A loan is cash, assets, a security or other liquid assets, which is given to another party for the loan value future repayment with interest or other agreed financial liabilities. A loan can be formalised as a one-time sum or a credit limit without term within an agreed maximum amount. Prior to concluding a loan transaction, the loan terms and conditions are agreed. If the creditor needs collateral for sense of security, then this will be established in the loan conditions. Most loans have fixed covenants, like maximum interest rate and repayment term.
The owner of the bond gives a company, municipality or state a loan. Thereby, a bond is a loan investment. Similarly to other creditors, the bondholder aims to earn interest on the loan and get back principal payments by previously agreed deadlines according to the terms of the bond. Generally, regular interest is paid on bonds, but the invested principal is paid back to the investor on the bond redemption date. A bond interest rate may be fixed or floating. Usually, the contract foresees the investor receiving regular interest payments, ordinarily several times a year, throughout the period until the bonds are redeemed.
Advantages of bonds for companies
Companies issue bonds in order to raise capital as an alternative to a bank loan. Baltic companies fund their operations with bonds mainly for four reasons. Firstly, bonds provide more discretion and flexible conditions. Secondly, bonds offer the possibility of a longer redemption date. Thirdly, bonds are suitable for funding capital-intense long-term projects. Fourthly, bonds increase brand recognition.
Categorisation of bonds
Based on issuer. Bonds are categorised on the basis of different parameters, and one category is based on issuer. The issuer may be the government, its agency, a local municipality or a corporation. Government bonds usually have a redemption period of three months to thirty years. Such securities are issued by the government of a country. Their risk level is usually low, but it depends on the country’s credit rating. Government bonds are categorised by maturity:
• short-term (treasury bills) – maturity up to 1 year
• medium length (treasury notes) – maturity up to 7 years
• long-term (treasury bonds) – maturity up to 30 years, but there are also perpetual bonds with no maturity
A local municipality may issue municipal bonds, usually with interest rates above the same country’s government issued bond yield. Corporate bonds usually carry a higher interest than government bonds, as they come with higher risk.
Based on security. Bonds are also divided into bonds with and without security. Bonds without security include commercial papers and other short-term commitments, issued by companies with strong credit rating and trusted by investors. In case of a secured bond, assets are pledged, which provides investors additional confidence they can realise the claim.
Based on expiration. Bonds are also categorised as callable bonds, puttable bonds and convertible bonds. In essence, these additional terms are similar to those of options. For example, callable bonds give the issuer the right to buy back bonds at a suitable time. The puttable bondholder has the obligation to sell the bond back to the issuer on a certain date before the redemption date. Convertible bonds give the owner the right to exchange the bond for the issuer’s shares if such an option has been prescribed in the bond terms and conditions. Therefore, documentation analysis is extremely important before investing.
Bonds suit investors with lower risk appetite
Bonds are suitable for investors with low risk appetite, interested in stable and consistent interest income. Compared to shares, the risk and return of a successful company’s bonds are lower. For example, in the case of company’s bankruptcy, bondholders are paid their part before shareholders. Unlike shares, a bond does not give the holder the right to decide over how the issuer does business.
Bonds are suitable for balancing an investment portfolio in case of sudden fluctuations in share prices. On the other hand, there are practically risk-free bonds but also ones with higher risk – risk and return go hand in hand. Generally, the main risks are the company’s solvency and interest rate risk.
In case of insolvency, the risk arises that the issuer experiences financial difficulties and is unable to pay the bondholders interest on time and in promised amounts. It may also happen that bonds cannot be redeemed on time and in agreed volume by maturity. In such a case, the bondholder may lose the invested capital in part or in full. Therefore, the investor has to run a thorough analysis of the issuer before purchasing bonds.
In case of an interest rate risk, overall change in interest rates on capital markets may affect the market price of the bond. The market price of fixed-income bonds goes down when general interest rates go up, but rises when interest rates decline.
Regional bond market
The local bond market has picked up in recent years. Companies have become more aware of bonds. This is reinforced by the fact that in addition to securities traded on the stock exchange, also an OTC bond market has emerged, which exceeds the bond volumes traded on the stock market.
Investors’ interest in local investment opportunities is confirmed by frequent oversubscriptions. Public offering of securities or preparing a listing particulars take quite a bit of time, but it opens the door to new investor groups like retail investors or institutional investors, who cannot make investments outside the exchange due to regulatory reasons. Subject to stock market requirements, public companies are more transparent and reliable for investors.
A suitable springboard to take a company to the stock exchange main list is the alternative market First North. This is a way to increase the company’s transparency and create a secondary market for securities. The requirements for trading are simpler and drawing up listing particulars is not obligatory.
Nasdaq Baltic regulated securities’ list includes Admiral Markets, Inbank and LHV Group bonds and from the alternative market First North’s list, Mainor Ülemiste and Magnetic MRO bonds.
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