6.2 Characteristics of bonds and equities

Treasury 8% 2015 is a bond issued by the government. Such bonds are often called

gilts or gilt-edged stock. Bonds issued by rms are usually called corporate bonds

or loan stock. Their characteristics are essentially the same as those of government

bonds. In most cases, however, the yields on corporate bonds tend to be higher

than those on gilts, reecting the fact that even the largest and best-established

companies could fail, while governments, in developed economies at least, are not

likely to default. One ingenious way of trying to predict the immediate future for

the economy involves comparing the yields on corporate bonds with those on gilts.

If the economy is entering a recession, for example, it is assumed that rms face

larger risks than when the economy is in an upswing and the risk attaching to

their bonds should rise and fall in parallel. By contrast, governments’ ability to pay

interest and to redeem maturing bonds is unaffected by the state of the economy.

Thus if we plot the differential, or spread, between yields on corporate bonds and

yields on gilts, a widening of the spread would suggest the economy is moving into

recession; a narrowing would suggest that the economy is about to experience a

boom. Notice though that what happens to these yields is determined by operators

in nancial markets. Strictly speaking, therefore, the behaviour of this spread is not

telling us for sure what will happen; it is telling us only what nancial markets think

the economy is about to do. This is just one example of a recent tendency among

economists (and policymakers) to regard nancial markets as a source of reliable

information. In section 7.8 we shall see that the spread between yields on long-term

gilts and short-term gilts (the ‘term structure of interest rates’) is sometimes used to

predict the future path of ination.

The characteristics which we have just described are those of xed-interest sterling

bonds – bonds denominated in sterling and issued in the UK. Such bonds, and

their counterparts in other countries, are sometimes called straights or plain vanilla

bonds, in order to distinguish them from the more exotic variants which we come

to in a moment. For most of this chapter we shall take these as typical of the whole

category of bonds. Nonetheless, the past few years have seen numerous innovations

in bonds, as in other nancial instruments. The latest developments have been the

issue of bonds denominated in euros and the ‘stripping’ of coupon payments from

conventional bonds. But long before these innovations, many variations on the

simple xed-term, xed-interest bond had emerged. Some of these are described in

the following list.

Callable and putable bonds

Callable bonds can be redeemed at the issuer’s discretion prior to the specied

redemption date. Putable bonds can be sold back to the issuer on specied dates,

prior to the redemption date.

Convertibles

These are usually corporate bonds, issued with the option for holders to convert

into some other asset on specied terms at a future date. Conversion is usually into

equities in the rm, though it may sometimes be into oating rate notes.

153

....

FINM_C06.qxd 1/18/07 11:32 AM Page 154

Chapter 6 • The capital markets

Eurobonds

Eurobonds are bonds issued in a country other than that of the currency of denomina-

tion. Thus bonds issued in US$ in London are eurobonds, as are yen bonds issued

in New York. The bonds themselves may be straights, that is xed-interest, xed-

redemption bonds like the sterling ones described above, or they may come in any

of the variations listed here. Eurobonds are issued by governments but more usually

by corporations. (Not to be confused with euro bonds.)

Euro bonds

These are bonds denominated in euros and issued in the euro currency area. The

Italian government issued the rst euro bond in March 1997. There is no reason why

bonds denominated in euros should not be issued outside the euro currency area.

These would be euro eurobonds. (Not to be confused with eurobonds.)

Floating rate notes (FRNs)

These are corporate bonds where the coupon can be adjusted at pre-determined

intervals. The adjustment will be made by reference to some benchmark rate, specied

when the bond is rst issued. An FRN might specify, for example, that its coupon should

be fty basis points above six-month treasury bill rate, or six-month LIBOR, adjusted

every six months. FRNs are, in part, a response to high and variable ination rates.

Foreign bonds

These are corporate bonds, issued in the country of denomination, by a rm based

outside that country. Thus, a US rm might issue a sterling bond in London. Foreign

bonds are often given colourful names, based upon the currency in which they are

issued. The US rm here would be said to have issued ‘Bulldog’ bonds. A UK rm

issuing US$ bonds in the US is issuing ‘Yankee’ bonds.