As we have seen earlier in the course, companies need money (capital) to function. Whether it is capital to start a business or financing to expand, add production, invest in research and development, enter new markets, or spend on marketing and sales, capital is truly the lifeblood of any business. In addition to using the free cash flow generated from operations, we have seen that companies raise outside capital principally in one of two ways. They can raise equity capital by issuing shares in which case the capital providers become stockholders in the company. They are "owners" who are taking a chance on the prospects and possible success of the business in the hope of making financial returns. They will be entitled to distributions from the company after the company has paid all its obligations, if as and when declared by the company's board of directors.
Companies also borrow money from lenders. The lenders might be banks in which case the form of borrowing is a loan agreement. But the lenders are often other financial institutions such as insurance companies or pension funds or even individuals. In these circumstances the company will issue bonds, which are really nothing more than elaborate promissory notes. You lend me X amount of dollars and I agree to repay you X dollars at the end of five, seven or ten years, for example. Of course, whether the form of borrowing is a loan or a bond the borrower is required to pay periodic payments of interest to compensate the lender for the use of the money. That's it. It is that simple! But, of course, not really.
Let's take a very simple example. Suppose you have $1000 in savings that you would like to invest. You don't know anything about the stock market (or perhaps you know a great deal about the stock market), and your local bank is offering minimal interest on deposits. Therefore, you are considering investing your $1000 in a new bond being issued by XYZ Corporation. The bond has a maturity date ten years from now and pays interest at the rate of 5% per annum, paid semi-annually. You know this means that you will receive interest twice a year in the amount of $25.
Before you make your decision, you ask yourself if the 5% per annum stated interest rate is fair and reasonable. How do you know? The interest rate paid on any bond will reflect two factors. First, the overall level of prevailing interest rates. This is determined by looking at the rate of interest that the US government is currently paying on its debt obligations. Lending money to the US government is considered risk-free (more on that in another course) so the interest rates it pays on its borrowings is referred to as the benchmark rate of interest. Let's assume (for simplicity) that at the time of your investment the ten-year Treasury rate is 4%. Second, as a lender you need to be induced to take additional risk so the rate of interest on the bonds of XYZ Corporation will need to be higher than on US government debt. This is referred to as the "spread" and just means the difference (always a positive number) between the rate on the company's bonds and the rate paid by the US government on debt having a similar maturity. In this case, XYZ's bonds will be priced at a spread over the US Treasury bond having a ten-year maturity.
But what is the appropriate spread? That depends upon the perceived credit risk of XYZ Corporation. By credit risk we mean the risk that the company will not be able to pay its bonds' interest and principal repayment in a timely fashion. As we discussed in class the credit analysis of any company focuses essentially on two factors. How strong is the company's ability to generate the cash necessary to repay the bond together with the required interest? And how much debt has the company taken on? Even a strong company with a good ability to generate free cash flow can overwhelm itself by taking on too much debt—becoming too leveraged. Therefore, it is not surprising that the rating agencies—Standard & Poor's, Moody's, and Fitch—look at numerous factors in each of these two categories to assign a credit rating to a company.
The details of their respective analyses are not important for our course. But I would like you to know a few facts. Credit analysis is very industry specific. Businesses that are inherently more stable such as consumer staples are clearly less risky from a credit point of view than businesses in industries that are much more susceptible to changes in the overall economy, such as luxury goods or building equipment or home builders. The two most important factors in the credit analysis of a company are its overall size and its interest coverage ratio (you remember this is the ratio of EBIT to interest expense). Size is important because years of experience have demonstrated that larger companies have much more financial and business flexibility to deal with unforeseen negative developments—for example, a downturn in the overall economy or the arrival of a new competitor who forces down prices and steals market share. The interest coverage ratio is extremely important in any credit analysis because it is the most direct measurement of the ability of the company to meet its interest obligations.
To get back to the question of whether the 5% coupon is fair for the bonds of XYZ Corporation I can check the credit rating of the company. The credit rating agencies publish their ratings, and they are readily available. I can compare the 5% coupon rate of XYZ Corporation's bonds to the interest rate on similarly rated companies in the same or similar industries. I can also do my own analysis by reviewing the published financial information of the company, including the 10-K, quarterly reports and other information filed with the Securities and Exchange Commission. Of course, since my investment is extremely modest in size, I am not likely to want to spend a whole lot of time or money doing my own analysis. I am very likely to rely on the published rating. By the way, sophisticated investors such as pension funds, mutual funds and hedge funds will not pay a whole lot of attention to the published ratings. They will do their own work!
Let's assume I have made the decision that the 5% interest rate (a 1% spread over the ten-year US Treasury rate) is fair and therefore I go ahead and purchase the bond of XYZ Corporation. I have now loaned money to the company and am technically one of the company's creditors. Is that the end of the story? Not at all.
The bond has a ten-year maturity and lots of things can change over that long a period. Perhaps the credit quality of the company deteriorates significantly as a result of a downturn in the economy. Or perhaps the company makes some incredibly stupid business decisions or misses some really important development in its business. (Look what has happened to RIMM, the maker of the Blackberry mobile device.) While stockholders will certainly see the value of their shares decline, perhaps precipitously, I may also become increasingly nervous that the company is running out of cash and will soon be unable to make its required payments of interest—not to mention have the ability to repay the principal at maturity. So, I decide that I want to get out by selling my bond. Can I do that? Absolutely! There exists in the US an extremely robust bond market where holders of bonds can buy and sell them in what is called the "secondary market." These transactions do not involve the company but are between other buyers and sellers only.
I go to sell my bond but I discover that the price being offered is substantially below the $100 that I originally paid for my bond. I believe the expression is "what the hell!" What is going on?
First, there is the problem that the credit of XYZ Corporation is a lot worse than when I first bought the bond. In fact, you weren't paying much attention, but you now realize that the credit rating agencies have downgraded the bonds. They are now perceived as significantly riskier than earlier. The market has now determined that that the appropriate spread over Treasuries is no longer 1% (technically referred to as 100 basis points—each basis point being 1/100th of 1%) but is now 2%. Since this deterioration happened fairly quickly there are still eight years remaining before maturity. Take your Bond app and do the computation. Remember semi-annual payments. FV=100. Annual Coupon Payment=5. Years to Maturity=8. Annual Yield %=6. (If you are using an HP or other calculator you may have somewhat different inputs.) Your bond is now worth only $93.72. If you choose to sell you are going to lose just over 6% of your money. Not pretty!
But wait a minute. When you go to check the value of your bond you find that, in fact, it is nowhere near even $93.72. It is a whole lot lower. Are you missing something here? Hmmm.
As you are contemplating your dilemma and wondering what is wrong with you, it finally hits you. When you originally bought your bond the ten-year US Treasury was yielding 4%. The 1% credit spread brought the interest rate to 5%. But now the ten-year Treasury is yielding 6.5%. Is that the source of your problem? Indeed, it is. Now do the math. A two percent spread over 6.5% means that your bond should now be trading at a yield of 8.5%. Go back to your Bond app and reprice your bond. FV=100. Annual Coupon Payment=5. Years to Maturity=8. Annual Yield%=8.5. Damn!! My bond is now worth only $79.98. You have just come face to face with interest rate risk. Let's take a very brief look at this risk that has absolutely killed your investment.
You remember that in our session on the Time Value of Money we looked at two different kinds of cash flows. We looked at perpetuities, where the fixed amount of payment was received forever. And we looked at annuities, where the fixed payment is received for a stated period of time, for example three, five, ten or even 30 years. Now we can see that our bond is really nothing more than an annuity. In the case of the bond, we purchased a ten-year annuity with payments of $2.50 received twice a year for ten years. The value of an annuity and hence our bond is equal to the present value of the expected cash payments discounted back to the present time at the appropriate rate of interest. That appropriate rate of interest is, as discussed above, the risk-free rate of US Treasury bonds of the same maturity plus the credit spread. It is not at all surprising that if the rates on US Treasuries increase, thereby increasing the appropriate discount rate, the value of my bond is going to decrease. If I am lucky enough to buy my bond before a decrease in US Treasury rates than the value of my bond will increase.
The volatility of a bond, i.e., its sensitivity to changes in interest rates, is principally determined by three factors. First, there is the maturity of the bond. In fact, the analysis is a bit more sophisticated than just looking at the final maturity. We use a concept called "duration" which looks at each of the stated cash flows of any bond—including all interest payments and the principal payment at maturity—and computes the weighted average maturity of the discounted present value of these cash flows. While that sounds like a complicated concept that is even hard to repeat, it essentially just means that we take each of the cash flows, discount them and then use those numbers to determine the weighted average maturity of the bond. Bonds with longer durations are more sensitive to changes in interest rates because for a given change in interest rates the present values will increase or decrease more. Think of it this way. If you have a cash flow that you expect to receive in two years and a cash flow that you expect to receive in ten years, a change in interest rates will affect the ten-year cash flow substantially more than the two–year cash flow. This is easy to confirm. Use your Bond app and your imagination!
Second, the coupon or interest rate on the bond affects its price sensitivity. Bonds with higher stated coupons are less sensitive to changes in interest rates than bonds with lower interest rates. Why? Again, it is related to duration. If you look at a bond and ask yourself about the total payments that you will receive during the life of the bond, you can see that a bond with higher coupons means that more of the total payments are received earlier. First, think of a six-year bond with 10% coupons. Over the term of the bond total payments to be received were $160—six coupons of $10 plus repayment of your $100 principal. Of that $160 total $100 would be received in ten years. That represents 62.5%. Compare that to a bond of similar maturity with a 2% coupon. Over the life of the bond your total payments will be $112. Of that again $100 will be received at maturity. That represents just under 90% of all payments. So not surprisingly the 2% bond has a longer duration than the 10 percent bond and is a whole lot more price sensitive.
Bonds are more volatile in lower interest rate environments. A given change in interest rates, say 1%, will represent a much bigger percentage change when prevailing rates are 1% or 2% than when rates are 5% or 10%. Therefore, bonds will move in price more in a lower interest rate environment.
Finally, there are the concepts of modified duration and convexity. These are well beyond the scope of what I would like you to learn in this class and I mentioned them in class only so you might recognize the concepts if you come across it somewhere (admittedly, a fairly unlikely event).
That's about it.