6.2 Characteristics of bonds and equities

to lenders, and that means issuing them on terms which compete with those avail-

able on existing securities. If share prices are high, for example, new shares can be

issued at a ‘high’ price and the cost of new capital will therefore be low. Thirdly, the

existence of an active secondary market has the effect of making securities very liquid.

Even large quantities can be bought and sold quickly and with low brokerage charges.

This makes them much more attractive to investors, lowers the return which they

require, and (again) keeps down the cost of capital to rms. Furthermore, the beha-

viour of nancial markets may have some indirect effect upon rms’ behaviour by

their impact upon the general state of ‘condence’ in the economy. Whatever its

objective relevance to rms’ spending plans, it is hard to imagine that the 40 per

cent fall in stock prices in 2001 and 2002 did not cause most people, rms included,

to be less certain about the future. Lastly, it should be remembered that securities

are assets in the portfolios of individuals and of nancial institutions. General price

movements, therefore, cause changes in wealth. People may change their spending

plans as security prices rise or fall; certainly banks and other nancial institutions

will revise their lending plans as the value of their assets rises and falls. The long

boom in the US economy during the 1990s was thought by many to have been due

to the steady rise in the stock market. During 2005 and 2006, central banks monitored

closely the recovery in share prices for signs that it might be encouraging too fast a

rise in consumer spending.

6.2Characteristics of bonds and equities

6.2.1Bonds

Bonds are normally issued with a xed period to maturity. Many are issued to mature

in ten or even twenty years’ time, but there are some government bonds in exist-

ence which will never be redeemed. The year of maturity normally forms part of the

bond’s title. Obviously, as time passes, the residual maturityof any bond shortens. It is

common to classify bonds by their residual maturity. Bonds with lives up to ve years

are called ‘shorts’; from ve to fteen are ‘mediums’; over fteen are ‘longs’.

Secondly, bonds pay a xed rate of interest. This interest payment is known as the

coupon and is normally made in two instalments, at six-monthly intervals, each

equal to half the rate specied in the bond’s coupon. The coupon divided by the

par value of the bond (£100) gives the coupon rate on the bond. We can illustrate

both these points by reference to the government bond known as Treasury 8% 2015.

Its title tells us that it will be redeemed in the year 2015 and that until then it will

pay £4 every six months to whoever is the registered owner. Thus someone buying

such a bond for £100 at the time of issue, intending to hold it to redemption, is

guaranteed a return of £8 p.a., or 8 per cent of its par value.

Thirdly, the par or redemption value of bonds in the UK is commonly £100. In

principle this will also be the price at which bonds are rst issued. However, since

the preparations for sale take time, market conditions may change in such a way as

to make the bonds unattractive at their existing coupon at the time they are offered

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Chapter 6 • The capital markets

for sale. They will then have to be sold at a discount to £100, in order to make the

coupon rate approximate the going market rate of interest. If, by contrast, market

interest rates fall, the coupon may make the bond attractive at a price above £100.

In these cases the issuers are making a last-minute adjustment to the price which they

hope will make the bonds acceptable to the market. In 1987 the Bank of England

began a series of experiments in the auctioning of new bonds. This was going one stage

further and effectively allowing the market to price new issues, rather than setting a

price and then seeing how many can be sold at that price.

Fourthly, because the coupon is xed at the outset, bond prices must uctuate

inversely with market interest rates. When we look at the demand for bonds in

section 6.3 we shall see precisely why this is the case, but for the moment we can

adopt the same reasoning that we adopted with bills. If market rates rise, people

will prefer to hold the new, higher-yielding issues in preference to existing bonds.

Existing bonds will be sold and their price will fall. Eventually, existing bonds with

various coupons will be willingly held, but only when their price has fallen to the

point where the coupon expressed as a percentage of the current priceapproximates

the new market rate. We can see this immediately by taking an example such as

Consols 2.5%. These are irredeemablebonds which pay a xed coupon of £2.50 a year

and will never be redeemed. Let us suppose that market interest rates are 10 per cent.

Why should anyone hold an asset paying £2.50? The answer of course is that it

all depends on the price. If its price is sufciently low that £2.50 approximates the

market rate, there will be buyers. (In this case the price will need to be c. £25.)

Fifthly, we need to note that the yield on bonds can be expressed and is com-

monly published in two forms: the redemption yieldand the runningor interest yield.

The redemption yield is the annualised yield on a bond held to redemption while

the running or interest yield is the coupon expressed as a percentage of the purchase

price. To understand why they differ, remember what we said about the price of a

bond standing at a discount or a premium to its redemption value depending on

whether its coupon was less or greater than the current rate of interest. If we buy a

stock with a coupon higher than the current rate of interest (a ‘high-coupon’ stock),

its price will stand at a premium to its redemption value. For as long as we hold it

we shall enjoy a series of large coupon payments. Dividing those payments by the

price we paid for the bond gives us the running yield. However, if we hold it to

redemption we shall receive only £100 for it. This will be less than the price we paid

and we shall nd that we have made a capital loss. The redemption yield annualises

this gain/loss and adds it to/subtracts it from the interest yield. On 28 April 2006,

the price of Treasury 9% 2012 was £122.87. The redemption yield was 4.74 per cent

(in line with other very low-risk interest rates at the time) while the running (or

interest) yield was 7.32 per cent.

Running yield (or interest yield):The return on a bond taking account only of the

coupon payments.

Redemption yield (or yield to maturity):The return on a bond taking account of the

coupon cash ows and the capital gain or loss at redemption.

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