Showing posts with label zero coupon bonds. Show all posts
Showing posts with label zero coupon bonds. Show all posts

Saturday 14 January 2017

How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s

How the Wall street created the junk bond market investment fads?

In the early to mid-1980's, Wall Street firms pushed junk bonds on investors.

They touted the positive historical results of high-yield debt. 

There were major differences between the debts of fallen angels versus newly issued bonds from fragile companies.

Debt from fallen angels:

  •  trades at a discount to par, 
  • downside risk is reduced. 
  • at the same time, the potential for capital appreciation is large. 
Newly issued debt from marginal companies 

  • does not share in these above characteristics.


How Wall Street can create investment fads, only to leave investors much poorer when the tide goes out.

That didn't stop Wall Street from pushing this form of debt (newly issued debt from marginal companies), nor did it stop investors from ponying up and falling victim to these issues.

The number and size of junk bond issues grew, despite the fact that this asset class was untested by an economic downturn, which should have made investors cautious. 

Investors were happy to gobble up zero coupon bonds (where the interest accrues to the issuer but is not paid out until the bond comes due) despite the clear risks! 

It took the downturn of the early nineties to wipe out those who were too eager to pay for assets that were risky.



Faulty Logic using EBITDA propelled the Speculation

One way investors were prodded into purchasing such securities were valuation measures based on EBITDA. 

Rather than considering cash flow or earnings, companies were valued using this accounting measure which doesn't include depreciation expenses. 

A company paying its debts from EBITDA is slowly liquidating itself (as it can't make capital expenditures) and leaving itself susceptible to a credit crunch.

Such fads will undoubtedly occur in the future, and those who are able to avoid them will do well.





Read also:


Thursday 8 September 2011

What is a Bond?


A bond is essentially a loan an investor makes to the bonds’ issuer. That issuer can be the federal government (as in the case of Treasury bonds) or a local government (municipal bonds), government-sponsored enterprises (like Fannie Mae), companies (corporate bonds) or even foreign governments or international corporations.
The investor, or bond buyer, generally receives regular interest payments on the loan until the bond matures or is “called,” at which point the issuer repays you the principal. Bond funds pool money from many investors to buy individual bonds according to the fund’s investment objective.
Most bonds pay regular interest until the bond matures.



Callable bonds allow the issuer to repay the bond before maturity.



Zero-coupon bonds offer a deep discount and pay all the accumulated interest at maturity.



Who issues bonds?

Governments, government sponsored enterprises and corporations issue bonds to raise money for their endeavors. The financial health of the issuer determines how highly (or not) the bonds are rated; higher rated bonds are considered to be safer and therefore pay less interest, whereas lower-rated bonds pay higher interest rates to compensate investors for taking on more perceived risk. An issuer’s credit rating can change in either direction over time. In addition to the ratings and interest payments, the institution issuing the bonds can also determine whether or not the income is taxable. A roundup of the types of bonds and information on their issuers follows:
Treasury bonds
The U.S. Treasury issues bonds to pay for government activities and service the national debt. Treasuries are considered to be extremely low-risk if held to maturity, since they are backed by “the full faith and credit” of the U.S. government. Because of their safety, they tend to offer lower yields than other bonds. Income from Treasury bonds is exempt from state and local taxes.
Agency bonds
Government-Sponsored Enterprises issue bonds to support their mandates, which typically involve ensuring certain segments of the population—like farmers, students and homeowners—are able to borrow at affordable rates. Examples include Fannie Mae, Freddie Mac, and the Tennessee Valley Authority. Yields are higher than government bonds, representing their higher level of risk, though are still considered to be on the lower end of the risk spectrum. Some income from agency bonds, like Fannie Mae and Freddie Mac are taxable. Others are exempt from state and local taxes.
Municipal bonds
States, cities, counties and towns issue bonds to pay for public projects (roads, sewers) and finance other activities. The majority of munis are exempt from federal income taxes and, in most cases, also exempt from state and local taxes if the investor is a resident in the state of issuance. As a result, the yields tend to be lower, but still may provide more after-tax income for investors in higher tax brackets.
Corporate bonds
Corporations issue bonds to expand, modernize, cover expenses and finance other activities. The yield and risk are generally higher than government and municipal bonds. Rating agencies help you assess the credit risk by rating the bonds according to the issuing company’s perceived creditworthiness. Income from corporate bonds is fully taxable.
Mortgage-backed securities
Banks and other lending institutions pool mortgages and “securitize” them so investors can buy bonds that are backed by income from people repaying their mortgages. This raises money so the lenders can offer more mortgages. Examples of MBS issuers include Ginnie Mae, Fannie Mae, and Freddie Mac. Mortgage-backed bonds have a yield that typically exceeds high-grade corporate bonds. The major risk of these bonds is if borrowers repay their mortgages in a "refinancing boom," it could have an impact on the investment's average life and potentially its yield. These bonds can also prove risky if many people default on their mortgages. Mortgage-backed bonds are fully taxable.
High yield bonds
Some issuers simply aren’t as credit-worthy as others. These can include local and foreign governments, but generally high yield bonds refer to corporate bonds issued by companies that are considered to be at greater risk of not paying interest and/or returning principal at maturity. As a result, the issuer will pay a higher rate to entice investors to take on the added risk. Ratings agencies such as Standard & Poor’s, Moody’s and Fitch evaluate the financial health of a bond issuer and assign a rating that indicates their opinion of whether the bond is investment grade or not. Bonds rated below investment grade are considered speculative and higher risk.

How a typical bond works

Bonds have three major components:
The first is the face value, also called par value. This is the value the bond holder will receive at maturity unless the issuer defaults. Investors pay par when they buy the bond at its original face value. If bonds are retired by the issuer before maturity, bond holders may receive the par value or a slight premium. The price investors pay when buying on the secondary market (in other words, not directly from the bond’s issuer) may be more or less than the face value. See Bond Prices, Rates, and Yields.
Bonds also have a coupon rate. This is the annual rate of interest payable on the bond. (The term coupon hearkens to the time bond certificates were issued on paper and had actual coupons that investors would detach and bring to the bank to collect the interest.) The higher the coupon rate, the higher the interest payments the owner receives. With fixed-rate bonds, the coupon rate is set at the time the bond is issued and does not change. Most bonds make interest payments semiannually, although some bonds offer monthly and quarterly payments.
Third, bonds have a stated maturity date. Generally, this is the date on which the money you've loaned the issuer is repaid to you (assuming the bond doesn't have any call or redemption features).

Callable bonds

Callable bonds are bonds that the issuer can repay early, sometimes after a period of several years, at a predetermined price. The attraction of callable bonds is that they typically offer higher rates than non-callable bonds.
However, you should understand the call risk. If interest rates drop low enough, the bond's issuer can save money by repaying its callable bonds and issuing new bonds at lower coupon rates. If this happens, the bond holder's interest payments cease and they receive their principal early. If the bond holder then reinvests the principal in bonds with similar characteristics (such as credit rating), he or she will likely have to accept a lower coupon rate, one that is more consistent with prevailing interest rates. This will lower monthly interest payments.
Example: A callable bond
An investor purchases a $30,000 10-year callable bond paying 6.5% interest, which is a higher interest rate than similar non-callable bonds. The bond is callable after five years at a price of 103—that is, 103% of the face value, or $30,900. If interest rates drop enough, the investor may wind up with their principal returned and, when seeking to reinvest the principal, be looking at yields that have fallen since the time of their original investment.

Zero coupon bonds

Zero coupon bonds, also known as “Strips”, are bonds that do not make periodic interest payments (in other words, there’s no coupon). Instead, you buy the bond at a discounted price and receive one payment at maturity. The payment is equal to the principal you invested plus the accumulated interest earned (compounded annually to maturity).
Perhaps the best-known example of a zero-coupon bond is a U.S. savings bond, which is a "non marketable" Treasury security that can be bought directly from the Treasury or most banks. (Fidelity sells other “marketable” zero-coupon Treasury securities that can be bought and sold on the secondary market.) There’s a reason these bonds are a favorite gift of many parents and grandparents: Zero coupon bonds are attractive when you want to save for a defined objective and date, such as when a child starts college. You receive your principal and interest in one lump sum at maturity.
Let’s say you’re saving for your child’s college education, which will begin in 10 years. You could buy a 10-year zero coupon bond that costs you $16,000, though its face value is $20,000. In 10 years, at maturity, you receive face value of $20K.
Zero coupon bonds have a few drawbacks. First, in most cases, you’ll have to pay taxes annually on the interest, even though you do not actually receive the interest until maturity. This can be offset if you buy the bonds in a tax-deferred retirement account, or in a custodial account for a child in situations where the child pays little or no tax.
Zero coupon bonds can also be particularly volatile in the open market, and particularly susceptible to interest rate risk. (For more on this and other risks, see Risks of Fixed Income Investing.) This doesn't matter if you keep the bond to maturity. But if you need to sell it early, you could incur a substantial loss.
In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. 

Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.

Any fixed income security sold or redeemed prior to maturity may be subject to loss.


Sunday 4 April 2010

Buffett (1989): His view on high growth rates, EBITDA and zero coupon bonds


We saw Warren Buffett make some significant dents in the efficient market theory and also got to know his take on arbitrage. Let us see what the master has to say in his 1989 letter to shareholders.

Have you ever wondered why despite such enormous wealth and infrastructure, the US economy canters at a mere 3%-4% growth rate per annum and why a country like India, which has very little infrastructure in comparison to the US, is galloping at 7%-8% rate. Or better still, what happened to the 40%-50% growth rates that the Indian IT companies notched up so successfully in the not so recent past? The master has the following explanation to these phenomena:

"In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor."

Indeed, in a world where resources are limited, consistently high growth rates would create pressure on those resources, thus resulting into either exhaustion of the resources or slowing down of growth. To better illustrate this point, let us return to the Indian IT industry. The demand for qualified IT professionals (a limited resource as we can produce only so much per year) has been so high in recent times that this has resulted in a disproportionate rise in salaries and attrition levels, thus impeding profit growth. Further, it is much easy to double revenues on a base of Rs 500 - Rs 600 m than on a base of Rs 50,000 m - Rs 60,000 m. Hence, those who are expecting these companies to grow at the same rate as in the past, might be in for some real surprise.

Another important topic that the master has touched upon in his 1989 letter is the gradual deterioration in the quality of representation of a company's true cash flow by certain promoters and their advisors in order to justify a shaky deal. While earlier, a company's cash flow, to justify its debt carrying capacity took into account its normal capex needs and modest reduction in debt per year, things had come to such a pass that EBITDA emerged as a substitute for a company's cash flow. Important to note that EBITDA not only excludes the normal capex needs of the company, but it was deemed enough to cover just the interest expense on debt and not the repayment of debt. This is what the master had to say on such practices:

"To induce lenders to finance even sillier transactions, they introduced an abomination, EBDIT - Earnings Before Depreciation, Interest and Taxes - as the test of a company's ability to pay interest. Using this sawed-off yardstick, the borrower ignored depreciation as an expense on the theory that it did not require a current cash outlay. Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet. As businessmen, Charlie and I relish having competitors who are unable to fund capital expenditures."

Thus, since EBITDA does not even cover the normal capex needs of the company, the master advises investors to be wary of companies and investment bankers who rely on these yardsticks to justify a leveraged deal. The master also touches upon a special type of bond known as the zero coupon bonds and goes on to add that whenever the inherent advantage that these bonds offer (deferring interest payment and not recording them till the maturity of bonds) combine with lax standards for cash flow estimation like the EBITDA, it sure is a recipe for disaster. This is what he has to say on the combination of both:

"Whenever an investment banker starts talking about EBDIT - or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures - zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures."