ACKNOWLEDGEMENT First of all, I would like to extend my gratitude to almighty “GOD” that enlightened me with the owner of knowledge. It gives me immensurable pleasure in expressing words of gratitude to all those great persons whose contribution in undertaking & completing this dissertation project work stands to be one of the most invaluable achievements of my life. I extend my heartfelt thanks to our esteemed Program Co- ordinator Dr. Nachiketa Mishra for providing me an opportunity to work on this topic. His timely advice and encouragement was one of the most important ingredients, which helped me throughout this project. I also take this opportunity to thank Mr. Amit Tyagi and Mrs. Pinki Singh for guiding me throughout this project I take the opportunity to express the deep sense of gratitude to various persons who provided me valuable information & their support during the course of this project. - 1 -
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ACKNOWLEDGEMENT
First of all, I would like to extend my gratitude to almighty “GOD” that enlightened me
with the owner of knowledge. It gives me immensurable pleasure in expressing words of
gratitude to all those great persons whose contribution in undertaking & completing this
dissertation project work stands to be one of the most invaluable achievements of my life.
I extend my heartfelt thanks to our esteemed Program Co-ordinator Dr. Nachiketa Mishra
for providing me an opportunity to work on this topic. His timely advice and
encouragement was one of the most important ingredients, which helped me throughout
this project. I also take this opportunity to thank Mr. Amit Tyagi and Mrs. Pinki Singh for
guiding me throughout this project
I take the opportunity to express the deep sense of gratitude to various persons who
provided me valuable information & their support during the course of this project.
RAHUL BHARTI
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INDEX
CONTENTS PAGE NO.
EXECUTIVE SUMMARY 4
OBJECTIVES 6
REVIEW OF LITRATURE
ASSET MANAGEMENT 7
PRIVATE PLACEMENT 10
PRIVATE PLACEMENT MEMORADUM 20
SECURITIES AND EXCHANGE COMMISSION 23
BONDS 25
PROCESS OF ISSUING BONDS 29
CORPORATE BONDS 31
BOND RATINGS 34
INVESTMENT BANKING FIRMS 41
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CREDIT RESEARCH PROCESS
CREDIT RESEARCH PROCESS 44
(The Real Thing)
CREDIT WRITE UP 47
METHODOLOGY 50
OBSERVATIONS AND FINDINGS
TOOLS OF FINANCIAL ANALYSIS 52
CONCLUSION 56
RECOMMENDATIONS 57
LIMITATIONS 58
BIBILIOGRAPHY 59
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EXECUTIVE SUMMARY
The project title given to me is “Asset Management – Credit Research Process”.
The project is totally related to U.S. financial market. It relates to as how the companies
in U.S. raises money by issuing bonds through Private Placement markets and how
very few selected companies invest in these bonds.
A Private Placement is a place where only a few selected companies can invest in other
companies bonds, the majority being Life Insurance Companies.
Securities and exchange Commission (S.E.C.) is the financial market regulator in the
U.S. But, for an issue in a Private Placement, it is not necessary to get registered with
S.E.C. (an exemption provided by S.E.C under section 4(2) of US Security Act of 1993.
Before a bond issue in the Private Placement market, the issuing company has to issue a
Private Placement Memorandum (PPM) containing information about the company,
and all the terms and conditions. In between the issuing company and the investing
companies, there exists a third party-Investment Banking Firms. These firms act as an
agent between the issuer and the investors who tries to make the deal a success.
In the U.S. financial market, there are various types of bonds that are traded. The focus of
this project is simply concentrated on U.S. corporate bonds – bonds that are issued by
corporate in U.S.
During a bond issue, there are various ratings that are being assigned to the bonds that
are being issued. The two best-known raters are Standard and Poor (S&P) and
Moody’s. The ratings parameters ranges from the companies’ financial background to
companies forecasted future profits. The ratings are in the form of grades ranging from
AAA (highest quality with lowest risk) to C or D (lowest quality with highest risk).
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The project “Credit Research Process” focuses on as how to find out that a particular
company is an attractive investment designation or not by finding out the
creditworthiness of the concerned concern.
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OBJECTIVES
The objective of the project is to find out that how to determine whether a particular
company is an attractive investment destination or not. As the project is regarding
Asset Management for a financial concern, the objective is regarding the management of
their Assets – how they manage them i.e. how to invest in other companies by giving
them credit. For giving the credit, the financial concern has to find out the
creditworthiness of the firm, among other things, and that’s the main goal of our project.
Apart from the above stated objective, the other objectives of the project are stated
below:
1) To find out what the term “Asset Management” means to a financial concern?
2) To know about Private Placement markets, its process and the investors.
3) To find who regulates the financial markets in the U.S?
4) To know about various types of bonds those are traded in U.S. and the process of
their issue.
5) To know more about U.S. Corporate bonds and their types.
6) To know why various ratings are assigned to bonds in the U.S., the raters and
their rating process.
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REVIEW OF LITERATURE
ASSET MANAGEMENT
In simple words, the term “Asset Management” means Management of Assets. The
meaning may seems to be very simple to look and read, but in reality it is very much
complex. The term Asset Management has a wide concept, (though said in just two
words), but its scope is very wide. The term means Management of all types of Assets,
whether fixed or current.
So, Asset Management means management of all types of Assets (both fixed and
current) of a business concern.
DEFINE
…”Asset management is the process of managing money for individuals, typically
through stocks, bonds and/or cash equivalents. Professional investors manage these assets
according to specific stated objectives or investment styles”.
…”Asset management is the process of managing money for individuals, typically
through stocks, bonds and/or cash equivalents. Professional investors manage these assets
according to specific stated objectives or investment styles”.
…”The process of managing demand and guiding acquisition, use and disposal of assets
to make the most of their service delivery potential, and manage risks and costs over their
entire life”.
…”Asset Management is a business discipline for managing the life cycle of
infrastructure assets to achieve a desired service level while mitigating risk. It
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encompasses management, financial, customer, engineering and other business processes.
True asset management is not a system you can buy, but is instead a business discipline
enabled by people, process, data, and technology”.
IN THIS PROJECT, THE FOCUS WILL BE ON ASSET MANAGEMENT FOR A
FINANCIAL CONCERN.
FINANCIAL CONCERN
A Financial Company is one whose business is to invest its funds in other companies or
businesses. The earnings of such a company are the returns that it earns on its investment.
Such a company has its Assets mostly in the form of Liquid Assets such as Accounts
Receivables; Cash in hand, Bank balance, investment in Short-term and Long-term
Marketable Securities, Accrued interest, etc. It may also have some Fixed Assets in
the form of land and building, but that is of negligible Amount.
ASSET MANAGEMENT FOR A FINANCIAL SERVICES FIRM
A Financial Company has Assets mostly in form of Liquid Assets. It invests heavily in
other companies and businesses. Such a company may have lot of Bad Debts if its
creditors don’t pay on time or never pay up. So, a financial company has to manage its
Assets in such a way so as to minimize the risk of Bad Debts and increase its rate of
return.
A Financial Company will prefer mostly to invest in a Manufacturing Concern because of
regularity in payment of both the Interest and the Principal. But, if it does not get its
money back in time, then it may face liquidity crunch.
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So, a Financial Company should manage its Assets such that it is able to maintain its
liquidity and continue investing in profitable ventures.
CREDIT PROCESS BY A FINANCIAL CONCERN
A Financial Firm can give credit to other companies or business by way of investing in
their Equity or Bonds.
In the US context, a Financial Concern can give credit to other businesses by investing in
their Bonds or Equity issued either through Public Market or Private Placements
Markets.
CREDIT PROCESS
(Financial Concern)
Investment Investment
EQUITY BONDS (Fixed Income)
Market Market
PUBLIC/PRIVATE
IN THIS PROJECT, THE FOCUS WILL BE ON THE THE CREDIT RESEARCH
PROCESS OF PRIVATE PLACEMENTS BONDS MARKET.
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PRIVATE PLACEMENTS- INTRODUCTION
Private placements (PPs) are the quiet corporate finance deal, private with a
capital "P".
PPs have been around for more than 50 years. They emerged in the wake of the US
Securities Act of 1933, which sought to protect individual investors from bankrupt
companies. An exemption to the law allowed companies to offer securities
privately to "qualified institutional buyers." And so the PP market was born,
bringing together sophisticated institutional investors and those requiring finance.
The PP market has enjoyed significant growth since then, particularly in the last 20
years. The majority of PP investors are in the US (where the range of deals tends
to be wider and PPs are an established form of financing for growing companies),
but issuance is now global, with market growth estimated at 15 to 25 per cent a
year during the last five years. The PP market is currently worth about $450bn.
NEED
Businesses of all size regularly require infusions of capital in order to break into the next
plateau, penetrate new markets or to sustain overall growth. While there is a multitude of
financing sources available to these business owners, each source has its own inherent
limitations, requirements and benefits.
Dealing with commercial banks in a traditional lending scenario can be ideal for
established companies with a proven track record of profitability. However, growing
businesses do not have this same option do to the fact that they may not meet the strict
requirements of most contemporary lending institutions. Although less seasoned than
their established contemporaries, these up-and-coming companies still possess merit and
creditability and fortunately, have practical options for financing. Private Placements are
an attractive alternative for growing companies for a variety of reasons.
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MEANING
In legal terms, the term, ‘Private Placement’ means an agreement between a willing
seller and a willing buyer(s) to exchange an unlisted, negotiated, registered promissory
note tailored to the requirements of both parties. An intermediary agent, who works to
make the deal a success, brings the lender and the borrower together.
A Private Placement is a market (in US) where companies can raise funds by issuing
bonds or stocks without being registered with Securities and Exchange Commission
(SEC, Financial Market Regulator in US). The investors in Private Placements Markets
are Institutional Investors such as Banks, Mutual Funds, Insurance Companies, Pension
Funds and Foundations who directly invest in the securities or take the help of Investment
Bankers who act as an agent for both the parties and make the deal a success, where the
deal size ranges from very small, say US$ 30M to US$ 1 billion.
DEFINITION
… “A US Private Placement is the direct sale of unregistered securities by a company to
one or more sophisticated Institutional Investors. Principally Insurance Companies.
Section 4(2) of US Security Act of 1993 is the provision under which the Private
Placements are exempt from SEC registration. Formal ratings are not required to sell the
notes and the Investment Bank as an agent for the issuer and not as an underwriter for the
issue.”
… “ The sale of entire issue of unregistered securities (mainly bonds) directly to one
purchaser pr a group of purchasers (usually financial intermediaries).
Eliminates the underwriting function of Investment Bnaker.
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The dominant Private Placement lender in this group is the Life Insurance
Category (Pension Funds and Bank Trust Departments are very active as well).”
FEATURES
Investors are primarily insurance companies that typically utilize a "buy and
hold" credit intensive strategy.
The typical deal size amount ranges from US$50 million to US$300 million, with
amounts in excess of US$500 million not uncommon. Smaller deals are also possible.
Security Types: Investors generally prefer pari passu senior note structures.
Callable at "Make-Whole" (generally) at T+50.
Maturities range from 3 to 20 years with the deepest interest currently in 7 to 12
years.
Interest rates are fixed at the pricing date at a spread over US Treasury Notes of
a similar maturity to the privately placed notes. Floating rate availability.
Disclosure requirements typically entail a confidential offering memorandum
describing the Company's history, operations, strategy and financial performance,
along with a term sheet, the draft note purchase agreement and audited financial
statements.
Credit ratings are not required to complete a financing.
A typical timetable for an investment grade credit is between 8 to 15 weeks from
engagement to funding.
Investors view financial covenants as a package and not individually. The typical
package of financial covenants will address: net worth, leverage, and operating
performance. Financial covenants are valued by USPP investors. Investors generally
like to have the same covenant package as current or future bank facilities but they
will frequently provide more flexibility.
As the market has grown, documentation has been standardized over the
years. A group of investors, law firms and investment banks specializing in USPP's
and two investment banks under took a project to simplify and standardize USPP
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documentation. This project led to the Model Form Note Purchase Agreement which
is now the standard for US private placements.
ADVANTAGES
1. There is a sizeable yield advantage : Depending upon various investment factors
(such the term, the credit risk, the structure), private placements can provide 50 to
200 basis points more than bonds issued by the same or similar issuers in the
public bond market.
2. Yield advantage can give rise to a stable source of alpha : Most benchmarks do
not include private placements in their universe. The added yield that private
placements offer provides an opportunity for portfolio performance to exceed the
benchmark. Also, this yield advantage can be less volatile than duration, curve or
sector rotation strategies towards investment grade transactions is inherently less
risky than investments in high yield bonds.
3. These investments can be diversified : Private placements are not confined to
any particular sector, type of credit, or credit rating. As such, investors have the
opportunity to diversify their portfolio of private placements.
4. Terms are typically negotiable : Ordinarily, investors are able to negotiate the
terms of the bonds. This provides an opportunity to enhance safeguards for the
investor. For example, an investor may wish to broaden the nature and frequency
of financial disclosure, added tailored financial covenants, or improves remedies
for investment risks. Also, transactions can be structured to suit investor
preferences. There is no guarantee that issuers will accede to the investor's
desires in every circumstance but the opportunity to negotiate exists.
5. Only qualified institutions can invest : Investors must have significant
experience in investing in bonds in order to sufficiently understand the risks and
rewards of purchasing Private placements and only qualified institutional
investors are likely to have the knowledge and resources to adequately weigh risk
and make these Judgments.
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6. Private placements : There is a ready market in which an investor may re-sell a
private placement. Other suitable investors within the QIB community would
have an interest in purchasing a private placement from a current holder.
7. Flexibility: Private Placements have a high degree of flexibility in regard to the
amount of money that can be raised. Private Placements can range in size from
less than $50,000 to upwards of $50 million. Private Placements come in a variety
of forms and may consist of debt, equity or a combination of debt and equity
financing.
8. Low Share Price : The main advantage that most investors seek when investing in
Private Placements is that one can normally buy shares of the company for very
low prices while it is still a privately held company. The ideal investment in a
privately held company is to buy shares just before the company goes public.
Once a company begins trading its shares on a public stock exchange, stock prices
tend to rise dramatically, enabling the Private Placement investor to sell his/her
stock at much higher prices.
9. Business Friendly Investors : The Investors that fund the Private Placements are
more “Business Friendly” than lending institutions or venture capitalists due to
the fact that they are "hand-picked" by the company raising money for itself. The
company can establish their own terms for return on investment. As long as these
terms are fully disclosed and agreed to by all parties involved, a highly beneficial
capital raise can be completed in a relatively short period of time. The more
reputable the company and the more promising their outlook, the easier it is to
complete the Private Placements.
THE PRIVATE PLACEMENT PROCESS
1) Preliminary Analysis : The first step in Private Placement process is to review
financial statements and compare this data to industry standards to determine
performance trends. In addition, future plans; management stability, competitive
environment, planned and current programs, and the regulatory environment
should be investigated. Next, reviewing of bond structures, call provisions,
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maturities and other options is done for potential financing programs available to
the particular institution. Research is done to identify alternative financing plans,
interest rates and size of debt.. Once completed, the preliminary analysis is then
combined with project financing information for presentation and
recommendation to management.
2) Offering Memorandum : The Company develops the structured financing plan,
working with accounting firms, lawyers and rating agencies to design the most
cost-effective financing. Since ratings affect the marketability of an issue, it
should prepare the borrowers for rating service reviews, initial and updated, for
both written submissions and oral presentations. The preparation of the PPM
(private placement memorandum) is usually completed within the first six weeks.
3) Bond Marketing: The Company arranges for a direct private Placement of Bonds
with Institutional investors, and suggests terms and conditions that are in the best
interest of the borrowers. By the end of the marketing period, the interest rate is
set. The marketing period is usually completed in six weeks period.
4) The Closing Process : The closing process is usually a four- to six-week period.
The parties negotiate and agree to final bond covenants.
5) Monitoring: Proper monitoring of the borrowers financials should be done while
keeping track of market innovations to recommend appropriate financial changes.
BORROWERS IN PRIVATE PLACEMENT MARKETS
Mid-size firms in the United States are the primary traditional borrowers in the private
placement markets. These companies are defined by annual sales of between five
million and one hundred million dollars. They generally maintain single plant
operations, and the majorities are privately held. According to the 1987 U.S. Census of
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Manufactures, single establishment firms employed 5 million American workers and
provided $212 trillion dollars of value added process to the United States economy
annually. These small, mostly private firms have limited access to capital. Because of
their size investors usually prefer debt financing to equity financing, and a substantial
debt to equity problem persists for middle market firms. Mid-size private companies seek
private placement debt issues because they are SEC exempt.
LENDERS IN THE PRIVATE PLACEMENT MARKET
With the latest occurrences of accounting fraud in the stock market, the private
investment market is an attractive alternative for investors and small businesses. It also
allows investors to get involved in a company on the "ground floor" in many cases. A
Private Placement investor has the opportunity to keep a closer eye on their investment,
than a public market investor, and has the opportunity to reap large financial benefits by
getting in on the ground floor of what could be a hugely successful company.
Although various institutions hold some traditional Private Placements in their portfolios ,
Life Insurance Companies purchase the great majority of them.
Example: The break-up of various investors in the Private Placement Market in a
particular year can be as shown in the following table:
Lender Share of the Market for Private Placement Markets in a
Particular year:
TYPE OF LENDER SHARE OF VOLUME (%)
Life Insurance Companies 82.6
Pension Funds 1.7
Financial Companies 1.4
Mutual Funds .7
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Casualty Insurance Companies 1.4
US Commercial Banks 3.3
Foreign Banks 3.6
US savings and loans and mutual
Saving banks .7
US Investment Banks .9
Unknown 3.7
INITIATING A PRIVATE PLACEMENT
In order for a business to initiate the Private Placement process, following conditions
must be satisfied-
A Thorough Business Plan.
A Private Placement memorandum (PPM) that fully discloses all the pertinent
facts of the investment and business.
Potential Investors or a Placement Agent to locate potential Investors.
Most importantly, a law firm or lawyer (Investment counselors) in Private
Placements and the creation of Private Placement Memorandums.
If an issuing company fails to qualify for the Private Placement exemptions relied upon,
it can face severe penalties and possible criminal repercussions.
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RISK INVOLVED
(At best, putting money into a private company is high risk. At worst, it can turn out
to be a scam)
Some investors looking for better returns are wading into the high-risk territory of
"private placements," lending money to or buying stock in small private companies.
EXAMPLE: Invest private Inc., which raised about $17.6-million for itself and its
affiliates, document which were given to the investors misrepresented the company’ a
background, and the use of money it raised, which includes paying of company’s
Chairman personal expenses.
Some Potential Pitfalls:
The company may not do well or may even go out of business, a particular risk if
it is relatively new or has inexperienced management.
Investors may have difficulty finding out how the company is doing financially.
Investors may have difficulty getting their money out of the company since there
is no public market for the securities.
The company may never go public, disappointing investors who buy stock hoping
for a big return.
The offering might be found to be illegal if all the requirements for the
exemptions are not met. To meet these exemptions, securities generally cannot be
advertised to the public.
A conflict of interest may exist if the company selling the investment benefit from
it.
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A BUOYANT MARKET
The US PP market recorded spectacular volumes in 2003, with nearly USD46bn of new
issuance. The 59% increase was boosted by a record amount of funds directed towards
this asset class by investors, predominantly US life insurers.
US Private Placement Market Historical Private Placement Issuance
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PRIVATE PLACEMENT MEMORANDUM
MEANING
The key requirement to conduct a Private Placement offering is the Private Placement
Memorandum or PPM; the legal document that includes all the disclosures required
by law so investors can make an informed decision as to the risk-reward scenario
before taking part in a private offering. The Private Placement Memorandum protects the
company as well as the investor by making perfectly clear that such transactions are
speculative in nature and should only be undertaken by individuals capable of sustaining
a loss of investment capital.
The Private Placement Memorandum and accompanying Subscription Agreement
guards the company from inadvertent non-compliance and also provides evidence of due
diligence in the event of a dispute.
DEFINITION
…” A confidential sales document that is provided to a potential sophisticated investor
for a private placement of bonds. The PPM contains relevant information about the
financial, economic and demographic characteristics of the borrower and its service
area.”
NEED
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The purpose of a Private Placement Memorandum is to disclose the material
information about the company and its business—especially the risk factors associated
with the investment in the company—to prospective investors.
The Private Placement Memorandum may not be technically required in very small stock
offerings to a few individuals who are sophisticated and who have access to all the
information they need about the company. However, a Private Placement Memorandum
is a useful way, in many circumstances, to prove that the company provided all-important
information to investors (in case the investment goes bad and investors insist on having
their money refunded).
PRINCIPLES
A complete Private Placement Memorandum needs to follow several important rules, so
it is necessary to consult with an experienced securities attorney when putting one
together. The following list contains some fundamental principles to adhere to when
creating a Private Placement Memorandum:
Be certain that your statements are true.
Don't mislead potential investors in any way.
Don't omit any information that may affect the investor's decision.
Lay out the risks to the potential investor.
Provide proof of your statements.
Don't exaggerate facts or projections.
If you don't follow the rules to the letter, a number of adverse consequences can follow,
including possible civil and criminal penalties and the investor's right to demand his or
her money back. The advice of a good securities lawyer is absolutely essential in this
area.
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CONTENTS OF PPM
1. Cover page.
2. Securities Legends.
3. Suitability Standards for Investors.
4. Summary of the Securities offerings.
5. Risk factors.
6. Capitalization of the Company.
7. Use of Proceeds from Securities offerings.
8. Dilution.
9. Plan of Distribution of Securities.
10. Selected Financial Data.
11. Management’s Discussion and Analysis of Financial Condition and Results of
Operation.
12. The Business of the Company.
13. Management and Compensation.
14. Certain Transactions (transactions between the Company and its shareholders,
officers, directors or affiliates).
15. Principal Shareholders.
16. Terms of the Securities Offered.
17. Description of Capital Stock of the Company.
18. Tax Matters
19. Legal Matters.
20. Experts.
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S.E.C. – WHAT IT IS?
Formed by Securities Exchange Act of 1934, Securities and Exchange Commission is
the primary overseer and regulator of the U.S. securities markets.
Joseph P. Kennedy, President John F. Kennedy's father, was the first Chairman of
the SEC.
…”The SEC is an independent federal agency that oversees and regulates the securities
industry in the US, and enforces securities laws. It requires registration of all securities
offered in interstate commerce, and of all individuals and firms who sell those securities.
Established by Congress in 1934, the SEC sets high standards for disclosure about
publicly traded securities, including stocks, bonds, and mutual funds, and works to
protect investors from misleading or fraudulent practices, including insider trading. The
SEC has also helped to establish a competitive national market system known as
Intermarket Trading System (ITS) for trading securities, and set up”.
…” The federal agency created by the Securities Exchange Act of 1934 to administer that
act and the Securities Act of 1933. The statutes administered by the SEC are designed to
promote full public disclosure and protect the investing public against fraudulent and
manipulative practices in the securities markets. Generally, most issues of securities
offered in interstate commerce or through the mails must be registered with the SEC”.
S.E.C. – WHAT IT DOES?
The Securities Exchange Act of 1934 empowers the SEC with broad authority over all
aspects of the securities industry. This includes the power to register, regulate, and
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oversee brokerage firms, transfer agents, and clearing agencies as well as the
nation's securities self regulatory organizations (SROs). The various stock exchanges,
such as the New York Stock Exchange, and American Stock Exchange are SROs. The
National Association of Securities Dealers, which operates the NASDAQ system, is also
an SRO.
The Act also empowers the SEC to require periodic reporting of information by
companies with publicly traded securities.
The primary mission of the U.S. Securities and Exchange Commission (SEC) is to
protect investors and maintain the integrity of the securities markets.
The SEC requires public companies to disclose meaningful financial and other
information to the public, which provides a common pool of knowledge for all investors
to use to judge for themselves if a company's securities are a good investment.
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BOND – WHAT IT IS?
In simple words, the term “Bond” means ‘a debt investment with which the investor
loans money to an entity (company or government) that borrows the funds for a defined
period of time at a specified interest rate’.
Bonds are loans. When you buy a bond, you are lending money to a bond issuer in return
for a set rate of interest. The issuer agrees to repay your principal on a specified future
date.
BONDS – DEFINED
…”A certificate of debt that is issued by a government or corporation in order to raise
money with a promise to pay a specified sum of money at a fixed time in the future
and carrying interest at a fixed rate. Generally, a bond is a promise to repay the
principal along with interest (coupons) on a specified date (maturity).
It is a tradable debt instrument that might be sold at above or below par (the amount paid
out at maturity), and are rated by bond rating services such as Standard & Poor's and
Moody's Investors Service, to specify likelihood of default. The Federal government,
states, cities, corporations, and many other types of institutions sell bonds. It is relatively
more secured than Equity and has priority over shareholders if the company becomes
insolvent and its assets are distributed”.
BOND MARKET
The market for all types of Bonds whether on an exchange or over-the-counter.
TYPES OF BONDS
Most bonds that we come across have been issued by one of three groups: the U.S.
government, state and local governments or corporations. But to confuse things, these
entities issue many different types of bonds that run the gamut in terms of risk and
reward. Here's a quick introduction to the ones we encounter most:
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1. U.S. GOVERNMENT BONDS : The bonds issued by U.S. Government are
called Treasuries. They're grouped in three categories.-
U.S. Treasury bills -- maturities from 90 days to one year.
U.S. Treasury notes -- maturities from two to 10 years.
U.S. Treasury Bonds -- maturities from 10 to 30 years.
Treasuries are widely regarded as the safest bond investments, because they are backed
by "the full faith and credit" of the U.S. government. And there's another benefit to
Treasuries: The income you earn is exempt from state and local taxes.
2. MUNICIPAL BONDS: Municipal bonds are a step up on the risk scale from
Treasuries, but they make up for it in tax trickery. These bonds are non-taxable,
but there is a cost involved – they offer a lower coupon rate. But depending on
your tax rate, your net return may be higher than it would be on a regular bond.
3. CORPORATE BONDS : The bonds issues by corporations are called Corporate
Bonds. Corporate bonds are generally the riskiest fixed-income securities of all.
But, Corporate Bonds can also be the most lucrative fixed-income investment,
since you are generally rewarded for the extra risk you're taking. The lower the
company's credit quality, the higher the interest you're paid.
4. ZERO-COUPON BONDS : Zero-coupon bonds are fixed-income securities that
don't make interest payments each year like regular bonds. Instead, the bond is
sold at a deep discount to its face value and at maturity; the bondholder collects
all of the compounded interest, plus the principal.
POTENTIAL INVESTORS IN BONDS
The most important financial investors in the market are institutional investors,
particularly in the large industrial countries. These include pension funds, insurance
companies, investment funds, and trust department of commercial banks.
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PENSION FUNDS
(Most Important)
INSURANCE COMPANIES
(Second Most Important)
BONDS INVESTORS
INVESTMENT FUNDS
(Mutual Funds and Hedge Funds)
COMMERCIAL BANKS
(Trust Departments)
RETAIL INVESTORS
WHY INVEST IN BONDS ?
Ever heard about co-workers talking around the water cooler about a hot tip on a Bond? I
didn't think so. Tracking bonds can be about as thrilling as watching a chess match,
whereas watching stocks can have some investors as excited as NFL fans during the
Super bowl. But don't let the hype (or lack thereof) mislead anyone.
The bond market is not glamorous. When the economy is going strong, we rarely hear
talk at parties or read articles about the hottest bonds or bond funds. However, for the
conservative portion of our portfolio, bonds are usually among the best investment
choices.
These are the reasons why we should include bonds in our portfolio-
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Safe Heaven for Investment: Investing in Bonds is safe. The underlying
assumption is that in comparison to Common Equity, which represents Ownership,
bonds represent Debt. So, Bonds enjoys a right for the repayment of money in
comparison to Common Stock Owners if the company goes into liquidation.
Financial Security: Who doesn't like the sound of “financial security”? There's a
reason that a bond is called a “fixed-income” security – not only the investors are
highly likely to get back your principal but can also count on receiving interest on
your investment.
Portfolio Balance and Diversification: Bonds can be great financial “buffers.”
When the stock market is on a roller-coaster ride, bonds can help steady our pulse
because they're a very safe financial tool to help balance the risk in your overall
portfolio.
Tax breaks: One of the not so well known facts about bonds is that they're very
often free from many taxes. For example, most bonds issued by state or local
governments (also known as “municipalities” or “munis”) are exempt from federal
income taxes.
Weighing the Risk : Probably the first thing we heard about investing is that it's
never risk-free. True enough. And although highly rated bonds are considered one of
the safest ways to invest your money, one should still take the risks into account
before making any decisions.
Rising Inflation: If inflation rises, the interest one make on your initial
investment will look low compared to bonds currently being issued. And with
investor money locked in a bond, they could lose some principal if they sell it in order
to move it into another investment that could give them a higher rate of return.
Selling the Bond Before Maturity: If we decide that we need our money back
earlier than the date that our bond matures, we are taking “a chance” that we may get
more, or less, than we paid. This depends mostly on the interest rates at which new
bonds are being issued. That's why individuals who invest in bonds typically plan to
hold them till they mature. And that's why it's important to determine when we will
want, or need, to reach our financial goal in order to purchase a bond that matures at
that same time.
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THE PROCESS OF ISSUING BONDS
When corporations or government bodies need to raise money, they may sell bonds to the
public. Because this is a highly technical and complicated process, the issuing
organizations usually hire special parties to do this work for them.
Once an organization decides to issue bonds, how does it proceed?
1) BOND-BUYING PROCESS : When a corporation or government agency is
considering issuing bonds--or stocks, for that matter--it usually contacts an
investment bank for advice on the marketplace, the possible issuing price, and
other factors. An investment bank is a firm that serves as an intermediary
between the organization issuing the securities and the investors who purchase
them. The bond issuer itself does not sell the bonds.
Investment banks possess knowledge and expertise they need to reach investors.
Investment bankers generally have an excellent understanding of capital markets,
relevant government regulations, and other factors affecting a bond issue.
2) ISSUING OF BONDS BY INVESTMENT BANKERS : In acting as an
intermediary between the bond issuer and the bond buyer, the investment banker
serves as an underwriter for the bonds. When investment bankers underwrite the
bonds, they assume the risk of buying the newly issued bonds from the
corporation or government unit; they then resell the bonds to the public or to
dealers who sell them to the public. The investment bank earns a profit based on
the difference between its purchase price and the selling price . This difference
is sometimes called the underwriting spread.
Sometimes the investment banker markets a new issue but does not underwrite it. The
investment bank simply acts as a sales agent under a best efforts agreement, promising to
do its utmost to market the bonds. The investment bank has the option to buy the bonds
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and usually purchases only enough bonds to meet buyer demand, receiving a commission
on the bonds sold.
After the bond issuer and the investment banker have completed and filed all necessary
documents, they can begin to sell the bonds.
3) LOCATING BOND BUYERS: Investment bankers generally have a good
understanding of where and how to market newly issued bonds. They usually
have well-developed investment banking networks and may identify the
brokers and sales forces most able to market a particular bond offering.
Investment bankers sometimes have established networks with investors who
may be interested in the offering; they may encourage the investors to contact
brokerage houses, specifying what they want in a bond.
Investment bankers also may sell newly issued bonds through Private Placements to
large, institutional investors like insurance companies or government unit retirement
funds. If the bonds are purchased for investment and not for resale, they do not need to be
registered with the SEC. Regardless of the sales channel, most newly issued bonds are
sold through investment bankers.
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CORPORATE BONDS – INTRODUCTION
Corporate bonds are debt securities issued by private and public corporations.
Companies issue corporate bonds to raise money for a variety of purposes, such as
building a new plant, purchasing equipment, or growing the business.
When you buy a corporate bond, you lend money to the "issuer," the company that issued
the bond. In exchange, the company promises to return your money, also known as
"principal," on a specified maturity date. Until that date, the corporation usually pays you
a stated rate of interest, generally semiannually. While a corporate bond gives you an
IOU from the company, you do not have an ownership interest in the issuing corporation
—unlike when you purchase the company's stock.
DEFINITION
…”A bond issued by a corporation. Such bonds usually have a par value of $1,000,
are taxable, have a term maturity, are paid for out of a sinking fund accumulated for
that purpose, and are traded on major exchanges. Generally, these bonds pay higher
rates than government or municipal bonds since the risk are higher. Corporate bonds
have a wide range of ratings and yields because the financial health of the issuers can
vary widely. A high-quality blue chip company might have bonds carrying an
investment-grade rating such as AA (with a low yield but a lower risk of default), while a
startup might have bonds carrying a
“Junk bond” rating (with a high yield but a higher risk of default). If a company goes
bankrupt, both bondholders and stockholders can make a claim on the company's assets,
but the claims of bondholders takes precedence over that of stockholders in liquidation.”
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FEATURES
All of these common features of corporate bonds are established at the time of issue.
Callability is the feature of a bond whereby the corporation that issued it can
redeem the bond before it matures. Corporations may call their bonds when interest
rates drop below their current bond rates. Call provisions must be made clear before a
bond is issued. These provisions include the call price, which is the price at which the
bond will be bought back from bondholders. The call price is usually above par.
A put provision is the privilege whereby the bondholder may redeem a bond at
its face value before it matures. Investors may want to do this when interest rates are
rising and they can take advantage of higher rates elsewhere.
Convertibility is the option of converting a bond into stock. Bonds with this
feature are called convertible bonds. They give the investor the option to convert the
bond into the issuing company's stock, usually the company's common stock. With
this provision, the company may have the option to pay investors in stock.
TYPES
There are two main types of corporate bonds (high-quality and high-yield).
1) HIGH-QUALITY CORPORATE BOND : This type of bond carries an
investment-grade credit rating of BBB or higher from Standard & Poor’s or other
recognized ratings agencies. Many such bonds are issued by icons of American
business. These blue-chip companies include well-known marketplace brands
such as IBM and General Motors.
Why invest in high-quality corporate bonds? They offer attractive yields compared to
government securities, and are relatively safe, though not as safe as government
securities.
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2) HIGH-YIELD CORPORATE BOND : Also called a junk bond, it is a security
with a credit rating below investment grade. Many such bonds are issued by
corporations that lack financial strength or proven track records.
Why invest in high-yield bonds? High-yield bonds provide a higher level of income
than government bonds and high-quality corporate bonds because of the higher credit risk
associated with them.
WHY OWN A CORPORATE BOND?
There are three main reasons to own corporate bonds:
1. Valuation: Corporate bonds are yielding much more than Government bonds on a
relative and absolute basis. Their valuations are at levels not seen since the peak of the
last two recessions in 1982 and 1990 IN THE U.S.
2. Issuance: The issuance of government bonds is poised to decrease dramatically, which
will shift portfolios that have relied on government bonds to offset their liabilities into the
corporate bond market. This flow of funds will create a new level of demand for
corporate bonds.
3. Performance: Corporate bonds have historically outperformed
government bonds. There is no reason to doubt that good quality
corporate bonds will continue to outperform government bonds as we
move forward.
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BOND RATINGS
HOW RISKY ARE CORPORATE BONDS?
Corporate bonds are fixed interest securities, so they are a low to moderate-risk
investment if you hold them until they mature.
The risk level of a corporate bond depends on:
The credit rating of the company issuing the bonds.
How each bond itself is ranked in the Capital Structure of the Company-
where it stands compared with other securities if the company was wound up?
WHY RESORT TO RATINGS?
When you’re saving and investing for the future, you want to rest assured that your
money is in the hands of a solid, reputable organization — in other words, that your
money is going to be there when you need it. You probably also want to know how these
assets are performing, relative to the risk level you’re comfortable with for meeting
your goals. Ratings of financial companies and investment funds can help answer
both of these questions.
WHAT IS A CREDIT RATING?
A credit rating is an independent assessment of the creditworthiness of a bond (note or
any security of indebtedness) by a credit rating agency. It measures the probability of
the timely repayment of principal and interest of a bond. Generally, a higher credit
rating would lead to a more favorable effect on the marketability of a bond. The credit
rating symbols (long-term) are generally assigned with "triple A" as the highest and
"triple B" (or Baa) as the lowest in investment grade. Anything below triple B is
commonly known as a "junk bond."
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THE RATERS
There are a number of independent rating agencies that analyze and publish a credit
rating on companies and governments that have debt securities such as bonds
outstanding. The two best-known agencies are Standard & Poor’s and Moody’s. Each
of these agencies aims to provide a rating system to help investors determine the risk
associated with investing in a specific company, investing instrument or market.
CREDIT RATINGS – HIGHEST TO LOWEST
The ratings lie on a spectrum ranging between highest credit quality on one end and
default or “junk” on the other. Long–term credit ratings are denoted with a letter: a
triple A (AAA)) is the highest credit quality, and C or D (depending on the agency
issuing the rating) is the lowest or junk quality. Within this spectrum there are different
degrees of each rating, which are, depending on the agency, sometimes denoted by a plus
or negative sign or a number.
Here is a chart that gives an overview of the different ratings symbols that Moody's
and Standard and Poor's issue:
Bond Rating
Grade RiskMoody's
Standard &
Poor's
Aaa AAA Investment Lowest Risk
Aa AA Investment Low Risk
A A Investment Low Risk
Baa BBB Investment Medium Risk
Ba, B BB, B Junk High Risk
Caa/Ca/C CCC/CC/C Junk Highest Risk
C D Junk In Default
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Investment grade generally refers to any bonds rated Baa or higher by Moody’s, or BBB
by Standard and Poor’s.
Junk bonds are the lowest-rated corporate bonds. There’s a greater-than-average chance
that the issuer will fail to repay its debt. Investors were willing to take the risk because
the yields were so much higher than another, safer bonds.
HOW ECONOMICAL RATINGS CAN BE?
Obtaining wider market access typically translates into reduced funding costs,
particularly for higher-rated issuers -- as the graph illustrates:
The credibility of a rating from a respected and globally established rating agency
may thus allow issuers to enter capital markets more economically and more frequently,
and to sell larger offerings at longer maturities.
HOW BONDS ARE RATED?
Ratings Services shall provide a rating only when it believes there is adequate
Information available to form a credible opinion and only after appropriate analyses have
been performed.
The rating process begins with an application to the rating agencies by the issuer or its
agent either via a telephone call or in writing. The rating request is usually done several
weeks before the issuance of the bonds to allow time for the rating agencies to perform
their review and analysis.
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Generally, the following documentations are provided to the rating agencies as soon
as possible:
The preliminary official statement,
Latest audited and unaudited financial statements,
The latest budget information, including economic assumptions and trends,
Capital outlays plans,
The bond counsel opinion addressing the authority and tax-exempt status of the
bond issuance,
All the legal documents relating to the security of the bonds, and,
Any other document that may pertain to the bond issuance as requested by the
rating agencies.
Following this, a meeting is set up at the rating agency's or issuer's office to present the
credit worthiness. The credit analyst prepares a municipal credit report which discusses
key analytical factors. The credit analyst presents credit for "sign-off" with the senior
analyst and makes a recommendation for rating. The credit analyst makes a presentation
before a rating committee comprised of senior analysts. Finally, the rating is released to
the issuer, and then to a wire service, followed by a publication of full credit report.
ELEMENTS INVOLVES IN DETERMINING A CREDIT RATING
ECONOMIC FACTORS
Evaluation of historical and current economic factors.
Economic diversity.
Response to business cycles.
Economic restructuring.
Assessing the quality of life in the given area.
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DEBT/ISSUE STRUCTURE
Economic feasibility and need for project.
Length of bond's maturity, short-term debt financing.
Pledged security and other bondholder protections.
Futuristic outlook: capital improvement plan.
FINANCIAL FACTORS
Sufficient resources accumulated to meet unforeseen contingencies and liquidity
requirements.
On-going operations are financed with recurring revenues.
Prudent investing of cash balances.
Ability to meet expenditures within economic base.
MANAGEMENT/STRUCTURAL FACTORS
Organization of government and management.
Taxes and tax limits.
Clear delineation of financial and budgetary responsibilities.
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ACCURATENESS OF CREDIT RATINGS
The first question that anyone legitimately raises about an opinion is the about the
accuracy of credit ratings. The following figure tracks Moody's record at predicting
defaults over the last 25 years.
The data show average cumulative default rates for corporate bond issuers at each
category over bond holding periods of one to twenty years. In general, the lower the
rating and the longer the holding period, the higher the expected default rate.
The record is impressive. For example, the default rate on bonds rated Aaa has been
extremely low. Only 0.1% of Aaa-rated issuers on average have defaulted within five
years, and the average Aaa default rate over ten-year periods has been less than 1%. By
contrast, some 28% of B-rated issuers have defaulted after five years, 40% on average
after ten years.
So, the credit ratings are accurate enough for the potential investors to resort to them and
make a proper decision about investment.
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LIMITATIONS OF THE RATINGS
Despite their widespread acceptance and use, bond ratings have some limitations that
are as follows:
The two agencies may disagree on their evaluations.
As most bonds are in the top four categories, it seems safe to argue that not all
issues in a single category (such as A) can be equally risky.
Finally, it is extremely important to remember that bond ratings are a reflection
of the relative probability of default, which says little or nothing about the
absolute probability of default.
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INVESTMENT BANKING FIRMS – WHAT THEY ARE?
Investment banking is the process of raising capital for businesses through public
floatation and private placement of securities. Investment banks work with companies,
governments, institutional investors and wealthy individuals to raise capital and provide
investment advice. Originally, investment banking meant the underwriting and
distribution of securities. Today investment bankers also invest a lot of effort into helping
companies design deals and the securities to finance them, and then use their brokerage
arms to sell the securities to the investing public, both retail and institutional.
ROLE OF MODERN INVESTMENT BANKS
The original purpose of investment banks was primarily raising capital and advising on
mergers and acquisitions. As banking firms have diversified, investment banks have
come to fill a variety of roles.
Underwriting and distributing new security issues.
Offering brokerage services to public & institutional investors.
Providing financial advice to corporate clients, especially on security issues,
M&A deals.
Providing financial security research to investors and corporate customers.
Market-Making in particular securities.
Investment banks have also moved into foreign currency exchanges, private banking,
and providing bridge loans.
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ROLE IN PRIVATE PLACEMENT PROCESS
Investment bankers also advise companies on private placements. Investment bankers
create value for their clients through three primary means:
They possess an extensive network of industry and financial contacts,
They create a competitive environment for the company's securities, and
They possess current knowledge about matters such as transaction structuring,
legal processes, and comparable market events.
A Corporation in the private placement hires an investment banker to help it sell its
bonds. The investment banker functions as an agent between the issuing corporation and
the potential investors. The bank will match the issuer of the security with potential
investors in an offering which is not made available to the public. Investment banking
professionals concentrate their efforts on identifying alternative sources of capital and
on developing innovative techniques to match the interest of users and providers of
capital.
The Investment Banker guarantees the proceeds of the offering to the issuing firm by
purchasing the bonds. But, actually, it does not purchase them, instead agrees to help the
firm to sell the issue to potential investors. It may re-sell the securities at a price which is
higher than the offer price. The difference represents the fee for the banker.
The Investment Banking Firm performs the following roles during a private Placement
Issue:
Assisting the clients with their Private Placement Memorandum (PPM).
Researching potential investors appropriate for the company's financing stage
and industry sector.
Developing a Marketing plan for distributing the PPM and arranging individual
meeting between management and potential investors.
Coordinating due diligence and follow-up meetings.
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Obtaining and Negotiating indicative term sheets from interested investors.
Helping management and the Board to obtain the best available terms and
valuation.
Finally, managing the legal documentation and closing for the Private Placement.