LECTURE FOUR

BOND MARKETS
 Introduction

• A bond is a debt security, under which the issuer owes the

holders a debt and, depending on the terms of the bond, is
obliged to pay them interest (the coupon) and/or to repay
the principal at a later date (the maturity date).

• Interest is usually payable at fixed intervals (annually,

semiannually, and sometimes monthly).

• Very often the bond is negotiable, i.e. the ownership of

the instrument can be transferred in the secondary
market.
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BONDS AND STOCKS

• Bonds and stocks are both securities, but the major difference
between the two is that
• stockholders have an equity stake in the company (i.e. they are
investors), whereas bondholders have a creditor stake in the
company (i.e. they are lenders).
• Being a creditor, bondholders have absolute priority and will be
repaid before stockholders (who are owners) in the event of
bankruptcy.
• Another difference is that bonds usually have a defined term, or
maturity, after which the bond is redeemed, whereas stocks are
typically outstanding indefinitely. An exception is an irredeemable
bond, such as Consols, which is a perpetuity, i.e. a bond with no
maturity.
 Cont…
•The primary advantage of being a creditor is a
• higher claim on assets than that of shareholders.
• That is, in the case of bankruptcy a bondholder will
get paid before a shareholder does.
• The bondholder, however, does not share in the profits
if a company does well he or she is entitled only to the
principal plus interest.

• To sum it up, there is generally less risk in owning

bonds compared to owning stocks, but this comes at
the cost of a lower return.
 BOND TERMINOLOGIES
• The terms under which money is borrowed are contained in an agreement
known as the indenture.
• The indenture defines the obligations of and restrictions on the borrower, and
forms the basis for all future transactions between the lender/investor and the
issuer.
• These terms are known as covenants and include both negative (prohibitions on
the borrower) and affirmative (actions that the borrower promises to perform).
• In addition to the payment schedule, the indenture also specifies a set of
restrictions on the issuer (in terms of sinking funds, further borrowing, dividend
policy, and collateral) to protect the rights of the holders of the bonds.
• The term to maturity (or simply maturity) of a bond is the length of time until
the loan contract or agreement expires.
• It defines the (remaining) life of the bond
 Cont…
• The maturity date represents the date on which the
bond matures, i.e., the date on which the face value is
repaid. The last coupon payment is also paid on the
maturity date.
• The par value of a bond is the amount that the borrower
promises to pay on or before the maturity date of the
issue.
• The coupon rate is the rate that, when multiplied by the
par value of a bond, gives the amount of interest to be
paid annually by the borrower (coupon amount).
• The required return is the rate of return that investors
currently require on a bond.
 Cont…..

• The bond market is a financial market where participants

buy and sell debt securities, usually in the form of bonds.
• The classification of a bond depends on its type of issuer,

priority, coupon rate, and redemption features. The

following chart outlines these categories of bond
characteristics:

Reading assignment
Cont…
 Bond Issuers
•Government (Treasury) Securities
•Municipal bonds:
•Revenue Bonds: These are bonds issued to finance a
particular project.
Revenues generated by the project will be used to pay
the interest payments and repay the principal.
•General Obligation Bonds: These are bonds that are
backed simply by the full faith and credit of the
governmental units that they will make the interest
payments and repay the principal.
•Subordinated and unsubordinated bonds
 Bond Issuers
•International bonds
•Eurobond: refers to any bond that is denominated in a
currency other than that of the country in which it is issued.
Bonds in the Eurobond market are categorized according to
the currency in which they are denominated. As an example, a
Eurobond denominated in Japanese Yen but issued in the U.S.
would be classified as a Euroyen bond.
•Foreign bonds: are denominated in the currency of the
country into which a foreign entity issues the bond. An
example of such a bond is the Samurai bond, which is a yen-
denominated bond issued in Japan by an American company.
•Global bonds: are structured so that they can be offered in
both foreign and Eurobond markets. Essentially, global bonds
are similar to Eurobonds but can be offered within the country
whose currency is used to denominate the bond.
 Cont…..
Corporate bonds
In order to fuel its growth (whether through building a
new plant or through mergers and acquisitions), a
company can choose to finance these business related
needs by issuing bonds (especially when these are long-
term needs). Corporate bonds are characterized by
higher yields because there is a higher risk of a
company defaulting than a government.
• The company's credit quality is very important: the
higher the quality, the lower the interest rate the
investor receives.
Coupon rate
• Bond issuers may choose from a variety of types of
coupons, or interest payments.
• 1. Fixed-rate bonds pay an absolute coupon rate over a
specified period of time. Upon maturity, the last coupon
payment is made along with the par value of the bond.
• 2. Floating rate debt instruments or floaters pay a
coupon rate that varies according to the movement of
the underlying benchmark. These types of coupons
could, however, be set to be a fixed percentage above,
below, or equal to the benchmark itself. Floaters
typically follow benchmarks such as the three, six, or
nine-month T-bill rate or LIBOR.
Coupon rate
• 3. Inverse floaters pay a variable coupon rate that changes in
direction opposite to that of short-term interest rates. An inverse
floater subtracts the benchmark from a set coupon rate. For
example, an inverse floater that uses LIBOR as the underlying
benchmark might pay a coupon rate of a certain percentage; say
6%, minus LIBOR.
• 4. Zero coupon or accrual bonds do not pay a coupon. Instead,
these types of bonds are issued at a deep discount and pay the
full face value at maturity.
• 5. Consols: These are bonds which make periodic interest
payments forever.
Not to many of these, they look like annuities
Embedded options

• Both investors and issuers are exposed to interest rate risk since
they are locked into either receiving or paying a set coupon rate
over a specified period of time. For this reason, some bonds
offer additional benefits to investors or more flexibility for
issuers:
• 1. Callable or a redeemable bond feature gives the bond issuer
the right but not the obligation to redeem their issue of bonds
before the bond's maturity the issuer, however, must pay the
bond holders a premium.

Slide 14 14
 Cont………
2. Puttable bonds give bondholders the right but not the obligation to
sell their bond back to the issuer at a predetermined price and date.
• These bonds generally protect investors from interest-rate risk.
• If the prevailing bond prices are lower than the exercise par of the
bond, resulting from interest rates being higher than the bond's
coupon rate, it is optimal for investors to sell their bond back to the
issuer and reinvest their money at a higher interest rate.
3. Convertible bonds give bondholders the right but not the obligation
to convert their bonds into a predetermined number of shares at
predetermined dates prior to the bond's maturity.
An embedded option that benefits the issuer will increase the yield
required by bond buyers. An embedded option that benefits the
bondholder will decrease the yield required on the bond.
BOND CREDIT RATING
• In investment, the bond credit rating represents
the credit worthiness of corporate or government
bonds.
• The ratings are published by Credit rating
agencies and used by investment professionals to
assess the likelihood the debt will be repaid.
• The rating of a bond is simply the grade it
received based on its likelihood of not meeting
any of its payments: the higher (or better) the
grade, the less likely the company will default on
its bond payments.
Cont…..
Moody’s S&P Description
Aaa AAA Capacity to pay interest and repay principal is extremely strong
Aa AA Very strong capacity to pay interest and repay principal; only slightly
less safe than debt rated triple A
A A Strong capacity to pay interest and repay principal, though somewhat
susceptible to adverse changes in financial and economic conditions
Baa BBB Adequate capacity to pay interest and repay principal, though more
susceptible to adverse changes in economic and financial conditions

• These four categories of bond ratings are considered

as investment grade bonds,
• which generally means that they are “safer” bonds and
thus more attractive to investors
• Other categories of bond ratings are considered as
speculative grade (or junk) bonds,
• which generally means that they are “risky” bonds and
thus less attractive to investors.
Cont….
Moody’s S&P Description
Ba BB Speculative; faces ongoing uncertainties or exposure to adverse conditions
which could lead to the inability to pay interest or repay principal

B B Vulnerable to default, but currently has the capacity to meet interest

and principal obligations
Caa CCC Currently identifiable vulnerability to default and is dependent on
favorable conditions to meet obligations
Ca CC More vulnerable to default and highly speculative
C C Extremely speculative; poor prospects for attaining any real
investment standing
D D Currently in default

• The rating of a bond reflects the financial health of the

issuer.
• The rating companies determine the ratings based on set of the
issuer’s financial ratios. There are five financial ratios that they look
at: (1) Coverage (or asset turnover) ratios; (2) Leverage ratios; (3)
Liquidity ratios; (4) Profitability ratios; and (5) Cash flow to debt
ratios.
BOND VALUATION
• Bonds are valued using the time value of money
concepts.
• When you invest in a bond, you are expected to
receive a steady stream of fixed interest payments
from the bond known as coupon amount C, these
payments are treated like an equal cash flow stream
(annuity). Their face value is treated like a lump sum.
Expected to reinvest them in the market at the
nominal market interest rate i .
• The nominal market interest rate is made up of three parts:
• (a) a real risk-free rate of return,
• (b) a compensation for expected inflation, and
• (c) a compensation for bond-specific characteristics (such as
ratings, call features, liquidity, etc.).
BOND VALUATION
• To determine the intrinsic value of a bond-
determine the present values of all the cash
flows (i.e. interest payments and principal)
generated by the bond throughout its lifetime.
• In other words, the intrinsic value of a bond is
simply the present value of all its interest
payments plus the present value of its principal
BOND VALUATION
 Example
• Calculate the price of a bond with a par value of TZS 1,000 to be paid in ten
years, a coupon rate of 10%, and a required yield of 12%. Assume that coupon
payments are made semi-annually to bond holders, and that the next coupon
payment is expected in six months.
• Here are the steps we have to take to calculate the price:
• Determine the number of coupon payments: Since two coupon payments
will be made each year for ten years, we will have a total of 20 coupon
payments.
• Determine the value of each coupon payment: Since the coupon payments
are semi-annual, divide the coupon rate in half. The coupon rate is the
percentage off the bond's par value. As a result, each semi-annual coupon
payment will be TZS 50 (TZS 1,000 X 0.05).
• Determine the semi-annual yield: Like the coupon rate, the required yield of
12% must be divided by two because the number of periods used in the
calculation has doubled. (If we left the required yield at 12%, our bond price
would be very low and inaccurate.) Therefore, the required semi-annual
yield is 6% (0.12/2).
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Cont……..

• From the above calculation,

• Use formula to determine the price of bond
• Price = 885.32
• the bond is selling at a discount: the bond price is less than its
par value because the required yield of the bond is greater
than the coupon rate.
• The bond must sell at a discount to attract investors, who
could find higher interest elsewhere in the prevailing rates.
• In other words, because investors can make a larger return in
the market, they need an extra incentive to invest in the bonds.
Cont……..
• Pricing Zero-Coupon Bonds
• So what happens when there are no coupon payments? For the
aptly-named zero- coupon bond, there is no coupon payment
until maturity. Because of this, the present value of annuity
formula is unnecessary.
• You simply calculate the present value of the par value at
maturity
• P = Par value /(1+r)^n
Example: Calculate the price of a zero-coupon bond that is
maturing in five years, has a par value of TZS 1,000, and a
required yield of 6%.
• zero-coupon bonds are always priced at a discount: if zero-
coupon bonds were sold at par, investors would have no way of
making money from them and therefore no incentive to buy
them.
Lessons from valuing a bond
• In the previous example, we know that the characteristics of a
bond (e.g. coupon rate, term to maturity, and payment
schedule) will have an impact on the intrinsic value (i.e. fair
market price) of the bond.
Lessons
1. There is an inverse relationship between the market interest
rate and the price of a bond, i.e. if the market interest rate goes
up (down), then the price of a bond will go down (up).
2. The price of a bond is affected by the relationship between its
coupon rate and the market interest rate.
Coupon rate > Market interest ≈ Price of bond > Par - Sold at premium
Coupon rate = market interest ≈ Price of bond = Par - Sold at par
Coupon rate < market interest ≈ Price of bond < Par - Sold at discount
BOND YIELDS
• The term yield is generally used to represent the return of an
investment. However, do you know that there are different
types of yield associated with a bond, each representing a
different way to measure the return of the bond?
• (a) normal yield, (b) current yield, (c) yield to maturity, and (d)
yield to call.
• Normal yield is the quoted coupon rate of the bond. For
example, a bond with an 8% coupon rate has a normal yield of
8%. Keep in mind that the normal yield of a bond is fixed (in
general) and does not take into consideration the current market
condition, which means that you should not rely on the normal
yield to help you determine the return of a bond. The normal
yield is simply the coupon payment (C) as a percentage of the
par value (Par).
• Normal Yield = C/par,
• Coupon yield is also called nominal yield.
 Cont….

• The current yield of a bond does take the current market condition into
consideration by incorporating the current market price into its
calculation
• Current yield = Annual coupon payment/ Current Bond price
• Example If you purchased a bond with a par value of $100 for $95.92 and it
paid a coupon rate of 5%, this is how you'd calculate its current yield:
• CY = {(5% * 100)/95.92}*100% = 5.21%

Yield to Maturity
• Yield to Maturity (YTM) is the rate of return that an investor would earn if he
bought the bond at its current market price and held it until maturity.
• Alternatively, it represents the discount rate which equates the discounted
value of a bond's future cash flows to its current market price.

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Cont….

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 Cont….
• Note that the yield to maturity of a bond is computed with the
assumption that the coupon payments received are reinvested at
the YTM rate.
• In situations when the market interest rates are fluctuating, you will
not get the promised yield to maturity because each coupon payment
is reinvested at a different rate.
• Note that also the yield to maturity of a bond is generally
treated as the same as the market interest rate of that bond.
• In other words, the YTM is generally used as the measurement of a
bond’s return
NOTE:
1. If a bond's current yield is less than its YTM, then the bond is
selling at a discount.
2. If a bond's current yield is more than its YTM, then the bond is
selling at a premium.
3. If a bond's current yield is equal to its YTM, then the bond is
selling at par.
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Cont…
• Example : Assume you have 15 year pays TZS 110 per year
(11%) in interest and TZS 1,000 after 15 years in principal
payment. The current price of bond is TZS 932.21. determine
the YTM, or discount rate. (11.94%≈ 12%)
Yield to call
• Measures the annual return of a bond if it is held until maturity.
• However, this is not always possible for a bond with an
embedded call feature.
• Callable bonds have the potential to be recalled (or retired) prior
to their maturities, especially when the interest rate is falling. As
a result, it is important for holders for such bonds to determine
the bonds’ yields to call (in addition to their yields to maturity).
• Calculating the yield to call is very similar to calculating the
yield to maturity: (a) replace the original term to maturity with
the time until first call and (b) replace the principal with the call
price. 30
 MANAGING BOND PORTFOLIOS
•Bond portfolio manager can pursue passive or active investment
management strategy.
•A passive investment strategy takes market prices of securities as
fairly set. Rather than attempting to beat the market by exploiting
superior information or insights, passive managers act to maintain
an appropriate risk-return balance given market opportunities.
•An active investment strategy attempts to achieve returns greater
than those commensurate with the risk borne.
•It can take number of forms, the active managers either use interest rate
forecasts to predict movements in the entire fixed income market, or
they employ some form of intramarket analysis to identify particular
sectors of the fixed income market or particular bonds that are relatively
mispriced.
•The interest rate risk is crucial to formulating both active and
passive strategies. For that reason we begin our discussion with an
analysis of the sensitivity of bonds prices to interest rate
fluctuations. This sensitivity is measured by the duration of the
bond

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 Risks associated with investing in bonds
• The most important risks associated with investing in bonds are interest rate risk,
reinvestment risk, and credit risk.
• 1. Interest rate risk. As the rates go up (down), bond prices go down ( up). This
is the source of interest rate risk, which is approximated by duration.
• 2. Call risk. Call protection reduces call risk. When interest rates are more
volatile, callable bonds have more call risk.
• 3. Prepayment risk. If rates fall, causing prepayments to increase, the investor
m u s t reinvest at the new lower rate.
• 4. Yield curve risk. Changes in the shape of the yield curve mean that yields
change by different a mounts for bonds with different maturities.
• 5. Reinvestment risk. occurs when interest rates decline and investors are
forced to reinvest bond cash flows at lower yields. Reinvestment risk is the
greatest for bonds that have embedded call options, prepayment options, or high
coupon rates, and is greater for amortizing securities t h a n for non-amortizing
securities.

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 Cont…
• 6. Credit risk. Credit risk comes in three forms-default risk, credit spread risk,
and downgrade risk.
• 7. Liquidity risk. Since investors prefer more liquidity to less, a decrease in a
security's liquidity will decrease its price, and the required yield will be higher.
• 8. Exchange-rate risk. This is the uncertainty about the value of foreign
currency cash flows to an investor in terms of his home country currency.
• 9. Volatility risk. This risk is present for fixed- income securities that have
embedded options-call options, prepayment options, or put options. Changes
in interest rate volatility affect the value of these options and thus affect the
value of securities with embedded options.
• 10. Inflation risk. This is the risk of unexpected inflation, also called
purchasing power risk.
• 11. Event risk. Risks outside the risks of financial markets (i.e., natural
disasters, corporate takeovers)

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 Interest Rate Sensitivity (Bonds Price Volatility)
• Bond price volatility is measured in terms of percentage changes
in bond prices. Bond with high price volatility or high interest
rate sensitivity is one that experiences a relatively large
percentage price change for a given change in yields.
Relationships between yield (interest rate) changes and bond
price behavior:
• 1. Bond prices move inversely to bond yields (interest rates): as
yield increase, bond prices fall; as yields fall, bond prices raise.
• 2. Prices of long-term bonds tend to be more sensitive to interest
rate changes than prices of short term bonds: thus, bond price
volatility is directly related to term to maturity.
• 3. The sensitivity of bond prices to changes in yields increases at
a decreasing rate as maturity increases. In other words, interest
rate risk is less than proportional to bond maturity.

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 Cont….
• 4. Bond price movements resulting from equal absolute increases
or decreases in yield are not symmetrical. An increase in a bond’s
yield to maturity results in a smaller price decline than the price
gain associated with a decrease of equal magnitude in yield.
• 5. Interest rate risk is inversely related to the bond’s coupon rate.
Prices of high coupon bonds are less sensitive to changes in
interest rates than prices of low coupon bonds.
• 6.The sensitivity of bond’s price to a change in its yield is
inversely related to the yield to maturity at which the bond
currently is selling.
• These six propositions confirm that maturity is a major
determinant of interest rate risk. However, they also show that
maturity alone is not sufficient to measure interest rate sensitivity.
Bonds may have same maturity, but the higher coupon bond has
less price sensitivity to interest rate change. Obviously, we need to
know more than a bond’s maturity to quantify its interest rate risk
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DURATION

• Duration differs from maturity as a measure of interest rate

sensitivity because duration takes into account the time of arrival
and the rate of reinvestment of all cash flows during the bond’s
life.
• Technically, duration is the weighted-average time to maturity
using the relative present values of the cash flows as the weights.
• Duration is more complete measure of bond’s interest rate
sensitivity than maturity because it consider the time of arrival of
all cash flows as well as the bond’s maturity
• The large the value of D that is calculated for the bond, the more
sensitive is the price of that bond to changes or shocks in interest
rates.

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Cont…

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Economic meaning of duration
• Besides being a weighted-average measure of maturity
(average life of a bond), Duration is also a direct measure of
interest rate sensitivity (interest rate risk).
• The higher the duration, the higher the bond's price risk,
ceteris paribus
• For small changes in interest rates, bond prices move in an
inversely proportional (linear) direction, according to the
length of duration. The higher the duration, the greater the
price change (in %), the greater the capital loss (gain), and the
greater the price risk

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Cont……

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Cont…..Example
1. a. Calculate the duration of a $1,000, 6% coupon
bond with three years to maturity. Assume that all
market interest rates are 7%.
b. Consider the bond in the above question. (i)
Calculate the expected rate of price changes when
interest rates drop to 6.75% using the duration
approximation. (ii) Calculate the actual price change
using discounted cash flows

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Solution

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 Bond convexity
• Convexity is a measure of the sensitivity of the price of a bond
to changes in interest rates.
• It is related to the concept of duration.
• Duration is a linear measure of how the price of a bond changes in
response to interest rate changes. As interest rates change, the price is
not likely to change linearly, but instead it would change over some
curved function of interest rates.
• The more curved the price function of the bond is, the more inaccurate
duration is as a measure of the interest rate sensitivity.
• Convexity is a measure of the curvature of how the price of a
bond changes as the interest rate changes, i.e. how the duration
of a bond changes as the interest rate changes.
• Specifically, duration can be formulated as the first derivative of
the price function of the bond with respect to the interest rate in
question.
• Then the convexity would be the second derivative of the price
function with respect to the interest rate 42
Cont…

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 Cont….
• Notice that the dP/di line is tangent to the price yield curve at a
given yield, as shown in the above figure.
• For small changes in yields (i.e. from y* to either y1 or y2 ), this
tangent straight line gives a good estimate of the actual price
changes.
• In contrast, for larger changes in yields (i.e. from y* to either y3
or y4 ), the straight line will estimate the new price of the bond at
less than the actual price shown by the price-yield curve.
• Thus, duration allows us to estimate bond price changes for a
change in interest rates. However, the equation is accurate only
for very small changes in market yield.
• The accuracy of the estimate of the price change deteriorates
with larger changes in yields because the modified duration
calculation is a linear approximation of a bond price change that
follows a curvilinear (convex) function
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 Determinants of Convexity

• Convexity is a measure of the curvature of the price-yield

relationship. Because duration is the slope of the curve at a given
yield, convexity indicates changes in duration.
• Mathematically, convexity is the second derivative of price with
respect to yield divided by price.

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Cont…. Example

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Cont…. Example

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TERM STRUCTURE OF INTEREST RATES

• Term structure of interest rates describes the relationship

between maturity and the yield of an instrument especially
bonds and other fixed income instruments.
• You know from bond properties that all other factors
remaining constant, as the maturity of the bond increases
investors will demand a higher yield.
• Therefore the Yield-To-Maturity (YTM) usually increases
as time to maturity of the bond increases, but this need not
always be true.
• Depending on economic conditions and people’s
expectations we may also see decreasing yields with
increasing maturity. The question is why should we be
interested in this relationship? 48
TERM STRUCTURE OF INTEREST RATES

• Interest rates are a very important factor in estimating various

economic variables.
• They serve as a measure of cost of capital, return expected by
investors for their investment, capital rents, inflation etc.
• The central bank manipulates them to implement monetary
policy.
• Firms need to know how interest rates will behave when
making investment or financing decisions.
• All asset valuation methods use interest rates. Recall that the
current price of an asset is the PV of all future cash flows
discounted at some rate, that discount rate which we use is the
current interest rate with adjustments for risk of the asset.
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 Theories of the Term structure
• Explain how interest rates on bonds with different terms to maturity are
related
(1) Expectations Theory –The interest rate on a long-term term bond will equal
an average of the short-term interest rates that people expect to occur over the
life of the long-term bond.
(2) Market Segmentation Theory - treats the determination of interest rates for
each bonds’ maturity as the outcome of supply and demand in that market only
(3) Liquidity premium theory- it views long-term interest rates as equal to the
average of future short-term interest rates expected to occur over the life of the
bond plus a liquidity premium.
(4) Preferred Habitat theory - expectations are not important, people have
already decided what sort of liquidity they want to be in i.e. the choice to be in
the short, medium or long or any other term is decided by their investment
horizon. They would invest in instruments whose maturity matches the
investor’s horizon. That is they have a preferred place in the market where
they wish to deal i.e. preferred habitat. They may shift to other maturities if
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they are compensated adequately for giving up their preferences. According to
this theory, yields respond to supply-demand within each maturity and due to
risk premium demanded by investors moving into other maturities