In some ways, bonds are very similar to loans. Both bonds and loans involve borrowing money from a lender – the key difference between the two is that while loans are typically
issued by banks or financial institutions, bonds are issued by the borrower themselves.
Corporate bonds have been around for a very long time. While there are earlier references to bond-like arrangements between a debtor and a creditor, we know that the Dutch East India Company issued bonds in the 17th century to raise capital for voyages and trading expeditions.
The word bond itself has an interesting etymology, originating from the Old English word ‘bund’ which means binding or tied. Bund is derived from the Proto-Germanic word bandaz, meaning band, fetter or something that binds. Over time, the term evolved and found usage in its current financial meaning – a security representing a debt owed by the issuer to the bondholder, creating a financial obligation that binds the two parties.
Bonds are often referred to as securities. The term security is a broad category encompassing various tradable financial instruments, such as shares in a company’s stock (equities), and bonds fall within this securities classification. Bonds can also be referred to using terms such as loan notes, fixed-income securities, debt instruments, debt securities, or simply fixedincome investments. These terms highlight different aspects of what the bonds represent in the financial landscape, but they are all still bonds.
The late 19th and early 20th centuries witnessed a surge in bond issuance. Companies, particularly in the United States and Europe, raised substantial capital through bonds to fund railway construction, infrastructure projects, and industrial expansion. This period is often considered one of the busiest for the issuance of bonds.
To this day many companies actively use bonds to raise capital. Companies operating within emerging economies often issue bonds for international fundraising. Larger companies use associated companies incorporated in offshore jurisdictions to issue bonds. This is for a number of reasons, including to enable access to a broader, more global, investor base, access to stable regulatory frameworks, and tax certainty.
Financiers sometimes refer to interest payable on bonds referred to as a ‘coupon’. The word coupon has its origins in the French language and is derived from the French word couper, which means to cut. The connection with cutting stems from the historical use of physical coupons attached to bond certificates. Each coupon represented a specific interest payment, and the act of cutting and redeeming them became known as using a coupon.
Unlike stocks and shares, owning bonds does not confer ownership or voting rights in the issuing entity. Bondholders are creditors, not owners. However, there is a type of bond or loan note that can convert into equity – known as convertible bonds or convertible loan notes. If certain conditions are met, these allow bondholders to convert their bond holdings into a predetermined number of common shares of the issuer’s stock. Convertible loan notes provide investors with the opportunity to benefit from potential stock price appreciation and the issuer a less leveraged balance sheet.
Investors can buy and sell bonds through bond markets. Readers will not be surprised to know that bond markets are also known as debt markets, financial instrument markets and – somewhat counter-intuitively – credit markets. Certain types of bonds are regulated by securities laws and supervisory bodies, creating a framework for oversight and investor protection.
The bond market allows participants to trade existing bonds rather than waiting for them to mature. This liquidity provides flexibility and opportunities for investors to manage their portfolios. This contrasts with loans, which are typically held by the lender until they are repaid.
Major players in the bond market include institutional investors such as pension funds, hedge funds, and asset management firms. Additionally, investment banks and broker-dealers actively participate. These entities engage in substantial trading volumes, contributing significantly to the liquidity and dynamics of the market.
Distinct from the concept of securities, secured bonds are a type of bond backed by specific assets of the issuer or other third party collateral, such as a guarantee, providing a safety net for bondholders in case of default. If the issuer defaults, there will be a mechanism to call on guarantees and/or take control of and manage pledged assets. This ensures that bondholders have a claim on the collateral to recover their investment.
Unsecured bonds, on the other hand, lack collateral, relying solely on the issuer’s future cash flows and creditworthiness for repayment.
bonds. These collateral agreements (which are not guarantees) involve a parent or related company becoming obliged to provide financial support under certain conditions to a bondissuing subsidiary. That support, depending on the terms of the keepwell deed, can provide liquidity funding or bolster balance sheet solvency. The purpose of keepwell deeds is to essentially provide additional security and lower market risk perception.
Keepwell deeds, standby deeds, and equity interest purchase undertaking deeds all aim to provide this additional security, but they are complex agreements and their effectiveness in certain situations (and, therefore, their value as effective security) is not always assured and can vary.
Bond trustees (also known as security trustees) serve as intermediaries, chiefly representing the interests of bondholders. Each party’s rights and obligations are set out in documents known interchangeably as an indenture or trust deed. The trust deed creates a framework for a bond trustee to effectively manage and police the rights of bondholders by ensuring the issuer complies with the agreement, manages the bondholder’s rights, and handles issues like defaults.
When a company can’t repay bondholders, it can lead to default. Bondholders may then take legal action to recover their investment.
If a bondholder believes that the company is in default or faces insolvency, their recourse is usually to communicate with the security trustee, who may then take appropriate legal actions on behalf of all bondholders.
In many jurisdictions, a bondholder who is represented by a security trustee typically (but not exclusively) cannot individually present a petition to wind up the company. The security trustee, as the legal representative of bondholders, often holds the authority to take such legal actions on behalf of the bondholders collectively.
The specific rights and powers of the security trustee, as well asany limitations on individual bondholders, should be set down in the legal documents governing the bonds.
It is crucial to refer to the specific terms of the bond agreement to understand the precise rights and limitations applicable in a given situation.
Whether a security trustee has the right to agree to a restructuring, potentially writing down bondholders’ capital or interest, depends on the terms outlined in the trust deed or other relevant legal agreements. The trust deed may provide the security trustee with sufficient authority to negotiate and consent to restructuring or cram-down arrangements on behalf of bondholders; however, it’s crucial to carefully review the specific provisions in the trust deed as they vary based on the terms negotiated at the time of the bond issuance.
During restructuring and insolvency events, bondholders often come together to form ad hoc committees. These committees aim to represent the collective interests of bondholders. They may work together to address concerns, propose modifications to bond terms, or participate in restructuring discussions on the basis of an organised and coordinated approach.
In my experience, the effectiveness of such committees can vary, though the formation of such committees is almost always useful in terms of creditor engagement and stakeholder management.
Bonds are an essential component of modern-day corporate finance with a distinct and considerable offshore market to access the global investor base.
While there is a plethora of sometimes interchangeable terminology, the underlying concept remains that of a debt obligation from one party to another.
The range of risk and reward available through bond investment is a feature of the market and the wider economy. While risks can be mitigated, they cannot be eliminated entirely.
This is starkly evident from the recent order of the Hong Kong court placing Evergrande into provisional liquidation: dollar bondholders are currently braced to expect a less than a 3% recovery of sums due.
Additionally, the effectiveness of keepwell deeds and equity interest purchase undertakings are currently a hot topic, with the enforceability of these types of security in a state of some flux. Judicial decisions from the Court of Appeal in Hong Kong are due in the coming months and will be of keen interest to issuers and investors alike.
The information boxes below provide a primer for bond investment due diligence, and what to consider when examining a bond trustee deed.
Clear Responsibilities: Clearly defined responsibilities for trustees, outlining their role in protecting bondholders’ interests, monitoring compliance, and taking necessary actions in case of default.
Information Access: Mechanisms to ensure that a trustee has access to all the relevant financial and operational information of the issuer so they can make informed decisions and act in the best interest of bondholders.
Default Triggers: Clearly specified conditions that constitute a default, enabling prompt action by the trustee if the issuer fails to meet its obligations.
Enforcement Powers: Well defined enforcement powers conferred on the trustee, including the ability to take legal action, manage collateral, and ensure bondholders’ claims are prioritised.
Communication Protocols: Obliging the trustee to ensure that bondholders are kept informed about significant developments, defaults, or changes in the issuer’s financial condition.
Fiduciary Duty: An explicitly stated fiduciary duty to bondholders by the trustee, emphasising an obligation to act in accordance with the deed of appointment and relevant laws.
Resolution Mechanism: Setting out proportionate provisions for dispute resolution and a clear process for addressing conflicts of interest.
Regular Reporting: Mandating regular reporting to bondholders, providing updates on the issuer’s financial health, compliance status, and any actions taken by the trustee.
Replacement Mechanism: Outlining a process for the appointment of a new trustee should the incumbent trustee be unable or unwilling to fulfil its duties.
Amendment Procedures: Specifying how and when the trust deed or agreement can be amended, and crucially who can amend the deed, ensuring transparency and protecting bondholders’ rights
Legal Structure: Understanding the legal structure of the bonds. Some bonds may have specific features or covenants that affect their terms.
Issuer’s Financial Health: Evaluating the financial health of the issuer. Analyse the issuer’s financial statements and overall stability.
Risk Profile and Credit Ratings: Assessing the risk and return profile of the bonds, considering factors like credit risk, interest rate risk, and market conditions.
Security: Assessing whether any security pledged in support of the bonds has an impact on the risk profile during the period of the bond.
Coupon Rate: Examining the interest rate. Understanding how much income the bond will generate and if it aligns with intended financial goals.
Maturity: Appraising the maturity period. Short-term bonds may offer quicker returns, while long-term bonds may provide more stability.
Liquidity: Assessing the likely liquidity of the bonds. Bonds with higher liquidity can be easier to buy or sell in the secondary market.
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