CHAPTER 7: BOND MARKETS

 BOND MARKET
Bonds are long-term debt securities (meaning their maturities are more than one year) that
are issued by government agencies or corporations.

Bond markets are the markets where bonds are issued and traded. They are used to assist in
the transfer of funds from individuals, corporations, and government units with excess funds
to corporations and government units in need of long-term debt funding.

 BOND MARKET SECURITIES

are long term debt securities issued by government agencies or corporations wherein the
issuer of a bond is obligated to pay coupon payments (interest payments) periodically
(annually or semi-annually) and the par value or principal at maturity date.

An issuer must be able to show that its future cash flows will be sufficient to enable it to
make its coupon and principal payments to bondholders. But if not, some investors will
consider buying bonds for which the repayment is questionable only if the expected return
from investing in the bonds is sufficient to compensate for the risk.

Cash flows are being ensured by issuers by guaranteeing the buyers on the cash flows that
will be generated from the purpose of the bond offering; ensured by the Philippine
government of any sovereign government if treasury bond; and ensured by issuing
corporations if corporate bond via a document called “indenture” , a legal contract that
specifies the rights and obligations of the bond issuer and the bond holders; all covenants
( terms of the bonds ) and cash flow movements are overseen by a trustee; in this case the
coupon tends to go lower since it lowers risk

 INSTITUTIONAL PARTICIPATION IN BOND MARKETS

These are investors in the bond market and it can be noted that financial institutions
dominate the bond market because they purchase a large proportion of bonds issued.

 BOND YIELDS
The yield on a bond can be viewed from the perspective of the issuer of the bond, who is
obligated to make payments on the bond until maturity, or from the perspective of the
investors who purchase the bond
 o Yield from the Issuer’s Perspective. The issuer’s cost of financing with bonds is
commonly measured by the yield to maturity, which reflects the annualized yield
that is paid by the issuer over the life of the bond.

The yield to maturity is the annualized discount rate that equates the future coupon
and principal payments to the initial proceeds received from the bond offering. It is
based on the assumption that coupon payments received can be reinvested at the
same yield.

o Yield from the Investor’s Perspective. An investor who invests in a bond when it is
issued and holds it until maturity will earn the yield to maturity. But since many
investors don’t really hold bond ‘til its maturity, they focus more on the holding
period return which is return from their investment over a particular holding period.

This means that if they hold the bond for a very short time period (such as less than
one year), they may estimate their holding period return as the sum of the coupon
payments plus the difference between the selling price and the purchase price of the
bond, as a percentage of the purchase price.

If they hold the bond for long periods, a better approximation of the holding period
yield is the annualized discount rate that equates the payments received to the
initial investment.

Since the selling price to be received by investors is uncertain if they do not hold the
bond to maturity, their holding period yield is uncertain at the time they purchase
the bond. Consequently, an investment in bonds is subject to the risk that the
holding period return will be less than expected.

FOUR MAIN TYPES OF BONDS

TREASURY BONDS/NOTES
 TREASURY AND FEDEGARL AGENCY BONDS
First of all, I would like to differentiate bonds and notes in terms of their maturity. Note
maturities are less than 10 years while bond maturities are 10 years or more.

Treasury bonds are government issued debt securities to match the government’s long term
financial needs.

So an example for the application of treasury bonds and notes is that in the US, the
government implements a fiscal policy of spending more than it receives from taxes. To
facilitate this, treasury bonds and notes are issued by the government to finance
government expenditures.

Because the Treasury notes and bonds are free from credit or default risk, they allow the
Treasury to borrow funds at a relatively low cost. So, the Treasury pays a yield to investors
that reflects the risk-free rate.

 TREASURY BOND AUCTIONS

The Treasury obtains long-term funding through Treasury bond offerings, which are
conducted through periodic auctions which are usually held in the middle of each quarter.
Bids can be competitive or non-competitive. Competitive bids specify a price that the bidder
is willing to pay and a dollar amount of securities to be purchased. Non-competitive bids
 specify only a dollar amount of securities to be purchased (subject to a maximum limit). All
competitive bids are accepted until the point at which the desired amount of funding is
achieved. This is commonly used because many bidders want to purchase more Treasury
bonds than the maximum that can be purchased on a non-competitive basis

 TRAIDING TREASURY BONDS

o Online Trading
o Online Quotations
 STRIPPED TREASURY BONDS
 INFLATION-INDEXED TREASURY BINDS

 SAVINGS BONDS
Savings bonds are issued by the Treasury which are attractive to small investors because
they can be purchased with as little as $25; although larger denominations are also available.
Savings bonds have a 30-year maturity and do not have a secondary market. Like other
Treasury securities, the interest income on savings bonds is not subject to state and local
taxes but is subject to federal taxes.

 FEDERAL AGENCY BONDS

Federal agency bonds are issued by federal agencies. The Federal National Mortgage
Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac)
issue bonds and use the proceeds to purchase mortgages in the secondary market. Thus
they channel funds into the mortgage market, thereby ensuring that there is sufficient
financing for homeowners who wish to obtain mortgages.

MUNICIPAL BONDS
 Municipal bonds are bonds issued by states or provinces to finance expenditures especially
because state and local governments (just like the federal government) spend more than the
revenues they receive. They can be classified as general obligation bonds or revenue bonds.
o general obligation bond- payment are supported by the municipal government’s
ability to tax
o revenue bonds- payments are generated by the revenues of projects such as toll
way, toll bridge, state college dormitory, and others for which the bonds were
issued.

Revenue bonds and general obligation bonds typically promise semi-annual interest
payments. Common purchasers of these bonds include financial and nonfinancial institutions
as well as individuals and there is a secondary market for these bonds, although it is less
active than the one for Treasury bonds.

Municipal bonds also contain a call provision, meaning the issuer can repurchase the bonds
at a specified price before the bonds mature. Lastly, these bonds are exposed to some
degree of credit/default risk.

 CREDIT RISK OF MUNICIPAL BONDS

Although municipal bonds are rarely defaulted, some government agencies have serious
budget deficits because of excessive spending, and may not be able to easily repay their
loans. If a municipality is unable to increase taxes, it could default on general obligation
bonds. If it does not generate sufficient revenue, it could default on revenue bonds. Thus,
the issuance of municipal bonds is also regulated by respective state governments.
 o Ratings of Municipal Bonds. Due to the credit risk of municipal bonds, ratings are
assigned to municipal bonds based on the ability of the issuer to repay the debt. The
ratings are important to the issuer because a better rating means investors will
require a smaller risk premium, which will lead to municipal bonds issued at a higher
price (lower yield).

o Insurance against Credit Risk of Municipal Bonds. Some municipal bonds are
insured to protect against default. Insurance is paid by the issuer so that it can be
issued at a higher price.

If I do say so myself, insuring the bonds is a smart action and is advantageous to the
issuer because the investors will then purchase it at a higher price making him
indirectly paying the insurance cost. And in cases where the insurer will default, the
investor will bear the loss.

 VARIABLE-RATE MUNICIPAL BONDS

Variable-rate municipal bonds have a floating interest rate, meaning the coupon payment
adjusts to movements in the benchmark. This type of municipal bonds is desirable to
investors who expect that interest rates will rise but, there is also a risk that interest rates
may decline over time, causing the coupon payments to decline as well.

 TAX ADVANTAGES OF MUNICIPAL BONDS

Interest income of municipal bonds are exempt from federal taxes and state taxes. Thus,
investors who reside in states that impose income taxes can reduce their taxes further.

 TRADING AND QUOTATIONS OF MUNICIPAL BONDS

 YIELDS OFFERED ON MUNICIPAL BONDS

CORPORATE BONDS
 A corporate bond is a longer-term debt instrument, with maturity of usually 10-30 years,
issued by a corporation in order to raise financing for a variety of reasons such as to ongoing
operations, or to expand business. The interest paid by the corporation to investors is tax
deductible to the corporation, which reduces the cost of financing with bonds and is usually
on a semi-annual basis.

 CORPORATE BOND OFFERINGS

o Public Offering- bonds are directly offered to buyers via financial institutions like
banks. A firm may hire an underwriter to assesses market conditions and attempt to
determine the price at which the corporation’s bonds can be sold and the
appropriate size of the offering. The goal is to price the bonds high enough to satisfy
the issuer but also low enough so that the entire bond offering can be placed.

o Private Placement- bond security is placed with one or few large institutional
buyers. Small firms that borrow relatively small amounts of funds may consider
private placements rather than public offerings, since they may be able to find an
institutional investor that will purchase the entire offering. Because privately placed
bonds do not have an active secondary market, they tend to be purchased by
 institutional investors (such as insurance companies, pension funds, and bond
mutual funds) that are willing to invest for long periods of time.
o Credit Risk of Corporate Bonds- Corporate bonds have default or credit risk. The
general level of defaults on corporate bonds is a function of economic conditions. So
when the economy is strong, firms generate higher revenue because they are able
to meet their debt payments. When the economy is weak, firms may not generate
enough revenue to cover their operating and debt expenses which leads to a default
on their bonds.

o Bond Ratings as a Measure of Credit Risk- Due to the credit risk of corporate bonds,
ratings are assigned based on the ability of the issuer to repay the debt. A corporate
bond’s rating may change over time if the issuer’s ability to repay the debt changes.
Thus, Corporate bonds that receive higher ratings can be placed at higher prices
(lower yields) because they are perceived to have lower credit risk. Aside from that,
since commercial banks only consider investing in bonds that have been given an
investment-grade rating, corporations must obtain bond ratings in order to verify
that their bonds qualify for at least investment-grade status.

o Junk Bonds- are corporate bonds that are perceived to have very high risk. Many
institutional investors (such as bond mutual funds) are more willing to invest in junk
bonds because it offers high yields that contain a risk premium (spread) to
compensate investors for the high risk and since the yields on more highly rated
bonds are so low.

Although investors always require a higher yield on junk bonds than on other bonds,
they also require a higher premium when the economy is weak because there is a
greater chance that the issuer will not generate enough cash to cover the debt
payments.

 SECONDARY MARKET FOR CORPORATE BONDS

o Dealer Role in Secondary Market
o Liquidity in Secondary Market
o Electronic Bond Networks
o Types of Orders through Brokers
o Trading Online

 CHARACTERISTICS OF CORPORATE BONDS

Corporate bonds can be described in terms of several characteristics. The bond indenture is
a legal document specifying the rights and obligations of both the issuing firm and the
bondholders. It is comprehensive and is designed to address all matters related to the bond
issue.

o Sinking fund provision- is a requirement that the firm retire a certain amount of the
bond issue each year. A sinking fund is required to raise up cash from to time to
meet coupon payments and ultimately the maturity principal amount. An advantage
of this provision is that it reduces the payments of the bondholders at maturity.
*example of page 212

o Protective covenants- certain limits or restrictions are set up on the issuing

corporation that are designed to protect bondholders from being exposed to
 increasing risk during the investment period. (example: retaining the capital
structure between debt and equity; no merger with another company, etc.)

Protective covenants frequently limit the amount of dividends and corporate

officers’ salaries the firm can pay and also restrict the amount of additional debt the
firm can issue. This can also prevent managers from taking excessive risk and
therefore cater to the preferences of bondholders.

o Call provisions- is the provision allowing the firm to call the bonds. It normally
requires the firm to pay a price above par value when it calls its bonds.

This characteristic is usually viewed as a disadvantage because it can disrupt

bondholders’ investment plans and reduce their investment returns. As a result,
firms must pay slightly higher rates of interest on bonds that are callable.

o Bond collateral- an asset is set up to back up the bond. Usually, collateral is a

mortgage on real property. The classifications of bonds by the nature of the
collateral is:

(a) first mortgage bond = the first to claim on the specified asset used as collateral
(b) chattel mortgage bond = secured by personal property
(c) debentures = bonds are unsecured by specific property or in short, there is no
collateral but is backed by the general credit of the issuing firm. These bonds are
usually issued by good sounding and popular large corporations whose ability to
service the debt is not in question
(d) subordinated debentures = having the last claim on the assets used as collateral,
meaning, owners of subordinated debentures receive nothing until the claims of
mortgage bondholders, regular debenture owners, and secured short-term creditors
have been satisfied

o Low- and Zero-Coupon Bonds- long-term debt securities that are issued at a deep
discount from par value. Low- and zero-coupon corporate bonds are purchased
mainly for tax-exempt investment accounts (such as pension funds and individual
retirement accounts).

o Variable Rate Bonds or Floating Rate Bonds- bonds issued which coupon rate are
adjusted to current market rate from time to time as it progresses over the life of
the bond. This became very popular in 2004, when interest rates were at low levels.
Because most investors presumed that interest rates were likely to rise, they were
more willing to purchase variable-rate than fixed-rate bonds.

o Convertibility- allows investors to exchange the bond for a stated number of shares
of the firm’s common stock. This offers investors the potential for high returns if the
price of the common stock rises. Thus, investors are willing to accept a lower rate of
interest, allowing the firm to obtain financing at a lower cost.

 HOW CORPORATE BONDS FINANCE RESTRUCTURING

Firms can issue corporate bonds to finance the restructuring of their assets and to revise
their capital structure. Such restructuring can have a major impact on the firm’s degree of
financial leverage, the potential return to shareholders, the risk to shareholders, and the risk
to bondholders.
 o Using Bonds to Finance a Leveraged Buyout (LBO)- LBO is the use of debt to
purchase shares from market and take the company back private, resulting to small
number of owners. Many firms that engaged in an LBO go public once they have
improved their operating performance and they commonly go public during a period
when stock prices are generally high because, under these conditions, they will be
able to sell their stock at a higher price.

o Using Bonds to Revise the Capital Structure- corporations commonly issue bonds
when they seek to revise their capital structure. A company having reliable cash can
go for debt securities like bond especially if they have sufficient cash flows to cover
their debt payments. This can imply a higher degree of financial leverage which
means it will be less costly as it allows the firm’s earnings to be distributed to a
smaller group of shareholders.

Bonds may be issued to retire outstanding shares to reduce equity (stock) financing
in the structure which we call debt-for-equity swap; or the other way around equity-
for-debt swap wherein new shares are issued to pay existing debt

 KEY FEATURES OF BONDS

o Par value = AKA face value of the bond. The par value the sum of money that the
corporation promises to pay at the bond's maturity.

o Coupon = Coupon rate is the rate of interest paid by bond issuers on the bond's face
value or the interest rate stipulated on the bond’s contract called indenture = fixed
rate bond, floating rate bond and zero coupon bond

o Maturity date = Bond maturity is the time when the bond issuer must repay the
original bond value to the bond holder or simply, the due date of the bond. A bond
that matures in one year is much more predictable and less risky than a bond that
matures in 20 years. Therefore, the longer the time to maturity, the higher the
interest rate. Also, a longer term bond will fluctuate more than a shorter term bond.

o Call provision = A call provision is a provision on a bond or other fixed-income

instrument that allows the issuer to repurchase and retire its bonds.

Corporate bonds usually have this to protect them from fluctuations/volatilities

during the term of the bond. If market interest rate decreases over time, the
corporation will be calling {retiring} the bonds as to replace them with newly issued
lower coupon bonds in tune with current market rates.

o Sinking funds = requires the issuer to put money aside to repay bondholders at
maturity. This feature of a bond allows investors to be more confident especially
when a corporation includes on its bond contract a setting up of funds from time to
time to ensure future payments on both coupons and principal; this tends to lower
down the coupon rate.

 COMMON KINDS OF BONDS

o Bonds with warrants = Bonds with warrants give the bondholder the right to buy a
certain number of shares at a fixed price for a specified period of time. Warrants are
 attached to the issuance of the bonds to make the bond saleable; and the
bondholder can exercise the warrant any time during its life span.

o Puttable bonds = provides the investor the right, to let the issuer redeem the bond
before its maturity date at their option which is prior to the maturity date and at a
prearranged price

o Income bond = is a bond in which the issuer is only responsible for making coupon
payments when it has sufficient income to do so and only the face value of the bond
is promised to be paid to the investor.