MSL
LESSON 5
DEBT MARKETS
The debt market is any market situation where the
trading Debt Instrument takes places, like:
→ Bonds
→ Commercial papers
→ Treasury bills
→ Government securities
DEBT MARKET INSTRUMENT
CHARACTERISTICS
GOVERNMENTS
→ Major issuers of bonds
DEBT MARKET RISK
→ Bonds secured on the assets of the issuing
company are known as debentures.
→ Bonds that are not secured are referred to
as loan stock.
IMPORTANT CHARACTERISTICS OF BONDS
→ Stable and less volatile
→ Provides steady income
→ Bonds pay a fix rate of interest
→ Residual maturity
YIELD ON BONDS
→ Interest yield (or running yield)
o the return on a bond taking account
only of the coupon payments.
→ Yield to maturity or redemption yield
o The return on a bond taking account
of the coupon cash flows and the
capital gain or loss at redemption.
BONDS
→ A bond is a certificate of debt issued by a
company.
→ Bond issuers: borrowers
→ Bond holders: lenders
GENERAL FEATURES OF A BOND ISSUE
→ Conversion feature
→ Call feature
→ Stock purchase warrants
CALL FEATURE
→ included in nearly all corporate bond issues.
It gives the issuer the opportunity to
repurchase bonds prior to maturity
CALL PRICE
→ stated price at which bonds may be
repurchased prior to maturity
CALL PREMIUM
→ The amount by which the call price exceeds
the bond’s par value
STOCK PURCHASE WARRANTS
→ instruments that give their holders the right
to purchase a certain number of shares of
the issuer’s common stock at a specified
price over a certain period of time.
TYPES OF BONDS
1. Callable and putable bonds
2. Convertible bonds
3. Eurobonds/external bonds
4. Foreign bonds
5. Euro bonds
6. Floating rate notes (FRNS)
7. Index linked bonds
8. Junk bonds
9. Strips
CALLABLE AND PUTABLE BONDS
→ Callable bonds can be redeemed at the
issuer’s discretion prior to the specified
maturity (redemption) date.
→ Putable bonds can be sold back to the
issuer on specified dates, prior to the
redemption date.
→ Example of putable bonds
o ABC Corp. issues putable bonds
with a face value of $100 and a
coupon rate 4.75%. The current
interest rate is 4%. The bonds will
mature in 10 years.
o The put option provides investors
with the right to force ABC to redeem
the bonds after the first five years.
o If interest rates:
▪ Increase – the investors do
not have an incentive to keep
the bonds until maturity
▪ Decrease – the investors do
not have an incentive to
exercise the put option.
CONVERTIBLE BONDS
→ These are usually corporate bonds, issued
with the option for holders to convert into
some other asset on specified terms at a
future date.
EUROBONDS/EXTERNAL BONDS
→ Eurobonds are bonds issued in a country
other than that of the currency of
denomination.
→ The bonds themselves may be straights,
that is fixed-interest, fixed redemption bonds
like the sterling ones described above, or
they may come in any of the variations
listed here.
→ Example:
o External bond issued in the
Japanese yen in the United States
will be a Euroyen bond.
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FOREIGN BONDS
→ These are corporate bonds, issued in the
country of denomination, by a firm based
outside that country.
→ The three largest foreign-bond markets are
Japan, Switzerland, and the United States.
→ Example:
o Ford Motor Corp. issuing a yen
denominated bond in Japan.
EURO BONDS
JUNK BONDS
→ These are bonds denominated in euros and
issued in the euro currency area.
FLOATING RATE NOTES (FRNs)
→ These are corporate bonds where the
coupon can be adjusted at pre-determined
intervals.
→ The adjustment will be made by reference
to some benchmark rate, specified when the
bond is first issued.
INDEX-LINKED BONDS
→ These are corporate bonds where the
coupon can be adjusted to high and variable
rates of inflation.
→ Adjusted for inflation by linking the
payments to some inflation indicator, such
as the Consumer Price Index (CPI) or Retail
Price Index (RPI).
→ Example:
o Bond CFI was issued at face value
of $1,000, at an annual coupon rate
of 10%, and with a maturity of 1
year. The Consumer Price Index
(CPI) when the bond was issued
was 170. A year later, CPI equals
175.
o Step 1: calculate the indexation
factor and inflation rate
o INDEXATION FACTOR = CPI @
MATURITY / CPI @ ISSUANCE
o 175 / 170 = 1.0294
o An indexation factor of 1.0294
indicates that the inflation rate is
2.94%.
o Step 2: calculate the cash flows from
the bond @ maturity
o Cash Flows from the Bond at
Maturity = Face Value + Interest
o Payment = $1,000 + ($1,000 x 0.10)
= $1,100
o Step 3: multiply the bond’s cash
flows @ maturity with the indexation
factor
o Amount Received at Maturity =
$1,100 x 1.0294 = $1,132.34
o The total amount received by
bondholders at maturity will be
$1,132.34.
o This amount includes the original
face value ($1,000), annual interest
payment ($100), and the amount
adjusted for inflation ($32.34).
→ These are corporate bonds whose issuers
are regarded by bond credit rating agencies
as being of high risk
→ Junk bonds are generally rated BB[+] or
lower by Standard & Poor's and Ba[1] or
lower by Moody's.
→ Advantage:
o Junk bond investors usually enjoy
higher rates of return as compared
to other fixed-income investments.
o If the issuer’s credit rating improves,
then the value of the bond increases
and this leads to increased returns
for its holders.
→ Disadvantage:
o Junk bonds have a higher likelihood
of default than other types of bonds.
o When interest rates on investment-
grade bonds increases, junk bonds
become less attractive to investors.
→ Example:
o As a growth-oriented corporation,
Netflix provided its streaming
services to customers for free for an
extended period, which resulted in a
negative cash flow. Therefore, it
issued high-yield bonds as part of its
attempt to compensate for its
financial difficulties.
o The value of Netflix bonds has
increased significantly. It put them in
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the ‘Rising Star’ category, improving
its junk bond rating and enabling it to
achieve the investment-grade bond
status in the future.
STRIPS
→ Separate Trading of Registered Interest and
Principal Securities
→ Stripping refers to the breaking up of a bond
into its component coupon payments and its
maturity (redemption) value.
HOW A STRIP BOND WORKS?
CONVENTIONAL BOND/COUPON BOND
→ makes regular interest payments to
bondholders who receive repayment for
their principal investment when the bond
matures.
→ Example: (residual)
o Bond Residual = $3,200
o Face Value = $5,000
o Maturity = 5yrs
o At maturity, the return on the strip
bond residual will be:
▪ $5,000 - $3,200 = $1,800
→ Example: (coupon)
o Coupon Rate = 4% (semiannual
payment)
o (4% ÷ 2) x $5,000 = $100
o Bond Residual = $3,200
o Face Value = $5,000
o Maturity = 5yrs
o ($3,200 ÷ $5,000) x $100 = $64
o Return @ maturity:
▪ $100 - $64 = $36
BOND MARKET
BOND MARKET CHARATERISTICS
→ Debt markets include:
→ Primary markets for bonds, i.e. the markets
in which newly issued instruments are
bought,
→ Secondary markets, in which existing or
secondhand instruments are traded.
NON-GOVERNMENT BOND MARKET
→ Unsecured bonds
→ Covered bonds
UNSECURED BONDS
→ Unsecured bonds are not secured by a
specific asset, but rather by "the full faith
and credit" of the issuer.
→ In other words, the investor has the issuer’s
promise to repay but has no claim on
specific collateral. This doesn’t necessarily
have to be a bad thing, though.
→ Example:
o DiKo na Kaya co. issued both
unsecured and secured bonds, and
later went into bankruptcy, the
holders of the secured bonds will be
paid first.
COVERED BONDS
→ Covered bonds are claims of the bond
holders against the issuing MFI that are
secured by a pool of cover assets on the
MFI’s balance sheet, such as mortgage
loans or loans to the public sector.
BOND MARKET YIELD/BOND YIELD
→ The return an investor expects to receive
each year over its term to maturity.
3 WAYS TO MEASURE BOND YIELD
→ Current yield
→ Yield to maturity
→ Yield to call
CURRENT YIELD
→
→ Example:
o a 1000 par value bond with an 8
percent coupon interest rate that
currently sells for 970.
o
YIELD TO MATURITY
→
→ C= coupon/interest payment
→ F= face value
→ P= price
→ n= years to maturity
→ Example:
o The bond has a price of $920 and
face value is $1000. The annual
coupons are at a 10% coupon rate
($100) and there are 10 years left
until the bond matures. What is the
yield maturity rate?
o
o ABC Co.’s bonds will mature in 10
years. The bonds have a face value
of $1000 and an 8% coupon rate,
paid semiannually. The price of the
bonds is $1000. The bonds are
callable in 5 years at a call price of
$1050. What is their yield to call?
o
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→ PV OF COUPONS:
FACTORS AFFECTING THE BOND YIELD

→ Term premium
→ Liquidity
→ Credit risk
o
TERM PREMIUM (RISK PREMIUM)
→ PV OF FACE VALUE:
→ The compensation investors demand for
bearing the risk that interest rates may
change during the bonds lifespan.
→ The term premium leads to a positive term
spread, i.e., the spread of yields for bonds
with longer maturity over yields for bonds
with shorter maturity, even when markets o
expect increasing and decreasing interest → Example:
rates to be equally likely. o annual interest rate of 5%, making
semiannual interest payments for 2
LIQUIDITY
years
→ Liquidity describes the degree to which an o YTM of 3%
asset can be quickly bought or sold in the o Face Value = P1,000
market at a price reflecting its intrinsic o Coupon rate (annual) = 5%,
value. therefore, Coupon rate (semi-
→ A market with many available buyers and annual) = 5% / 2 = 2.5%
sellers and comparatively low transaction o C = 2.5% x P1000 = P25 per period
costs. o t = 2 years x 2 = 4 periods for semi-
→ 3 dimensions of liquidity: annual coupon payments
o Tightness – refers to a low bid-ask o T = 4 periods
spread o r = YTM of 3% / 2 for semi-annual
o Depth – volume of transactions compounding = 1.5%
necessary to move prices
o Resiliency – speed with which prices
return to equilibrium following a large o
trade.
→ The spread between the yield of a bond with
liquidity and a similar bond with less liquidity
is referred to as the liquidity premium.
→ The more illiquid the investment, the greater o
o Value of the bond= P1,038.54
the liquidity premium that will be required.
SHORTCUT:
CREDIT RISK

→ Credit risk arises from the potential that a

borrower or counterparty will fail to perform
on an obligation.
BOND VALUATION

→ Bond valuation is a way to determine the

theoretical fair value (or par value) of a
particular bond
→ It involves calculating the present value of a
bond's expected future coupon payments,
or cash flow, and the bond's value upon
maturity, or face value → Example:
FAIR VALUE OF BONDS o A company needs $ to expand. It
issues a 10-year $1000 bond that
pays $30 every six months. If the
current market interest rate is 7%,
→ what is the fair market value of the
→ P = Fair Value or Par Value bond?
→ C = Future Cash Flows, or Coupon o C = $30
Payments o m=2
→ r = Discount Rate, or Yield To Maturity o t = 10
→ t = Number of periods o r = 7%
o F = $1000
→ F = Face Value of the Bond
→ T = Time to Maturity
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REALIZED COMPOUND YIELD

→ the return that bondholders receive if they

reinvest all coupons at some given
reinvestment rate
TYPES OF RISK ENCOUNTERED BY
INVESTORS IN BONDS
PRICE RISK
o
DISTINCTIONS IN BOND PRICES → the risk that bond prices can change.

CLEAN PRICE REINVESTMENT RISK

→ the price of a bond ignoring any interest → the uncertainty of the interest rate at which
which may have accrued since the last coupons and redemption sums can be
coupon payment invested.

DIRTY PRICE BOND PRICE VOLATILITY

→ the price of a bond, including any accrued
interest
MACAULAY’S DURATION
→ The extent to which a bond’s price
fluctuates due to changing interest rates is
called its volatility.
→ The price of the bond is inversely related to
the required yield of that bond.
→ A bond’s volatility depends on these factors:
o Coupon Rate
o Maturity
o Trading Yield Level

→ It calculates the weighted average time

before a bondholder would receive the
bond's cash flows.

→
EEFECTIVE ANNUAL YIELD → Example:

→ It is the amount actually received from

bonds when the dividends are reinvested, in
other words, it takes into account the power
of compounding interest, as it builds over
time. o

o
→
→ Example:
o A bond has a coupon rate of 5.2%
and is compounded quarterly.
o Coupon rate: 5.2%=0.052
o Number of payments: quarterly = 4
o [1+(.052/4)]^4 -1 = 0.053 o
o therefore, the effective annual yield
is 5.3%
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ZERO COUPON BONDS
→ are bonds that do not pay interest during the
life of the bonds. Instead, investors buy zero
coupon bonds at a deep discount from their
face value, which is the amount the investor
will receive when the bond "matures"
→ The higher the coupon rate, the shorter the
duration
→ The lower the coupon rate, the longer the
duration
MODIFIED DURATION
→ It measures the price sensitivity of a bond
when there is a change in the yield to
maturity.
→
→
o When the yield to maturity increases
by 1%, the bond price would
decrease by 1.8% (inverse
relationship)
o Yield = 10% - 11%
o 96.16 (1-0.018) = 94.43
→ Coupon rate effect
o The lower the coupon rate, the
higher the price volatility
→ Maturity effect
o The longer the maturity, the greater
the price volatility
→ Effect of Yield to Maturity
o The higher the level of yield, the
lower the price volatility
BEHAVIOR OF MACAULAY’S DURATION
→ RULE 1:
o The duration of a zero coupon bond
equals its time to maturity.
→ RULE 2:
o Holding time to maturity and
redemption yield constant, duration
is inversely related to the coupon.
→ RULE 3:
o Holding the coupon rate constant,
duration generally increases with
time to maturity.
→ RULE 4:
o Holding coupon and maturity
constant, duration is inversely
related to redemption yield.
→ RULE 5:
o If bond pays the same coupon each
period forever without the principal
ever being repaid, the duration
equals (1+r)/r
IMMUNIZATION
→ A risk-mitigation strategy that matches asset
and liability duration so portfolio values are
protected against interest changes.
→ Can be accomplished by cash flow
matching, duration matching, convexity
matching, and trading forwards, futures and
options on bonds.
→ Example:
o Assume an investor needs to pay a
$10,000 obligation in five years.
o Cash Flow Matching:
▪ The investor can purchase a
security that guarantees a
$10,000 inflow in five years.
o Duration Matching:
▪ The investor must match the
portfolio’s duration to the
investment time horizon.
BOND CONVEXITY
→ A relationship between bond prices and
bond yields, which shows how a bond’s
duration changes with interest rates.
→
BOND DURATION
→ Measures the changes in a bond’s price
when interest rates fluctuate.
CONVEXITY AND RISK
→ Convexity is a better measure for assessing
the impact on bond prices when there are
large fluctuations in interest rates.
NEGATIVE CONVEXITY
→ A bond’s duration increases as yields
increases.
→ As yields increase, bond price will decline
by a greater rate.
POSITIVE CONVEXITY
→ A bond’s duration rises and yields fall.
→ As yields fall, bond prices rise by a greater
rate.
BOND ANALYSIS
INVERSE FLOATERS AND FLOATING RATE
NOTES
→ Financial engineering can create derivatives
from a non-derivative investment, e.g. the
division of a conventional bond into an
inverse floater and floating rate note.
INVERSE FLOATER
→ Is a bond whose interest rate is inversely
related to a market rate.
→ Example:
o An inverse floater might pay a
coupon rate of 10% p.a. minus
LIBOR
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o LIBOR-benchmark interest rate that
reflects market rates.
→ Not only does the coupon rate fall when
interest rates rise, but the rate at which the
coupons and principal value are discounted
also rises.
→ There are two effects of interest rate rises
that act to reduce the bond price.
→ Conversely interest rate falls have two
positive effects on the bond price; the higher
→
coupons are accompanied by a lower
discount rate.
FLOATING RATE NOTE

→ Is a bond whose coupon rate moves in line

with market rates.
→ For example, the coupon rate on a floating
rate note might be 2% p.a. plus EURIBOR.
CALLABLE BONDS

→ Callable or redeemable bonds are bonds

that can be redeemed or paid off by the
issuer prior to the bonds' maturity date.

→
VALUES OF CALLABLE BONDS, NON-CALLABLE
BONDS AND THE CALL OPTION

→
CONVERTIBLE BONDS

→ A convertible bond is a type of debt security

that provides an investor with a right or an
obligation to exchange the bond for a
predetermined number of shares in the
issuing company at certain times of a
bond’s lifetime.
→ It is a hybrid security that possesses
features of both debt and equity.