Corporate bonds: an opportunity for firms and investors

SSL in the Money

Wednesday, October 31, 2012    

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SINCE January, the yield on the benchmark interest rate has ranged between 6.5 per cent and 6.8 per cent. These rates come as no surprise to the market as current economic conditions continue to foster a low interest rate environment, at least for Bank of Jamaica (BOJ) instruments. The current environment, however, may do more than stabilise yields, it may create the paradigm shift needed to generate sustained economic growth.

Presently, the low interest rates are not outpacing inflation and as such, investors with capital are looking for yields above what is being offered on Government paper. At the same time, businesses and new entrepreneurs are seeking lower financing rates that can make them globally competitive. This is an ideal situation to be the catalyst for the paradigm shift where both parties can be in a win-win situation. A vehicle through which this may be achieved is the corporate bond market.

Currently, the local corporate bond market is thin when compared to the market for government paper and the equities market. There are only a handful of corporate bonds such as the Jamaica Public Service Company’s bond. There are also a few municipal corporate bonds and government agency-issued bonds; however, these are backed by the Government of Jamaica (GOJ). Given the lack of depth in the market, there is space for new issues in the market, and consequently new instruments for individuals to invest in.

This brings us to one of the main advantages of corporate bonds — attractive yields. Investors who desire a higher rate of return than that offered by treasury bills and other GOJ instruments, and who are willing to expose themselves to more risk, should consider investing in corporate bonds. While these instruments pay a higher interest rate, they also are inherently riskier instruments because they stand on the financial strength and integrity of the company rather than the faith of the government.

Corporate bonds also satisfy diversification objectives. Unlike ordinary shares, they offer periodic returns that are fixed and thus can be matched to suit each individual’s specific investment goals or cash flow needs. If the current low-rate environment persists, more and more investors may be enticed to include corporate bonds as a part of their portfolio.

Undoubtedly the current environment provides the impetus for investors to demand corporate bonds but what of the supply side? Will companies want to issue corporate bonds? If relatively low interest rate loans cannot be sourced from traditional means, Jamaican businesses can use their ingenuity to foster active capital markets to source the funds they need at rates that will allow their businesses thrive. This in turn will help grow Jamaica’s economy as soon businesses will be able to expand and employ more workers. Large and medium companies may choose to issue corporate bonds instead of raising the capital that they need from other sources, for a number of reasons.

Firstly and most important, the rate at which companies can borrow money in the bond market is one of the lowest cost sources of financing available; it is at least cheaper than a typical commercial bank loan. Although interest rates have been reduced from the BOJ side, some banks have not followed suit comparatively.

Additionally, some banks are not in the business of lending to companies for long periods of time. Corporate bond issues on the other hand, can afford the borrower a longer time period in which to repay funds. Lastly, some companies may not want to dilute the percentage ownership of their existing common stock by issuing additional shares and instead issue debt in the form of bonds.

It is important to note that corporate bonds are not just the prerogative of large companies but may be offered by companies of varying sizes. As a result, corporate bonds may have a wide range of yields because of the varying financial health of the issuers. All companies are different and have a different likelihood of defaulting on their obligations. For example, a wellestablished blue chip firm is far less likely to default than say a new financial company. The blue chip’s bonds might carry a comparatively low yield (but still higher than Tbills etc) while, the less stable company might issue bonds with a higher yield due to increased risk.

Investors can diversify their bond investments among several different issuers to minimise the possible impact of any single issuer’s default. They can also create a “laddered” portfolio of bonds with different maturities, for example: one, three, five and 10 years. A laddered portfolio has principal being returned at defined intervals. When one bond matures, you have the opportunity to reinvest the proceeds into another bond or alternate investment.

It is exciting to imagine the possibility of this market developing to the stage where corporate bonds are commonplace and traded regularly on the Jamaica Stock Exchange. At this point, Jamaica will have found another way to efficiently and simultaneously channel cheap capital to established companies and budding entrepreneurs while rewarding a greater number of investors who are willing to take on some degree of risk.



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