Question

Debt and Share Markets

a) Why would a borrower choose to finance with a bond issue instead of a share issue?

b) What are the general benefits and risks to an investor of investing in a bond compared to investing in a share?

c) Like any other financial markets, bond issuers constantly develop and introduce innovative instruments with new features. List and explain three important innovations in the bond markets, in terms of what they are, when were they developed and are they likely to grow importance? (Hint: asset-backed bonds, index bonds, climate bonds, forest bonds etc.)

Answer 1

a) If a borrower dont want to give up control of the company, then he may prefer to issue bonds to shares. If a company issue shares , it can dilute the ownership of the existing shareholders and the value of the shares. It reduces their voting power and also not every company can raise money through shares issue , in order to get shareholders , they need to see the history of positive price changes and dividend payments before they invest. If the borrower credit raing is good then he prefers to issue bonds instead of shares as it is easy to raise money with lower interest rates. By issuing bonds company get tax benefits as interest paid for the bonds are tax deductible. Issuing bonds can also protect the borrower from interest rate hikes.

b)Benefits of an investor investing in bond than in stock

• Bonds are considered as relatively safe investment when compared to stocks as they give fixed interest for the life of the bond
• If a company goes bankrupt, bond holders should be paid first and the shareholders are compensated in the end

Risk of an investor investing in bond than in stock

• Re-investment risk: Future cash flows needs to be reinvested in a security with lower yield
• Callable bonds issuers can call back their bonds and retire the issue when interest rate falls
• Default risk : When issuer cant pay the interest or principal in a timely manner
• Inflation risk: When the price increases, it detoriates the returns associated with the bond

c)Asset backed Securities : These are bonds backed by financial assets like credit card receivables, home equity loans and auto loans. They are introduced during mid 1980s and it still remains the smallest subset of the fixed income securities. However it is important to know that there is lot of chance for ABS to grow as it offers investors to diversify by investing in variety if asset types.

Climate bonds : They are linked to climate change solutions. They are issued in order to raise finance for climate change solutions. Cimate bonds can be issued by governments, multi-national banks or corporations. Cimate bonds were introduced during 2010. Cimate bonds market share is very low but growing rapidly but they have potential to grow as they provide assurance for investors about the environmental integrity and provides climate related investment opportunities

Forest bond: Forest bond offers the investors a choice between cash or carbon-credit coupon. A carbon credit is a tradable certificate or a permit representing the right to emit one ton of carbondioxide or another greenhouse gas with an equivalent to one ton of carbondioxide. Investors choosing the carbon credit coupons can retire the credits to offset corporate greenhouse gas emissions or sell them on the carbon market.