Bonds & Bond Markets - Corporate Finance

Bonds & bond markets - Corporate Finance

Joris Kersten, Place: Uden/ Netherlands, March 27th 2020

www.joriskersten.nl

Consultant & Trainer Joris Kersten

I am an independent M&A consultant and Valuator from The Netherlands.

In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world (New York, London, Asia, Middle East).

This at leading (“bulge bracket”) investment banks, corporates and universities.

My training in “Business Valuation & Deal Structuring” this March 2020 in The Netherlands is rescheduled due to the corona virus.

But my NEW training calendar in The Netherlands is as follows:

1.     17, 18, 19, 20 and 22, 23 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;

2.     24, 25, 26, 27 and 29, 30 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;

3.     28, 29, 30, 31 October 2020 + 2, 3 November 2020: 6 days - Business Valuation & Deal Structuring. Location: Amsterdam Zuidas/ The Netherlands;

4.     16, 17, 18, 19 November 2020: 4 days - Financial Modelling in Excel. Location: Amsterdam Zuidas/ The Netherlands.

All info on these open training sessions can be found on: www.joriskersten.nl 

And 130 references on my training sessions can be found on: www.joriskersten.nl 

Introduction

In this sequence of blogs on “bonds” I will talk about:

·       Bond markets,

·       ratings agencies,

·       government & corporate bonds,

·       international bonds,

·       bond calculations & risk,

·       investment methods, and,

·       building a portfolio of bonds.

The book I use as a source for these blogs is:

·       Bonds – An introduction to the core concepts (2012). Mark Mobius. Publisher: Wiley.

For any corporate finance (M&A + valuation) professional I really recommend you to read the book. Since a good understanding of bonds is needed.

This in order to be able to determine the “cost of debt” in the WACC (weighted average cost of capital).

And to be able to model the “acquisition financing” in for example a Leveraged Buyout (LBO) or M&A model in Microsoft excel.

The book used as a source discusses the topic ‘bonds’ in a broad perspective, but also gives more than enough detail. Highly recommended! ??

This is the 2nd blog in this sequence, in case you have not read the first one yet, the link is:

Article 1: Bonds - An introduction

https://www.dhirubhai.net/pulse/corporate-finance-bonds-introduction-joris-kersten-msc-bsc-rab/

Bond markets: An introduction

When people are talking about the capital markets they generally mean the:

·       Money markets;

·       Equity markets, and,

·       Bond markets.

The money markets consist of financial institutions and dealers who buy, sell, borrow and lend cash instruments and short term financial instruments. And these with durations from overnight to up to 12 months.

Equity markets refer to markets where equities or company stocks, or stock derivatives, are traded. And bond markets are those markets in which participants buy and sell debt securities.

Bonds are loans lasting from 12 months to over 30 years. They normally pay interest at regular intervals and they pay back their principle at maturity date.

These bond markets are also called debt-, credit- or fixed-income markets.

In bond markets the borrowers are the issuers of the bonds. This can be governments, corporations, banks, (international) organisations, individual etc.

And lenders are the entities that lend through buying the bonds.

(Mobius, 2012)

Operations of the bond market

Domestic bond markets handle all types of debt like government securities and corporate issues. And these are issued in their own domestic currency.

If a domestic market is too small or too restrictive to meet an organisation’s needs, then there is the international bond market.

The most prominent international bonds are Eurobonds. And these are bonds that are denominated in a currency different from the currency of the country where the bond is issued or traded.

For example, a US dollar bond issued and traded in Germany would be considered a Eurobond.

Eurobonds are helpful for multinational companies in order to raise money in the various countries in which they are operational. So for example a Japanese company may issue a Eurobond in Switzerland denominated in euros.

There are a number of other types of international bonds. For example “foreign bonds” are issued by foreign companies or governments and denominated in the currency of the issuing domestic market.

And “Dragon bonds” are issued in Asia and usually denominated in US dollars. More on this in one of a subsequent blog on “international bonds” in this sequence.

(Mobius, 2012)

Over the counter (OTC) trading

The domestic and international bond markets consist of a large interconnected networks of dealers and traders all over the world.

Transactions are conducted between broker-dealers and large institutions “over the counter” (OTC). In OTC trades, traders deal directly with another party over the phone or computer.

The bond market is decentralised. However, some bond trading still takes place on established exchanges. Such as the NYSE (New York Stock Exchange), and this is the largest centralised bond market in the US.

A wide range of bonds are traded on that market, including corporate and government bonds. And corporate bonds and other corporate debt issues account for the largest part.

Also at LSE (London Stock Exchange) debt securities are traded, from simple Eurobonds to complex asset-backed issues, high yield bonds and convertible bonds.

Issuers there include governments and their agencies, large corporations and supranational bodies, such as the European Bank for Reconstruction and Development. 

(Mobius, 2012)

Players in the bond market

The bond market includes three main players: issuers, investors and intermediaries.

Issuers are the organisations (e.g. governments and companies) that are looking to borrow money.

And since the requirements of these organisations often exceed the bank’s appetite, large bond issues are a good alternative for these borrowers.

Investors are individuals or institutions that provide capital to bond issuers.

Institutions such as insurance companies, mutual funds, pension funds and savings institutions dominate the bond market and account for most of the bond holdings globally.

And intermediaries are the market players that bring issuers and investors together. Think of merchant banks, investment banks, financial advisors and brokers.

These intermediaries play a vital role during issuing the bonds in the “primary market” and trading them in the “secondary market”.

(Mobius, 2012)

The primary market

When an organisation decides to issue a bond, the first step in the process is to contact a “underwriter” to arrange the sale.

Most of these primary market bond issues are done by the big well known investment banks like JP Morgan and Goldman Sachs.

And these underwriters are responsible for advising an issuer on the timing of the sale and the terms of the offering (e.g. interest rate + size of the offering).

To price the issue correctly is critical in the process in order to sell them well. And knowing the major purchasers of the bonds is essential as well for underwriters. Since they will be stuck with the bonds when they are unable to sell them.

Another aspect of the selling process is to obtain a rating from a rating agency giving a stamp of approval on the issue.

Favourable ratings are sought after by underwriters to make the bond more appealing. In fact, for some bond buyers a rating is required before a purchase is made.

In the next blog in this sequence “bonds” I will talk about the “bond ratings” and “rating agencies” in detail.

(Mobius, 2012)

Types of bonds

There are three types of bond ownership forms: Bearer bonds, registered bonds and book entry bonds.

The name bearer bonds describes that whoever holds, or bears, the bond is the owner. And the bond issuer has no control over how the bond ownership can be transferred since no record is kept of who owns them.

With registered bonds the issuers maintains a record of who owns each bond with the owner’s name and address printed on the certificate.

And with book entry bonds ownership is recorded electronically by a central depository or central register. Whenever a bond is sold the transfer from the old owner to the new owner is made by the depository on its computer records. 

(Mobius, 2012)

The secondary market

Once a bond has been issued in the primary market, then it can be traded in the secondary market.

Like in the bond market operated by the NYSE. However, most trading activity occurs electronically via computers and phones through a network of dealers.

In this secondary market investors purchase the existing bonds from other investors instead of the issuers.

Most bonds are traded by investment banks. So they are the market makers for specific debt issues. And investors who want to buy or sell a bond need to call the bank that makes a market in that bond, and ask for a price quotation.

(Mobius, 2012)

The Repo market

“Repo” is an abbreviation of “repossession”.

The “repo rate” is the discount rate that a central bank uses to repurchase government securities from commercial banks. And this depends on the level of money supply the central banks want to have in a country’s system.

So therefore to temporarily expand money supply the central bank decreases the repo rate. The commercial banks can then swap their government bond holdings for cash at a relatively low rate. And in order to reduce the money supply the central banks increase the repo rate.

So “repos” refer to “repurchase agreements” that involve selling and buying back a bond (or other financial asset). And this at an agreed price and a future date.

In other words, the seller is temporarily selling a financial asset in order to obtain a short term loan. And the securities are “pledged” as a collateral. But with the understanding that the seller must purchase the asset back in the future.

The difference between what the assets are sold for, and what the costs are to buy back, represents the interest gain (or repo rate). And this is the interest gain for the purchasing party when they return the asset to the original seller.

Repo transactions are conducted by institutions, professional investors and high net worth individuals. And central banks often use repos as a form of monetary control by adding or taking cash from the markets (through commercial banks).

(Mobius, 2012)

In the next blog in this sequence I will talk about “bond ratings” and “rating agencies”. Stay tuned!

Source used for this blog

·       Bonds – An introduction to the core concepts (2012). Mark Mobius. Publisher: Wiley.

For any corporate finance (M&A + valuation) professional I really recommend you to read the book. Since a good understanding of bonds is needed.

This in order to be able to determine the “cost of debt” in the WACC (weighted average cost of capital).

And to be able to model the “acquisition financing” in for example a Leveraged Buyout (LBO) or M&A model in Microsoft excel.

The book used as a source discusses the topic ‘bonds’ in a broad perspective, but also gives more than enough detail. Highly recommended! ??

Under here you can find my previous blogs (over 35) on valuation:

Earlier blogs on “net debt” (cash & debt free)

Article 1: Valuation: Introduction to "net debt" (cash & debt free)

https://www.dhirubhai.net/pulse/valuation-introduction-net-debt-cash-free-joris-kersten-msc-bsc-rab/

Article 2: Valuation: Net debt (cash & debt free)

https://www.dhirubhai.net/pulse/valuation-net-debt-cash-free-joris-kersten-msc-bsc-rab/

Article 3: Valuation: Adjusted net debt – Cash like items

https://www.dhirubhai.net/pulse/valuation-adjusted-net-debt-cash-like-items-kersten-msc-bsc-rab/

Article 4: Valuation: Adjusted net debt – Debt like items

https://www.dhirubhai.net/pulse/valuation-adjusted-net-debt-like-items-joris-kersten-msc-bsc-rab/

Earlier blogs on Financial Modelling

Article 1: Financial Modelling in Excel: Circular references, interest calculations and iterations

https://www.dhirubhai.net/pulse/financial-modelling-excel-circular-references-kersten-msc-bsc-rab/

Article 2: Excel basics for Finance: SUM, MAX, MIN, AVERAGE, IF, cell referencing, named ranges

https://www.dhirubhai.net/pulse/excel-basics-finance-sum-max-min-average-cell-named-joris/

Article 3: Excel for Valuation: COUNTIF, VLOOKUP, INDEX and MATCH

https://www.dhirubhai.net/pulse/excel-valuation-countif-vlookup-index-match-kersten-msc-bsc-rab/

Earlier blogs on “various topics”

Article 1: Financing a M&A transaction: An introduction

https://www.dhirubhai.net/pulse/financing-ma-transaction-introduction-joris-kersten-msc-bsc-rab/

Article 2: Valuation: How to adjust for “Operating Lease” (under Dutch GAAP)

https://www.dhirubhai.net/pulse/valuation-how-adjust-operating-lease-under-dutch-gaap-joris/

Article 3: M&A closing mechanisms: Locked Box & Completion Accounts

https://www.dhirubhai.net/pulse/ma-closing-mechanisms-locked-box-completion-accounts-joris/

Article 4: Scoping a financial model built primarily for business valuation:

https://www.dhirubhai.net/pulse/scoping-financial-model-built-primarily-business-joris/

Article 5: Consolidation of M&A targets and Purchase Price Allocation (PPA)

https://www.dhirubhai.net/pulse/consolidation-ma-targets-purchase-price-allocation-joris/

Earlier blogs on “bonds”

Article 1: Bonds - An introduction

https://www.dhirubhai.net/pulse/corporate-finance-bonds-introduction-joris-kersten-msc-bsc-rab/

Earlier blogs on “Valuation & funding of start-ups”

Article 1: Valuation & funding of start-ups - Funding rounds

https://www.dhirubhai.net/pulse/valuation-funding-startups-rounds-joris-kersten-msc-bsc-rab/

Article 2: Startup valuation: Pre-money and post-money valuation

https://www.dhirubhai.net/pulse/startup-valuation-pre-money-post-money-joris-kersten-msc-bsc-rab/

Article 3: Valuation methods for Startups (early stage) – Part 1

https://www.dhirubhai.net/pulse/valuation-methods-startups-early-stage-part-1-kersten-msc-bsc-rab/

Article 4: Valuation methods for Startups (early stage) – Part 2

https://www.dhirubhai.net/pulse/valuation-methods-startups-early-stage-part-2-kersten-msc-bsc-rab/

Earlier blogs on the “cost of capital”

Article 1: Valuation & Betas (CAPM)

https://www.dhirubhai.net/pulse/valuation-betas-capm-joris-kersten-msc-bsc-rab/

Article 2: Valuation & Equity Market Risk Premium (CAPM)

https://www.dhirubhai.net/pulse/valuation-equity-market-risk-premium-capm-joris-kersten-msc-bsc-rab/

Article 3: Is the Capital Asset Pricing Model dead ? (CAPM)

https://www.dhirubhai.net/pulse/capital-asset-pricing-model-dead-capm-joris-kersten-msc-bsc-rab/

Article 4: Valuation & the cost of debt (WACC)

https://www.dhirubhai.net/pulse/valuation-cost-debt-wacc-joris-kersten-msc-bsc-rab/

Article 5: Valuation & Capital Structure (WACC)

https://www.dhirubhai.net/pulse/valuation-capital-structure-wacc-joris-kersten-msc-bsc-rab/

Article 6: International WACC & Country Risk – Part 1

https://www.dhirubhai.net/pulse/valuation-international-wacc-country-risk-part-1-joris/

Article 7: International WACC – Part 2

https://www.dhirubhai.net/pulse/valuation-international-wacc-part-2-joris-kersten-msc-bsc-rab/

Article 8: Present Values, Real Options, the Dot.com Bubble

https://www.dhirubhai.net/pulse/valuation-present-values-real-options-dotcom-bubble-joris/

Article 9: Valuation: Different DCF & WACC techniques

https://www.dhirubhai.net/pulse/valuation-different-dcf-wacc-techniques-joris-kersten-msc-bsc-rab/

Article 10: Valuation of a company abroad

https://www.dhirubhai.net/pulse/valuation-company-abroad-joris-kersten-msc-bsc-rab/

Article 11: Valuation: Illiquidity discounts, control premiums and minority discounts

https://www.dhirubhai.net/pulse/valuation-illiquidity-discounts-control-premiums-joris/

Article 12: Valuation: Small firm premiums

https://www.dhirubhai.net/pulse/valuation-small-firm-premiums-joris-kersten-msc-bsc-rab/

Earlier blogs on “Business valuation to Enterprise Value”

From June until August I have written the following blogs on valuation:

1)    Leveraged Buyout (LBO) Analysis:

https://www.dhirubhai.net/pulse/leveraged-buyouts-lbos-joris-kersten-msc-bsc-rab/

2)    M&A Analysis – Accretion/ Dilution:

https://www.dhirubhai.net/pulse/ma-model-accretion-dilution-joris-kersten-msc-bsc-rab/

3)    Discounted Cash Flow Valuation:

https://www.dhirubhai.net/pulse/discounted-cash-flow-valuation-dcf-joris-kersten-msc-bsc-rab/

4)    Valuation Multiples 1 – Comparable Companies Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-1-comparable-companies-analysis-joris

5)    Excel Shortcuts & Business Valuation:

https://www.dhirubhai.net/pulse/excel-shortcuts-business-valuation-joris-kersten-msc-bsc-rab

6)    Valuation Multiples 2 – Precedent Transaction Analysis:

https://www.dhirubhai.net/pulse/valuation-multiples-2-precedent-transaction-kersten-msc-bsc-rab

Earlier blogs on Wall Street

Article 1: Wall Street – A general introduction

https://www.dhirubhai.net/pulse/wall-street-general-introduction-joris-kersten-msc-bsc-rab/

Article 2: Wall Street – The Federal Reserve banking system

https://www.dhirubhai.net/pulse/wall-street-federal-reserve-banking-system-kersten-msc-bsc-rab/

Training calendar

My training in “Business Valuation & Deal Structuring” this March 2020 in The Netherlands is rescheduled due to the corona virus.

But my NEW training calendar in The Netherlands is as follows:

1.     17, 18, 19, 20 and 22, 23 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;

2.     24, 25, 26, 27 and 29, 30 June 2020: 6 days - Business Valuation & Deal Structuring. Location: Uden/ The Netherlands;

3.     28, 29, 30, 31 October 2020 + 2, 3 November 2020: 6 days - Business Valuation & Deal Structuring. Location: Amsterdam Zuidas/ The Netherlands;

4.     16, 17, 18, 19 November 2020: 4 days - Financial Modelling in Excel. Location: Amsterdam Zuidas/ The Netherlands.

All info on these open training sessions can be found on: www.joriskersten.nl 

And 130 references on my training sessions can be found on: www.joriskersten.nl