Why do governments issue debt?

About the author

Article written in July 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Government debt

June 14, 2021 by Rodolphe CHOLLAT-NAMY

Government debt

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023) introduces you to government debt.

A government debt is a debt issued and guaranteed by a government. It is then owed in the form of bonds bought by investors (institutional investors, individual investors, other governments, etc.).

According to the OECD: “Debt is calculated as the sum of the following liability categories (as applicable): currency and deposits; debt securities, loans; insurance, pensions and standardized guarantee schemes, and other accounts payable.”

Before the Covid-19 crisis, the government debt of all countries in the world was estimated at $53 trillion. According to the IMF, it is expected to rise from 83% to 96% of world GDP as a result of the crisis.

In order to better understand debt, it is necessary to go back to several points. How does a government issue debt? Who holds government debt? How is government debt measured?

How does a government issue debt?

There are two principal ways to issue bonds: syndication and auction.

Syndication

Syndication is the most common way to issue debt. It is when several financial institutions join together to ensure the placement of a bond with investors in order to reduce their risk exposure. However, since the 1980’s, governments tend to use the auction method.

Auction

The auction can be “open”, i.e. all direct participants in public securities auctions (credit institutions, management and intermediation companies, etc.) have the possibility of acquiring part of the security put up for auction. It can also be “targeted”, i.e. the issue is reserved only for the primary dealers – banks or other financial institutions that has been approved to trade securities – of the issuing State.

A few days before the planned date of an auction, the State makes an announcement, confirming, postponing or cancelling the operation. It also gives the characteristics of the securities to be issued, i.e. the type of securities, the maturity and the amount it wishes to raise. Buyers can then submit several bids, each specifying the desired quantity and price. The issue lines are then auctioned to the highest bidders. The higher the demand is, the lower the issue rate is.

Auction is used because it provides investors, among other things, with transparency and free competition on an investment product with an attractive benefit in relation to a low risk level.

Each country that issues bonds uses different terms for them. UK government bonds, for example, are referred to as gilts. In the US, they are referred to as treasuries: T-bills (that expire in less than one year), T-notes (that expire in one to ten years) and T-bonds (that expire in more than ten years). In France, the government issues short-term liabilities (“Bons du Trésor”) and long-term liabilities (“OAT for “Obligations Assimilables du Trésor”) with maturity between 2 and 50 years.

Who holds government debt?

Government debt can be broken down into domestic and external debt depending on whether the creditors are residents or non-residents.

Domestic debt

Domestic debt refers to all claims held by economic agents (households, companies, financial institutions) resident in a sovereign state on that state. It is mostly denominated in the national currency. A government can call for savings, but savings used to finance the deficit can no longer be used to finance private activity and in particular productive investment. This is known as the crowding-out effect. A government must therefore deal with this limit.

External debt

External debt refers to all debts owed to foreign lenders. A distinction must be made between gross external debt (what a country borrows from abroad) and net external debt (the difference between what a country borrows from abroad and what it lends abroad). A level of debt that is too high can be dangerous for a country. In the event of fluctuations in the national currency, the interest and principal amounts of the external debt, if denominated in foreign currency, can quickly become a burden leading to default.

The case of France

In France, non-residents are the main holders of French public debt. They hold 64% of the bonds issued by the government. They are institutional investors, but also sovereign investment funds, banks and even hedge funds. In addition, as regards domestic debt, French insurance companies hold nearly 20% of French securities. They are used for life insurance investments. Finally, French banks and French mutual funds hold 10% and 2% respectively.

How to measure government debt?

While the French debt has risen from 2000 billion euros in 2014 to 2700 billion in 2021, the debt burden has fallen from 40 billion to 30 billion. What do these two ways of looking at a country’s debt mean?

In the European Union, the current measure of public debt is the one adopted by the Maastricht Treaty. It takes into account the nominal amount borrowed. This is a relevant criterion for measuring the government’s budgetary misalignments, i.e. its financing needs. It also makes it possible to introduce debt rules: the debt must be less than 60% of GDP.

Another way of measuring debt is to take into account the interest charges on public debt. This criterion makes it possible to account for the cost of the debt and not its amount. It is this criterion that must be considered in order to anticipate future financing needs, to plan taxes and interest charges in the government budget.

Useful resources

Rating agencies

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023).

Examples of companies issuing bonds

June 14, 2021 by Rodolphe CHOLLAT-NAMY

Examples of companies issuing bonds

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) provides you with examples of companies issuing bonds.

In order to better understand corporate bonds, it is appropriate to look at recent issues to see their different characteristics: Veolia, Essilorluxottica and LVMH.

Véolia: EUR 700 million 6-year bond issuance with negative interest rate

The company

Veolia is a French multinational utility company. It markets water, waste and energy management services for local authorities and companies.

It employs more than 163,000 employees and had revenues of €27 billion in 2019.

The company recently made headlines in the financial news with its takeover bid for Suez. After months of financial, political and media battle, the French giants finally agreed on a merger. The new group is expected to have a 5% share of the world market with 230,000 employees.

The bond issuance

On Monday, January 11, 2021, Veolia issued €700 million of bonds maturing in January 2027 at a negative rate of -0.021%.

This is the first time that a BBB-rated issuer has obtained a negative rate for this maturity. This was due to strong demand from investors who welcomed the transaction. As a result, the order book reached up to 2 billion euros, which allowed for a negative yield. This reflects the very positive perception of Veolia, as well as the credibility of its proposed merger with Suez.

This example is quite symptomatic of the low-rate period we are currently in. Indeed, we see here that a company can take on debt at negative rates.

Essilorluxottica: €3 billion bond issuance

The company

EssilorLuxottica is a Franco-Italian multinational company, resulting from the 2018 merger of the French company Essilor and the Italian company Luxottica. It is one of the leading groups in the design, production and marketing of ophthalmic lenses, optical equipment, prescription glasses and sunglasses.

The group employs more than 153,000 people and had sales of EUR 14 billion in 2002.

The bond issuance

On Thursday, May 28, 2020, EssilorLuxottica issued €3 billion of bonds. The bonds have maturities of 3.6 years, 5.6 years and 8 years, with rates of 0.25%, 0.375% and 0.5% respectively.

Demand was very high as the order book reached almost 11 billion euros, reflecting investors’ confidence in EssilorLuxottica’s model.

This example allows us to notice that during an issue, bonds of different maturities can be issued at the same time. This allows us to respond adequately to financing needs by allowing us to play on the maturity and therefore on the rates. Here, the rates increase with time. In fact, outside of recessionary periods, this correlation is observed because the risks for investors increase with time. In the same way, their money is immobilized for a longer period of time and therefore must be remunerated for that.

LVMH: 9.3-billion-euro bond issuance

The company

LVMH is a French group of companies, today a world leader in the luxury goods industry. The firm has a portfolio of seventy brands including Moët, Hennessy, Louis Vuitton, Dior, Céline, …

The group employs more than 163,000 employees and had a turnover of 53 billion euros in 2019.

Announced in November 2019, then canceled because of Covid-19, the takeover of Tiffany finally took place in January 2021 for a total amount of $ 15.8 billion.

The bond issuance

On February 6, 2020, LVMH issued €9.3 billion in bonds, denominated in euros and pounds sterling. This was the largest bond issue in Europe since AB inBev in 2016. The maturities of the bonds issued range up to 11 years with a yield of 0.45%. Some tranches, including the four-year euro tranche, have a negative yield. The overall cost of this financing is estimated at 0.05%.

The purpose of this issue was to refinance the acquisition of Tiffany. It received strong interest from investors with an order book of nearly 23 billion euros. In addition, LVMH benefited from very favorable market conditions. Indeed, January had been rather weak in terms of the volume of issues by companies in the investment grade category and had been dominated by those in the high yield category. Thus, investors had a lot of liquidity to invest in more secure investments. Finally, LVMH issues few bonds even though the group is highly rated. Investors were therefore looking to acquire its debt.

This example allows us to understand the conditions of a record issue. Moreover, it also allows us to underline that it is possible to resort to borrowing to finance new projects, current expenses or, in this case, an acquisition.

Useful resources

Rating agencies

▶ Rodolphe CHOLLAT-NAMY Bond valuation

▶ Rodolphe CHOLLAT-NAMY Bond risks

▶ Rodolphe CHOLLAT-NAMY Bond markets

▶ Bijal GANDHI Credit Rating

▶ Jayati WALIA Credit risk

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

The rise in corporate debt

June 14, 2021 by Rodolphe CHOLLAT-NAMY

The rise in corporate debt

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) analyzes the rise in corporate debt.

Since the financial crisis of 2007-2008, the level of debt in the world has increased significantly. Global debt, which includes the debt of (non-financial) corporations, financial institutions, governments and households, has risen from 292% of global GDP in 2008 to 318% in 2018. This increase in global debt is primarily driven by the growth of non-financial corporate debt after the subprime crisis. Indeed, the debt of non-financial companies rose from 78% to 92% of GDP between 2008 and 2018. What are the reasons for this increase? How did the coronavirus crisis impact debt levels? What are the consequences of rising debt levels?

Growth in corporate debt through the bond markets, mainly driven by emerging countries

An increase linked to an increase in bond issues

Until the 2008 crisis, the banking sector was the fastest growing corporate financing tool, notably through international banks. Since the 2008 crisis, there has been a shift. Companies then began to take on more debt on the financial markets (bonds) than from banks (credit). Thus, the increase in corporate debt since the 2008 crisis has been mainly through the bond markets. The main driver of this increase is the accommodating monetary policies pursued by the developed economies.

An increase driven by developing countries

Moreover, the rise in non-financial corporate debt has not been uniform across the world. It has actually been concentrated in emerging economies. Between 2008 and 2018, this type of debt in emerging economies grew from $9 trillion to $28 trillion. This growth is much faster than the growth of the GDP of these countries. Indeed, over the same period, the debt of non-financial companies has increased from 56% to 96% of GDP. At the same time, the debt of non-financial corporations has grown at the same rate as GDP since 2008 in the developed economies (with the exception of China).

The growing share of bond markets, in the case of emerging economies, is noteworthy. Indeed, between 2008 and 2018, the share of bonds in the total debt of non-financial companies in emerging economies rose from 19% to 32%, effectively increasing by 13 percentage points.

A rise in non-financial private sector debt with the Covid-19 pandemic

The exceptional measures taken by governments around the world eased financial conditions to support the economy of their own country. This response to the pandemic helped maintain the flow of credit to households and businesses, facilitated the recovery and contained financial risks. Nevertheless, this support has increased private non-financial sector indebtedness in both advanced and emerging economies.

While we saw above that the debt-to-GDP ratio of firms in developed countries was constant between 2008 and 2018, it worsened with the Covid-19 pandemic. The debt of private non-financial firms in developed countries rose from 149% of GDP in Q3 2019 for the US to 160% in Q3 2020. Similarly, debt of private non-financial firm in the Eurozone rose from 120% to 129% over the same period. Debt levels are not uniformly high as it depends on the size of the company and its sector of activity.

Companies have had massive recourse to borrowing first of all to cope with their cash flow difficulties, between a fall in activity and marked tensions in terms of payment. In addition to this, there is also a precautionary attitude which is pushing companies to use their borrowing capacity to the maximum in order to build up an extra cash cushion. Finally, large companies will also take advantage of borrowing facilities for other purposes. In particular, they will use debt to conduct share buyback programs and pay dividends.

What are the consequences of increased debt?

The growth in debt financing can have a number of positive aspects. It may indicate that firms are less constrained in their financing, allowing them to raise more funds to pursue profitable investment projects and expand. Similarly, it may mean that firms are obtaining new financing outside the traditional banking system, which helps them grow by diversifying their sources of funding.

However, it also poses a number of risks. In the aftermath of the Covid-19 crisis, corporate debt reached a worrying level. The question is: how will companies manage the repayment of their debt?

The accumulation of high levels of debt in a period of weak economic growth and declining corporate profits has been accompanied by increased default risks.

In addition, refinancing risks may have increased, as the fastest growth in corporate debt has been through bond financing, which is more difficult to refinance.

Finally, the post-covid recovery is likely to be asynchronous and divergent across countries. Financial conditions are likely to tighten in developed country markets, making it more difficult to finance companies in emerging economies.

Useful resources

Rating agencies

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Credit analyst

June 14, 2021 by Rodolphe CHOLLAT-NAMY

Credit analyst

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to the job of credit analyst.

Within an investment bank, several jobs are directly linked to bonds. Among them is that of credit analyst. What does a credit analyst do? What are the qualities required to be a credit analyst?

The missions of a credit analyst

Within a bank, the role of the credit analyst is to study in depth the financial situation of companies (risk assessment, analysis of strengths and weaknesses, analysis of financial accounts, etc.) in order to determine their solvency.

More concretely, analysts have three main tasks:

Firstly, as mentioned above, analysts conduct in-depth analyses of the financial statements and credit applications of the companies under their responsibility. They keep abreast of their current situation and closely monitor any developments that may affect their debt capacity.

Secondly, analysts provide recommendations related to the analysis and evaluation of the credit risk. If they think that the company is solid, they can for example propose to buy bonds of this company, which would thus constitute a safe investment. On the other hand, if they believe that the risk of default is increasing, they will propose to sell.

Finally, a significant part of analysts’ job is to present their results. This may take the form of a daily summary publication, or a more in-depth quarterly or annual publication. In addition, analysts may have to meet with the bank’s clients, mainly investors, to present their recommendations.

In addition, there may be ancillary tasks. For example, analysts may seek to develop new mathematical and statistical models to improve their understanding of bond risks.

What is the day-to-day life of a credit analyst like?

Analysts’ day starts early, before the financial markets open, so that he has time to brief investors on the latest bond news in the sectors they follow.

After that, their day depends very much on the calendar of the companies he or she follow. During the quarterly publications of these companies, they will spend time reading them and collecting the information contained in them. Similarly, they will attend the various conferences organized by these companies to explain the published results. The rest of the time, they will analyze this information, update their projection models and update their recommendations.

As the end of the semester or the year approaches, credit analysts’ days can become longer because they have to produce a semiannual or annual publication in which their recall the economic context and their recommendations. Following the publication of this, they will often make a tour of their clients to present it. This is known as a roadshow.

The qualities required to be a good credit analyst

Several qualities are necessary to be a good credit analyst.

First of all, credit analysts have strong corporate finance skills. In particular, they have a good understanding of corporate debt and liquidity ratios. The main ratios are: the debt-to-equity ratio which informs on the financial structure of the company, the interest coverage ratio which measures the capacity of a company to pay its interests and the debt-to-EBITDA ratio which measures the capacity of the company to repay its debt with the money generated by its activity.

Secondly, it is imperative to be very rigorous. Indeed, the quality of the analyses depends on the data collected. Analysts cannot afford to make mistakes in the figures they report. To this end, they have recourse to several sources of information: companies’ annual reports, press releases, financial statements, as well as market analyses produced by other players. It is important to note that all this information is public. Indeed, for legal reasons, to avoid insider trading, analysts have limited access to the information.

In addition, analysts must have strong synthesis skills. It is their analysis that investors will buy. It must therefore be as relevant as possible in order to present the best possible guidance. Moreover, the format of these analyses must also be carefully designed. They must be easily understandable by its readers. Analysts must therefore have presentation skills in order to sell them. It is important to take care of the content and the form.

Finally, analysts improve over time. They usually cover a particular sector. For example, he or she will be a specialist in the automotive sector. The better their knowledge of the sector, the more relevant their analysis. To do this, they must be familiar with the general environment of the sector they are following in order to identify future trends. Secondly, they must build up a database of the companies they follow. The more accurate and long-standing the database, the better they will be able to put the new information they collect into perspective.

Useful resources

Rating agencies

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Why do companies issue debt?

June 14, 2021 by Rodolphe CHOLLAT-NAMY

Why do companies issue debt?

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) provides insights into why companies issue bonds.

A company can finance its activities in different ways: by internal financing (self-financing) and by external financing comprising debt and equity. Often, internal funds are not sufficient. The company must therefore make a choice between raising debt and raising equity. So, it is necessary to ask what might lead a company to prefer one over the other.

The advantages of debt over equity for a company

Debt is often preferred to equity because it is structurally less costly for the following reasons:

– The interest on the debt is tax deductible. The debt therefore costs the interest minus the tax savings (assuming that the company makes profit and pays taxes…).

– Investing in stocks is riskier than investing in bonds because of a number of factors. For instance, the stock market has a higher volatility of returns than the bond market, capital gains are not a guarantee, dividends are discretionary, stockholders have a lower claim on company assets in case of company default. Therefore, investor expect higher returns to compensate it for the additional risk. Thus, for the company, financing itself through debt will be less expensive than through equity.

– The remuneration of the debt is not strictly proportional to the increase of the risk taken by the company, because there are multiple ways for lenders to take guarantees: leasing, mortgage….

Debt has other advantages over equity:

Debt can be used to gain leverage. It provides a leverage effect for shareholders who contribute only part of the sums mobilized in the investment. This effect is all the more important when the interest rate at which the debt is subscribed is low and the economic profitability of the investment is high.

Raising equity dilutes ownership of existing stockholders. When a company sells equity, it gives up ownership of its business. This has both financial and day-to-day operational implications for the business. Debt does not imply such a dilution effect.

There is a practical benefit for using debt. Issuing debt is easier than issuing equity in practice.

Finally, the terms of repayment of principal and interest payments are known in advance. This allows companies to anticipate future expenses.

The disadvantages of debt over equity

First, unlike equity, debt must be repaid at some point. This is because equity financing is like taking a share in the company in exchange for cash. Thus, where cash outflows are required to pay interest on debt and repay principal, this is not useful for equity.

Moreover, in equity financing, the risk is carried by the stockholders. If the company fails, they will lose their stake in the company. In contrast, in debt financing, creditors often require assets to be secured. Thus, if the company goes bankrupt, they can take the collateral.

Finally, the debt capacity of a company is limited. Indeed, the more debt a company takes on, the higher the risk of default. Thus, creditors will ask an already highly leveraged company for higher interest rates to compensate for the risk they are taking. Conversely, equity financing allows companies to improve their capital structure, and thus present better debt ratios to investors.

Useful resources

Rating agencies

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Corporate debt

May 30, 2021 by Rodolphe CHOLLAT-NAMY

Corporate debt

In this article, Rodolphe Chollat-Namy (ESSEC Business School, Grande Ecole – Master in Management, 2019-2023) introduces you to corporate debt.

Investors seek to determine how the different characteristics of a bond can influence its intrinsic value in order to know whether it is a good investment or not. To do this, they will look at the theoretical value of a bond, i.e. its present value. How can this be determined? How to interpret it?

Composition of a company’s debt

The debt of a company is composed of short-term liabilities and of long-term liabilities.

Short-term liabilities: accounts payable, deferred revenues, wages payable, short-term notes, current portion of long-term debt.

Long-term liabilities: Bonds payable, capital leases, long-term loans, pension liabilities, deferred compensation, deferred income taxes.

Let us have a look to the long-term liabilities:

Bonds payable: A bond payable is a form of long-term debt issued by the company.
Capital leases: A capital lease is a contract entitling a renter to the temporary use of an asset.
Long-term loans: A long-term loan involve borrowing money over a specified period with a pre-planned payment schedule.
Pension liabilities: A pension liability is the difference between the total amount due to retirees and the actual amount of money the company has on hand to make those payments.
Deferred compensation: Deferred compensation is an arrangement in which a portion of an employee’s income is paid out at a later date after which the income was earned.
Deferred income taxes: Deferred income taxes result from a difference in income recognition between tax laws and the company’s accounting methods.

When looking at a company’s debt, analysts often look at net debt. It is equal to the sum of the short-term liabilities and of the long-term liabilities minus the cash and the cash equivalents, that are liquid investments with a maturity of 90 days (certificates of deposit, treasury bills, commercial paper, …). It is a metric that measures a company’s ability to bay all its debts if they were due today.

For example, assume that a company has a line of credit of $5,000, a current portion of long-term debt of $25,000, a $60,000 long-term bank loan, and $40,000 in bonds. Moreover it has $10,000 in cash and $5,000 in Treasury bills.

The short-term debt would be equal to $5,000 + $25,000 = $30,000

The long-term debt would be equal to $60,000 + $40,000 = $100,000

And the cash and cash equivalents would be equal to $10,000 + $5,000 = 15,000

So the net debt of the company would be equal to $115,000.

Debt Ratios

Nevertheless, an absolute value will not give us much indication of the health of the company. In order to understand the company’s indebtedness, we need to compare the amount of debt with other metrics. To do this, we will use what are called ratios.

We will focus here on three important ratios: the debt-to-equity ratio, the EBIT-to-interest expenses ratio and the debt-to-EBITDA ratio.

Debt-to-equity ratio (D/E)

The D/E ratio, also known as gearing, is a ratio that measures the level of debt of a company in relation to its equity. Simply put, it tells us about the financial structure of the company.

Changes in long-term liabilities have more influence on the D/E ratio than changes in short-term liabilities. Thus, investors will use other ratios if they want information on short-term liabilities.

The higher the ratio, the more indebted the company is. The risk is therefore higher. Between 0 and 0.1, the ratio is theoretically excellent. Above 1, the ratio is theoretically bad.

Beware, this ratio has its limitations. First of all, the reading of this ratio depends on the industries. Capital intensive industries, such as TMT or oil and gas, will tend to have higher ratios. It is therefore necessary to compare the ratios of companies in the same sector. On the other hand, a low D/E ratio can also mean that a company is afraid to invest. In the long run, this can present a risk of downgrading compared to its competitors.

It is therefore important to keep in mind, and this is also true for other ratios, that it is one indicator among others and that it cannot be perfect. It is important to put it into context and to compare comparable companies.

Interest Coverage ratio (ICR)

The ICR is the ratio of financial expenses to operating income. It measures a company’s ability to pay the interest on its debt.

A low ICR means that less profit is available for interest payments and that the company is more vulnerable to rising interest rates.

Usually, the ICR is considered low when it is below 3. However, it varies according to the type of industry. On the other hand, we can also look at the trends that are emerging. A falling ICR is worrying for investors.

Debt-to-EBIDTA ratio

This ratio measures the company’s ability to repay its debt with the money generated by its activity. It tells us how many years of profit it would take to pay off the entire debt. It is often referred to as leverage.

Analysts often use this ratio, which is easy to calculate. The lower the ratio, the healthier the company. A good ratio is between 2 and 4. However, again, it depends on the industry.

About the author

Article written in May 2021 by Rodolphe Chollat-Namy (ESSEC Business School, Grande Ecole – Master in Management, 2019-2023).

Bond risks

May 30, 2021 by Rodolphe CHOLLAT-NAMY

Bond risks

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to bond risks.

Holding bonds exposes you to fluctuations in its price, both up and down. Nevertheless, bonds offer the guarantee of a coupon regularly paid during for a fixed period. Investing in bonds has long been considered one of the safest investments, especially if the securities are held to maturity. Nevertheless, a number of risks exist. What are these risks? How are they defined?

Default risk

Default risk is the risk that a company, local authority or government fails to pay the coupons or repay the face value of the bonds they issued. This risk can be low, moderate or high. It depends on the quality of the issuer.

For a given product, the default risk is mainly measured by rating agencies. Three agencies share 95% of the world’s rating requests. Moody’s and Standard & Poor’s (S&P) each hold 40% of the market, and Fitch Ratings 14%. The highest rated bonds (from Aaa to Baa3 at Moody’s and from AAA to BBB- at S&P and Fitch) are investment-grade bonds. The lowest rated bonds (Ba1 to Caa3 at Moody’s and BB+ to D at S&P and Fitch) are high yield bonds, otherwise known as junk bonds.

It should be noted that the opinions produced by an agency are advisory and indicative. Moreover, some criticisms have emerged. As agencies rate their clients, questions may be asked about their independence and therefore their impartiality. The analysis done aby rating agencies is most of the time paid by the entities that want their product to be rated.

In addition, companies issuing bonds are increasingly using the technique of “debt subordination”. This technique makes it possible to establish an order of priority between the different types of bonds issued by the same company, in the event that the company is unable to honor all its financial commitments. The order of priority is senior, mezzanine and junior debt. The higher the risk is, the higher the return is. It should also be noted that bonds have priority over equity.

To highlight the level of risk of an issuer, one can compare the yield of its bonds to those of a risk-free issuer. This is called the spread. Theoretically, it is the difference between the yield to maturity of a given bond and that of a zero-coupon bond with similar characteristics. The spread is usually measured in basis points (0.01%).

Liquidity risk

Liquidity risk is the degree of easiness in being able to buy or sell bonds in the secondary market quickly and at the desired price (i.e. with a limited price impact). If the market is illiquid, a bondholder who wishes to sell will have to agree to a substantial discount on the expected price in the best case, and will not be able to sell the bonds at all in the worst case.

The risk depends on the size of the issuance and the existence and functioning of the secondary market for the security. The liquidity of the secondary market varies from one currency to another and changes over time. In addition, a rating downgrade may affect the marketability of a security.

On the other hand, it may be an opportunity for investors who want to keep their illiquid bonds. Indeed, they usually get a better return. This is called the “liquidity premium”. It rewards the risk inherent in the investment and the unavailability of funds during this period.

Interest rate risk

The price of a bond fluctuates with interest rates. The price of a bond is inversely correlated to interest rates (the discount rate used to compute its present value). Indeed, the nominal interest rates follow the key rates. Thus, if rates rise, the coupons offered by new bonds will be higher than those offered by older bonds, issued with lower rates. Investors will therefore prefer the new bonds, which offer a better return, which will automatically lower the price of the older ones.

The interest rate risk is increasing with the maturity of the bond (more precisely its duration). The risk is low for bonds with a life of less than 3 years, moderate for bonds with a life of 3 to 5 years and high for bonds with a life of more than 5 years. However, interest rate risk does not impact investors who hold their bonds to maturity.

Inflation risk

Inflation presents a double risk to bondholders. Firstly, if inflation rises, the value of an investment in bonds will necessarily fall. For example, if an investor purchases a 5% fixed-rate bond, and inflation rises to 10% per year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. Secondly, high inflation can lead central banks to raise rates in order to tackle it, which, as we can see above, will depreciate the value of the bond.

To protect against this, some bonds, floating-rates bonds, are indexed to inflation. They guarantee their holders a daily readjustment of the value of their investment according to the evolution of inflation. However, these bonds have a cost in terms of return.

As with interest rate risk, the risk increases with the maturity of the bond. Also, the risk rises as the coupon decreases. The risk is therefore very high for zero-coupon bonds.

Currency risk

An investor can buy bonds in a currency other than its own. However, as with any investment in a foreign currency, the return on the bond will depend on the rate of that currency relative to the investor’s own currency.

For example, if an investor holds a $100 US bond. If the EUR/USD exchange rate is 1.30, the price of the bond will be €76.9. If the euro appreciates against the dollar and the exchange rate rises to 1.40, the price of the bond will be €71.4. Thus, the investor will lose money.

Useful resources

Rating agencies

▶ Rodolphe CHOLLAT-NAMY Bond valuation

▶ Rodolphe CHOLLAT-NAMY Bond markets

▶ Bijal GANDHI Credit Rating

▶ Jayati WALIA Credit risk

About the author

Article written in May 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Bond valuation

May 30, 2021 by Rodolphe CHOLLAT-NAMY

Bond valuation

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023) introduces you to bond valuation.

Present value of a bond

The price of a bond is equal to the present value of the cash flows it generates. The holder of a bond will, by definition, receives a set of cash flows that will be received over a period of time. These flows are not directly comparable. A euro at time t1 does not have the same value as a euro at time t2. It is therefore necessary to determine the present value of future cash flows generated by the bond. This is calculated by multiplying these flows by a discount factor.

The discount rate chosen for this operation is determined by observing those already applied on the market to bonds comparable in duration, liquidity and credit risk. The convention is to discount all flows at a single rate, even if this does not reflect reality.

The present value of a bond is equal to the sum of the present value of the nominal amount and the present value of future coupons.

Where:

C = coupon payment
r = discount rate
F = face value of the bond
t = time of cash flow payment
T = time to maturity

This formula shows that the present value of the security varies with the discount rate. In addition, the longer a bond has to mature, the greater the impact of discounted income on the value. This is known as the bond’s sensitivity.

Note that this formula includes the accrued coupon. This is known as the <i>gross</i> price. Most often the price in question is the price at the coupon footer. This is known as the clean price.

Now, let us see an application of this formula:

Consider a 2-year coupon bond with a 5% coupon rate and a nominal value of €1,000. We assume that coupons are paid semi-annually. A 3% discount rate is used. What is its present value?

The result is PVbond = €1,038.54

Yield To Maturity (YMT)

The YTM (“taux de rendement actuariel” in French) represents the rate of return on a bond for someone who buys it today and holds it to maturity. This is equivalent to the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.

To calculate the yield to maturity of a bond, the compound interest – in other words “interest on interest” – method is used. This method takes into account the fact that the interest from holding a bond is added back to the principal each year and itself generates interest.

The YTM is the rate that equates the price of the bond with the present value of the future coupons and the final repayment.

We therefore have the following relation:

Where y corresponds to the YTM.

Example

Let us take an example:

Consider a 3-year coupon bond with a 10% coupon rate and a nominal value of €1,000. We assume that the present value of the bond is €980. What is the yield to maturity?

To find out the yield to maturity, you have to solve the following equation:

The YMT is 10.82%.

If a bond’s coupon rate is less than its YMT, then the bond is selling at a discount. If a bond’s coupon rate is more than its YMT, then the bond is selling at a premium. If a bond’s rate is equal to its YTM, then the bond is selling at par.

Useful resources

longin.fr Evaluation d’obligations à taux fixe

About the author

Article written in May 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023).

Bond Markets

May 24, 2021 by Rodolphe CHOLLAT-NAMY

Bond markets

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to bond markets.

The bond market allows the financing of medium and long-term needs of States, local authorities and companies. In return, it offers opportunities to invest medium and long-term financing capacities. In order to understand the bond market, it is necessary to distinguish two markets. The primary market, where bonds are issued, and the secondary market, where they are traded. What are their characteristics?

The primary market

When an organization issues new bonds, it uses the primary bond market, where its securities are acquired by various investors.

The issue price of a bond is expressed as a percentage of the face value of the security. If the issue price is 100%, the price is said to be at par. If the issue price is above 100%, the price is said to be above par. If the issue price is below 100%, the price is said to be below par.

The nominal interest rate is used to calculate the coupon that will be paid to the bondholder. The interest rate at the issuance date depends on the default risk of the issuer reflecting its financial quality. This default risk is usually evaluated by rating agencies (S&P, Moody’s, Fitch).

There are two principal ways to issue bonds: syndication and auction.

Syndication

Syndication is the most common way to issue debt, widely used by companies, governments and other organizations. Syndication is when several financial institutions join together to ensure the placement of a bond with investors in order to reduce their risk exposure.

In a syndication, there are two types of financial institution: the lead bank, which arranges the transaction and manages the loan syndication, and the so-called “junior” banks, which participate in the transaction without setting the terms.

There are two types of syndication. “Full commitment” is where the lead bank commits to providing the company with the capital it needs and then subcontracts part of the financing to the other members of the syndicate to limit its exposure. “Best effort” is when the amount of the loan is determined by the commitments that the banks are willing to make in a financing transaction.

Auction

Auction is used by governments only. It is their preferred method of issuing sovereign debt. It allows the acquisition of a debt security through an auction system.

Auction is used because it provides investors, among other things, with transparency and free competition on an investment product with an attractive benefit in relation to a low risk level.

The secondary market

Once issued, a bond can be traded on the secondary bond market. It then becomes a tradable financial instrument, and its price fluctuates over time.

On entering the market, a bond will compete with other bonds. If it offers a higher return than other bonds for the same risk, the bond will be in demand, which will drive up its price. For the most part, transactions are conducted over the counter (OTC). Buyers and sellers interrogate several “market makers” who give them buying or selling prices, and then choose the intermediary who makes the best offer.

A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the CAC40 for stocks. The most common American benchmarks are the Barclays Capital Aggregate Bond Index and Citigroup BIG.

A bond is quoted as a percentage of its face value. Thus, if it is trading at 85% of its nominal value of €1,000, it is quoted at €850. In addition, the bond is quoted at the coupon footer, i.e. without the accrued coupon.

The accrued coupon is the interest that has been earned but not yet paid since the most recent interest payment. It is calculated as follows: accrued coupon = (number of days/365) x face rate – with the face rate being the rate on the basis of which interest is calculated at the end of a full year for the nominal value of the bond -.

To better understand this mechanism, let us take an example:

Consider a 6% bond with a nominal value of €1,000, with an entitlement to dividends on 12/31 (coupon payment date). It is assumed that the bond is worth €925 on 09/30.

Gross annual interest: 1,000 x 6% = €60.

The accrued coupon on 09/30 is: 60 x 9/12 = 45 €.

Quotation at the foot of the coupon: 925 – 45 = €880.

Percentage quotation: 880 x 100/ 1000 = 88%.

The quoted price will be: 88%.

In the market, bondholders are subject to risks (interest rate risk, exchange rate risk, inflation risk, credit risk, etc.). We will come back to this in a future article.

Useful resources

Rating agencies

▶ Rodolphe CHOLLAT-NAMY Bond valuation

▶ Rodolphe CHOLLAT-NAMY Bond risks

▶ Bijal GANDHI Credit Rating

▶ Jayati WALIA Credit risk

About the author

Article written in May 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Introduction to bonds

April 12, 2021 by Rodolphe CHOLLAT-NAMY

Introduction to bonds

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to bonds.

While the bond market is growing fast and is worth about $115,000 billion as of 2021, in the following series of articles we will try to understand what it is all about. It is therefore appropriate here, firstly, to try to define what a bond is.

What is a bond?

A bond is a debt security, i.e. a tradable financial asset, that represents a loan made by an investor to a borrower. It allows the issuer to finance its investment projects and the creditor to receive interest payments at regular intervals until maturity when it is repaid the nominal amount. Creditors of the issuer are also known as debt holders.
Bonds are fixed-income securities because you know from the debt contract the exact amount of cash you can expect in the future, provided you hold the security until maturity.

What are the main characteristics of a bond?

A bond has several characteristics:

The face value, also known as the par value or principal, equal to the original capital borrowed by the bond issuer divided by the number of securities issued.
The maturity, which expresses the number of years to wait for the principal to be repaid. This is the life of the bond. The average maturity of a bond is ten years.
The coupon, that refers to the payment of interest to the creditor at regular intervals. The interest rate paid may be fixed or variable. It is the creditor’s remuneration for the risk taken as a bondholder. The higher the risk, the higher the return, the coupon, will be.

Example

Let us take the example of a company needs to borrow ten million euros in the bond market.

It decides to issue fixed-rate bonds. It divides this issuance into 1,000 shares of €10,000. The face value of each bond is therefore €10,000. The nominal interest rate is set at 5%. Interest payments are made on an annual basis. The annual coupon is then equal to €500 (=0.05*10,000). The maturity of the bond is set at 10 years.

In terms of cash flows, you will receive €500 per year for ten years. At the end of the tenth year, the issuer will pay you a final installment of €10,000 in addition to the interest payment of €500.

What are the different types of bonds?

The bonds issued can be diverse. Their maturity, interest rate and repayment terms vary. In order to better understand them, we must first distinguish their issuer and then the terms of payment of interest.

Types of issuers

There are three main types of issuers: governments, local authorities, and companies.

Government bonds

A government bond represents a debt that is issued by a government and sold to investors to support government spending. They are considered low-risk investments since the government backs them. So, because of their relative low risk, they are typically pay low interest rates. Country that issues bonds use different terms for them. UK government bonds, for example, are referred to as gilts. In the US, they are referred to as treasuries: T-bills (expire in less than one year), T-notes (expire in one to ten years) and T-bonds (expire in more than ten years).

Municipal bonds (“munis”)

A municipal bond represents a debt that is issued by a local authority (a state, a municipality, or a county) to finance public projects like roads, schools and other infrastructure. Interest paid on municipal bonds is often tax-free, making them an attractive investment option. Because of this tax advantage and of the backing by their issuer, they are also pay low interest rates.

Corporate bonds

A corporate bond represents a debt that is issued by a company in order for it to raise financing for a variety of reasons such as ongoing operations (organic growth) or to expand business (mergers and acquisitions). They have a maturity of at least one year, otherwise they are referred to as commercial paper. They offer higher yields than government or local authority bonds because they carry a higher risk. The more fragile the company is, the higher the return offered to the investor is. They are divided into two main categories High Grade (also called Investment Grade) and High Yield (also called Non-Investment Grade, Speculative Grade, or Junk Bonds) according to their credit rating reflecting the firm financial situation.

Technical characteristics

In addition, the way in which interest is paid may vary from one bond to another. For this purpose, there are several types of bonds:

Fixed-rate bonds

A fixed-rate bond is a bond with a fixed interest rate that entitles the holder to receive interest payments at a predetermined frequency. The interest rate is set when the bond is issued and remains the same throughout the life of the bond. This is the most common type of bond.

Floating-rate notes

A floating-rate note is a bond with an interest rate that changes according to market conditions. The contract of issuance fixes a specific reference serving as a basis for the calculation of the remuneration. For example, the most common references for European bonds are Eonia and Euribor.

Zero-coupon bonds

A zero-coupon bond is a bond that does not pay regular interest. They are therefore sold at a lower price than the value redeemed at maturity by the issuer. This difference represents the investor’s return.

Convertible bonds

A convertible bond is a bond with a conversion right that allows the holder to exchange the bond for shares in the issuing company, the two parties having previously fixed a conversion ratio which defines the number of shares to which the bond gives right.

Useful resources

Rating agencies