Chapter 8 Summary

Prepared by Mr. Al Mannaei

Capital Market : is financial market for the buying and selling of long-term debt or equity.

Features :

- Long-term : more than a year.

- Higher risk. (compared to money market)
- Higher yield.
- Issued by governments (mainly bonds) and corporations ( bonds & Stocks).

1. Treasury Bonds (T-Bonds) : A marketable (tradable) , fixed-interest U.S. government

debt security with a maturity of more than 10 years. Treasury bonds make interest
payments semi-annually, issued with a minimum denomination of $1,000 with maximum
purchase of 5 million.

2. Treasury Notes (T-Notes) : A marketable U.S. government debt security with a fixed
interest rate and a maturity between one and 10 years. Treasury bonds make interest
payments semi-annually, issued with a minimum denomination of $1,000 with maximum
purchase of 5 million.

T-Bonds & T-Notes are sold through auctions either in a competitive or noncompetitive
bid. In competitive bid, bidders (lender) specify their yield they want; however, this does
not mean that your bid will be approved. Bidder with lowest yield should win the deal
(from the point view of the government (borrower) lowest yield mean lowest cost of
borrowing). In case of noncompetitive bid, government determine the yield and lender
has the choice of accepting or rejecting the deal.

3. Treasury Inflation Protection Securities (TIPS): A treasury security that is indexed

to inflation in order to protect investors from the negative effects of inflation. TIPS are
considered an extremely low-risk investment since they are backed by the U.S.
government and since their par value rises with inflation, as measured by the Consumer
Price Index (inflation), while their interest rate remains fixed. Interest on TIPS is paid
semiannually.
Chapter 8 Summary
Prepared by Mr. Al Mannaei

Example 1 :

Sara bought a TIPS with original principal of $1000,10% semi-annual coupon If the
inflation rate is 3%, Calculate her first coupon ? and Tips yield

Answer : the new principle = original principal * (1+inflation) = 1000 * (1.03) = 1030

TIPS (First coupon) = 1030 * 10%/2 = $51.5

TPIS Yield = 51.5/1000 = 5.15%

Example 2 :

• Suppose an individual invests $1,000 on January 15 in a new inflation-protected 10-

year note with a 3% real rate of return.

• If inflation was 1% during the first six months of that year, then by mid-year the
inflation-adjusted principal amount of the security would be $1,010. ($1,000 x 1.01 =
$1,010).

• In addition, at mid-year, on July 15, the investor would receive the first semiannual
interest payment of $15.15 ($1,010 times 3% divided by 2).

• Suppose, then, that inflation accelerated during the second half of the year, so that it
reached 3% for the full year.

• By the second semiannual interest payment date, January 15, the inflation-adjusted
principal amount of the security would be $1,030. ($1,000 x 1.03 = $1,030).

• The second semiannual interest payment would be $15.45 ($1,030 times 3% divided
by 2).

The yield on TIPS provides a direct measure for real interest rate. Therefore expected
inflation can be calculate through subtracting the yield on TIPS from the yield of
comparable security.

Example 3 : yield on 5 –year TIPS= 1.10%.yield on 5-year Treasury note =3.49%

Expected inflation = 3.49-1.10= 2.39%

Chapter 8 Summary
Prepared by Mr. Al Mannaei

Example 4 : if a nominal 10-year Treasury bond is priced with a 5% yield and a similar
TIPS is priced with a 2.5%, calculate the expected inflation ?!

Answer : to calculate the expected inflation, simply we have to subtract Bond yield from
TIPS yield = 5% - 2.5% = 2.5% >> expected inflation.

4. Separate Trading of Registered Interest and Principal (STRIP) : a bond where

both the principal and regular coupon payments -which have been removed- are sold
separately at discount where each payment called zero bond.

How does STRIPS works ?!

Suppose that a bank decides to buy T-Notes and covert it to STRIPS. The T-Note has the
following characteristics: maturity of 4 years; coupon rate 6% (semi-annual); face value
of $10,000; and at its purchase price, a yield to maturity of 5.8%.

The Bank separate the T-Note to 9 payments

Why 9 payments ?!

n (number of years) * m (Compounding frequency) + 1 = (4 * 2) + 1 = 9

Question : why do investor invest in STRIPS ?!

Answer : investor use STRIPS to hedges against interest rate risk.

Example 1 :

Suppose that KFH decides to purchase a bond and convert it into a STRIP. The bond has
the following characteristics: Maturity of 4 years; Coupon rate of 8% (semi-annual) ;
yield 10% and Face value of $1000.

 How many separate securities can be created ?

(n*m)+1 = (4*2)+1 = 9 payments

 Calculate the face value of each zero-bond?

The 9 payments consist of ( 8 coupons + 1 principle )

Each coupon = 8%/2 * 1000 = $40

Principle = $1000

 Calculate the price of second, third payment and the principle ?

40
Second payment mature at end of first year   36.28
1.05 2
Chapter 8 Summary
Prepared by Mr. Al Mannaei
40
Third payment mature after 18 months (1.5 years )   34.55
1.05 3
Principle mature at maturity (after four years)  10008  676.84
1.05

Municipal Bond (muni)

A debt security issued by a state, municipality or local government to finance its capital
expenditures.

Questions :

Does Municipal Bond = Government Bond ?! No Muni is indirectly related to government.

Does municipal bond considered as risk-free ?! No, although it consider very low risk.

Corporate bond vs. municipal bond yield ?! municipal bond pay lower yield.

Types of municipal bonds

1. General Obligation Bonds ( GO) : A municipal bond backed by the credit and "taxing
power" of the issuing jurisdiction rather than the revenue from a given project. No assets
are used as collateral. Issuer use GO bond to finance basic services to the community
such as : Schools, hospitals, roads ..etc. notice all these project don’t make high revenue
or don’t make revenue at all. Most general obligation bonds are sold through competitive
bid.

2. Revenue Bonds : A municipal bond supported by the revenue from a specific project,
such as a toll bridge, highway or local stadium. Revenue bonds are municipal bonds that
finance income-producing projects and are secured by a specified revenue source.

3. Industrial Development Revenue Bonds (IDB):Municipal debt securities issued by a

government agency on behalf of a private sector company and intended to build or
acquire factories or other heavy equipment and tools.

4. Mortgage-backed bonds (MBS) :Sometimes referred to as a housing bond, which is

issued by a local housing authority. These bonds can either be short- or long-term, and
are often used for construction of low- or middle-income housing or projects that help the
community and the environment. Short-term bonds are typically sold as $5,000
denominations with a maturity that varies between 18 months to four years. Longer-term
bonds are issued under federal agency contracts.
Chapter 8 Summary
Prepared by Mr. Al Mannaei

Corporate Bond yield vs. Municipal Bonds

Although Corporate bond is taxable, still pay higher yield compared to municipal bonds.

Example 1 :an Investor considering the following bonds, with tax rate 30%, which bond
should investor choose ?

AA Municipal AA
Corporate
4% 6%
Answer :

AA Municipal AA Corporate
Pre-tax 6%
After-tax 4%

Pre-tax for Municipal = 4 / (1-30%) = 5.7%

After-tax for Corporate = 6% * (1-30%) = 4.2%

According to the after-tax, if risk-averse investor might choose Municipal bond with 4%
yield and lower risk compared to corporate bond. Another investor might go for corporate
bond with higher yield 4.2% and face higher risk compared to municipal bond. Therefore,
both choices are right!

What is the Tax rate increase to 40% ?

Now , which investor will choose ?!

AA Municipal AA Corporate
Pre-tax 6%
After-tax 4%

Pre-tax for Municipal = 4 / (1-40%) = 6.67%

After-tax for Corporate = 6% * (1-40%) = 3.6%

In this case, investor must choose municipal bond, because it pay higher yield and face lower
risk. Choosing corporate bond – in this case – is WRONG decision.

Clearly, we can say that, as tax rate increase municipal bond become more attractable than
taxable securities and vice versa.
Chapter 8 Summary
Prepared by Mr. Al Mannaei

Types of bonds according to ownership record

1. Bearer Bond : A fixed-income instrument that is owned by whoever is holding it

(NO name documented on the bond!). Coupons representing interest payments are
likely to be physically attached to the security. Bearer bonds are getting harder and
harder to find these days.

2. Registered Bond : A bond whose owner is registered with the bond's issuer. The
owner's name and contact information is recorded and kept on file with the company,
allowing it to pay the bond's coupon payment to the appropriate person. If the bond is
in physical form, the owner's name is printed on the certificate. Most registered bonds
are now tracked electronically, using computers to record owners' information.

Types of bonds according to maturity

1. Term bonds : Bonds from the same issue that share the same maturity dates. Most
corporate bonds are term bonds

2. Serial bonds : has various maturity schedules at regular intervals until the issue is
retired. Most municipal bonds are serial issue, which mean that the issue contains a
variety of maturity dates.
Chapter 8 Summary
Prepared by Mr. Al Mannaei

Indenture vs. Debentures Bonds

1. Indenture :
a. Equipment Trust Certificate : The debt issue is secured by the equipment or
physical assets, as the title for the equipment is held in trust for the holders of
the issue. When the debt is paid off, the equipment becomes the property of
the issuer, as the title is transferred to the company.

b. Collateral trust certificate : a bond that is secured by a financial asset - such

as stock or other bonds - that is deposited and held by a trustee for the holders
of the bond.

2. Debentures : if no assets are pledged, the bond are secured only by firm potential
(ability) to generate cash flow. These type of bonds pay higher yield compared to
indentures.

a. Senior debt : in case of default, giving the bondholders first priority to firm’s
assets after the secured claims.

b. Subordinated debt :Bondholder’s claims to the company’s assets rank behind

the senior debt. Also known as “junior debt”.

• Why investor invest in Corporate bonds ?

In general, investors in corporate bonds are seeking steady income from their
investments (long-term cash flow), safety (low risk by choosing high credit
rating), and tax consideration. Therefore, main investors in corporate bonds are
pension funds, life insurance company ( both looking for long-term investment
and liquidity is not needed), foreign investors (for tax consideration) and
households.

Junk Bonds : a high-yield or non-investment grade bond. Junk bonds carry a

rating of 'BB' or lower by Standard & Poor's, or 'Ba' or below by Moody's. Junk
bonds are bearing high default risk, therefor it pay high yield ( 3–4 % than
government bonds). This type of bonds become attractive during the economic
expansion as default risk decrease. Junk bond Also known as “ High yielding
bonds” or “ Speculative bonds”.
Chapter 8 Summary
Prepared by Mr. Al Mannaei

Test your knowledge

1. ABC bought 5 Year Bond and convert it into STRIPS. The bond has the following
features 6% Coupon – Semi Annual. Yield = 8%.

a. How many separate payment can be made ?

(n*m)+1= (5 *2) + 1 = 11

b. What is the face value of each payment ?

Coupons = 6%/2 * 1000 = $30

Principal = $1000

c. Calculate the price for the third and last payment ?

Third payment exist after 1.5 years, because compounded semi-annual, the
number of years should be multiplied by 2.

$30
C3   $26.67
(1  .04) 3

$1030
last_Payme nt   $695.83
(1  .04)10
In the question, its required to calculate the last payment, which is the principle (1000) +
coupon (30).

2. For example, suppose that Treasury STRIPS have a yield of 7.75 percent. Using
semiannual compounding, the present value of these zero coupon bonds providing a
principal payment of $100 million at a 5-year maturity is calculated as follows:

$100 M
Principal   $68,373
(1  .0775 2)10
3. What is the price of a STRIPS maturing in 15 years with a face value of $100,000
and a yield to maturity of 6.5%?

$100,000
STRIPS Price   $38,308.77
(1  .065 2) 30

Note : in this question, its required to calculate the price, in this case calculating the price is
similar to calculate the principle.
Chapter 8 Summary
Prepared by Mr. Al Mannaei

4. A bank bought 3 Year Bond with $50,000 face value and convert it into STRIPS.
The bond has the following features 8% Coupon – Semi Annual. Yield = 8%.

a. What is the face value of each payment (zero bonds) ?

Principle = $50,000 ; Each Coupons = 8%/2 * $50,000 = $2000

Note : The principle – in this case – is NOT $1000 because it is given in the question that
face value equal $50,000.