CHAPTER 12:

THE BOND MARKET

 PURPOSE OF THE CAPITAL MARKET

• The primary reason that individuals and firms choose

to borrow long-term is to reduce the risk that
interest rates will rise before they pay off their
debt.
• Most long-term interest rates are higher than short-
term rates due to risk premiums.
• Despite the need to pay higher interest rates to
borrow in the capital markets, these markets remain
CAPITAL MARKET PARTICIPANTS
• Primary issuers are national and local governments and corporations.
• The national government issues long-term notes and bonds to fund the
national debt.
• Local and municipal governments also issue long-term notes and
bonds to finance capital projects, such as school and prison
construction.
• Governments never issue stock because they cannot sell ownership
claims.
• Corporations issue both bonds and stock.
• Corporations decide whether it should finance its growth with
debt or equity.
• The distribution of a firm’s capital between debt and equity is
called its capital structure.
• Corporations may enter the capital markets because they do not
have sufficient capital to fund their investment opportunities.
• They may choose to enter the capital markets because they
want to preserve their capital to protect against unexpected
needs.
• During the 2008–2009 financial crisis, funds for business
expansion dried up.
• This led to reduced business activity, high unemployment,
and slow growth.
• The largest purchasers of capital market securities are
households.
• Individuals and households deposit funds in financial
institutions that use the funds to purchase capital market
instruments such as bonds or stock.
CAPITAL MARKET TRADING
• Occurs in either the primary market or the secondary
market.
• The primary market is where new issues of stocks and
bonds are introduced.
• Investment funds, corporations, and individual investors
can all purchase securities offered in the primary market.
• When firms sell securities for the very first time, the issue
is an initial public offering (IPO).
• A secondary market is where the sale of previously
issued securities takes place.
• Secondary markets are critical in capital markets
because most investors plan to sell long-term bonds
at some point before they mature.
• There are two types of exchanges in the secondary
market for capital securities: organized exchanges
and over-the-counter exchanges.
• An organized exchange has a building where
securities (including stocks, bonds, options, and
futures) trade.
• Exchange rules govern trading to ensure the efficient
and legal operation of the exchange.
• The exchange’s board constantly reviews these rules
to ensure that they result in competitive trading.
 TYPES OF BONDS
• Bonds are securities that represent a debt owed by the issuer to the
investor.
• Bonds obligate the issuer to pay a specified amount at a given date,
generally with periodic interest payments.
• The par, face, or maturity value of the bond (they all mean the same
thing) is the amount that the issuer must pay at maturity.
• The coupon rate is the rate of interest that the issuer must pay, and
this periodic interest payment is often called the coupon payment.
This rate is usually fixed for the duration of the bond and does not
fluctuate with market interest rates.
 TREASURY NOTES AND BONDS
• The Treasury issues notes and bonds to finance the national
debt.
• The difference between a note and a bond is that notes
have an original maturity of 1 to 10 years while bonds
have an original maturity of 10 to 30 years.
TREASURY BOND INTEREST RATES
• Have very low interest rates because they have no default risk.
• Since the 1980s the interest rate on Treasury bonds has been above
the inflation rate and is also above the interest rate on money
market securities because of interest-rate risk.
• The rate of return on the short-term bill is below that on the 20-
year bond.
• Short-term rates are more volatile than long-term rates.
• Short-term rates are more influenced by the expected rate of
inflation.
 TREASURY INFLATION-PROTECTED SECURITIES (TIPS)

• An innovative bond designed to remove inflation

risk from holding treasury securities.
• The inflation-indexed bonds have an interest rate that
does not change throughout the term of the security.
• The principal amount used to compute the interest
payment does change based on the consumer price
index.
• At maturity, the securities are redeemed at the
greater of their inflation-adjusted principal or par
amount at original issue.
• Inflation-indexed (or protected) securities give both
individual and institutional investors a chance to
buy a security whose value won’t be eroded by
inflation.
• They are offered by the Treasury with maturities of
5, 10, and 30 years.
TREASURY STRIPS
• Separate Trading of Registered Interest and Principal
Securities- bonds in book entry form
• No physical document exists; instead, the security is
issued and accounted for electronically.
• Separates the periodic interest payments from the final
principal repayment.
• Each interest payment and the principal payment
becomes a separate zero-coupon security.
• Each component has its own identifying number and maturity and can
be held or traded separately.
• A Treasury note with five years remaining to maturity consists of a
single principal payment at maturity and 10 interest payments,
one every six months for five years.
• When this note is STRIPPED, each of the 10 interest payments and
the principal payment becomes a separate security. Thus, the single
Treasury note becomes 11 securities that can be traded individually.
• STRIPS are also called zero-coupon securities because the only time
an investor receives a payment during the life of each STRIPS
component is when it matures.
AGENCY BONDS
• Republic Act 9501: Magna Carta for Micro, Small and
Medium Enterprises
• An act to promote entrepreneurship by strengthening
development and assistance programs to micro, small and
medium scale enterprises.
• PHILHEATH, PAG-IBIG, National Home Mortgage
Finance Corporation, Phil. Savings and Loan Association,
AFPSLAI, among others.
 MUNICIPAL BONDS
• Issued by local (municipal and city) governments
• Used to finance public interest projects, such as schools,
utilities, and transportation systems.
• Interest earned on municipal bonds that are issued to pay for
essential public projects are exempt from taxation.
• No taxation allows the municipality to borrow at a lower cost.
• Investors will be satisfied with lower interest rates on tax-
exempt bonds.
TWO TYPES OF MUNICIPAL BONDS
• GENERAL OBLIGATION BONDS do not have specific
assets pledged as security or a specific source of revenue
allocated for their repayment.
• Backed by the “full faith and credit” of the issuer.
• The issuer promises to use every resource available to repay
the bond as promised.
• Most general obligation bond issues must be approved by the
taxpayers because the taxing authority of the government is
pledged for their repayment.
• REVENUE BONDS are backed by the cash flow of a
particular revenue-generating project.
• For example, revenue bonds may be issued to build a toll
road, with the tolls being pledged as repayment.
• If the revenues are not sufficient to repay the bonds, they
may go into default, and investors may suffer losses.
• Local governments cannot print money, and there are real
limits on how high they can raise taxes without driving
the population away.
CORPORATE BONDS
• Bond indenture is a contract that states the lender’s rights and
privileges and the borrower’s obligations.
• Any collateral offered as security to the bondholders is also
described in the indenture.
• The degree of risk varies widely among different bond issues
because the risk of default depends on the company’s health,
which can be affected by a number of variables.
• The interest rate on corporate bonds varies with the level of
risk.
CHARACTERISTICS OF CORPORATE BONDS

1. RESTRICTIVE COVENANTS- imposition of rules and

restrictions on managers designed to protect the
bondholders’ interests.

Limits the amount of dividends the firm can pay (to

conserve cash for interest payments to bondholders) and the
ability of the firm to issue additional debt.

The firm’s involvement in mergers, may also be restricted.

2. CALL PROVISIONS- the issuer has THE RIGHT TO
FORCE THE HOLDER TO SELL THE BOND BACK.
Requires a waiting period between the time the bond is initially
issued and the time when it can be called.
If interest rates fall, the price of the bond will rise. If rates fall
enough, the price will rise above the call price, and the firm will
call the bond.
TO BUY BACK THEIR BONDS ACCORDING TO THE
TERMS OF THE SINKING FUND.
A sinking fund is a requirement in the bond indenture that the
firm pay off a portion of the bond issue each year.
 Firms may have TO RETIRE A BOND ISSUE if the
covenants of the issue restrict the firm from some activity
that it feels is in the best interest of stockholders.
Firms may choose to ALTER ITS CAPITAL
STRUCTURE.
3. CONVERSION- can be converted into shares of
common stock.
One way firms avoid sending a negative signal to the
market.
The price of the bond will reflect the value of this option
and so will be higher than the price of comparable
nonconvertible bonds.
The higher price received for the bond by the firm
implies a lower interest rate.
TYPES OF CORPORATE BONDS
1. SECURED BONDS- With collateral attached
Mortgage bonds are used to finance a specific project.
Equipment trust certificates are bonds secured by
tangible non-real-estate property, such as heavy
equipment and airplanes.
The presence of collateral reduces the risk of the bonds
and so lowers their interest rates.
2. UNSECURED BONDS- No specific collateral is pledged
to repay the debt.
Debentures are long-term unsecured bonds that are backed
only by the general creditworthiness of the issuer.
Usually have an attached contract called INDENTURE that
spells out the terms of the bond and the responsibilities of
management.
Have a higher interest rate than otherwise comparable
secured bonds.
Subordinated debentures are similar to debentures except
that they have a lower priority claim.
 Variable-rate bonds (which may be secured or unsecured)
are a financial innovation spurred by increased interest-
rate variability.
The interest rate on these securities is tied to another
market interest rate, such as the rate on Treasury bonds,
and is adjusted periodically.
The interest rate on the bonds will change over time as
market rates change.
3. JUNK BONDS- Speculative-grade bonds
A bond with a rating of AAA has the highest grade
possible.
Bonds at or above Moody’s Baa or Standard and Poor’s
BBB rating are considered to be of investment grade.
Those rated below this level are usually considered
speculative.
Poor liquidity and a very real chance existed that the
issuing firms would default on their bond payments
FINANCIAL GUARANTEES FOR BONDS
• Ensures that the lender (bond purchaser) will be paid
both principal and interest in the event the issuer
defaults.
• Large, well-known insurance companies write what
are actually insurance policies to back bond issues.
• The credit rating of the insurer is substituted for the
credit rating of the issuer.
• The resulting reduction in risk lowers the
interest rate demanded by bond buyers.
• Credit default swap (CDS)- provides insurance
against default in the principal and interest
payments of a credit instrument.
OVERSIGHT OF THE BOND MARKETS
• The Insolvency Law and Civil Code provide details on
bondholder rights.
• Philippine Market Regulatory Structure
1. Bangko Sentral ng Pilipinas
• The BSP supervises banks and non-bank financial
institutions that perform quasibanking functions. It also
supervises the registration of foreign investments in the
country and monitors the inflow and outflow of capital.
2. Securities and Exchange Commission
• The Securities and Exchange Commission (SEC) regulates both
primary and secondary debt markets, and oversees the
Philippine Stock Exchange, the three subsidiaries of the
Philippine Dealing Systems Holdings Corporation (PDS Group),
brokers, registrars, transfer agents, and clearinghouses.
3. Department of Finance and Bureau of the Treasury
• The Department of Finance (DOF) regulates the issuance of
government securities in the market while the DOF’s Bureau of
the Treasury operates and monitors daily debt-market activity.
• 4. Philippine Dealing System (PDS) Group of
Companies
• The PDS Group manages the country’s first
electronic platform for trading, clearing,
settlement, depository, registry, and custody of
fixed-income securities and derivatives.
CURRENT YIELD
• The current yield is an approximation of the yield to
maturity on coupon bonds that is often reported because it
is easily calculated. It is defined as the yearly coupon
payment divided by the price of the security,
• The yield to maturity is equal to the coupon rate (the
coupon payment divided by the par value of the bond).
• The current yield is also equal to the coupon rate when
the bond price is at par.
• When the bond price is at par, the current yield equals the
yield to maturity.
• The current yield is negatively related to the price of the
bond.
• The current yield better approximates the yield to
maturity when the bond’s price is nearer to the
bond’s par value and the maturity of the bond is
longer.
• It becomes a worse approximation when the bond’s
price is further from the bond’s par value and the
bond’s maturity is shorter.
HOW TO FIND THE VALUE OF A SECURITY

1. Identify the cash flows that result from owning the

security.
2. Determine the discount rate required to compensate
the investor for holding the security.
3. Find the present value of the cash flows estimated in
step 1 using the discount rate determined in step 2.
INVESTING IN BONDS

• Bonds are lower risk than stocks because they have a higher
priority of payment.
• Bondholders get paid before stockholders.
• Should the firm have to liquidate, bondholders must be paid
before stockholders.
• Bonds offer relative security and dependable cash payments.