Appreciating investment valuation models (II)
This feature is a continuation of an earlier publication on the valuation models available to governments and their agencies, managements of corporate bodies, and investors to make meaningful and productive investment decisions. Discussions in the previous write-up ended on some types of bonds and their effect on investment valuation and decisions.
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Bonds in this category are usually not callable, they are held until maturity by investors. Term bonds are several bonds with the same maturity date. Stated differently, term bonds are two or more bonds issued simultaneously with the same maturity date.
Term bonds may be registered or non-registered. They are registered term bonds when the issuing organisation takes the necessary steps to have detailed documentation on the sold bonds to ease traceability of the holder, should the need arise. Inversely, the issuer may not deem it necessary to register the bondholder.
In such situations, it may be difficult for the issuer to contact the bondholder should the need arise. Bonds issued in this category are called unregistered term bonds.
Due to their uniqueness, term bonds are sometimes called bullet bonds or bullet maturity bonds. Assume Perlisto Corporation issued three-year bonds worth $520,000 on January 4, 2018. All the bonds issued are expected to mature on the same date.
This suggests on January 4, 2021, Perlisto Corporation would make payments to the bondholders or investors. If the bond sale and purchase agreement were to extend to say, 12 years, the same repayment method would apply. Coupon rates associated with term bonds are usually low.
Term bonds are usually risk-free and exempt from tax; they may be held for a shorter or longer period. For instance, investors may purchase and hold term bonds with a three-year (short period) maturity or 12-year (long period) maturity.
The term bullet portfolios is used to describe portfolios that hold bullet or term bonds.
Financial commitments of an investor to some term bonds may be very high. In such cases, the investor may require the issuer to establish a fund into which period or annual deposits would be made to ease repayment of the debt at the maturity date. Such a fund, when established, is called a sinking fund.
To allay investor fears and facilitate fund mobilisation in the bond markets, an issuing firm may back its term bonds with a collateral security. The collateral security guarantees the bond issuer’s repayment to the holder at maturity; collateral security assures the bondholder of the issuer’s commitment to repay at maturity. This category of bonds is referred to as secured term bonds.
Conversely, an organisation may issue term bonds without the need for collateral security, the issuing organisation’s historical records in terms of operations and financial performance are an ample evidence of its debt repayment capabilities. Term bonds issued without the need for a collateral security are called unsecured term bonds.
Term bonds are the inverse of serial bonds which are called at varying maturity dates until they are retired fully by the issuer. Because repayments on these bonds are serialised and involve varying dates, different coupon rates may be applied.
Amortised bonds
It is likely for a bond issuing institution to issue a bond below its face or par value. When this occurs, we say the bond is discounted. For accounting purposes, amortised bonds are recorded in the assets section of the balance sheet; the difference between the par value and the issued value, which is the discount, is amortised to expense over the life of the bond.
Like depreciation, the amortised value is matched against the revenues it helps the organisation to generate over the life of the bonds. Depending on the jurisdiction and the acceptable accounting practices, the bond discount may be treated, after the transaction, as an expense or amortised and reduced to expense over the life of the asset (amortised bond).
Adjustment bonds
An organisation saddled with bankruptcy usually requires a financial ingenuity that would ensure its operational turnaround. An organisation stirred with bankruptcy would require restructuring.
Prior to the restructuring stage, the firm might have issued outstanding bonds to bondholders. At the restructuring stage of its existence, the firm may issue adjustment bonds to these bondholders.
The issuing organisation would take the necessary steps to recapitalise its debt obligations; it would consolidate and transfer the outstanding bond issue to the adjustment bond. Recapitalisation is intended to provide the organisation with a financial “life-line” to assure its continuous operations and existence.
Through recapitalisation, varying maturity terms and premium rates are reviewed to emerge with common maturity term and premium rate. This eases the firm’s financial burden and enhances its chances of repaying the debt.
Continuous operations are likely to enhance an organisation’s performance, financial reputation, and value. Discontinued operations or liquidation may result in partial payment to the bondholder by the liquidated organisation. However, profit-oriented investors would not be interested in this development.
The organisation issuing adjustment bonds is likely to receive the co-operation of its outstanding bondholders since the operational failure of the former would have dire financial implications for the investment of the latter.
Junk Bonds: These bonds are usually issued by organisations with questionable operational performance; junk bonds may be issued by firms with questionable business strategy, model or earnings. Due to the uncertainty surrounding the firm’s operations and earnings, it is believed to rate high in terms of default risk.
This affects negatively the credit rating of the organisation. A lower credit rating affects the interest of existing and potential investors in the issuing organisation. An investor’s decision to purchase and hold bonds in such an organisation implies assuming higher risk.
To compensate for the high investment risk, junk bondholders often demand higher premium rate as a meaningful return on their investment; investors demand higher coupon rate on junk bonds than they do in the case of Government bonds, which are believed to be safe in the bonds market. Junk bonds are also called speculative bonds or high-yield bonds.
Emerging market bonds
Emerging economies across the globe and their corporate bodies require additional funds to finance their development projects and to meet other pressing social and economic needs of the citizenry.
However, most countries in this category are often characterised by weaker socio-economic development structures. Some emerging economies suffer political unrests and unstable economic performance.
This reduces the countries’ credit ratings and increases their cost of borrowing; investors in emerging market bonds often demand higher coupon rate to compensate for the higher risk they assume.
Angel bonds
These bonds may be described as the inverse of junk bonds. As the name implies, an angel bond is very limited in investment blemish; issuers of angel bonds are believed to have a higher credit rating in the investment market. Therefore, issuers of this bond category often offer lower premium rate to holders. — GB
The writer is the Lead Consultant/CEO
Eben Consultancy and a Fellow & Council Member, ICEG
Email: [email protected]
Website: www.ebenezerashley.com