Corporate Finance: Bonds
Yerbolat Yeleshev, Director of Investment Banking, RESMI Investment and Financial House
It is no secret that any company faces a need at certain stages in its development to raise additional funds. These may be needed to purchase new equipment or top up working capital. Very often top managers resolve this issue by raising bank loans. Yet, there are a host of other means to find money, with bond issues being, in our opinion, among the most promising.
A bond is a debt security, which entitles bondholders to be paid by the issuer its nominal amount and interest on a stated future date. In fact, this is a contract, according to which a party undertakes to repay the other party, in a certain time, the loaned funds and pay interest on such amount throughout the bond term. Interest periods are determined by the issuer and may be annual or semi-annual. The principal is called the nominal amount of the bond, and interest coupon or discount.
Bonds differ by:
· issuers: governmental and corporate;
· types of coupon: discount, fixed-rate and floating-rate;
· security: secured and unsecured; and
· types of redemption: at par and convertible.
For instance, you could issue a bond with a nominal amount of 1 million tenge and a maturity of 5 years. The coupon rate is 10% paid annually. This is a so-called simple term bond. In such a case, payments will be made as shown in Figure 1. This is the simplest scheme of loan repayment.
There are many types of bonds that differ by redemption schemes. So, bonds may be traded at a discount. This means that the issuer sells the bond at a discount to its nominal value and, when the bond reaches maturity, repays the investor its full nominal amount. In this case, coupons are not paid and the investor’s return is the difference between the discounted bond price and its nominal value.
Another type of redemption is repayment of the principal in a series of periodic instalments over the bond term (serial bonds), which helps reduce the debt burden in the last year of the issue. Since the principal decreases annually, the coupon will also go down. This option is shown in Figure 2.
An advantage of bonds is that the issuer can repurchase its bonds before maturity if it has extra money. Thereby, the issuer reduces its debt since it needs not to pay the coupon or repay the principal on the bonds it holds.
According to law, bonds may be issued by the Kazakh Government (in the person of the Finance Ministry), the National Bank, or any company with the exception of pension funds, pension asset management companies, insurance companies, non-for-profit organisations and state institutions that are prohibited by law from issuing such securities.
The development of the Kazakh bond market was determined by a great deal of factors, the most important being macroeconomic stabilisation and economic growth. In addition, a sharp rise in the assets of institutional investors such as commercial banks, pension and investment funds and insurance companies created a stable demand for these securities, mainly corporate bonds that balance high yields against acceptable risks.
Table 1 shows the number of corporate bond issuers and issues listed at the Kazakhstan Stock Exchange (KASE) in 2000-2006. This data demonstrates that the number of issues in the period grew by 16.6 times!
As of 11 June 2007, A-, B- and C-listed issuers issued corporate bonds with a total nominal value of 1,653.3 billion tenge. The official list of corporate bonds published by KASE includes 214 issues and 83 issuers.
The increasing popularity of bonds suggests that this form of funding is rather attractive to Kazakh companies; this is mainly because of the significant advantages offered by these instruments. The most important ones are listed below.
Lending terms. The issuer is in a position to determine the loan structure on its own, including the amount of the issue, its price, interest (coupon), maturity and terms of redemption. To achieve this, the issuer may involve a professional securities market player to get advice on placing the issue.
Loan amount. The issuer determines the amount of funds to raise proceeding from how many investment it needs in the company. This amount depends solely on the issuer’s solvency.
No security. Unlike loans, a bond does not require compulsory security. Yet some companies, particularly those who make their debut on the market, issue secured bonds because newcomers do not have a credit record on the stock market and, correspondingly, an established reputation. Obligations under such bonds are secured by pledging the issuer’s property or a bank guarantee. For instance, out of 214 bond issues listed at KASE 44 are secured (including 42 mortgage bonds).
Relatively low-cost lending. Unlike bank loans, interest rates for bonds are lower by 3-4%. The average coupon rate of KASE-listed bonds is 10-12% p.a.
Tax advantages. According to the tax laws, a legal entity is entitled to reduce its total annual income by the capital gains received from trading bonds on KASE. If bonds are listed on the special trading floor of the Almaty Regional Financial Centre (ARFC), then, in certain instances, audit costs are also subject to reimbursement.
A wide range of investors attracted. Public bond offerings on a centralised securities market help attract a wide range of investors and, therefore, raise the liquidity of the issuer’s securities. Additionally, the issuer has no dependence on any lender.
Positive image on the stock market. Public bond offerings and their redemption in accordance with the terms of the issue strengthen the company’s image, guarantee the success of subsequent securities issues and raise the issuer’s attractiveness to investors. So, the issuer can count on a reduction in fund-raising costs in the future.
These features of corporate bonds show that these instruments are very efficient when long-term investment is needed. In addition, they help the borrower to build its public image and finance new projects (Table 2).
Bonds may be issued by any joint-stock company or limited-liability partnership. To trade bonds on KASE, they must be listed in official category A, B or C. The main difference between these categories is stricter requirements for the companies, which intend to issue A-listed bonds. Additionally, the coupon rate for A-listed bonds is generally lower. From 2007, issuers can also trade their bonds on the ARFC’s special trading floor. The listing procedure there is simpler than that of KASE. To offer bonds to a wider range of investors, an issuer can list them on both KASE and ARFC. And in doing so, it only needs to pay a single listing fee.
The main bond listing requirements for non-financial companies are described in Table 3. For the bonds to be included in C category on ARFC, the issuer must meet one of the following three requirements:
the issuer must be listed on a stock exchange recognised by ARFC (e.g., KASE, London or New York Stock Exchanges);
the securities and their issuers must have ratings from one of the credit rating agencies (Fitch, Standard&Poor’s, or Moody’s Investors Service); or
the issuer must comply with the requirements set out in Table 3.
According to the listing requirements, for the securities to be listed on an exchange, the issuer, which is not a financial organisation, needs to have a financial adviser – a professional securities market participant holding a broker-dealer licence for the securities market. In fact, such an adviser is an intermediary between the exchange and the issuer. At the very first stage, financial advisers help determine the optimum terms of the loan proceeding from the financial performance and investment goals of the issuer. Then they help prepare the documents necessary to register the bonds with an authorised governmental body (prospectus) and list them on an exchange (investment memorandum).
The adviser can also act as an underwriter for the issue and, if they are experienced in offering bonds, help attract more investors. Careful selection of the financial adviser is key to the success of the issue and one of the most important stages in arranging a bond issue.
In conclusion we can say that bonds definitely help Kazakh companies become more flexible in raising funds and are one of the most attractive types of lending.
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