A bond is a debt instrument whereby an entity can raise capital to finance their operations by attracting investors to participate. Simply put it is a loan to the entity (referred to as the issuer) and will have certain contractual features such as principal amount (Face Value), rate of interest payable (coupon rate), coupon dates (dates on which interest is payable) and a maturity date. Some bonds may have additional features such as a call date and security. The former gives the issuer the right to call back (repay) the bonds from the bondholder (investor) after the date specified while the latter is assets that have been pledged to secure the debt in the event the issuer is unable to repay the bond holder. Many of these bonds are traded on international exchanges.
Governments and corporate institutions worldwide borrow / raise funds through the issuance of bonds. This has been a popular vehicle through which they have been able to raise funds to finance government expenditures and company’s operations but how are they different? A Sovereign bond is debt issued by a national government and can be denominated in the company’s own currency or alternatively in a foreign currency. Countries with strong currencies e.g. the United States of America have the luxury of issuing such bonds as their economy is strong and their currency is accepted worldwide. Countries with weak currencies on the other hand pose a greater risk to bondholders and therefore to eliminate the currency risk will issue their bonds in a foreign currency e.g. US Dollars. Jamaica is a typical example of one such country and has gone the route of issuing their bonds in US dollars. Whilst this eliminates the currency risk it certainly does not eliminate the country’s credit risk.
A Corporate Bond, on the other hand, is debt issued by a corporation and is one of the prime sources of capital for businesses in addition to bank loans and equity financing through the issuance of shares. Similar to governments, a company has to have a good reputation and the potential to generate consistent income from their operations in order to appeal to investors for their bond offerings. In some instances, corporations have to offer much more e.g. providing collateral to secure the bond to make them more attractive to the market.
In comparing both classes of bonds we start with the credit risk. Both are evaluated by their ability to repay and a measure of this is the relative credit rating each enjoys by international credit rating agencies such as Standard and Poor’s, Moody’s and Fitch. The rating agencies will use a country’s fiscal accounts or a corporation’s financials in addition to other data regarding future earnings and political risk to determine that rating. It is this rating that will determine the cost of raising the funds in the market to the issuer. Sovereigns are normally considered less risky than corporates but this is dependent on the country of issue and whether the market is international or domestic. As an example Jamaica currently has a B+ rating by Standard and Poor’s but their bonds are trading at a premium which brings the effective yield to investors willing to buy, equivalent to that of a bond of a higher rating and in the investment grade category. This is partly due to the confidence that locals in Jamaica and the diaspora have in the country’s ability to honour its obligations. Their relatively lower risk will be applicable in comparison to their local corporate investments but not by external investors. We have seen countries that have defaulted on their bonds due to political risk and Argentina has been one such country in recent times. Currently Venezuela is approaching that critical point. Corporations operating in such countries are also subjected to such similar risk and as such will prejudice their ability to raise funds and the subsequent cost of funds on the capital market.
We mentioned previously the currency risk for sovereign bonds and it should be borne in mind that this would be applicable for corporations operating in lesser developed countries. They too will issue in a currency other than their local currency to eliminate the risk to investors. For both they are exposed to the risk that any deterioration in their fiscal/financials could lead to a devaluation of their local currency thereby placing more strain domestically on them to service their obligation.
In closing, both classes of bonds are similar in a number of respects but local investors will view their sovereign bond a little differently from an international investor. Local investors will have a better feel for their own government’s attitude and ability to honour their obligations as opposed to an overseas investor. For investors who are not savvy in making their own research it is recommended that they seek advice from a qualified investment adviser.
Ian Watson is Vice President, Sales & Marketing at Sterling Asset Management Ltd. Sterling provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: [email protected] or visit our website at www.sterling.com.jm
Investing in a low interest rate environment can be very challenging. Investors are actively seeking new types of instruments to place their hard earned life savings. They will sometimes overlook many obvious risks just for the sake of earning high returns and it turns out that there are many new and different structured investment instruments out in the market. We have seen a lot of new issues-including Local Corporate and International Corporate bonds issued recently and with that in mind, we will examine the pros and cons of investing in these instruments.
Local Corporate Bonds are issued through local institutions (Jamaican/Caribbean entities) from time to time and are generally sold only to accredited investors. Accredited investors are so described when their net worth is J$50m and over or they are investing a minimum of US$100,000. It is also believed that this type of investor is better able to take on risk either because of a higher level of sophistication/knowledge and/or a larger financial cushion to handle losses.
Locally issued bonds have the advantage of being readily recognizable by local investors. This familiarity leads to an increased willingness to participate in such issues and a tendency to overlook any details pertaining to the credit worthiness or even basic financial strength of the issuer. This is further compounded by the peer pressure that is likely to occur, given that friends may also be investing, so there is strength in numbers type of mentality.
Some of the challenges experienced with locally issued bonds may include issues related to the currency of the bond, some relate to the currency of the ultimate borrower, liquidity and tradability to name a few. You have to pay attention to the currency that is being used which varies from local currency, to US currency to indexed bonds (i.e. indexed to the U.S. currency). Check carefully, if the entity paying back the loan is based in a country (for e.g. Trinidad or Barbados) with strict currency controls. Many times a buy and hold strategy is very straight forward, however, if you wish to come out of your bond, it may be at a substantial discount if at all, i.e. there may not even be a market for that bond at the time you need to sell (in part or in whole).
International Corporate Bonds are bonds issued by foreign companies and are normally issued in US dollars. This may or not be the currency that the company earns. The challenge with these types of bonds is the opposite of local bonds, i.e. many times investors are simply not familiar with the companies and are therefore highly reticent to invest their funds. This means that it is that much more important to research the company thoroughly before investing. However, there are several advantages: the first being that these companies are usually rated, so it makes it a little easier to assess their credit worthiness. Secondly, the companies, on reaching the international market, are usually far larger than local companies. The size normally means increased cash flow and capacity to pay and access to far larger markets. These companies are traded often, and getting in and out is normally much faster than local companies.
When choosing to invest internationally, consider the political risk if any, as well as the ease with which you can access information on the company. For companies that are publicly owned, it will always be easier to obtain information on their performance, than privately owned companies.
Your next question may be: why do I have to choose? Can’t I have both? The simple answer is yes, you can have both, in fact it is certainly useful to build a well-diversified portfolio. However, no matter what you are investing in, it is critical to do your due diligence and take a long hard look at the 4 Cs of credit, the character, the capacity, collateral and capital.
Diversification plays a huge role in investing in corporate bonds in general. International bonds can balance out some of the portfolio’s risk. Give some thought as to what kind of risks you are willing to take, given the nature of your other investments and - together with your advisor - consider exploring the wide world of global bonds. The risk may be worth the reward.