Finance - X
Bonds and Stocks
11 Jan 2025
Long-term external financing sources for businesses
Businesses obtain long-term financing through internal funds (e.g. profits) or from external funds obtained through capital markets. Some businesses requiring large amounts of capital (e.g. airlines, high-growth tech companies) need to raise funds from external sources because they are unable to generate enough internal funds for their capital needs.
Long-term financing needs are met through the issuance of bonds and stocks. Most of the funds are raised through bonds rather than stocks because (1) borrowing is cheaper than raising equity, and (2) bonds have a fixed maturity date whereas stocks do not.
Bonds may be sold through public offerings or private placements. Public offerings are made to a large number of investors. However, they must be approved by the SEC, and the company must disclose detailed information about its financial condition and operations. Private placements do not require SEC approval, and they do not require public disclosure of company information.
Companies may also borrow funds overseas. They do this because it is easier to raise funds in the country where they have operations or facilities. Financing costs (e.g. interest rates) may also be lower. They can also avoid SEC regulations. Furthermore, the global market can make up for the lack of funds in the domestic market.
Bonds
A bond is an agreement between a lender and a borrower. Bondholders are different from the firm's owners (i.e. stockholders). For instance, if a company goes bankrupt, bondholders are paid before stockholders. Other characteristics of bonds include:
Most bonds have maturity dates, which is the date when the borrower must pay the principal amount (par value/face value) to the bondholder. Most bonds pay interest to the bondholder called the coupon rate. If a bond has an 8 percent coupon and a par value of $1000, it pays annual interest of 8 percent of $1000, or $80. The bondholder receives $80 each year until the bond matures.
The legal status of bondholders is that of creditors, meaning they have priority claims on the firm's assets and cash flow. Interest payments are paid to bondholders before dividends are distributed to stockholders. This is why bonds are considered less risky than stocks, and why they have lower returns. However, bondholders are not owners of the firm, so they do not have much say in how the firm is run. For instance, bondholders do not have voting rights.
Bonds can be registered bonds or bearer bonds. Registered bonds are issued in the name of the bondholder, and the issuer maintains a record of the bondholder's name and address. Bearer bonds do not have the bondholder's name on them, and they are payable to whoever "bears" the bond.
Although bonds can be purchased by individuals, most bonds are purchased by large institutional investors such as pension funds or insurance companies.
The trust indenture is a legal document that outlines the terms and conditions of the bond issue. It is a contract between the issuer and the bondholders, and it indicates the rights and obligations of both parties. The indenture contains information such as the par value, maturity date, coupon rate, and various covenants, which are restrictions on the borrower's activities. Covenant clauses help protect the bondholder's interests by limiting the borrower's actions that could affect the bondholder's investment. For example, the firm may be required to maintain a certain level of working capital, or it may be required to send audited financial statements to the bondholders. Without covenants, the value of the bond could depreciate if the firm's financial condition deteriorates (bonds are backed by the firm's assets).
Bond ratings
Bond issuers purchase bond ratings from rating agencies. The rater examines the credit quality of the issuer, the indenture agreement, covenants, and expected trends in the industry. It then assigns a bond rating that indicates the likelihood of default. Bond ratings make it easier for issuers to sell bonds because they provide information about the creditworthiness of the issuer. Issuers seek high ratings because (1) they add credibility to the issuer, and (2) they reduce the cost of borrowing, since interest rates are lower for higher-rated bonds. Bonds below investment grade are called junk bonds or high-yield bonds. Junk bonds are rskier, but investors still buy them because they offer higher returns.
Bond quotes
Bond quotes typically have the following information:
Types of bonds
Different types of bonds offer different levels of security and return.
Mortgage bonds are secured by real estate. For example, a company may issue a mortgage bond to finance the construction of a new factory. The mortgage will include a lien on the factory, which means that if the company defaults on the bond, the bondholders can take possession of the factory.
An equipment trust certificate is a bond secured by equipment (or rolling stock, or moving assets). For example, an airline may issue an equipment trust certificate to finance the purchase of new airplanes. The serial number of each airplane will be listed in the bond indenture.
Closed-end mortgage bonds are secured by specific assets that cannot be used to secure any future bond issues. Open-end mortgage bonds, however, allow the same assets to be used as collateral for future bond issues.
Debenture bonds are unsecured bonds, meaning they are not backed by any specific collateral. Instead, they are backed by the general credit of the issuer. A subordinated debenture is a bond whose claim on assets is junior to the claims of other debenture holders, meaning if the issuer goes bankrupt, the subordinated debenture holders are paid after the senior debenture holders.
Mortage bonds may also be securitized, meaning the cash flows that are generated from the mortgage payments are used as collateral for new bond issues. Lenders do this so that they can issue new loans without having to wait for the old loans to mature, and so that they can reduce their risk exposure by passing on the risk to the holders of the securitized bonds.
Convertible bonds are bonds that can be converted into a specified number of shares of the issuer's common stock. The conversion ratio is set initially when the bond is issued, usually at an unfavorable rate to the bondholder. However, if the stock price rises, the value of the convertible bond also rises. Companies issue convertible bonds when they want to raise funds when the firm's stock price is low.
Callable bonds are bonds that the issuer can redeem before the maturity date. The issuer may do this if interest rates fall, because it can issue new bonds at a lower interest rate. Most indentures include a stated call price, which is the price at which the issuer can call the bonds (usually at a premium to the par value). Investors who buy callable bonds are exposed to call risk. When interest rates fall, the issuer may call the bonds, forcing the investor to reinvest the proceeds at a lower interest rate. Therefore, callable bonds typically have higher coupon rates than noncallable bonds. Their indentures also include a call deferment period, which is the period during which the issuer cannot call the bonds.
Putable bonds are bonds that the bondholder can sell back to the issuer at a specified price before the maturity date. Indenture terms typically specify the circumstances under which the bondholder can put the bonds back to the issuer. One example is a bond rating downgrade. Putable bonds are less riskier than other bonds, so they have lower coupon rates.
Extendable bonds are bonds whose coupon rate can be reset periodically. At each reset, the holder can choose to accept the new coupon rate (effectively extending the bond's maturity) or to put the bond and redeem it at par value.
Most bonds pay a fixed amount of yearly interest over the bond's life. However, some bonds pay interest that is tied to an index or benchmark, such as a 10-year Treasury note.
Zero-coupon bonds do not pay interest. Instead, they are sold at a discount to their face value, and the bondholder receives the face value when the bond matures. Investors looking to make long-term investments buy zero-coupon bonds because they can lock in at the current interest rate. With the interests earned on regular bonds, there is reinvestment risk, meaning the interest earned on the bond may have to be reinvested at a lower interest rate.
Investors face inflation risk when they invest in bonds. To protect against inflation risk, investors can buy Treasury Inflation-Protected Securities (TIPS). TIPS are indexed to inflation (via the consumer price index), so the principal amount of the bond increases with inflation.
Corporate equity capital
Corporate equity capital is the financial capital supplied by the owners of a corporation. Ownership claim is represented by a paper stock certificate, although most stock ownership is now held electronically. Stock certificates can be kept in the owner's name or in the name of a brokerage firm (kept in street name).
Equity securities may be grouped into two classes: common stock and preferred stock.
Common stock
Common stock represents ownership shares in a corporation. Ownership shares give the holder certain rights and privileges, such as selecting the board of directors, voting on major corporate decisions, and receiving dividends. Common stock characteristics include:
Common shareholders have a claim on all business profits after all other obligations have been met (e.g. bondholders, preferred stockholders). However, some profits may be retained by the corporation for reinvestment in the business. Thus, only the board of directors can decide to pay dividends to common shareholders. Dividends are cash payments, and they may grow over time if the firm's profits grow. Of course, dividends are not guaranteed, and the board may decide to reduce or eliminate them if the firm's profits decline, and this is where the risk of common stock ownership comes in.
The common stock of a corporation may be assigned a par value (e.g. $1 per share), but this value bears no relationship to the market price of the stock. It's simply there for accounting and legal purposes.
Common stocks may be divided into special groups, based on the rights and privileges they confer. The most common right is voting rights, which allow shareholders to vote on important issues such as the election of the board of directors, mergers and acquisitions, and changes to the corporate charter. The SEC typically doesn't allow corporations to issue classes of stock that do not confer voting rights to shareholders, as they lead to a concentration of ownership control.
Preferred stock
Preferred stock is an equity with a senior claim on assets and cash flow over common stock. Also, preferred stock has a fixed dividend rate, which is expressed either as a percentage of the par value of the stock or as a fixed dollar amount. Preferred stock holders see this dividend rate as a trade-off for having senior claims over common stockholders.
Preferred stock characteristics include:
Preferred stocks are typically nonvoting, and corporations issue them to raise capital without diluting the voting power of common stockholders.
Dividends are paid out only if the board of directors declares them. Cumulative preferred stockholders have the right to receive dividends that were not paid in previous years before common stockholders receive dividends.
Callable preferred stock is preferred stock that the issuer can retire at its option (usually at a premium to the par value). Convertible preferred stock is preferred stock that can be converted into common stock at a specified conversion ratio. Preferred stock that is cumulative and convertible is popular with investors who are looking into purchasing shares of stock in small firms with high growth potential.
Participating preferred stock is preferred stock that allows holders to receive dividends in excess of the stated dividend rate, if sufficient profits are available and if common stockholders receive more dividends than the preferred stockholders.
Stock quotes
Stock quotes typically have the following information:
Dividends and stock repurchases
Unlike bond interest, dividends payments are not legally required. The board of directors decides whether to pay dividends, and they may decide to reduce or eliminate dividends if the firm's profits decline. Dividends are typically paid on a quarterly basis.
Divident reinvestment plans (DRIPs) allow shareholders to reinvest their dividends in additional shares of stock. Fractional shares are allowed, and the shareholder does not have to pay brokerage fees.
Firms that issue dividends try to maintain a stable dividend payout ratio, which is the percentage of earnings paid out as dividents. Very rarely do firms distribute all of their earnings as dividends, as they need to retain some earnings for reinvestment in the business.
The decision to start paying dividends is a signal to investors that the firm is profitable and has good growth prospects. Since information about company operations and financial condition is not always available to investors, they use dividends as a signal of the firm's financial health.
Some firms pay special dividends, which are one-time payments that are not part of the regular dividend schedule. Special dividends are usually paid by firms in industries with cyclical earnings, or by firms that have sold off a major asset.
Firms use other dividend payment strategies, such as residual dividend policy, which pays dividends from residual earnings after all investment opportunities have been funded, or constant payout ratio policy, which pays dividends as a constant percentage of earnings.
The board of directors will consider several factors when deciding to pay dividends, such as the firm's ability to generate profits, the firm's growth prospects, any legal or contractual restrictions on dividend payments, cost of raising funds, and dividend tax rates.
A stock dividend is a dividend paid in the form of additional shares of stock, rather than cash. A stock split is a corporate action that increases the number of shares outstanding by a certain multiple. In both cases, the stockholder's ownership percentage remains the same. In other words, the stockholder has more shares, but each share is worth less.
Instead of distributing dividends, some firms repurchase their own stock. Firms do this for various reasons: to support stock option incentive programs for employees, to use them as currency for acquisitions, or to signal to investors that the stock is undervalued.
Valuation principles
The present value of a series of future cash flows represents the price someone is willing to pay today for the right to receive those cash flows in the future. For instance, suppose that an investor is looking at a 5-year annuity that pays $100 per year. If the investor expects a 10 percent annual compound rate of return (e.g. 6% risk-free rate and 4% default risk), the present value of the annuity for the investor is $379. In other words, the investor would be willing to pay $379 today to receive $100 per year for 5 years, given the 10 percent rate of return.
Valuation of bonds
The intrinsic value of a bond is the sum of the present value of the bond's principal and the present value of the bond's coupon payments (i.e. future cash flows). The intrinsic value is the maximum price an investor should be willing to pay for the bond, based on estimates of the bond's future cash flows and the discount rate.
Suppose that a bond with $1000 par value has an 8 percent coupon rate and a 10-year maturity. This means that the bondholder is liable to receive $80 per year for 10 years, plus the $1000 principal at the end of the 10 years.
Investors are interested in two things:
If investors expect a return of 8 percent on the bond (i.e. the sum of the risk-free rate, the default risk premium, maturity risk premium, inflation premium etc.), then the intrinsic value of the bond to the investor is $1000. This is unsurprising, as the bond's coupon rate equals the investor's expected rate of return.
However, if investors expect a higher return of 10 percent (perhaps due to higher interest rates in the economy, or perhaps the bond has a lower credit rating than before), then the intrinsic value of the bond would drop, to $875. Although the bond pays 8% per year, the investor expects 10% per year (due to other investment opportunities), so the bond's price must be lower to attract investors. The opposite occurs when investors expect a lower rate of return: the intrinsic value of the bond increases above its par value.
A bond purchased for less than its par value is called a discount bond, while a bond purchased for more than its par value is called a premium bond. Moreover, the prices of bond track changes in interest rates. If interest rates rise, the price of the bond falls, and vice versa. This is simply because the bond's coupon rate is fixed, and given that interest rates have changed, other investment opportunities that are more attractive become available.
In addition to computing the price of a bond, we can also compute the bond's yield to maturity (YTM), which is the rate of return an investor would receive if the bond were held to maturity. Given the bond's price, the coupon rate, the par value, and the number of years to maturity, we can compute the YTM.
Assuming all other factors remain constant:
Investors in domestic bonds face three types of risk:
Investors in nondomestic bonds face additional risks, such as political risks (e.g. changes in government policy), and exchange rate risks (e.g. changes in currency values).
Valuation of stocks
Stock valuation is slightly more complex than bond valuation, as stocks do not have a fixed maturity date. Instead, stock valuation is based on the present value of expected future cash flows, i.e. dividends. To simplify analysis, we can assume that the stock pays a constant dividend each year, or that the dividend grows at a constant rate each year.
Assuming that a stock pays a constant dividend each year, we can treat the present value of the stock as a perpetuity, or an annuity that continues indefinitely. The present value of a perpetuity is simply the dividend/cash flow divided by the discount rate. For example, if a stock pays $2 dividends each year, and the investor expects a 10 percent rate of return, then the present value of the stock is $2/10 = $20. Notice that if the dividend increases, or if the discount rate decreases (e.g. due to lower interest rates), the present value of the stock increases.
For stock that pays a growing dividend each year, we can use the Gordon growth model (or constant dividend growth model) to compute the present value of the stock. This model has four parameters:
All other factors being equal:
Stockholders face higher risks than bondholders: poor corporate performance, changes in industry conditions, changes in economic conditions, changes in interest rates, junior claims on assets and cash flow, and no guaranteed dividends all contribute to the higher risk of stock ownership.