My friend, I could probably write an essay on the first question
alone. Where do I start?
You first have to consider the alternatives to bond financing. There's
equity financing (raising money from the stock market) and loan
financing (borrowing from banks).
In a nutshell, bond financing is cheaper than equity financing because
bondholders typically demand a lower rate of return compared to
shareholders. But interest payments have to be honoured regardless of
economic conditions, while dividends can be withheld at the discretion
of management in the event of an economic slump. So it's obvious that
equity finance provides financial flexibility for the firm in crisis
situations.
If you're a big company with a favourable credit rating like General
Electric, then issuing your own bonds will be cheaper than a bank loan
because you raise funds directly from the market and cut out the
financial "middleman". If you're a small upstart, however, your
ability to raise funds from the bond market is limited and besides,
the investment banking fees you would have to pay the underwriter
would eclipse the amount you raised from the bond issue. A bank loan
in this case would be cheaper.
Bond prices fluctuate with interest rates. So as with any security,
there is price risk if you use it as a speculative instrument. As an
investment vehicle, your principal is guaranteed upon maturity, in
addition to coupon payments. So while interest rate fluctuations do
not affect your total return ultimately, you incur "opportunity cost"
if the rates (i.e. FED rate) move against you. That said, there is a
DEFAULT Risk, which is low for treasuries but extremely high for
junk-bonds. There is a distinct possibility that the company might go
belly up with no capital left to repay bondholders.
Why is bond valuation important? Well, bonds make up an important part
of any well-diversified portfolio, so learning how to value, and thus,
profit from them, is important too.
My answer's a little short. But hey, you didn't have to pay for it did you? :-)
Cheerio! |
