Abstract
Bonds and variants, such as debentures, loans, and notes, are IOUs provided by governments, administrations, and corporations as a method of fund generation. Often, financial institutions refer bonds to as fixed income and fixed interest securities. The distinguishing factor between bonds and equities is that returns from bonds are at regular intervals. However, the case is not always the same, at the time the returns are not predictable. The bonds earn fixed interest payments. As such, the interest differs from the dividends paid on equities, which at times are variable. In most of the financial institutions, they allow redeeming of bonds after a specified period. Vanilla bond is not an exception to the other type of bonds, and thus, the bond owners are assured of interest at a fixed interval. The main advantage of the regular payment is the capability to acquire more bonds at the time of redemption.
Introduction
A bond is a debt security. A bond is as an instrument of indebtedness by the bond issuer to any bondholder. Under some agreed terms, the bond issuer owes the investor a particular debt. This essay analyzes different aspects of bond evaluation. These elements include the types of bonds, bond evaluation methods, factors affecting bond valuation and relevant terminologies in bond valuation. The essay adequately analyzes protective methods and bond aspects. It, therefore, discusses the different protective covenants of the bonds, and their effectiveness. It relates the findings of research into various market levels, their issues, and their effectiveness. Additionally, it outlines the strategies adopted by the bondholders in an attempt to minimize the risks associated with these bonds.
Analysis of the types of bonds
Various types of bonds include government bonds also referred to as treasury bonds. The government issues treasury bonds to raise money. Zero-coupon is a bond type whose interest is not regular but usually traded at a deep discount. The holder of a bond can decide to exchange a bond to common stock of a company. Such kind of a bond is known as convertible bond. Companies issue corporate bonds to cater for their debt capital. Fixed coupon bonds pay same interest amount for the whole period.
The value of the bond can be calculated by adding the present value of the principal amount to the present value of coupon payments. As such, bond valuation is usually annual, semi-annual, and quarterly. The other method of price valuation is the relative price approach. Investors who use this technique buy underpriced bonds. Investors of these bonds use this method to detect over-priced bonds and then sell them later. The third method of Bond Valuation is the stochastic calculus approach. Investors use this technique in the evaluation of the risk-free bonds with quantities adjusted continuously. The approach also requires the construction of a stochastic differential equation. Therefore, one should know the stochastic and non-stochastic differential equations governing the bond price in order to compute the bond’s value. Finally, the arbitrage-free pricing approach is another method used in the bond evaluation. The method evaluates a bond considering the series of cash flows. Each cash flow assumed to be a zero-coupon bond.
The different factors that affect the bond valuation are as follows. Firstly, interest rate and the rate of return affect bond prices. The real risk-free rate, the expected rate of inflation, and the risk premium are the methods used to determine the interest rates. When interests rate are high, the bond prices increase, and vice versa. Secondly, the rate of inflation may also affect bond valuation. The inflation rate varies inversely with the value of the bonds. The various terminologies used in bond valuation include yield to maturity, yield to call and realized return. Yield to call measures the return rate that investors receive for holding a bond until it reaches the call date. Realized yield computes the expected return rate of a bond that investors expect to sell prior to the bonds maturity. Yield to maturity indicates the fully compounded return rate promised to investors, who buy bonds at prevailing prices.
Protective bonds’ covenants
The firms financing, restriction of dividends and the restrictions on the investments form the basis of defining the protective agreement. In accordance with the above statement, contracts containing exceptional deeds bide the bonds under standard provisions. These requirements dictate the criteria for a satisfactory record keeping and maintenance of a business. In addition, the restrictive covenant forms part of the agreement and contains the components of the contractual clauses. Based on the terms, constraints pertaining to finance and operation are established in bond issues. The restrictions protect bondholder against the existing and the upcoming risks associated with the borrowers. The bondholder bears the right to the debt repayment if the restrictive agreements are violated.
Bondholders’ interest is paramount in financial institutions specializing in bond provision. Most researchers note that bondholders play an unquestionable role during the payments of interests. As such, they head to the top of the pecking order even during the time when there are financial difficulties in the companies. For this reason, the companies bring them into minds and heart of negotiations, freezing out the shareholders. Companies have initiated moves towards the debt-for-equity swaps.
A study aimed at evaluating the ethical poison included in the offering of bonds focused on the upcoming covenant provisions as provided by United States’ firms. These covenants result from the bondholders having experienced substantial losses of wealth in the previous decade. The experienced losses came because of negative grading, recapitalisation, and takeovers of the bonds. The actions were undertaken by the bond agencies. The study established that firms have adopted the event risk protections in the offerings of bonds. As such, they can attract more investors. Such event-risk protections included the poison put, which was the most commonly used by many firms. From the study, it is conclusive that the method offers protection to the bondholders since they have an opportunity to utilize the poison provisions. Under the explained method, the firm managerial team prioritises the equity and debt holders. Therefore, before the interests of any other person, the management puts the stakeholders’ needs in the forefront.
The bondholders and stockholders have different returns. The stockholders are on the gaining side whereas the bondholders lose their wealth at the geared buyout. Consequently, it protects the bondholders from the impending loss of their wealth during the firm restructuring. In the year, over 40% of the bonds had the poison put imposed. Major companies used the poison put during restructuring process as protection measure. The poison put is advantageous to bondholders as it guards them against losses that may be accrued during restructuring11. The investors have the opportunity to cash out the bonds to where they acquired the bonds. Such an action is only possible during the restructuring period.
The United States’ firm changed the public debt agreement in 2010. A study that was conducted on the firm found that the covenants was optimal during the issue of the bonds and that it would not necessarily remain optimal over time. The changes in the investment and economic environment of the firms led to the fluctuation of the optimal conditions of the covenants. These covenants restricted the ability of the companies to pay dividends. As such, the companies did not incur additional debt. The implication is that the companies are not in a position to dispose off their assets through control of the shareholders. In addition, the bond purchaser cannot assume the companies’ obligations. Therefore, the companies are positioned to protect the wealth of the bondholders from expropriation.
Considering a firm in United States that sold its assets and resulted to the shareholders and bondholders gaining the wealth, the covenant restriction protected the two parties enabling them to earn dividends. The application of the act in such a case does not give room for the expropriation of the wealth of the bondholder.
The United States managerial team opted to shift the business risks. The managers moved the risk involved in finance from the shareholders to the bondholders. The implication for the adopted method is that it does not involve the compensation of packages and stock. These options align the interests of the managers with the interests of the shareholders as well as those of the bondholders. Various studies used to evaluate bond contracts presume that any manager acts in line with the interest of the shareholders. The bondholders should be prevented from the transfer of their wealth. The protection requires designing of sophisticated clauses and contracts.
The markets are affected by the systematic risks. Specific investments are affected by unsystematic risks. The best way to get rid of these is through diversification. The elimination does not reduce the expected returns when the investor holds enough different investments but only removes the unsystematic risk. An application of the method does not affect the firm’s returns but only impacts the risks.
Before implementing any investment plans, one should have sufficient information about the risks likely to be encountered. The same case applies to the bondholders. As such, the shareholders are responsible for the risks involved in the investment in a particular type of bond. In an efficient market, the risk is proportional to the return. For this reason, to achieve the highest efficiency of a market, both the investor and the bond issuer should familiarise themselves with all these information. In markets, such as in the New Zealand, there is a better protection for the informed investors. The information prevents the expropriation of the investor’s wealth by the firm’s management. Equally, in cases of efficient markets, the knowledge protects the lenders from expropriation, as there is compensation with a lower price or during higher yield.
Method and Sources
For effective analysis and evaluation of bonds, there is a requirement for a detailed analysis of fifteen recent bond issues in markets such as in New Zealand. The degree of protection was ascertained by a study that focussed on the wealth transfer of the bondholders. The study concentrated on various protective covenants often adopted to protect the investors, bondholders, shareholders and at the same time maintaining the company. These protective methods included the discussions outlined below.
The researchers analysed the statement of the investment related to the bond and provided detailed information. Firstly, the study started with the identification of the offered covenants in a particular bond market. Secondly, the study entailed the process to determine the effectiveness of the identified covenants as offered. The analysis method depended on a particular approach to determine the effectiveness of all the covenants differently. The study established that the covenant on prohibition could not be effective assessed by a quantifiable measure. In such case, there existed several immeasurable and subjective, which formed important factors that needed to be considered. Adequate information was available from the analysis of the study and measures put forward to protect the sale of the bonds. The knowledge obtained was sufficient for making judgment in connection with the subject matter.
Investment policy restriction
Some of the projects undertaken are very risky and might result in massive loss by the bondholders. The policy provides the required protection to the bondholders in case a company takes a risky project. The policy is very critical, such that, in every fifteen bonds, two of them utilize the restrictions. The two bonds were void when raising funds for a particular project. However, the covenant has the provision for an engagement in a negotiation prior to the end of the original agreement. The provision allows the issuer to incorporate other projects that are income generating with the acknowledgment of the investors.
Increasing Leverage restrictions
The method entails the prevention of bondholders from accruing risks that stem from various projects in the firms. According to the regulations on this covenant, the issuer has no right to multiply the geared projects. Small firms cannot increase any of their leveraged projects since the policy restricts such actions. The study showed that restrictions, which related to increasing the leveraged projects, were present in nine out of the bonds analysed. Covenant restrictions were very broad in sic bonds; hence, limiting their definitions. Violations of the restrictive covenants were thus probable in the firms that had the broad restrictions. The companies were at a position to raise the cost of the leveraged projects. Therefore, the Covenant does not provide an effective protection to the bondholder.
Dividend Policy restriction
The protection of the bondholders from finance shortages is the main role of the dividend policy restriction, which also protects the bondholders from increased advantages during the payment equity holders. The bondholder is further protected from the loss of wealth if the company sells its assets. During the research on the New Zealand market, it was established that bond analysed from the corporations did not have a protection covenant to safeguard the bondholders. From analysis, nine bonds were equipped with the limited agreements. Since the policy is not implemented in the New Zealand Markets, the company makes payments based on equity and the bondholders risk wealth expropriation.
Least amount of liquidity policy
The companies should ensure they have sufficient money to cater for the interests of the bondholders. The policy sets the minimum requirements that ought to be maintained at any given time by the firms issuing bonds. The policy provides surety of interest to the stakeholders. In real sense, few bonds contain the agreements for the companies to have the required level of liquidity.
Prohibition on selling assets
In some cases, the agreement prohibits a company from selling of a large proportion of its assets. The sell-offs in some cases may cause the relocation of wealth from shareholders to the bondholders. The shareholders and bondholder are in a position to recover their bonds from the assets if the company is dissolved. However, in the undertaken study, it showed that the method was not common in the market.
Prohibition on the Company Calling the Bonds
Bondholders are poised to benefit in some instances. In some situations, the bondholders can have advantages. These benefits are such as the drop in the interest rates since they have fixed rates of returns. However, there is no guarantee of the advantage in cases such as when the company recalls the bonds. In these cases, disadvantages arise in which the bondholders are left with no alternative but to reinvest when there are low interest rates. The sale results in the loss of some or even whole of their capital gains on their bonds. From various investigations, larger percentage of these bonds issuer stated that the company could call the bonds describing viable reasons that allowed a company to recall the bonds during some circumstances.
Poison Puts
In the study of this approach, the findings coincided with another study that was conducted in 2012. Even though major bonds were considering restructuring, a significant percentage of them embraced the poison put method. The study established that poison put method was evident in six out of the studied cases. However, only two of these bonds provided an effective protection bondholder. Therefore, despite the poison put being in the covenants, they were in the bond contract agreement.
Security
The assets of a firm can be used in obtaining a bond. The approach is known as security. As such, the bondholder owns a greater chance to recover their investment during the cases of liquidation. The secured bonds usually rank higher than the unsecured creditors. However, in some cases, the companies have the ability to erode the security through its practices, such as the company layering. In the course of layering, the firm inserts the emerging debt between the bondholders and the debt from banks. Therefore, the company puts the bondholders at the base rung of claimants for payback. The bonds studied showed that the bondholders were provided with security. The findings were witnessed in six of the studied bonds. From the bonds discussed above, half of them contain ant-laying agreements or covenants.
Discussion
Bonds are essential in business and thus a number of protective approaches and covenants characterize the bond market. The parties involved in the bond market should be aware of their rights contained in the approaches. The focal point of the research was the New Zealand Bond concentrating particularly on the effectiveness of the market. In the course of the study, few other markets were analysed, paying close attention to the covenants. The study looked at a number of bonds that were often in the bond market of New Zealand. The issues were sufficient to determine the level of protection provided by these protective covenants of the bonds. Bondholders should be protected from expropriation of wealth by the bond issuers. Several mechanisms offer the required protection and they have been analysed properly.
With respect to the protective covenants, it is evident that there are rules that are set in order to ensure smooth operation of the bonds transfer form one party to the other. Such restrictions are collectively known as protective agreements. According to the study conducted, restrictive covenants were found to be most employed in most cases. The company offering the bonds requires their borrowers to maintain their liquidity at the minimum level. At least two bonds contain the covenant in every fifteen bonds acquired by the either same bondholder or different bondholders. Companies prevent future shortage of finances by encouraging their borrowers to maintain their accounts that have the status to be receivable. The decisions of not selling such accounts help the firms in attaining the obligations at hand. The borrowers are further restricted from converting their fixed to cash. If such an action takes place, the company may be unable to overcome the challenge of meeting the payments of bonds. If the company is not in a position to cash the bonds, then it will end up with losing its assets and, hence, it can be dissolved. The ideal situation of the market, in most cases, does not abide to the discussed conditions. The above concept is drawn from the sampled bonds, in which none of them seemed to coincide with the covenant restrictions. The amount payable to the dividends is limited and calculated on specified conditions or factors. More than half of the bonds analyzed had limited covenants, which was an indication that the protection offered was not sufficient.
One of the assumptions in the study is that there are covenants that limit or prevent payment of dividends. The assumption was extended to the point that the company has power to manipulate the shareholder to carry out certain transactions. Additionally, the company has no capability to sell its assets without forcing its purchaser to assume it obligations, which will assume protection of the wealth of the bondholders against the expropriation. Companies tend to deviate from the covenants that might expose them to risks arising from the issuance of the bonds. In such situations, the bondholder does not receive full protection from the company. Additionally, the study found that the protective covenants identified recently in the New Zealand bond market issues did not, in any cases, restrict the companies from increasing the advantage. The approach also did not take on the new risky projects. As such, it makes the payments of the dividends to equity holders, and undercutting the security that are the basis of the loans. In addition, the study did not show any correlation between the approach of the protective covenant involved and the advantage buyouts, the sale of the assets, the purchase of the shares, or even the issuing of the new security. A large proportion of the bonds contained regarded the features as advantageous to the bond issuer. For this reason, a number of dividend strategies implemented created a means for bondholders to transfer any form of wealth that they had accumulated to any of their shareholders.
In a study on interests earned by the bondholders, it was found out that, for the past one year, there was a positive trend on the subject matter. On the other hand, the bondholders play a subservient role since the payments of the interests still exist. Consequently, the bondholders move towards to the top of the pecking order when the companies come into the financial difficulties. As such, the company motivates the bondholders into the heart of negotiations. However, the company froze its shareholders. There are moves towards the debt for equity swaps. The results of the research, however, established that the restrictive covenants contained in the contract agreement of the recently identified case in the New Zealand bond market.
Contribution
In the research, I conducted the study in the stated study field. The main aim was to collect the first-hand data from the field. After I had collected sufficient data, I analysed it carefully weighing all the possible outcomes and considering the assumptions made during the data collection. I have used the data to come up with the report, which precisely explains the state of bonds in the market. During the data collection session, I faced a number of challenges. The primary challenge was that the respondents were not willing to deliver the exact information about their bonds. In addition, it was almost impossible to access the company departmental heads concerned with the bonds. I was able to overcome the challenge by considering the second option, that is obtaining the information I required from the junior staff.
Conclusion
A thorough analysis of the findings from the study reveals that adequate protective agreements were evident in a considerable small number of bonds. These are the covenants adopted by the companies as restrictions on the investment policies as the bond issuers. Further, it shows that only nine of the studied bonds contained the restrictions on the increasing geared projects. However, the broadness of some of these restrictions made it difficulties in their definition. As such, the study could not provide a concrete definition. Further, some of the bonds issues identified contained limited protection to the bondholders. From the conducted study, it is conclusive that small portions of the bonds are under the required covenants. It was also noted that none of the studied bonds restricted the bond issuer from the sale of the assets. On the other hand, only forty percent of the studied bonds adopted the approach of the Poison Put, and two of the approaches gave an effective protection to the bondholders.
References List
Bond S, Stanley, W & Graham, B 2008, ‘The Rhetoric of Billy Graham: a description, analysis, and evaluation’. The Journal of Financial Research, vol 9, no. 11, pp. 11-19.
Bream, R 2012, ‘Bondholders wrest power from equities’. Financial Times, vol 1, no.1, p. 25. Chulia, H & Torra, H 2008. ‘The economic value of volatility transmission between the stock and bond markets’. Journal of Future Marketing, vol. 28, no. 11, pp.1066-1094.
Crabbe, L 2012, ‘Event risk: An analysis of losses to bondholders and “super poison put” bond covenants.’ Journal of Finance, vol. 46, no. 2, pp. 689-706.
Datta, S & Iskandar-Datta, M 1996, ‘‘Who gains from corporate asset sales?’’ The Journal of Financial Research, vol 19, no. 1, pp. 41-59.
Harikumar, T 2011, ‘Leverage, risk-shifting incentive, and stock-based compensation’. The Journal of Financial Research, vol.19, no. 3, pp. 417-429.
Stafford, J 2010. ‘Bond evaluation, selection, and management’. The Journal of Business, vol 16, no. 4, pp. 499-516.
Kahan, M & Tuckman, B 2010, ‘Do bondholders lose from junk bond covenant changes?’ The Journal of Business, vol.66, no.4, pp. 499-516.
Mcllroy, C 2000, ‘Developers find intelligent life in growing junk bond market’. The National Business Review, vol.1, no.1, p.58.
Shi, G & Sun, J 2014. Corporate Bond Covenants and Social Responsibility Investment. Journal of Business Ethics, vol. 1, no. 2, pp. 15-27.
Sironi, A & Gabbi, G 2009. Which Factors Affect Corporate Bond Pricing? Evidence from Eurobonds Primary Market Spreads. SSRN Journal vol. 1, no. 1, pp. 21-45.
Perumpral, S, Davidson, D & Sen, N 2009, ‘Event risk covenants and shareholder wealth: Ethical implications of the “Poison Put” provision in bonds’. Journal of Business Ethics, vol.22, no. 2, pp. 119-132.
Prasanna, K & Bansal, B 2014. Foreign Institutional Investments and Liquidity of Stock Markets: Evidence from India. International Journal of Economics and Finance, vol. 6, no. 6, pp. 101-114.