Introduction to Corporate Finance

4: Valuing Bonds

When corporations and state government bodies issue bonds in the primary market, they do so with

the help of investment bankers. Investment bankers assist bond issuers with the design, marketing and

distribution of new bond issues.

Once bonds are issued in the primary market, investors trade them with each other in the secondary

market. However, many bonds issued in the primary market are purchased by institutional investors who

hold the bonds for a long time. As a result, secondary market trading in bonds can be somewhat limited.

For instance, if the Commonwealth Bank raises money by conducting a new bond offering, it is likely

that their bonds will not trade as actively as Commonwealth Bank ordinary shares do. Although some

specific bond issues do not trade a great deal once they are issued, the sheer size of the global bond

market means that investors interested in adding bonds to their portfolio have a wide range of choices.

We now turn to an overview of the choices available to bond investors. There are several ways to structure

an overview of the bond market, beginning with the types of bond issuers.

4-3a BY ISSUer

Bonds come in many varieties and are classified in different ways. Perhaps the simplest classification

scheme puts bonds into categories based upon the identity of the issuer. Large non-financial companies

who need money to finance new investments and to fulfil other needs issue corporate bonds. Corporations

issue bonds with maturities ranging from one to 100 years. When a company issues a debt instrument

with a maturity of one to three years, that instrument is usually called a note rather than a bond; but notes

and bonds are essentially identical instruments. Most Australian corporate bonds have a face value of $100

and pay interest semiannually. Up until about 2000, the Australian corporate bond market was relatively

small in comparison with the state and federal government bond markets. Since then, the non-financial

corporate bond market in Australia has grown very rapidly. It had about $250 billion of bonds on issue at

the end of 2014.^9 Bonds issued by financial corporate (banks and non-bank financial institutions) totalled

over $500 billion at the same time.

In New Zealand, the corporate bond market is dominated by bond issues from banks and from

utilities such as energy companies, airports and NZ Post. New Zealand’s government bond market –

based on the national government – is relatively larger than the corporate bond market, echoing the

pattern in Australia.

The Australian federal and state governments significantly increased their bond issues from 2008.

This was a fundraising measure in response to the global financial crisis, which ran from mid-2007.

The governments adopted policies requiring significantly higher levels of spending in order to support

aggregate demand in the economy, which had fallen because of the sudden decline of spending by the

private sector in response to considerable reductions of Australian bank lending at that time. Although

the apparent requirement for cash to buttress the Australian economy during the crisis diminished after

2010, the level of bond issues by all Australian governments has continued at a strong rate.

Australian government bonds, which include long-term bonds called Treasury bonds, range in maturity

from a few weeks (such as 90-day bills) up to 15 years. The short-term bonds are called Treasury Notes.

Because the Australian government has the power to raise revenues by taxation (income confiscation)

on individuals and corporations – and has been successful in doing so to meet its bond borrowing

needs for over a century – the risk for lenders to the government is very low, and the coupon rates are

commensurately low. They are considered ‘risk-free’ in general terms. State governments in Australia also

9 Data from Reserve Bank of Australia: http://www.rba.gov.au/chart-pack/bond-issuance.html. Accessed 15 December 2015.

corporate bonds

Bonds issued by corporations

Australian government

bonds

Debt instruments issued by

the Australian government

Treasury bonds

Debt instruments issued by

the federal government that

mature between one and 15

years