CHAPTER SIX

6. BOND MARKETS
AREGA SEYOUM (PhD)
 Chapter Preview
 In this chapter, we focus on longer-term securities:
bonds. Bonds are like money market instruments,
but they have maturities that exceed one year.
 These include Treasury bonds, corporate bonds,
mortgages, and the like.
Purpose of the Capital Market
 Original maturity is greater than one year, typically
for long-term financing or investments
 Best known capital market securities:
─ Stocks and bonds
Capital Market Participants
 Primary issuers of securities:
─ Federal and local governments: debt issuers
─ Corporations: equity and debt issuers
 Largest purchasers of securities:
─ You and me
Capital Market Trading
1. Primary market for initial sale (IPO)
2. Secondary market
─ Over-the-counter
─ Organized exchanges (i.e., NYSE)
4.1 Overview of the Bond Markets

◙ A bond is a long-term contract under which a borrower

agrees to make payments of interest and principal, on
specific dates, to the holders of the bond.
◙ A bond is a promise to make periodic coupon payments
and to repay principal at maturity; breech of this promise
is an event of default.
◙ Carry original maturities greater than one year so bonds
are instruments of the capital markets
◙ Issuers are corporations and government units
Types of Bonds:
Sample Corporate Bond
Overview of the …Cont’d
 For example, on January 3, 2002, Allied Food
Products borrowed $50 million by issuing $50
million of bonds. For convenience, we assume that
Allied sold 50,000 individual bonds for $1,000 each.
Actually, it could have sold one $50 million bond,
10 bonds with a $5 million face value, or any other
combination that totals to $50 million. In any event,
Allied received the $50 million, and in exchange it
promised to make annual interest payments and to
repay the $50 million on a specified maturity date.
Overview of the …Cont’d
 Investors have many choices when investing in bonds, but
bonds are classified into four main types: Treasury,
corporate, municipal, and foreign. Each type differs with
respect to expected return and degree of risk.
Treasury Bond
 Treasury bonds, sometimes referred to as government bonds,

are issued by the federal government. It is assumed that the

federal government will make good on its promised
payments, so these bonds have no default risk.
 However, Treasury bond prices decline when interest rates

rise, so they are not free of all risks.

Overview of the …Cont’d
Corporate Bonds
 Corporate bonds, as the name implies, are issued by corporations.

 Unlike Treasury bonds, corporate bonds are exposed to default

risk—if the issuing company gets into trouble, it may be unable to

make the promised interest and principal payments.
 Different corporate bonds have different levels of default risk,

depending on the issuing company’s characteristics and on the

terms of the specific bond.
 Default risk is often referred to as “credit risk,” and, the larger

the default or credit risk, the higher the interest rate the issuer
must pay.
Overview of the …Cont’d
Municipal Bonds
 Municipal bonds, or “munis,” are issued by state and local

governments.
 Like corporate bonds, munis have default risk.

 However, munis offer one major advantage over all other

bonds: the interest earned on most municipal bonds is

exempt from federal taxes and also from state taxes if the
holder is a resident of the issuing state. Consequently,
municipal bonds carry interest rates that are considerably
lower than those on corporate bonds with the same default
risk.
Overview of the …Cont’d
Foreign Bonds
 Foreign bonds are issued by foreign governments or foreign

corporations.
 Foreign corporate bonds are, of course, exposed to default

risk, and so are some foreign government bonds.

 An additional risk exists if the bonds are denominated in a

currency other than that of the investor’s home currency. For

example, if you purchase corporate bonds denominated in
Japanese yen, you will lose money—even if the company
does not default on its bonds—if the Japanese yen falls
relative to the dollar.
4.2 Key Characteristics of Bonds
 Differences in contractual provisions, and in the
underlying strength of the companies backing the
bonds, lead to major differences in bonds’ risks,
prices, and expected returns.
 To understand bonds, it is important that you
understand the following terms.
Key Characteristics of Bonds
PAR VALUE
 The par value is the stated face value of the bond;

for illustrative purposes we generally assume a par

value of $1,000, although any multiple of $1,000
(for example, $5,000) can be used.
 The par value generally represents the amount of

money the firm borrows and promises to repay on

the maturity date.
Key Characteristics of Bonds
COUPON INTEREST RATE
 The stated annual interest rate on a bond.

 For example, Allied’s bonds have a $1,000 par

value, and they pay $100 in interest each year. The

bond’s coupon interest is $100, so its coupon
interest rate is $100/$1,000 = 10 percent.
 This payment, which is fixed at the time the bond is

issued, remains in force during the life of the bond.

Key Characteristics of Bonds
FLOATING RATE BONDS
 A bond whose interest rate fluctuates with shifts in the

general level of interest rates.

 The coupon rate is set for, say, the initial six-month period,

after which it is adjusted every six months based on some

market rate.
 Some corporate issues are tied to the Treasury bond rate,

while other issues are tied to other rates.

 Many additional provisions can be included in floating rate

issues. For example, some are convertible to fixed rate debt.

Key Characteristics of Bonds
ZERO COUPON BOND
◘ Some bonds pay no coupons at all, but are offered at a
substantial discount below their par values and hence
provide capital appreciation rather than interest income.
◘ These securities are called zero coupon bonds
(“zeros”). Other bonds pay some coupon interest, but
not enough to be issued at par.
◘ In general, any bond originally offered at a price
significantly below its par value is called an original
issue discount (OID) bond.
Key Characteristics of Bonds
MATURITY DATE
 A specified date on which the par value of a bond must be repaid.

CALL PROVISIONS
 Most corporate bonds contain a call provision, which gives the

issuing corporation the right to call the bonds for redemption.

 The call provision generally states that the company must pay the

bondholders an amount greater than the par value if they are called.
 The additional sum, which is termed a call premium, is often set

equal to one year’s interest if the bonds are called during the first
year, and the premium declines at a constant rate of INT/N each
year thereafter, where INT = annual interest and N = original
maturity in years.
Key Characteristics of Bonds
 For example, the call premium on a $1,000 par
value, 10-year, 10 percent bond would generally be
$100 if it were called during the first year, $90
during the second year (calculated by reducing the
$100, or 10 percent, premium by one-tenth), and so
on.
 However, bonds are often not callable until several
years (generally 5 to 10) after they were issued. This
is known as a deferred call, and the bonds are said to
have call protection.
Key Characteristics of Bonds
 Suppose a company sold bonds when interest rates were
relatively high. Provided the issue is callable, the company
could sell a new issue of low-yielding securities if and when
interest rates drop. It could then use the proceeds of the new
issue to retire the high-rate issue and thus reduce its interest
expense. This process is called a refunding operation.
 The call privilege is valuable to the firm but potentially
detrimental to the investor, especially if the bonds were
issued in a period when interest rates were cyclically high.
Accordingly, the interest rate on a new issue of callable
bonds will exceed that on a new issue of noncallable bonds.
Key Characteristics of Bonds
SINKING FUNDS
 Some bonds also include a sinking fund provision that

facilitates the orderly retirement of the bond issue.

 On rare occasions the firm may be required to deposit money

with a trustee, which invests the funds and then uses the
accumulated sum to retire the bonds when they mature.
 Usually, though, the sinking fund is used to buy back a

certain percentage of the issue each year.

 A failure to meet the sinking fund requirement causes the

bond to be thrown into default, which may force the

company into bankruptcy.
Key Characteristics of Bonds
OTHER FEATURES
 A bond that is exchangeable, at the option of the

holder, for common stock of the issuing firm.

 Bonds issued with warrants are similar to convertibles.

 Warrants are options that permit the holder to buy

stock for a stated price, thereby providing a capital

gain if the price of the stock rises.
 Bonds that are issued with warrants, like convertibles,

carry lower coupon rates than straight bonds.

Key Characteristics of Bonds
INDEXED (PURCHASING POWER) BOND
 A bond that has interest payments based on an inflation

index so as to protect the holder from inflation.

 First became popular in Brazil, Israel, and a few other

countries plagued by high inflation rates.

 The interest rate paid on these bonds is based on an

inflation index such as the consumer price index (CPI).

 The interest paid rises automatically when the inflation

rate rises, thus protecting the bondholders against

inflation.
Bond Market Instruments Outstanding,
1994-1999 ($Bn)

10000

8000

6000

4000

2000

0
1994 1995 1996 1997 1998 1999

Treas bonds Muni securities Corp bonds Total

Treasury Notes and Bonds

 T-notes and T-bonds issued by the U.S. treasury to

finance the national debt and other federal government
expenditures.
 Backed by the full faith and credit of the U.S.
government and are default risk free.
 Pay relatively low rates of interest (yields to maturity.
 Given their longer maturity, not entirely risk free due to
interest rate fluctuations.
 Pay coupon interest (semiannually), notes have maturities
from 1-10 yrs, bonds 10-30 yrs.
Treasury Strips

 A treasury security in which the periodic interest

payment is separated from the final principal payment.
 Effectively creates two sets of securities--one for each
semiannual interest payment one for the final principal
payment.
 Often referred to as “Treasury zero-coupon bonds”
 Created by U.S. treasury in response to separate trading
of treasury security principal and interest that been
developed by securities firms, only available through
FIs and government securities brokers.
The Primary Market in Treasury Notes and
Bonds
◙ Similar to the primary market T-bill sales, the treasury sells T-
notes and bonds through competitive and noncompetitive auctions.

Auction Pattern for Treasury Notes and bonds

Security Purchase Minimum General Auction

Schedule

2-year note $1,000 Monthly

5-year note $1,000 Feb, May-Aug, Nov
10-year note $1,000 Feb, May-Aug, Nov
30-year note $1,000 Feb, Aug, Nov
Secondary Market in Treasury Notes and
Bonds
 Most secondary market trading occurs directly through
brokers and dealers
 Wall Street Journal shows full list of Treasury securities
that trade daily
Municipal Bonds (munis)

 Securities issued by state and local governments to fund

either temporary imbalances between operating
expenditures and receipts or to finance long-term capital
outlays for activities such as school construction, public
utility construction or transportation systems
 Tax receipts or revenues generated are the source of
repayment
 Attractive to household investors because interest (but
not capital gains) are tax exempt
Tax Exemption and Muni Yields

ia = ib(1 - t)
Where:
ia = After-tax (equivalent tax exempt) rate of return on a
taxable corp. bond
ib = Before-tax rate of return on a taxable bond
t = Marginal income tax rate of the bond holder
Example:
☻You can invest in taxable corporate bonds that are paying 10%
annually on munis. Your marginal tax rate is 28%, the after-tax
rate of return on the taxable bond is: 10%(1-.28) = 7.2%
Types of Municipal Bonds

☺General Obligation Bonds

 bonds backed by the full faith and credit of the issuer
☺Revenue Bonds
 bonds sold to finance a specific revenue generating project
and are backed by cash flows from that project
Primary Market Placement Choices for
Munis
☻General Public Offering
 underwriter is selected either by negotiation or by
competitive bidding
 the underwriter offers the bonds to the general public
☻Rule 144A Placement
 bonds are sold on a semi-private basis to qualified investors
(generally FIs)
Contracting Choices with the Underwriter

 Firm commitment underwriting

 the issue of securities in which the investment bank
guarantees the corp. a price for newly issued securities by
buying the whole issue at a fixed price from the corporate
issuer then seeks to resell to suppliers of funds (investors)
at a higher price
 Best efforts underwriting
 the issue of securities in which the underwriter does not
guarantee a price to the issuer and acts more as a placing or
distribution agent, bank acts as agent on a fee basis related
to its success in placing the issue
Secondary Market for Munis

 Secondary market is thin (i.e. trades are relatively

infrequent) due to a lack of information on bond issuers,
who are generally much smaller than corporate bond
issuers
Corporate Bond

◘ All long-term bonds issued by corporations.

◘ Minimum denominations publicly traded corporate bonds
is $1,000
◘ Generally pay interest semiannually
◘ Bond indenture
 legal contract that specifies the rights and obligations of
the bond issuer and the bond holder.
Types of Corporate Bond

♣ Bearer bonds
 coupons attached that are presented by the holder to the
issuer for interest payments when due
♣ Registered bonds
 the owner of the bond is recorded by the issuer and coupon
payments are mailed to the registered owner
♣ Term bonds
 entire issue matures on a single date
♣ Serial bonds
 mature on a series of dates
Types of Corporate Bond

♠ Mortgage bonds
 issued to finance specific projects which are pledged as
collateral
♠ Debentures
 backed solely by the general credit of the issuing firm
and unsecured by specific assets or collateral
♠ Subordinated debentures
 unsecured debentures that are junior in their rights to
mortgage bonds and regular debentures. (continued)
Types of Corporate Bond

♦ Convertible bonds
 may be exchanged for another security of the issuing firm at the
discretion of the bond holder
♦ Stock Warrant
 give the bond holder an opportunity to purchase common stock at a
specified price up to a specified date
♦ Callable bonds
 allow the issuer to force the bond holder to sell the bond back to the
issuer at a price above the par value (call price)
♦ Sinking Fund Provisions
 bonds that include a requirement that the issuer retire a certain amount
of the bond issue each year
Primary and Secondary Markets for Corp
Bonds
☺Primary sales of corporation bonds occur through either a
public sale (issue) or a private placement similar to
municipal bonds.
☺Two secondary markets
 the exchange market (e.g., the NYSE)
 the over-the-counter (OTC) market
☺OTC electronic market dominates trading in corporate
bonds.
Bond Ratings

● Bonds are rated by the issuer’s default risk.

● Large bond investors, traders and managers evaluate
default risk by analyzing the issuer’s financial ratios and
security prices.
● Two major bond rating agencies are Moody’s and
Standard & Poor’s (S&P) 500.
● Bonds assigned a letter grade based on perceived
probability of issuer default.
 Bond Credit Ratings

Explanation
Explanation Moody’s
Moody’s S&P
S&P
Investment
Investmentgrade
gradecategories:
categories:
Best
Bestquality;
quality;smallest
smallestdegree
degreeofofrisk
risk Aaa
Aaa AAA
AAA
High
Highquality;
quality;slightly
slightlymore
morelong-term
long-term Aa1
Aa1 AA+
AA+
risk
riskthan
thantop
toprating
rating Aa2
Aa2 AA
AA
Aa3
Aa3 AA
AA
Upper
Uppermedium
mediumgrade;
grade;possible
possible A1
A1 AA
AAimpairment
impairment
ininthe
thefuture
future A2
A2 A+
A+
A3
A3 A-
A-
Medium
Mediumgrade;
grade;lack
lackoutstanding
outstanding Baa1
Baa1 BBB+
BBB+
investment
investmentcharacteristics
characteristics Baa2
Baa2 BBB
BBB
Baa3
Baa3 BBB-
BBB-
Bond Credit Ratings

Explanation
Explanation Moody’s
Moody’s S&P
S&P
Speculative
Speculativeinvestment
investmentgrades:
grades:
Speculative
Speculativeissues;
issues;protection
protectionmay
may Ba1
Ba1 BB+
BB+
be
bevery
verymoderate
moderate Ba2
Ba2 BB
BB
Ba3
Ba3 BB-
BB-
Very
Veryspeculative;
speculative;may
mayhave
havesmall
small B1
B1 B+
B+
assurance
assuranceofofinterest
interestand
andprincipal
principal B2
B2 BB
payment
payment B3
B3 B-
B-
Issues
Issuesininpoor
poorstanding;
standing;may
maybe
beinindefault
default Caa
Caa CCC
CCC
Speculative
Speculativeininaahigh
highdegree
degree Ca
Ca CC
CC
Lowest
Lowestquality;
quality;poor
poorprospects
prospectsofofattaining
attaining CC CC
real
realinvestment
investmentstanding
standing DD
Bond Market Indexes

♥ Managed by major investment banks

♥ Reflect both the monthly capital gain and loss on bonds
plus any interest (coupon) income earned.
♥ Changes in values of the broad market indexes can be
used by bond traders to evaluate changes in the
investment attractiveness of bonds of different types and
maturities.
Bond Market Participants

♣ The major issuers of debt market securities are federal,

state and local governments and corporations.
♣ The major purchasers of capital market securities are
households, businesses, government units and foreign
investors.
♣ Businesses and financial firms (e.g., banks, insurance
companies, mutual funds) are the major suppliers of
funds for all three types of bonds.
Eurobonds, Foreign Bonds, Brady Bonds
and Sovereign Bonds
☻Eurobonds
 long-term bonds issued and sold outside the country of the currency
in which they are denominated (e.g., dollar-denominated bonds
issued in Europe or Asia)
☻Foreign Bonds
 long-term bonds issued by firms and governments outside of the
issuer’s country, usually denominated in the currency of the country
in which they are issued
☻Brady Bonds and Sovereign Bonds
 a bond that is swapped for an outstanding loan to a lesser developed
country, sovereign bonds carry the creditworthiness of the lesser
developed country
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.
 Determining the Value of Bonds

 The value of any financial asset—a stock, a bond, a lease,

or even a physical asset such as an apartment building or a
piece of machinery—is simply the present value of the cash
flows the asset is expected to produce.
 The cash flows from a specific bond depend on its
contractual features as described above.
 For a standard coupon-bearing bond such as the one issued
by Allied Foods, the cash flows consist of interest payments
during the 15-year life of the bond, plus the amount
borrowed (generally the $1,000 par value) when the bond
matures.
Determining the Value of Bonds
 The value of a bond is the present value both
of future interest to be received and the par
or maturity value of the bond.
 The process of valuing a bond requires

knowing of three essential elements: (1) the

amount and timing of the cash flows to be
received by the investor, (2) the time to
maturity of the loan, and (3) the investor’s
required rate of return.
Determining the Value of Bonds

Example:
 On November 5, 2013, Hidassie Corp.
issued a 10% coupon interest rate, 10 year
bond with Br. 1,000,000 par value that pays
interest annually.
 Case 1: Assume that the investor requires a

10% rate of return on this bond. What is

the value of the bond to the investor?
Determining the Value of Bonds
Solution:
Periodic/ Annual interest on the bond = Br. 1,000,000 x 0.1 = Br. 100,000
Face /par Value of Bond = Br. 1,000,000.00
Investor’s Required Rate of Return = 10 percent
Term of the bond = 10 years

Present Value Discount Factor of Ordinary Annuity (PVDF-OA 10, 10%) = 6.1446
PV of 10 payments of Br. 100,000 at 10% interest (Br. 100,000 x 6.114) = Br. 614, 460

Present Value Discount Factor of Single Sum for 10 periods, at 10% = 0.3855
PV of Br. 1,000,000 for 10 periods, at 10% (Br. 1,000,000 x 0.3855) = 385, 500
The value of the bond today is, therefore, Br. 1,000,000

NB: When the required rate of return on a bond is the same as its coupon
rate, the value of the bond is always equal to its par value.
Determining the Value of Bonds
 On the other hand, when the required rate
of return falls below the coupon interest
rate, the bond value will be greater than its
par value. In this case, the bond is said to
sell at a premium.
Determining the Value of Bonds
Case 2:
◙ Assume that another investor viewed the
bond of Hidassie Corp. to be riskier and
thus requires 12% rate of return on this
bond. Determine its value?
Determining the Value of Bonds
Solution:
Periodic/ Annual interest on the bond = Br. 1,000,000 x 0.1 = Br. 100,000
Face /par Value of Bond = Br. 1,000,000.00
Investor’s Required Rate of Return = 12 percent
Term of the bond = 10 years

Present Value Discount Factor of Ordinary Annuity (PVDF-OA10, 12%) = 5.650

PV of 10 payments of Br. 100,000 at 12% interest (Br. 100,000 x 5.650) = Br. 565,000

Present Value Discount Factor of Single Sum for 10 periods, at 12% = 0.322
PV of Br. 1,000,000 for 10 periods, at 12% (Br. 1,000,000 x 0.322) = 322,000
The value of the bond today is, therefore, Br. 887,000

Note: When the required rate of return on the bond is greater than
the coupon rate, the bond is said to be issued at a discount and the
intrinsic value of the bond is less than the par value.
Determining the Value of Bonds
Case 3:
◙ Further assume that an investor requires
8% return on this bond. Determine its
value?
Determining the Value of Bonds
Solution:
Periodic/ Annual interest on the bond = Br. 1,000,000 x 0.1 = Br. 100,000
Face /par Value of Bond = Br. 1,000,000.00
Investor’s Required Rate of Return = 8 percent
Term of the bond = 10 years

Present Value Discount Factor of Ordinary Annuity (PVDF-OA10, 8%) = 6.710

PV of 10 payments of Br. 100,000 at 12% interest (Br. 100,000 x 6.710) = Br. 671,000

Present Value Discount Factor of Single Sum for 10 periods, at 8% = 0.463

PV of Br. 1,000,000 for 10 periods, at 8% (Br. 1,000,000 x 0.463) = 463,000
The value of the bond today is, therefore, Br.1,134,000

Note: When the required rate of return on the bond is less than the
coupon rate, the bond is said to be issued at a premium and the
intrinsic value of the bond is greater than the par value.