Question

a) Atlantis Limited is listed on the ASX and is expanding its business operations into China. In order to expand, the company will need to raise additional funds through the issue of corporate bonds direct to the capital markets. Discuss the structure and attributes of two securities that are often issued into the corporate bond market. Which carries more risk and why?

Answer 1

Both public & private companies issues bonds to raise capital for funding its new projects, Research & development, for expanding into foreign markets, buyback of shares, refinancing debt, financing merger & acquisition, to long term change captal structure of the co., for buying new equipment. Corporate bonds are types of debt securities. When the company raises saher capital, then the investor who purchases the stock, becomes the shareholder/owner of the co. However, in case of corporate bonds issue, the co. borrows the money from the investor in return of which the investor gets intersest/coupon payments & the principal on the bond, irrespective of the profitability or current market share price of the co. Co.s generally issue blocks of bonds with the face value $1000, wih say, a coupon rate of 10%. Coporate bonds usually carries higher risks than govt. bonds.

Corporate bonds can be categorized based on the following criteria:-

1. The industry sector in which the co. is operating in, like, manufacturing, service, public utilities, banks, financial institutions, transportation (airlines, rail, truckroads)
2. Based on the maturity period, they are of following types :-
   Short term - less than 3 years maturity
   Medium term- 4- 10 years
   long term - more than 10 years and upto 30 years maturity.
3. Based on credit rating- The bond's credit quality is rated by the credit rating agencies such as standard & poors, moodys, fitch etc. The corporate bonds are of 2 types :-
   Investment grade - They are least risky bonds with minimum likelyhood of default, and having a maturity of more than 10 years. They are rated as Baa3 or higer by moody's, BBB- or higher by S&P, Fitch.
   Non - investment grade/ high yeild bonds - They pay higher interest rates, highy speculative due to greater risk of default, generally issued by startup cos., of shorter maturity period,they get rating like BB by S&Ps, Fitch, Ba by Moodys.

Securities of bonds are those underlying assets that are used as collateral for the corporate bond issue.

Types of securities issued :-

1) Mortgage - backed securities/ Mortgage bonds

Mortgage bonds are backed by mortgage backed securities. When a person buys a house, he/she may finance it with the loan taken from the bank or any othet financial institution supported by a mortgage.However, the lender often does'nt retain the ownership of that mortgage. the lender sells the indivudal mortgages to the entites in the secondary markets like Freddie Mac, Fannie Mae, Ginnie Mae etc. They then bundle these mortgages into pool of loans that are securitizes the mortgage bond. This process is called securitization & the security is caled the mortgage backed security. A mortgage pool can contain 200 to 200,000 mortgages.

Mortgage bonds features are like liquidity, regular payment schedule etc. In case of the default of the bond issuer, the buyer has claim over the interest and the principal payments of the mortgage pool of loans. Mortgage bonds are secured by a pool of loans having similar characteristics like real estate mortgages that have similar interest rates & maturity dates.

They are of two types of mortgage bonds :-

• Pass-Through Mortgage-Backed Securities :-

1. They are having maturities of 5-30 years
2. They are operated by the trusts who collect the mortgage payments and pass- through directly to the investors
3. It contains both fixed rate & adjustible rate mortgages

• Collateralized Mortgage Backed Securities

1. These are more complex types of mortgage bonds
2. A CMO is composed of numerous pools of securities, which are again subdivide into different tranches.
3. Each tranch is governed by seperate set of rules for determining how the principal & interests are to be distributed among the investors.

Mortgage backed security bonds are safer bonds or carry lower risks for the investors. Because in case of corporation defaults, the investor of the corporate bond has little recourse in terms of gaining back his investments. However, in case of mortgage bonds the investor has a claim against the properties in case of default.
Mortgage bonds pay regular monthly interests & a part of the principal until the maturity.
As per the Federal Housing Finance Agency, these bonds are highly liquid which attracts the small time investors. The bondholders can actually liquidate the properties that represent the default mortgage. This liquidity in return helps in lowering the interest rate for the home owners & the mortgage investors when they go to purchase a property.

The mortgage bond however faces prepayment risk i.e. the bond issuer may pay the principal earlier than the expiry of the maturity period. However, iwake of the financial crisis of 2008 that was created by subprime lending or subprime mortgages, it has become important for the investors to check the company's credit history before investing in the mortgage bonds. The investor can refer to the credit ratings of a particular MB, for checking credit worthiness of a particular company.

2) High yield corporate bonds / Junk Bonds

• They are rated as non investment grade bonds. They get ratings like BB by S&Ps, Fitch, Ba by Moodys. These are speculative bonds with higher risks of default. They offer higher rate of interest. When the co's with higher risk default issue bonds, its very unlikely that their bonds will be rated as investment grade by the credit rating agencies, hence they pay higher interest rates in order to lure the investors.
• These bonds are issued by the firms who are highly leveraged or are facing financial diffculites.
• They can also be issued by new start up firms with unproven operating track record.
• Some risk - tolerant investors may find these bonds attractive due to their higher interest rates.
• Investors can buy these bonds directly from the brokers or indirectly, by buying shares in mutual funds or exchange-traded funds (ETFs) with high-yield bonds in their portfolio.
• These bonds have following types of risks :-
  

1. Default risk/credit risk - It means the co. will fail or default in the timely payment of the interest and principal amt.s.The default may also occur when the co. fails to meet its debt obligations.
2. Interest rate risk - The market interset rates have an impact on the bond yeild, the price of a bond moves in the direction opposite to the market interest rates. Again, the longer duration bonds have graeter interest rate risks as compared to shorter duration bonds having the same credit quality.
3. Economic risk - When the economy gets bad, several investors would try to substitute their high yield bonds holding with safer investments, like US treasury bonds. In such a case, if there are more sellers than buyers for the high yield bonds, the price of the bond will fall. At the same time, in uncertain & challenging economic conditions the bond issuing co. may be unable to cope up with the financing difficulties resulting in its default.
4. Liquidity risk -Bonds which are traded frequently and in gigh volumes are more liquid. Hence, liquidity risk is that when an investor tries to sell his bond he does'nt get the appropriate price for it. High yield bonds have high liquidity risk as compared to investment grade bonds

An example of best performing high - yield bond in 2020 - Metropolitan West High Yield Bond Fund
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