Republic of the Philippines

POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

Module 6 – Debt Securities Market

Overview
Financial market refers to channels or places where funds and financial instruments such as
stocks, bonds and other securities are exchanges between willing individuals and/or entities.
There are two types of financial market based on the instrument traded; money market and capital
market. The first type already discussed in Module 4, while the second type, the capital market
will be discussed in this module and in the succeeding module. Capital market is divided into two:
debt and equity/stock transaction. This module focuses on the debt securities market.
Module Objective
After successful completion of this module, you should be able to:

• Describe Debt securities market

• Differentiate Debt instrument and Debt securities
• Identify different types of debt instruments and debt securities
• Identify different types of bond markets
• Understand bond valuation
Course Materials
Debt Securities Market
Debt Securities Market is the financial market where the debt instruments or securities are
transacted by suppliers and demanders of funds.

Debt Instrument
Debt instrument is a paper or electronic obligation that enables the issuing party to raise funds by
promising to repay a lender in accordance with terms of a contract.

Examples of debt instruments:

• Notes
• Bonds
• Debentures
• Certificates
• Mortgages
• Leases
• Other agreements between a lender and a borrower

Importance of debt instruments:

• It makes the repayment of debt legally enforceable
• It increases the transferability of the obligation, giving it increased liquidity and giving
creditors a means of trading these obligations on the market.
 Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

Types of debt instruments:

• Short term Debt Instruments – these are debt instruments that have repayment terms of
less than 12 months such as credit card bills, payday loans, car title loans and other
consumer loans
• Long term Debt Instruments – these are debt instruments that have repayment terms of
more than 12 months such as mortgage repayments or car loans.
Debt Security
It refers to a debt instrument that can be bought or sold between two parties and has basic terms
defined. Examples are government bond, corporate bond, certificate of deposit, municipal bond
or preferred stock. Also known as fixed – income securities.

Basic terms defined in debt security:

• Notional amount (amount borrowed)
• Interest rate
• Maturity and renewal date

Types of debt securities:

• Money market debt securities
These are debt securities with maturities of less than one year. Examples are Treasury
bills and Certificate of deposits.
• Capital market debt securities
These are debt securities with maturities of more than one year. Examples are notes,
bonds and mortgage-backed securities

Debt Security vs. Debt Instrument

• Technically, these two are different
• Not all financial instrument are securities
• To be considered securities, a debt instrument should be negotiable and tradable and hold
some type of monetary value.
• A credit card bills and payday loan are just debt instrument but not debt securities since it
cannot be negotiated and traded
• Government bonds are debt instrument and also debt securities since they carry value
that is negotiable and tradable in the financial market and that holder will still be able to
receive cash.

The Bond Market

Securities traded in the debt market are mostly in the form of bonds, thus, debt market or debt
securities are also known as bond market. The goal of the bond market is to provide long-term
financial aid and funding for public and private projects and expenditures.

Types of Bond Market:

• Corporate Bond – these are bonds provided by corporations to raise money for different
reasons such as financing ongoing operations or expanding businesses.
• Government Bonds – these are bonds issued by the national government. National
government provides the face value on the agreed maturity date with periodic interest
which makes this attractive for conservative investors.
 Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

• Municipal Bonds – these are bonds issued by local governments and their agencies,
states, cities, special – purpose districts, public utility districts, school districts, publicly
owned airports and seaports and other government – owned entities to fund their projects.
• Mortgage Bonds – a bond in which holders have a claim on the real estate assets put up
as its collateral. These are locked in by the pledge or particular assets. They pay monthly,
quarterly or semi-annual interest.
• Asset-backed bonds (ABS) – these are bonds collateralized by a pool of assets such as
loans, leases, credit card debt, royalties or receivables.
• Collateralized Debt Obligation (CDO) – a collection of pooled assets that generate income,
such as mortgages, bonds and loans.

Characteristics of Bonds:
• Coupon rate – the fixed return that an investor earns periodically until it matures. It also
known as interest rate
• Maturity date – date on which the payment of full-face value is due. For corporate bonds,
the face value is usually P1,000 and for government bonds, P10,000. Maturity date could
be short-term or long-term.
• Current or market price – price of the bond is determined using the current interest rate in
the environment compared to the interest rate stated on the bond. If interest rate
increases, the value of bond will decrease since the coupon rate will be lower than the
interest rate in the economy, otherwise, the value of the bond will increase. The investor
may purchase a bond at par, below par (at discount) or above par (at premium). However,
the bondholder will be paid the full face value of the bond at maturity even it is purchased
at premium or at discount.
Current interest rate > coupon or nominal rate, bond will be issued at discount
Current interest rate < coupon or nominal rate, bond will be issued at premium

Bond valuation:
A technique for determining the theoretical fair value of a particular bond.
It includes calculating the present value of bond’s future interest payment and bond’s value upon
maturity, also known as face value or par value.
Formula:

Where:

Example:
Suppose a 10-year, 10% bond with a par value of P1,000 is traded in the market. The
similar debt instrument is expecting 9% returns in the market. How much is the value of
the bonds?
 Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

**Since, current interest rate, 9%, is lower than the nominal rate, 10%, we can expect that
the bond can be issued at premium.
Using the formula:

= (P1,000 x 10%) x 6.4177* + 1,000 x .4224*

= 641.77 + 422.41
= P1,064.18 (higher than the par value – at premium)
*6.4177 = the present value factor of ordinary annuity at 10 years, 9%
*4244 = the present value factor of single payment 10 years, 9%
Present value of annuity formula:
= 1_ x 1- 1 = 6.4177
9% (1.09)10

Present value of single payment: or (1+i)-n = 1_

(1.09)10 = .4224

If Interest payment is non-annual:

Semiannually: I interest and kd required on return should be divided by 2
N no. of years to maturity should be multiplied by 2
Quarterly: I interest and kd required on return should be divided by 4
N no. of years to maturity should be multiplied by 4

Assume the same information in the previous example, except that interest is paid
semiannually:

= (P1,000 x 5%) x 13.0079* + 1,000 x .4146*.

= 650.395 + 414.60
= P 1,065.00
*6.4177 = the present value factor of ordinary annuity at 20 years, 4.5%
*4244 = the present value factor of single payment 20 years, 4.5%
Present value of annuity formula:
= 1_ x 1- 1 = 13.0079
4.5% (1.045)20

Present value of single payment: or (1+i)-n = 1_

(1.045)20 = .4146
 Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

Approaches in Valuation:
• Option-free bonds – plain bond with no option embedded.
o Bond valuation for option-free bonds (Treasury bond)
Traditional approach
Discount every cash flow of a bond by the same interest rate (discount rate) to
calculate the present value of securities and use the same discount rate or the cash
flow for each period.
Arbitrage free Valuation approach
Discount cash flow of a bond by different interest rates (discount rate). Each cash
flow will be discounted by the theoretical rate that the Treasury would have to pay
to issue a zero-coupon Treasury bond for each maturity. Another name used for the
zero-coupon Treasury rate is the Treasury spot rate. Spot rates are available from
vendors of financial information such as Bloomberg and Reuters.
Example:
Suppose we want to calculate the value of a P1000 par, 5% coupon, 5-year maturity
bond. We also have the following spot rates for the next 5 years:

Assuming this is an annual pay bond, the bond will have the following cash flows:
Year 1: 50 Year 2: 50 Year 3: 50 Year 4: 50 Year 5: 1000 + 50
The value of the bond can be calculated by discounting these cash flows by their
respective spot rates:
We will use the formula of present value of single payment since we will be using
different discount rates for each cash flows for each period:

Year 1 2 3 4 5
= 50 + 50_ + 50__ + 50 + 1050
(1.04)1 (1.043)2 (1.0451)3 (1.047)4 (1.048)5
= P1,010.33
o Bond valuation for option-free bonds (Non-treasury bond)
Discount cash flow of a bond by adjusted interest rates (discount rate). Adjusted
means that the risk premium or credit spread is added to the risk-free rate. The problem
with this approach is that the credit spread might be different depending upon when
the cash flow is received.
So, for the previous example in traditional approach, assuming 9% is a risk free
discount rate, and the appropriate risk premium/credit spread is 1%. We will use the
adjusted discount rate: 9%+1% = 10% for valuing the bond instead of 9%.

o Valuation for bond with embedded option

 Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH

An embedded option is a provision in a in bond that provides an issuer or holder of the

security a certain right but not an obligation to perform some actions at some point in
the future. For example:
call provision – type of embedded option that affords holders the power to redeem the
bonds before its scheduled maturity;
putable provision - type of embedded option on a bond that positions holders to demand
early redemption from the issuer.
Two commonly used models are used in valuation for bond with embedded option:
Lattice model – used to value callable bonds and putable bonds
Monte carlo simulation – used to value mortgage-backed securities and certain type
of asset-backed securities
We will not go into the details of these two models since these are more complex and
sophisticated.

Activities / Assessments

Using your own words, answer the following questions (1-3) in well-composed sentences.

1. Discuss Debt securities market.

2. Differentiate Debt instrument and Debt securities.

3. Identify different types of debt instruments and debt securities. Explain each.

4. Game Now, Inc. issues ten-year bonds (par P1,000) with an annual coupon of 8.6%.
Similar ten-year bonds are paying 8.0% interest. What is the value of one of Game Now's
new bonds -- that is, what should be its price?

5. Using the same information in no.4, except that the interest is paying semiannually. What
is the value of Game Now’s bond?

E6-1 True or False (page 160-163)

Republic of the Philippines
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Office of the Vice President for Branches and Satellite Campuses
BATAAN BRANCH