Financial Markets and

Institution
Lecture 6
The Bond Market

 Learning Objectives
To look

at how business firms issue debt

securities and negotiate loans in order to raise
funds in the money and capital markets.
To review the innovation in Treasury notes and
bills.
To discuss the characteristics and types of
corporate bonds.
To compute the current yield and the value of
coupon bond.

19-2

Introduction
Business

firms draw on a wide variety of fund

sources to finance their daily operations and to
carry out long-term investment.

In

2006, nonfinancial business firms in the U.S.

raised nearly $1.9 trillion, of which
approximately $516 billion was supplied from
the financial markets through issues of bonds,
stocks, notes, and other financial instruments.

19-3

Purpose of the Capital Market

Original

maturity is greater than one year,

typically for long-term financing or
investments.

Use

of capital market securities to reduce

the interest rate risk.

Best

known capital market securities:

Stocks

and bonds

Capital Market Participants

Primary

issuers of securities:

Federal

and local governments: debt

issuers
Corporations:
Largest
You

equity and debt issuers

purchasers of securities:

and me

Capital Market Trading

1.

2.

Primary

market for initial sale (IPO)

Subsequent sale (primary market transaction)

Secondary market

Over-the-counter

Organized exchanges (i.e., KLSE)

Listed bond bursa Malaysia

Unlisted bond OTC facilitated by BNM via FAST system.

Background on Bonds

Long term debt securities (10 30 years)

issued by treasury, federal agencies and
corporations.
Bonds are securities that represent debt
owed by the issuer to the investor, and
typically have specified payments on
specific dates.
The issuer is obligated to pay coupon (or
interest) payments periodically and the
par value (or principal) at maturity.
Malaysia bond market size: $282.3 billion.

Types of Bonds
Long-term

government bond

Treasury

bonds

Agency

bonds

Municipal

bonds

Corporate

bonds.

Types of Bonds:
Sample Corporate Bond

Treasury Notes and Bonds

The U.S. Treasury issues notes and bonds to finance

its operations (finance national debts).

The following table summarizes the maturity

differences among the various Treasury securities.

No default risk low interest rate (risk-free rate)

Treasury Bond Interest Rates

Treasury Bond Interest Rates:

Bills vs. Bonds

Treasury Bonds:
Recent Innovation
Treasury

Inflation-Indexed Securities

(TIPS):
the principal amount is tied to the current
rate of inflation to protect investor
purchasing power
Treasury

STRIPS: the coupon and principal

payments are stripped from a T-Bond
and sold as individual zero-coupon bonds.

 TIPS:

interest rate does not change but principal

amount change based on the consumer price index.
At maturity, the securities are redeemed at the
greater of their inflation-adjusted principal (par
value). Normally used by retirees. Value wont be
eroded by inflation rate.

STRIPS:

separate the interest payment and

principal payment becomes a separate 0-coupon
security. Create interest only or principal only bonds.

Treasury Bonds: Agency Debt

Although

not technically Treasury

securities, agency bonds are issued by
government-sponsored enterprises (federal
agencies).

The

debt has an implicit guarantee that

the U.S. government will not let the
debt default. This guarantee was clear
during the 2008 bailout (the case of Fannie
Mae and Freddie Mac).

 The

default risk for agency bond is low:

1. Secured

by loans that are made with the

funds raised by the bond sales.

2. May

use agencies credit line with treasury

department to meet obligation.

3. Fed

would not let it fail. It will bailout those fed

agencies.

The 20072009 Financial Crisis:

Bailout of Fannie and Freddie
Both

Fannie and Freddie managed their

political situation effectively (through
lobbying), allowing them to engage in
risky activities, despite concerns raised.

By

2008, the two had purchased or

guaranteed over $5 trillion in mortgages
or mortgage-backed securities.

The 20072009 Financial Crisis:

Bailout of Fannie and Freddie
Part

of this growth was driven by their

Congressional mission to support affordable
housing. They did this by purchasing subprime
mortgages.

As

these mortgages defaults, large losses

mounted for both agencies.

Both

agencies also have their capital ratio far

lower than the commercial banks.

1. Fannie and Freddic have a mission to promote affordable

housing. The best way to help is buying subprime mortgage.

2. But with a weak regulator, they over guarantee over $5

trillion mortgages or mortgage-backed securities.

1.

When subprime mortgage default (due to the property sector

bubble which cause property price drops tremendously),
investors pull out their money from both agencies.

2.

Gov cant let it fail as it would have disastrous effect on the

availability of mortgage credit. So they provides $200 billion to
bailout.

3.

Then gov took over and have their regulator oversee their
day-to-day operations.

Malaysia Government-Related Bonds

Khazanah

bond: zero-coupon bond, based on

Islamic principle

Cagamas

bond: issued by national mortgage

corporation, mainly use to finance the purchase
of housing loan.

Municipal Bonds
Issued

by local, county, and state

governments

Used

to finance public interest projects at

the local level (e.g. school, utilities,
transportation system).

Tax-free

municipal interest rate (ETFR)

taxable interest rate (1marginal tax

rate)

Municipal Bonds: Example

Suppose the rate on a corporate bond is 9%
and the rate on a municipal bond is 6.75%.
Which should you choose?
Answer: Find the marginal tax rate:
6.75% 9% (1 MTR), or MTR 25%
If you are in a marginal tax rate above 25%,
the municipal bond offers a higher after-tax
cash flow.

Municipal Bonds: Example

Suppose the rate on a corporate bond is 9% and
the rate on a municipal bond is 6.75%. Which
should you choose? Your marginal tax rate is 28%.
OR Answer: Find the equivalent tax-free rate:
ETFR 9% (1 MTR) 9% (1 0.28)
The ETFR 6.48%. If the actual muni-rate is
above this (it is), choose the muni.
ETFR = equivalent tax free rate

Municipal Bonds
Two types
General obligation bonds backed by the full
faith and credit.
Revenue bonds backed by cash flow of a
particular revenue-generating project.
NOT default-free
Local government cannot print money & limited
taxes raising.
Defaults in 1983 amounted to $225 billion in this
market.
Liquidity risk

Municipal Bonds: Comparing Revenue

and General Obligation Bonds

Corporate Bonds
Typically

have a face value of $1,000,

although some have a face value of $5,000 or
$10,000
Pay interest semi-annually or annually.
Cannot be redeemed anytime the issuer
wishes, unless a specific clause states this
(call option).
Degree of risk varies with each bond. Hence,
the required interest rate varies with level of
risk.

Corporate Bonds: Interest Rates

on various bonds from 19732009.

Corporate Bonds: Characteristics

of Corporate Bonds
Registered

Bonds

Replaced
IRS

bearer bonds

can track interest income this way

Restrictive

Covenants

Mitigates

conflicts with shareholder interests

May

limit dividends, new debt, involvement in

M&A, etc.

Usually

includes a cross-default clause

Corporate Bonds: Characteristics

of Corporate Bonds
Call

Provisions

Higher yield (call price set at a price higher or equal to par value)

Its flexibility promotes the use of callable bonds.

Sinking

fund

Conversion

Some debt may be converted to equity

Price of stock must raise substantially.

Issue convertible bonds better than issue stock due to asymmetric

information.

Corporate Bonds: Characteristics

of Corporate Bonds
Secured Bonds: with collateral attached.
Mortgage bonds building as a collateral
Equipment trust certificates heavy equipment
or airplanes as a collateral
Unsecured Bonds
Debentures backed only by general
creditworthiness of issuer.
Subordinated debentures lower priority claim
than debentures.
Variable-rate bonds interest rate tied to other
market interest rate

Corporate Bonds: Characteristics

of Corporate Bonds
Junk Bonds
Debt that is rated below BBB
Often, trusts and insurance companies
are not permitted to invest in junk debt
Michael Milken developed this market in
the mid-1980s, although he was
subsequently convicted of insider
trading

Corporate Bonds: Debt Ratings (a)

2012 Pearson Prentice Hall. All rights reserved.

1232

Corporate Bonds: Debt Ratings (b)

2012 Pearson Prentice Hall. All rights reserved.

1233

Debt Rating in Malaysia

There

are 2 agencies provide

independent opinion on credit risks and
potential default risks:
Rating

Agencies Malaysia (RAM)

Malaysian

Rating Corporation (MARC)

Financial Guarantees for

Bonds
Some

debt issuers purchase financial

guarantees to lower the risk of their debt.

The

guarantee provides for timely

payment of interest and principal, and
are usually backed by large insurance
companies.

Malaysia:

Danajamin Nasional

Bond Current Yield

Calculation
What is the current yield for a bond with a
face value of $1,000, a current price of
$921.01, and a coupon rate of 10.95%?
Answer:
ic C / P $109.50 / $921.01 11.89%
Note: C ( coupon) 10.95% $1,000
$109.50

Finding the Value of Coupon

Bonds
Bond

pricing is, in theory, no different than pricing

any set of known cash flows. Once the cash flows
have been identified, they should be discounted
to time zero at an appropriate discount rate.
The table on the next slide outlines some of the
terminology unique to debt, which may be
necessary to understand to determine the cash
flows.

Finding the Value of Coupon

Bonds

Finding the Value of Coupon

Bonds
Lets use a simple example to illustrate the
bond pricing idea.
What is the price of two-year, 10% coupon
bond (semi-annual coupon payments) with a
face value of $1,000 and a required rate of
12%?

Finding the Value of Coupon

Bonds

Solution:
1.Identify the cash flows:
$50

is received every six months in interest

$1000 is received in two years as principal repayment
2.Find

the present value of the cash flows

(calculator solution):
4, FV 1000, PMT 50, I 6
Computer the PV. PV 965.35
N

What is the current yield?

Investing in Bonds
Bonds

are the most popular alternative to

stocks for long-term investing.

Even

though the bonds of a corporation

are less risky than its equity, investors still
have risk: price risk and interest rate
risk.

Investing in Bonds
The

next slide shows the amount of bonds

and stock issued from 1983 to 2009.

Note

how much larger the market for new

debt is. Even in the late 1990s, which
were boom years for new equity
issuances, new debt issuances still
outpaced equity by over 5:1.

Investing in Bonds

Tutorial Question

Mishkin

& Eakins. 2012. Financial Markets and

Institutions, 7th ed. Pearson.

Quantitative

problem

- Questions 1, 2, 3, 4, 9, 11
- (Chapter 12 pg. 340-341) Quantitative Problems
1,2,3,8,10,15