This is “The Bigger Picture”, section 9.5 from the book Finance for Managers (v. 0.1).
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Bonds allow entities to borrow money easily from investors. When banks demand too much return or are unwilling to accept more risk, bonds can be the avenue to raising more capital. Corporations (or govenments, municipalities, etc.) can then use the capital raised to invest in new projects or pay for ongoing projects.
As managers, we need to consider how our actions will influence our ability to issue bonds and raise capital. As investors, we need to consider bonds as an investment class.
One side benefit of bond markets is that we can witness the perceived current value of the bond as they trade. From these prices, we can deduce the return demanded by the market, and use this information to learn more about the market (for example, risk tolerance or inflation expectation) or the issuer (for example, perceived risk of default) of the bond.
When issuing bonds, companies have an incentive to look like safe investments, since this will lower the return demanded by the market. Some companies will make decisions based upon how their balance sheet will appear (and how they believe it will affect the rating!) for an upcoming bond issue. The legitamacy of such manipulations can be difficult to distinguish, especially if it is solely a matter of transparency.
Ratings companies are meant to be objective judges of risk, but their revenue comes from fees paid for each bond issue, raising the specter of conflict of interest. Also, while ratings companies also include details about the risk of an issue, many investors fail to look beyond the assigned ratings, despite the potential complexity of some bonds.
Investors need to consider that buying a bond is, in effect, supporting the borrowing of the issuer. If a government is engaging in policies contrary to the conscience of the investor, or a company’s revenue source is objectionable, an investor should consider avoiding the investment.