needed to launch the project. Technically, such instruments are claims against the income of the business represented by a certificate, receipt, or other legal document. In this process of initiating and implementing the idea, both real and financial assets are therefore created. The real assets consist of both the tangible and intangible capital goods, as well as human capital, which are combined with labor to form the business. The business, in turn, transforms the idea into the production and sale of goods or services that will generate a future stream of earnings. The financial assets, however, consist of the financial claims on the earnings. Those individuals or institutions that provided the initial funds and resources hold these assets. Furthermore, if the idea is successful, then the new business may find it advantageous to initiate other new projects that it again may finance through the sale of financial claims. Thus, over time, more real and financial assets are created.

The creation of financial claims, of course, is not limited to the business sector. The federal government's expenditures on national defense, entitlements, and infrastructures, and state governments' expenditures on the construction of highways, for example, represent the creation of real assets that these units of government often finance through the sale of financial claims on either the revenue generated from a particular public sector project or from future tax revenues. Similarly, the purchase of a house or a car by a household often is financed by a loan from a savings and loan or commercial bank. The loan represents a claim by the financial institution on a portion of the borrower's future income, as well as a claim on the ownership of the real asset (house or car) in the event the household defaults on its promise.

Modern economies expend enormous amounts of money on real assets to maintain their standards of living. Such expenditures usually require funds that are beyond the levels a business, household, or unit of government has or wants to commit at a given point in time. As a result, to raise the requisite amounts, economic entities sell financial claims. Those buying the financial claims therefore supply funds to the economic entity in return for promises that the entity will provide them with a future flow of income. As such, financial claims can be described as financial assets.

All financial assets provide a promise of a future return to the owners. Unlike real assets, though, financial assets do not depreciate (since they are in the form of certificates or information in a computer file), and they are fungible, meaning they can be converted into cash or other assets. There are many different types of financial assets. All of them, though, can be divided into two general categories—equity and debt. Common stock is the most popular form of equity claims. It entitles the holder to dividends or shares in the business's residual profit and participation in the management of the firm, usually indirectly through voting rights. The stock market where existing stock shares are traded is the most widely followed market in the world, and it receives considerable focus in many investment and security analysis texts. The focus of this book, though, is on the other general type of financial asset—debt. Businesses finance more of their real assets and operations with debt than equity, whereas governments and households finance their entire real assets and operations with debt. This chapter provides an overview of the types of debt securities and markets, whereas Part Two provides more detailed analyses.

Types of Debt Claims

Debt claims are loans wherein the borrower agrees to pay a fixed income per period, defined as a coupon or interest, and to repay the borrowed funds, defined as the principal (also called redemption value, maturity value, par value, and face value). Within this broad description, debt instruments can take on many different forms. For example, debt can take the form of a loan by a financial institution. In this case, the terms of the agreement and the contract instrument generally are prepared by the lender/creditor, and the instrument often is nonnegotiable, meaning it cannot be sold to another party. A debt instrument also can take the form of a bond or note, whereby the borrower obtains her loan by selling (also referred to as issuing) contracts or IOUs to pay interest and principal to investors/lenders. Many of these claims, in turn, are negotiable, often being sold to other investors before they mature.

Debt instruments also can differ in terms of the features of the contract: the number of future interest payments, when and how the principal is to be paid (e.g., at maturity—the end of the contract) or spread out over the life of the contract (amortized), and the recourse the lender has should the borrower fail to meet her contractual commitments (i.e., collateral or security). For many debt instruments, standard features include the following:

Term to maturity is the number of years over which the issuer promises to meet the obligations. (Maturity refers to the date that the debt will cease to exist.) Generally, bonds with maturities between 1 and 5 years are considered short term; those with maturities between 5 and 12 years are considered intermediate term; and those with maturities greater than 12 years are considered long term.

Principal is the amount that the issuer/borrower agrees to repay the bondholder/lender.

Coupon rate (or nominal rate) is the rate the issuer/borrower agrees to pay each period. The dollar amount is called the coupon. There are, though, zero-coupon bonds in which the investor earns interest between the price paid and the principal, and floating-rate notes where the coupon rate is reset periodically based on a formula.

Amortization. The principal repayment of a bond can be either repaid at maturity or over the life of the bond. When principal is repaid over the life of the bond, there is a schedule of principal repayments. The schedule is called the amortization schedule. Securities with an amortization schedule are called amortizing securities, whereas securities without an amortized schedule (those paying total principal at maturity) are called nonamortizing securities.

Embedded options. Bonds often have embedded option features in their contracts, such as a call feature giving the issuer the right to buy back the bond from the bondholder before maturity at a specific price—callable bond.

Finally, the type of borrower or issuer—business, government, household, or financial institution—can differentiate the debt instruments. Businesses sell three general types of debt instruments, corporate bonds, medium-term notes, and commercial paper, and borrow from financia...