Viewpoint:

Is partnership an attractive form of business in terms of management?

8. BONDS

Companies finance most of their activities by way of internally generated cash flows. If they need more money they can either sell shares or borrow, usually by issuing bonds. More and more companies now issue their own bonds, because this is often cheaper.

Bond-issuing companies are rated by private ratings companies such as Moody’s and Standard & Poors, and given an ‘investment grade’ according to their financial situation and performance. Obviously, the higher the rating, the lower the interest rate at which a company can borrow.

Most bonds are bearer certificates, so after being issued they can be traded on the secondary bond market until they mature. Bonds are therefore liquid, although their price on the secondary market fluctuates according to changes in interest rates. Consequently, the majority of bonds on the secondary market are traded below or above par. A bond’s yield at any particular time is thus its coupon (the amount of interest it pays) expressed as a percentage of its price on the secondary market.

Bond interest is tax-deductible, i e. a company deducts its interest payments from its profits before paying tax, whereas dividends are paid out of already-taxed profits. One should remember that increasing debt increases financial risk: bond interest has to be paid, even in a year without any profits from which to deduct it.

Governments, of course, unlike companies, do not have the option of issuing equities. Consequently they issue bonds when pubic spending exceeds receipts from income tax, VAT, and so on. Long-term government bonds are known as gilt-edged securities, or simply gilts, in Britain, and Treasury bonds in the US. The British and American central banks also sell and buy short-term Treasury Bills as a way of regulating the money supply. To reduce the money supply, they sell these bills to commercial banks, and withdraw the cash received from the calculation; to increase the money supply they put them back.

Comprehension:

1. How do companies finance most of their activities?

2. When do they sell shares or borrow?

3. Is issuing their own bonds cheaper for companies?

4. What is Moody’s and Standard & Poors?

5. How are bonds traded on the secondary market?

6. Is bond interest tax-deductible?

7. What kind of bonds do governments issue?

8. Is there any difference between guilt-edged securities and Treasury Bills?

9. How do the British and American central banks regulate the money supply?