Bonds Market
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 ate, generally with periodic interest payment. The par,
face, or maturity value of the bond is the amount that the issue must pay at maturity. The coupon
rate is the rate of interest that the issuer must pay.
Purpose of the Capital Market
Long-term borrowing helps in reducing risk when it comes to increased interest rates before they
can pay off their debts.
For example: A firm chooses to finance a plant by issuing money-market securities. There would
be no problem if there will be no increase in the interest rate. However, if they do, the firm will
have to reissue at a higher rate. It may be found out that it does not have the cash flows or
income to support the plant at the increased rate.
Capital Market Participants
1. Primary issuers of securities:
- Federal and Local Governments
o The federal government issues long-term notes and bonds to fund the national
debt. State and municipal governments issue long-term notes and bonds to
finance capital projects. Government never issue stock because they cannot
sell ownership claims.
- Corporations
o A firm decides whether it should finance its growth with debt or equity.
Capital Structure is the contribution of a firm’s capital between debt and
equity.
2. Purchasers
- Households
o Individuals and households deposit funds in financial institution that use the
funds to purchase capital market instruments such as bonds or stock.
Capital Market Trading
1. Primary Market
- One where the issuer of the security receives the proceeds of the sale. Initial public
offering (IPO) is the issue when firms sell security for the very first time. Subsequent
ones are primary market transactions.
2. Secondary Market
- Where the sale of previously issued securities take place. There are two exchanges:
o Organized exchanges
Has a building where securities trade
o Over-the-counter exchanges
Types of Bonds
1. Long-term government notes and bonds
2. Municipal bonds
3. Corporate bonds
Treasury Notes and Bonds
Federal Government notes and bonds are free of default risk because the government can always
print money to pay off the debt if necessary. This does not mean that these securities are risk-
free.
Treasure Bond Interest Rates
Type Maturity
Treasury Bill Less than 1 year
Treasury Note 1 to 10 years
Treasury Bond 10 to 30 years
1. In most years, the rate of return on the short-term bill is below that on the 20-year bond.
2. Short-term rates are more volatile than long-term rates.
Why?
Short-term rates are more influences by the expected rate of inflation. Investors in long-term
securities expect extremely high or low inflation rates to return to more normal levels, so
long-term rates do not typically change as much as short-term rates.
Treasury Inflation-Protected Securities (TIPS)
In 1997 the Treasury Department began offering 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 advantage of inflation-indexed
securities, also referred to as inflation-protected securities, is that they give both individual and
institutional investors a chance to buy a security whose value won’t be eroded by inflation. These
securities can be used by retirees who want to hold a very low-risk portfolio. In addition to
bonds, notes, and bills, in 1985 the Treasury began issuing to depository institutions bonds in
book entry form called Separate Trading of Registered Interest and Principal Securities, more
commonly called STRIPS. A STRIPS separates the periodic interest payments from the final
principal repayment. When a Treasury fixed-principal or inflation- indexed note or bond is
“stripped,” 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. 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
Congress has authorized a number of U.S. agencies, to issue bonds. The government does not
explicitly guarantee agency bonds, though most investors feel that the government would not
allow the agencies to default. The risk on agency bonds is actually very low. They are usually
secured by the loans that are made with the funds raised by the bond sales.
Municipal Bonds
Municipal bonds are securities issued by local, county, and state governments. The proceeds
from these bonds are 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 federal taxation. There are two types of municipal bonds:
general obligation bonds and revenue bonds. General obligation bonds do not have specific
assets pledged as security or a specific source of revenue allocated for their repayment. Revenue
bonds, by contrast, are backed by the cash flow of a particular revenue-generating project.
Corporate bonds
A corporate bond is a debt security issued by a corporation and sold to investors. The backing for
the bond is usually the payment ability of the company, which is typically money to be earned
from future operations. In some cases, the company's physical assets may be used as collateralfor
bonds.
Corporate bonds are issued in blocks of $1,000 in par value, and almost all have a standard
coupon payment structure. As the investor owns the bond, he receives interest from the issuer
until the bond matures. At that point, the investor can reclaim the face value of the bond.
Corporate bonds may also have call provisions to allow for early prepayment if prevailing rates
change, and investors may also opt to sell bonds before they mature.
Characteristics of Corporate Bonds
Registered Bonds
- replaced “bearer bond”
- IRS can track interest income this way
Restrictive Covenants
- mitigates conflicts with shareholder interests
- may limit dividends, new debt, ratios, etc.
-usually includes a cross-default clause
Call Provisions
- Higher yield
- Sinking fund
-Interest of the stockholder
-Capital structure flexibility
Convertability
- some debt may be converted to equity
-similar to a stock option, but usually more limitedy
Secured Bonds
- Mortgage Bonds
- Equipment trust certficates
Undecured Bonds
- Debentures
- Subordinated debentures
- Variable-rate 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 convicted of insider trading
Financial Guarantees for Bonds
Financially weaker security issuers frequently purchase financial guarantees to lower risk of their
bonds. A financial guarantee ensures that the lender will be paid both the principal and interest in
the event the issuer defaults. The guarantee provides for timely payment of interest and principal,
and is usually backed by large insurance companies. The bond buyer will no longer have to be
concerned with the financial health of the bond issuer but will only be interested in the strength
of the insurer.
In 1995, credit default swap (CDS) is introduced by J.P Morgan which is a new way to insure
bonds. It simple provides insurance against default in the principle and interest payments of a
credit instrument.
Current Yield Calculation
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 the yearly coupon payment divided by the price of
the security. The formula is ic = , where ic is the current yield yield, P is the price of the coupon
bond and C is the yearly coupon payment.
It has an identical formula with the calculation of the yield to maturity for a perpetuity because
when a coupon bond has a long term to maturity, it is very much like a perpetuity where it pays
coupon payments forever. The current yield is a rather close approximation of the yield to
maturity for a long-term coupon bond.
When the bond price is at par, the current yield equals the yield to maturity. This means that the
nearer the bond to the bond’s par value, the better the current yield will approximate to the yield
to maturity.
Needless to say, the current yield and the yield to maturity always move together 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 of the yield to
maturity when the bond’s price is further from the bond’s par value and the bond’s maturity is
shorter.
Finding the Value of the Coupon Bonds
Bond pricing is, in theory, no different than pricing any set of known cash flows. The current
price is the present value of all future cash flows. The value of all financial assets is found the
same way. If you have the present value of a future cash flow, you can exactly reproduce that
future cash by investing the present value amount at the discount rate. The value of a security can
be found in three simple steps (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.
When the bond sells for less than the par value, it is selling at a discount. When the market price
exceeds the par value, the bond is selling at a premium.
Investing in bonds
There are two ways to make money by investing in bonds. The first is to hold those bonds until
their maturity date and collect interest payments on them. Bond interest is usually paid twice a
year.
The second way to profit from bonds is to sell them at a price that's higher than what you pay
initially.
Advantages of investing in bonds
One advantage of putting bonds in your portfolio is that they're a relatively safe investment.
Bond values don't tend to fluctuate as much as stock prices, so they're less likely to keep you up
at night worrying.
Another benefit of bonds is that they offer a predictable income stream. Because bonds pay a
fixed amount of interest twice a year, you can generally rely on that money to come in as
expected. Municipal and Treasury bonds offer the additional benefit of paying tax-exempt
interest to varying degrees.
Disadvantages of investing in bonds
Bonds require you to lock your money away for extended periods of time.
Speaking of risk, because bonds are a relatively long-term investment, you'll face what's called
interest-rate risk once you buy them. As we just learned, each bond pays a certain amount of
interest. But what happens if you buy a 10-year bond paying 3% interest and a month later, that
same issuer offers bonds at 4% interest? Suddenly, your bond drops in value, and if you hold it,
you'll lose out on potential earnings by getting stuck with that lower rate.
Furthermore, while bonds are a relatively safe investment, they're not completely risk-free. If an
issuer defaults on its obligations, you risk losing out on interest payments, getting your principal
repaid, or both.
One final drawback of buying bonds is that, due to the way they trade, there's less transparency
in the bond market than in the stock market. As such, brokers can sometimes get away with
charging higher prices, and you might have a harder time determining whether the price you're
quoted for a given bond is fair.
