Capital market and Bond market

The capital market refers to the financial market where individual firms and governments

can raise funds by trading different financial instruments. Capital Market acts as a bridge

between investors with surplus funds and entities seeking capital investment (Central Bank,

2009). Bond Markets, on the other hand, are dedicated markets where funds are raised by

trading fixed-income securities called bonds. Bonds are debt instruments issued by governments

and corporations to finance capital. The bond market allows issuers to access and raise funds by

buying new ones or trading existing bonds (Central Bank, 2009). Since the bond market offers

liquidity and flexibility to both investors and issuers, it fits into the definition of capital market as

it shares common ground on risk appetite, returns expectations and investment objectives. In

addition, the bond market allows investors to manage their debt and allocate their funds among

different financial instruments.

Differences between a Discount yield and a Bond yield

Discount yield is also called Bank discount Yield and it refers to the return on a short-

term debt instrument with a maturity of less than a year. It is calculated based on a discount from

the face value of the instrument. Since short-term debt instruments don't have regular coupon

payments, the yield is calculated as a difference between the purchase price and face value

(Thornton, 1986). Bond equivalent yield, on the other hand, refers to the return on fixed-income

debt instruments with a maturity of more than a year, for instance, bonds. It is calculated based

on coupon payments and the purchase price of bonds (Thornton, 1986). Likewise, discount yield

is used to compare the attractiveness of short-term investment options like treasury bills, whereas

bond equivalent yield is used to compare the attractiveness of long-term bones. Treasury bills

quotes is are discount yield bonds based on the difference between the purchase price of
Treasury bills and their face value expressed as a percentage of face value given their short-term

nature and no coupon payment.

T-bills, T-notes and T-bonds

The major differences between Treasury bills (T-bills), Treasury Notes (T-notes), and

Treasury bonds (T-bills) lie in their maturity, interest payment, liquidity and yields. T-bills have

the shortest maturity period ranging from a few days to one year, t-notes have intermediate

maturity periods ranging from two to ten years and T-notes have the longest maturity period

from 10-30 years (Fleming, 2001). Likewise, T-bills don't pay any periodic interest while T-

notes and T-bonds be semi-annual interest until maturity. T-bills have the highest liquidity,

making them easiest to buy and sell, followed by T-notes and T-bonds respectively (Fleming,

2001). Furthermore, T-bills have the lowest yields, T-notes offer a slightly higher yield and T-

bonds offer the highest yield among the three.

STRIPS

STRIPS plans for separate trading of registered interest and principal security, which is

created by 'stripping' interest and principle of Treasury security into separate securities. When

notes or bond is issued by a treasury, they can be converted into STRIPS by separating interest

payment and principal payment, leaving zero-coupon security (Bhansali, 2022). Investors who

would invest in STRIPS could involve income-oriented investors, yield-oriented investors and

fixed-income portfolio managers. Since strips provide a higher yield than traditional coupon-

paying bonds without the need for reinvestment, investors can use STRIPS to enhance

diversification within their portfolio with a predictable income stream.

TIPS Bonds
 TIPS, Treasury Inflation-Protected Securities refer to U.S. Treasury securities designed to

protect against inflation for investors. TIPS is considered a safe investment option due to its

protection against inflation with a guaranteed real return. The principal value and interest rate of

TIPS is adjusted with the consumer price index (CPI), ensuring that the investor receives a fixed

real rate of return while the investment keeps pace with inflation (Bhansali, 2022). However,

investment in TIPS is disadvantageous due to potentially lower nominal yields, volatility in real

yields, and deflation risk. TIPS offer lower nominal yields than Treasury bonds or corporate

bonds and can fluctuate with changes in market conditions like changes in demand, supply and

interest rate expectations (Bhansali, 2022). Also, despite protecting against inflation, the

principal value of TIPS can decrease with deflation, leading to lower interest payments.

Process of Bond issuance

The issuance of Treasury notes and Treasury bonds involves several steps. Initially, the

upcoming T-notes and T-bonds are announced by U.S. Department with details like maturity

date and coupon rate (Spaulding, n.d.). Then, they enter the auction process (competitive or

noncompetitive), which is held regularly either monthly or quarterly. The bits are then submitted

on behalf of auction notes or bonds indicating desired amount and price. The bids are reviewed

by the Treasury and accepted bids are issued to successful bidders. This process of issuance and

settlement usually occurs one to three business days later after the auction and are delivered to

the bidders' account. After the settlement process, T-notes and T-bonds offer periodic interest

and can further be traded in secondary markets like various exchanges and trading platforms.

General obligation bonds (GO Bonds) and Revenue bonds

General obligation bonds (GO Bonds) and revenue bonds are types of municipal bonds

issued by local government. The differences between GO Bonds and revenue bond lies in the
source of repayment, risk profile, purpose of issuance and interest rates (Gaur & Singh, 2023).

The repayment of GO Bonds is backed by full faith, and creditworthiness whereas that of

revenue bonds is generated by specific revenue streams. Likewise, GO bonds are considered a

lower-risk investment, whereas revenue bonds carry a higher level of risk. Similarly, GO bonds

are used to fund a broad range of projects and operations, whereas revenue bonds are used to

finance revenue-generating projects. In addition to that, GO bonds have lower interest rates

compared to revenue bonds due to a lower risk profile than revenue bonds.

Third-party insurance for Municipal Bond

A municipal bond is a debt security issued by a state or municipality to fund public

projects such as infrastructure development. A municipal bond issuer may choose to purchase

third-party insurance on bond payments for various reasons like enhanced credit rating,

marketability, lower interest cost and refunding opportunities (Gaur & Singh, 2023). When one

purchases third-party insurance, the issuer transfers credit risk and will also be able to issue

bonds at lower interest risk. Also, having insurance on bones can ease the refund process, while

increased marketability can result in better pricing and trading opportunities. The cost-

effectiveness of outbound depends on prevailing market conditions like credit enhancement and

interest savings.

Bond Indenture

A bond indenture is called Bond Agreement and it is a legal document that outlines the

terms and conditions of bond issuance. It serves as a binding agreement between the issuer of the

bond and the bondholder. The bond indenture states details like the issuer's name, bonds, face

value and maturity date along with adequate time and payment method. Likewise, it also

includes covenants that highlight the rights and responsibilities of the issuer and bondholder. The
indenture defines various events that could be considered like violation of covenants, and

bankruptcy (Gaur & Singh, 2023). Hence, a bond indenture helps establish a contractual

framework for bond transactions.

Bond types and Characteristics

The bond, which has the highest cost to the bond issuer, is a subordinated debenture.

They are ranked lowest in priority to receiving payments in events like bankruptcy or liquidation.

Subordinated debenture has a comparatively higher risk to bond issuers resulting in a higher cost.

Likewise, the bone which has less cost to the bondholder is a mortgage bond. They are backed

by assets like real estate properties to have a claim in case of defaults, which reduces the risk of

losing their investment. Similarly, the bond with the highest yield to a bondholder is a debenture.

The debenture isn't backed by any collateral and has a higher level of risk compared to mortgage

bonds or subordinated debentures. Also, a higher yield or return compensates for the increased

risk of investing in unsecured debts.

 References

Bhansali, V. (2022, September 1). TIPS ‘N’ STRIPS. Forbes.

https://www.forbes.com/sites/vineerbhansali/2022/08/28/tips-n-strips/

Central Bank. (2009). Importance of Capital Market as an instrument of Economic

Development. Economic Review, (109).

https://www.centralbank.org.ls/images/Publications/Research/Reports/

MonthlyEconomicReviews/2009/Econo_Rev_August_2009.pdf

Fleming, M. J. (2001). Measuring Treasury Market Liquidity. SSRN Electronic Journal, 83-

108. https://doi.org/10.2139/ssrn.276289

Gaur, P., & Singh, A. B. (2023). Market-based Financing Through Municipal Bond in India:

Investor’s Checklist Using Structural Equation Modeling (SEM). Business Perspectives

and Research. https://doi.org/10.1177/22785337231165843

Spaulding, W. C. (n.d.). United States Treasury Securities. Personal Finance, Investments, and

Economics. https://thismatter.com/money/bonds/types/government/treasury-

securities.htm

Thornton, D. L. (1986). The Discount Rate and Market Interest Rates: What’s the Connection.

Review, 68. https://doi.org/10.20955/r.68.5-21.ssw