BOND MARKETS

What are Bonds?

Have you ever borrowed money? Of course you have! Whether we hit
our parents up for a few bucks to buy candy as children or asked the
bank for a mortgage, most of us have borrowed money at some point in
our lives.

Just as people need money, so do companies and governments. A

company needs funds to expand into new markets, while governments
need money for everything from infrastructure to social programs. The
problem large organizations run into is that they typically need far more
money than the average bank can provide. The solution is to raise
money by issuing bonds (or other debt instruments) to a public market.
Thousands of investors then each lend a portion of the capital needed.
Really, a bond is nothing more than a loan for which you are the lender.
The organization that sells a bond is known as the issuer. You can think
of a bond as an IOU given by a borrower (the issuer) to a lender (the
investor).

Of course, nobody would loan his or her hard-earned money for nothing.
The issuer of a bond must pay the investor something extra for the
privilege of using his or her money. This "extra" comes in the form of
interest payments, which are made at a predetermined rate and
schedule. The interest rate is often referred to as the coupon. The date
on which the issuer has to repay the amount borrowed (known as face
value) is called the maturity date. Bonds are known as fixed income
securities because you know the exact amount of cash you'll get back if
you hold the security until maturity.

For example, say you buy a bond with a face value of Php1,000,
a coupon of 8%, and a maturity of 10 years. This means you'll receive a
total of Php80 (Php1,000*8%) of interest per year for the next 10 years.
Actually, because most bonds pay interest semi-annually, you'll receive
two payments of Php40 a year for 10 years. When the bond matures
after a decade, you'll get your Php1,000 back.
Debt Versus Equity

Bonds are debt, whereas stocks are equity. This is the important
distinction between the two securities. By purchasing equity (stock) an
investor becomes an owner in a corporation. Ownership comes with
voting rights and the right to share in any future profits. By purchasing
debt (bonds) an investor becomes a creditor to the corporation (or
government). The primary advantage of being a creditor is that you have
a higher claim on assets than shareholders do: that is, in the case of
bankruptcy, a bondholder will get paid before a shareholder. However,
the bondholder does not share in the profits if a company does well - he
or she is entitled only to the principal plus interest.

To sum up, there is generally less risk in owning bonds than in owning
stocks, but this comes at the cost of a lower return.

Characteristics

Bonds have a number of characteristics of which you need to be aware.

All of these factors play a role in determining the value of a bond and
the extent to which it fits in your portfolio.
Face Value/Par Value

The face value (also known as the par value or principal) is the amount
of money a holder will get back once a bond matures. A newly issued
bond usually sells at the par value. Corporate bonds normally have a par
value of Php1,000, but this amount can be much greater for government
bonds. What confuses many people is that the par value is not the price
of the bond. A bond's price fluctuates throughout its life in response to a
number of variables (more on this later). When a bond trades at a price
above the face value, it is said to be selling at a premium. When a bond
sells below face value, it is said to be selling at a discount.

Coupon (The Interest Rate)

The coupon is the amount the bondholder will receive as interest

payments. It's called a "coupon" because sometimes there are physical
coupons on the bond that you tear off and redeem for interest.
However, this was more common in the past. Nowadays, records are
more likely to be kept electronically.

As previously mentioned, most bonds pay interest every six months, but
it's possible for them to pay monthly, quarterly or annually. The coupon
is expressed as a percentage of the par value. If a bond pays a coupon of
10% and its par value is Php1,000, then it'll pay Php100 of interest a
year. A rate that stays as a fixed percentage of the par value like this is a
fixed-rate bond. Another possibility is an adjustable interest payment,
known as a floating-rate bond. In this case the interest rate is tied to
market rates through an index, such as the rate on Treasury bills.

You might think investors will pay more for a high coupon than for a low
coupon. All things being equal, a lower coupon means that the price of
the bond will fluctuate more

Maturity

The maturity date is the date in the future on which the investor's
principal will be repaid. Maturities can range from as little as one day to
as long as 30 years (though terms of 100 years have been issued). A
bond that matures in one year is much more predictable and thus less
risky than a bond that matures in 20 years. Therefore, in general, the
longer the time to maturity, the higher the interest rate. Also, all things
being equal, a longer term bond will fluctuate more than a shorter term
bond.

Issuer

The issuer of a bond is a crucial factor to consider, as the issuer's

stability is your main assurance of getting paid back. For example, the
U.S. government is far more secure than any corporation. Its default risk
(the chance of the debt not being paid back) is extremely small - so small
that U.S. government securities are known as risk-free assets. The
reason behind this is that a government will always be able to bring in
future revenue through taxation. A company, on the other hand, must
continue to make profits, which is far from guaranteed. This added risk
means corporate bonds must offer a higher yield in order to entice
investors - this is the risk/return tradeoff in action.

Yield, Price And Other Confusion

Understanding the price fluctuation of bonds is probably the most

confusing part of this lesson. In fact, many new investors are surprised
to learn that a bond's price changes on a daily basis, just like that of any
other publicly-traded security. Up to this point, we've talked about
bonds as if every investor holds them to maturity. It's true that if you do
this you're guaranteed to get your principal back; however, a bond does
not have to be held to maturity. At any time, a bond can be sold in the
open market, where the price can fluctuate - sometimes dramatically.
We'll get to how price changes in a bit. First, we need to introduce the
concept of yield.

Measuring Return With Yield

Yield is a figure that shows the return you get on a bond. The simplest
version of yield is calculated using the following formula: yield = coupon
amount/price. When you buy a bond at par, yield is equal to the interest
rate. When the price changes, so does the yield.
Let's demonstrate this with an example. If you buy a bond with a 10%
coupon at its Php1,000 par value, the yield is 10% (Php100/Php1,000).
But if the price goes down to Php800, then the yield goes up to 12.5%.
This happens because you are getting the same guaranteed Php100 on
an asset that is worth Php800 (Php100/Php800). Conversely, if the bond
goes up in price to Php1,200, the yield shrinks to 8.33%
(Php100/Php1,200).
Yield To Maturity

Of course, these matters are always more complicated in real life. When
bond investors refer to yield, they are usually referring to yield to
maturity (YTM). YTM is a more advanced yield calculation that shows the
total return you will receive if you hold the bond to maturity. It equals all
the interest payments you will receive (and assumes that you will
reinvest the interest payment at the same rate as the current yield on
the bond) plus any gain (if you purchased at a discount) or loss (if you
purchased at a premium).

Knowing how to calculate YTM isn't important right now. In fact, the
calculation is rather sophisticated and beyond the scope of this tutorial.
The key point here is that YTM is more accurate and enables you to
compare bonds with different maturities and coupons.

Characteristics of the various bond market securities

1. Bearer Bonds
- is a bond or debt security issued by a business entity such as a
corporation, or a government. As a bearer instrument, it differs from
the more common types of investment securities in that it is
unregistered—no records are kept of the owner, or the transactions
involving ownership

Example #1

Let us understand the meaning of the bearer bond with the help of a
simple example:
 Bearer bonds are like our currency notes. The moment we hold it in
our possession, it becomes ours. For instance, while walking on a
road, if we find a dollar, we pick it up, and it becomes ours with no
validation required. The same is with the case of a bearer bond.
Whoever possesses it owns it.

2. Registered Bonds
- is a debt instrument whose bondholder's information is kept on
record with the issuing party. By archiving the owner's name, address,
and other details, issuers ensure they're making the bond's coupon
payments to the correct person.

Registered bonds include debt obligations that have the owner’s

name and contact information registered on file at the issuing company.
Only the individual recognized as the registered owner, as of the interest
payment date, may receive the agreed-upon earnings. Anyone who
presents a bond certificate that is not the registered owner on file will be
denied the coupon payment. If a registered bond is lost, stolen, or
destroyed, it can be easily replaced due to the fact that the owner’s
information is on file with the issuer.

3. Term Bonds
- refers to bonds from the same issue with the same maturity dates.
In effect, term bonds mature on a specific date in the future and the
bond face value must be repaid to the bondholder on that date. The
term of the bond is the amount of time between bond issuance and
bond maturity.

Example

An example, let's assume a company issues a million dollars worth of

bonds in Jan. 2019, all of which are set to mature on the same date two
years later. The investor can expect to receive repayment from these
term bonds in Jan. 2021.

4. Serial Bonds
- (or installment bonds) describes a bond issue that matures in portions
over several different dates. Instead of facing a large lump-sum principal
re-payment at maturity, an issuer can opt to spread the principal
repayment over several periods.

For example, the issuer of $100 million in traditional bonds with ten-
year maturities will have to make a $100 million principal payment at
the end of the tenth year (see the table below). But the issuer of $100
million in serial bonds might structure the offering such that $20 million
matures after five years, another $20 million matures the year after, $20
million the year after that, and so on.

5. Mortgage Bonds
- refers to a bond issued to investor which is backed by a pool of
mortgages secured by collateral of real estate property (residential or
commercial) and therefore, makes the borrower pay predetermined
series of payment, failure of which may lead to sale or seizure of the
asset.

Example

Suppose 10 people took a loan of $100,000 at 6%each by keeping the

house as collateral in ABC bank, totaling a mortgage of $1,000,000. Bank
would then sell this pool of mortgage amounting to an investment bank
XYZ and use that money to make fresh loans. XYZ would sell bonds of
$1,000,000 (1000 bonds of $1000 each) at 5% backed by these
mortgages. ABC bank would pass on the interest received ($5,000) plus
payment component in 1st month to XYZ after keeping a margin or fee.
Let’s say the fee kept is 0.6% (0.05% monthly) of the loan amount, so the
amount passed on 1st month to XYZ is $4500 plus the repayment
amount. XYZ would also keep its spread of 0.6% (0.05% monthly)on the
loan amount and pass on the rest of the interest of $4000plus
repayment amount the first month to mortgage bondholders.

This way, the investment bank can purchase more mortgages from a
bank through money received from selling bonds, and the banks can also
use money received from selling mortgages to make fresh loans. In case
of default by homeowners, the mortgage could be sold to pay off
investors.

6. Equipment Trust Certificate

-refers to a debt instrument that allows a company to take possession of
and enjoy the use of an asset while paying for it over time. The debt
issue is secured by the equipment or physical asset. During this time, the
title for the equipment is held in trust for the holders of the issue

7. Debenture
- is a type of bond or other debt instrument that is unsecured by
collateral. Since debentures have no collateral backing, debentures must
rely on the creditworthiness and reputation of the issuer for support.
Both corporations and governments frequently issue debentures to raise
capital or funds

8. Subordinated Debentures
- A class of unsecured bond that, in the event of liquidation, is prioritized
lower than other classes of debt. In essence, a subordinated debenture
bond is an unsecured loan, which has no collateral. Should the issuer be
liquidated, all other bonds and debts must be repaid before the
subordinated debenture bond is repaid. This class of debt carries higher
risk, but also pays higher interest than other classes. It is a type of junior
debt.

9. Convertible Bonds
- a hybrid debenture1 bond issued by corporations that combines a
normal coupon-paying bond with an option to convert that bond into a
pre-specified amount of that company’s common stock
 For example, suppose the bond had a par value of $1000 (which is the
standard denomination) and a strike price of $50 per share. This would
mean that the bond could be converted into 20 shares of stock ($1000
divided by the strike price of $50). This number is known as the
conversion ratio

10. Stock Warrants

- is a financial contract between a company and investors that gives the
investor the option to purchase the company's stock at a specific price
and by a specific date. A stock warrant allows the holder to receive
newly issued stock from the same company that provided the warrant.
While the warrant expires after a certain date, the investor is still
allowed to make the stock warrant purchase (via common stocks) at a
later date if he or she chooses.

For example, let's say ABC Corp. gives the stock warrant holder a
contract to purchase 100 shares of the company at $20 per share (the
strike price) over the next 10 years. ... You, as a valued investor or
employee of a company, are given a stock warrant that allows you to
buy ABC stock at $20 per share on Sept. 1, 2019.

11. Callable Bonds

- gives the borrower (issuer) the right to pay back the obligation to the
lender (bondholder) before the stated maturity date.

To simplify the concept, let's look at an example:

Company ABC decides to borrow $10 million in the bond market. The
bond's coupon rate is 8%. Company analysts believe interest rates will
go down during the 7 year term of the bonds. To take advantage of
lower rates in the future, ABC issues callable bonds.

Under the terms of the bonds (the "indenture"), ABC has the option
to call the bonds (meaning, pay them back) any time after year 3.
However, if ABC decides to exercise its right to call, it needs to pay
bondholders $102 for every $100 of principal.
 Let's assume that in year 4, interest rates fall to 6%. ABC exercises its
right to redeem the bonds. It borrows money from a bank at 6% and
pays back the 8% bonds.

Even though ABC had to spend $10.2 million to pay back its current
bondholders, it will benefit going forward because future interest
payments will be only $612,000 per year ($10,200,000 * 6%) vs.
$800,000 per year ($10,000,000*8%).

12. Sinking fund provision

- is a type of fund that is created and set up purposely for repaying debt.
The owner of the account sets aside a certain amount of money
regularly and uses it only for a specific purpose. Often, it is used by
corporations for bonds and deposits money to buy back issued bonds or
parts of bonds before the maturity date arrives. It is also one way of
enticing investors because the fund helps convince them that the issuer
will not default on their payments.

Example

A company issuing $1 million of bonds that are to mature in 10 years.

Given this, it creates a sinking fund and deposits $100,000 yearly to
make sure that the bonds are all bought back by their maturity date.