Index-linked bonds

In the UK, these were rst issued by the government in 1981 in response to high

and variable rates of ination. While other bonds have a redemption value xed

in nominal terms and therefore suffer a decline in real value as a result of ination,

both the value and the coupon of an index-linked bond are uprated each year in line

with lagged changes in a specied price index. For example, assume that the rate of

ination in the relevant time period turns out to have been 4 per cent p.a. An index-

linked 2 per cent bond will actually pay a coupon of £2.08, and its redemption value

will be adjusted from £100 to £104.

Junk bonds

Junk refers not to the type of bond but to its quality. Junk bonds are corporate bonds

whose issuers are regarded by bond credit rating agencies as being of high risk. Thus

they may be xed-interest, convertibles, FRNs, eurobonds, etc., but they will carry

a rate of interest at least 200 basis points above that for the corresponding bonds

issued by high-quality borrowers. We return to credit ratings in the next section.

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6.2 Characteristics of bonds and equities

Strips

Stripping refers to the breaking up of a bond into its component coupon payments

and its redemption value. Thus a ten-year bond, paying semi-annual coupons, would

make twenty-one strips. Each strip is then sold as a zero-coupon bond. That is, it

pays no interest but is sold at a discount to the payment that will eventually be

received. In this sense, it is like a long-dated bill. The strips entitling holders to the

early coupon payments from our ten-year bond will have a small discount while

the strips giving the holders the coupons due in eight, nine, ten years and the strip

giving the holder the £100 paid on redemption will sell at large discounts. Because

the payment comes at the end of the investment period, strips will have a ‘duration’

(see below) which is longer than that of a whole bond of corresponding maturity. Its

price will therefore be more interest-sensitive and this has attractions for investors

who want to take a position based on the belief that interest rates will fall in future.

Furthermore, the fact that the return comes in the form of capital appreciation rather

than periodic income payments will have tax advantages for some investors. A strips

market for government bonds began in the UK in December 1997. The strips are

created from conventional bonds by gilt-edge market makers.

6.2.2Equities

‘Equities’ is a commonly used alternative name for company shares, though strictly

it should be used only for ordinaryshares. Ordinary shares give their holders claims

to variable future streams of income, paid out of company prots and commonly

known as dividends. The owners of equity stock are legal owners of the rm. The

law requires that the company provides them with specied information in the

annual report and accounts and that the rm must hold an annual general meeting

at which the directors’ conduct of the rm’s affairs is subject to approval by such

shareholders, each of whom has a number of votes matching the size of his share-

holding. Preference shares pay a xed dividend and in many ways are more like

bonds. They confer no voting rights.

Ordinary shareholders have no preferential claim upon a rm’s prots or its assets.

They are entitled to a share only in those prots which remain after bondholders

and preference shareholders have been paid; if the rm goes into liquidation, share-

holders have a claim on any remaining assets only after prior claimants have been

paid. Obviously, therefore, ordinary shareholders are exposed to much greater risk

than are bondholders and preference shareholders. However, they also face the

prospect of greater benets. Remember that a shareholding is a part ownership of

the rm. In normal circumstances the monetary value of the rm will grow as a

result of both real expansion and ination. If the value of the whole rm increases,

so too must the value of the shares in it. In the long run, the value of shares should

increase where the value of bonds will not. Also, in a year when the rm does well,

bondholders will receive only their guaranteed interest, leaving perhaps a substantial

surplus to be divided among shareholders.

For precisely this reason, the proportion of bond nance to equity nance within

a rm (sometimes called the debt:equity ratio or gearing) affects the variability of

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Chapter 6 • The capital markets

returns to shareholders. Clearly, the higher the proportion of bond nance, the larger

the xed annual sum to be paid as interest; equally, the fewer are the shares over which

remaining prot has to be spread. Once prots exceed the level necessary to pay the

interest, therefore, the whole of any marginal addition to prot accrues to this small

number of shareholders. On the other hand, if prots fall, the whole of the fall

has to be borne by a reduction in payments to this small number of shareholders.

The higher the debt : equity ratio, the greater the variability in dividend payments to

shareholders, and since the uncertainty of magnitude of future dividend payments

is normally said to be part of the risk of owning shares, shares in ‘highly geared’

companies are normally regarded as riskier than those in ‘low geared’ companies.

Gearing:The amount of debt, relative to equity, in a rm’s capital structure. Usually

expressed as the ratio of debt to equity, D/E, or debt to total capital D/(D E).

To understand how share price behaviour is reported and analysed we might

imagine the following rm whose issued capital consists entirely of 50 million

ordinary shares. Suppose that its pre-tax prots in the last nancial year amounted

to £4m and that the directors decided to distribute three-quarters of that as dividends

to shareholders, retaining the rest for future use within the rm. If the market price

of each share is £4, we have the following information expressed in the language of

the market.

Shares in issue	50 million
Market price	£4
Market capitalisation	£200m
Earnings	£4m
Earnings per share	8p
Distributed prot	£3m
Dividend per share	6p
Payout ratio	0.75

Dividend yield1.5 per cent

Earnings yield2.0 per cent

Price/earnings or P/Eratio50

The rst two items need no explanation. Market capitalisationis the market’s

valuation of the rm and is found by multiplying the number of shares by their

market price. Earningsare prots. Earnings may be quoted pre- or post-tax. Obviously,

for most purposes the post-tax gure is the more useful, but it is very difcult for

analysts to know exactly what a rm’s tax position is. Thus, earnings gures quoted

post-tax are often accompanied by the assumption that the rm is liable for tax at

the going rate of corporation tax. Earnings per shareare prots divided by the number

of shares in issue, here 8p per share.

In our example the directors have chosen to pay out three-quarters of earnings

(the payout ratio) as dividends to shareholders. The dividend per share, therefore, is 6p

(£3m/50 million). At the current price of the share that provides a dividend yieldof

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