Bond Markets

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Learning Objectives
After studying this chapter, the students should be able to:
Identify the major bond markets.
Describe the characteristics of the various bond market securities.
Explain the major bond market participants.
Describe types of securities trade in international bond markets.
Describe bond markets in Tanzania.

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Overview of Bond Markets
The bond market (also debt market or credit market) is a financial market where
participants can issue new debt, known as the primary market, or buy and sell debt securities,
known as the secondary market.
This is usually in the form of bonds, but it may include notes, bills, and so on for public and
private expenditures.
Bonds are long-term debt obligations issues by companies and government units.
Proceeds from a bond issue are used to raise funds to support long-term operations of the
issuer (e.g., for capital expenditure projects).
In return for the investor’s funds, bond issuers promise to pay a specified amount in the future
on the maturity of the bond (the face value) plus coupon interest on the borrowed funds (the
coupon rate times the face value of the bond).

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Overview of Bond Markets…
If the terms of the repayment are not met by the bond issuer, the bond holder (investor)
has a claim on the assets of the bond issuer.
Bond markets are markets in which 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 markets are traditionally classified into three types:
1. Treasury notes and bonds,
2. Municipal bonds, and
3. Corporate bonds.
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Bond Market Securities
• Government units and corporations are the major bond security issuers.
• They issue bonds to borrow.

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Treasury Notes and Bonds
• A Treasury note (T-note for short) is a marketable government debt security with a fixed
interest rate and a maturity between 2 and 10 years. Treasury notes are available from the
government with either a competitive or non-competitive bid.
• Treasury bonds (T-bonds) are fixed-rate government debt securities with a maturity range
between 10 and 30 years. T-bonds pay semi-annual interest payments until maturity, at which
point the face value of the bond is paid to the owner.
• Treasury notes have maturities from two to 10 years, while Treasury bonds have maturities of
greater than 10 years. These both pay interest semi-annually, and the only real difference
between Treasury notes and bonds is their maturity length.
• A bond is debt issued to the public, who buy the bonds. A note is a debt arrangement
between the county and a financial institution.

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Treasury Notes and Bonds…
• Like, T-bills, T-notes and bonds are backed by the full faith and credit of the government
and are, therefore, default risk free.
• As a result, T-notes and bonds pay relatively low rates of interest (yields to maturity) to
investors.
• In contrast to T-bills, which are sold on a discount basis from face value, T-notes and
bonds pay coupon interest (semi-annually).
• Further, T-bills have an original maturity of one year or less.
• As seen earlier, T-notes have original maturities from over 1 to 10 years, while T-bonds
have original maturities from over 10 years.
• See Tanzanian T-Bonds different coupon rates: Treasury Bonds Coupon Rates.pdf

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Treasury Notes and Bonds…
• T-notes and bonds are issued in minimum denominations of $1,000, or in multiples of
$1,000.
• Like T-bills, once issued T-notes and T-bonds trade in very active secondary markets.

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Treasury Note and Bond Yields
• T-note and bond yield to maturities and prices are calculated using bond valuation formulas.
• The general bond valuation formula is:
𝐼𝑁𝑇
• 𝑉𝑏 = 𝑃𝑉𝐼𝐹𝐴 𝑖𝑑 + 𝑀(𝑃𝑉𝐼𝐹 𝑖𝑑
𝑚
𝑚,𝑁𝑚 𝑚,𝑁𝑚
where
Vb = Present value of the bond
M = Par or face value of the bond
INT = Annual interest (or coupon) payment on the bond, equals the par value times the coupon rate
N = Number of years until the bond matures
m = Number of times per year interest is paid
id = Interest rate used to discount cash flows on the bond.

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Primary and Secondary Market Trading in T-Notes and T-Bonds

• T-notes and bonds are sold through competitive and non-competitive Treasury auctions.
• See Bank Of Tanzania Auction Summary of 11/May/2022: Treasury Bonds Auction
Summary.pdf
• Bids may be submitted by government securities dealers, businesses, and individuals
through Central Banks.
• Most secondary market trading of T-notes and bonds occurs directly through broker and
dealer trades

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Municipal Bonds
• Municipal bonds are securities issued by state and local (e.g., counties, cities, schools)
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 system.
• Municipal bonds are attractive to household investors since interest payments on
municipal bonds are exempt from income taxes.
• The interest borrowing cost to state or local government is lower because investors are
willing to accept lower interest rates on municipal bonds relative to comparable taxable
bonds such as corporate bonds.

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Municipal Bonds Yields
• To compare returns from tax-exempt municipal bonds with those on fully taxable
corporate bonds, the after-tax rate of return on a taxable bond can be calculated as
follows:
ia =ib (1-t)
where
ia = After-tax (equivalent tax exempt) rate of return on a taxable corporate bond
ib = Before-tax rate of return on a taxable bond
t = Marginal income tax rate of the bond holder (i.e., the sum of his/her marginal tax)

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Municipal Bonds Yields…
Example 1: Comparison of Municipal Bonds and Fully Taxable Corporate Bond Rates
Suppose you can invest in taxable corporate bonds that are paying a 10% annual interest
rate or municipal bonds. If your marginal tax rate is 28%, the after-tax or equivalent tax
exempt rate of return on the taxable bond is:
10%(1 – 0.28) = 7.2%
Thus, the comparable interest rate on municipal bonds of similar risk would be 7.2%.

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Municipal Bonds Yields…
Example 2: Conversion of a Municipal Bond Rate to a Tax Equivalent Rate
You are considering an investment in a municipal bond that is paying ia = 6.5% annually. If
your marginal tax rate (t) is 21%, the tax equivalent rate of interest on this bond (ib) is:

8.23% = 6.5% / (1 – 0.21)

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Corporate Bonds
• Corporate bonds are all long-term bonds issued by corporations.
• The bond indenture is the legal contract that specifies the rights and obligations of the bond
issuer and the bond holders.
• The bond indenture contains a number of covenants associated with a bond issue.
• These bond covenants describe rules and restrictions placed on the bond issuer and bond
holders.
• These bond covenants include such rights for the bond issuer as the ability to call the bond issue
and restrictions as to limits on the ability of the issuer to increase dividend.
• The bond indenture helps lower the risk (and therefore the interest cost) of the bond issue.
• All matters pertaining to the bond issuer’s performance regarding any debt covenants as well
bond repayments are overseen by a trustee (frequently a bank trust department) who is
appointed as the bond holders’ representative or “monitor”.

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Corporate Bonds…
• The trustee acts as the transfer agent for the bonds when ownership changes as a result
of secondary market sales and when interest payments are made from the bond issuer to
the bond holder.
• The trustee also informs the bond holders if the firm is no longer meeting the terms of
the indenture.
• In this case, the trustee initiates any legal action on behalf of the bond holders against
the issuing firm.
• In the event of a subsequent reorganization or liquidation of the bond issuer, the trustee
continues to act on behalf of the bond holders to protect their principal.

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Bond Characteristics
• Corporate bonds have many different characteristics that differentiate one issuer from another.
Bearer versus Registered Bonds – corporate bonds can be bearer bonds or registered
bonds,
With bearer bonds, coupons are attached to the bond and the holder (bearer) at the time of the coupon
payment gets the relevant coupon paid on presentation to the issuer.
With a registered bond, the bond holder’s (or owner’s)identification information is kept in an electronic
record by the issuer and the coupon payment are mailed or wire-transferred to the bank account of the
registered owner.
Term versus Serial Bonds – most of corporate bonds are term bonds, meaning that the
entire issue matures on a single day. Some corporate bonds (and most municipal bonds), on the
other hand, are serial bonds, meaning that the issue contains many maturity dates, with a
portion of the issue paid off on each date.

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Bond Characteristics….
Mortgage bonds – bonds that are issued to finance specific projects that are pledged as
collateral for the bond issue.
Thus, mortgage bond issues are secured debt issues.
Bond holders may legally take title to the collateral to obtain payment on the bonds if the issuer of a
mortgage bond defaults.
Because mortgage bonds are backed with a claim to specific assets of the corporate issuer, they
are less risky investments than unsecured bonds.
As a result, mortgage bonds have lower yields to bond holders than unsecured bonds.

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Bond Characteristics….
Debentures and Subordinated Debentures – bonds backed solely by the general credit
of the issuing firm and unsecured by specific assets or collateral.
Debenture holders generally receive their promised payments only after the secured debt holders,
such as mortgage bond holders, have been paid.
Subordinated debentures are also unsecured, and they are junior in their rights to mortgage
bonds and regular debentures.
In the event of a default, subordinated debenture holders receive a cash distribution only after all
non-subordinated debt has been repaid in full.
As a result, subordinated bonds are the riskiest type of bond and generally have higher yields than
non-subordinated bonds.

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Bond Characteristics….
Convertible Bonds – are bonds that may be exchanged for another security of the
issuing firm (e.g., common stock) at the discretion of the bond holder.
If the market value of the securities the bond holder receives with conversion exceeds the market
value of the bond, the bond holder can return the bonds to the issuer in exchange for the new
securities and make a profit.
Thus, convertible bonds are hybrid securities involving elements of both debt and equity.
They give the bond holder an investment opportunity (an option) that is not available with non-
convertible bonds. As a result, the yield on a convertible bond is usually lower than that on a non-
convertible bond.
icvb = incvb - opcvb
where, opcvb = value of the conversion option to the bond holder.

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Bond Characteristics….
Stock Warrants – bonds that give the bond holder an opportunity to purchase common
stock at a specified price up to a specified date. Bond holders will exercise their warrants
if the market value of the stock is greater than the price at which the stock can be
purchased through the warrant. Further, the bond holder may sell the warrant rather
than exercise it, while maintaining ownership of the underlying bond.
Callable Bonds – bonds that allows the issuer to force the bond holder to sell the bond
back to the issuer at a price above the par value (at the call price). The difference
between the call price and the face value on the bond is the call premium.
Sinking Fund Provisions – bonds that include a requirement that the issuer retire a
certain amount of the bond issue each year.
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Bond Ratings
• A bond rating is a grade given to a bond by a rating service that indicates its credit
quality. The rating takes into consideration a bond issuer's financial strength or its ability
to pay a bond's principal and interest in a timely fashion.
• Bonds with a rating of BBB- (on the Standard & Poor's and Fitch scale) or Baa3 (on
Moody's) or better are considered "investment-grade." Bonds with lower ratings are
considered "speculative" and often referred to as "high-yield" or "junk" bonds.
• Bonds rated AAA, AA, A or BBB are considered investment grade while those rated BB, B,
CCC, CC, C or D are considered speculative or junk grade bonds.

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Bond Rating Agencies
• Bond rating agencies are companies that assess the creditworthiness of both debt
securities and their issuers. These agencies publish the ratings used by investment
professionals to determine the likelihood that the debt will be repaid.

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Bond Rating Agencies…
KEY TAKEAWAYS
• Bond rating agencies are companies that assess the creditworthiness of both debt
securities and their issuers.
• In the United States, the three primary bond rating agencies are Standard & Poor's
Global Ratings, Moody's, and Fitch Ratings.
• The bond rating agencies provide useful information to the markets and help investors
save on research costs.
• Bond rating agencies were heavily criticized early in the 21st century for assigning flawed
ratings, particularly for mortgage-backed securities.

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Understanding Bond Rating Agencies
• In the United States, the three primary bond rating agencies are Standard & Poor's Global
Ratings, Moody's, and Fitch Ratings. Each uses a unique letter-based rating system to quickly convey to
investors whether a bond carries a low or high default risk and whether the issuer is financially stable.
Standard & Poor's highest rating is AAA, and a bond is no longer considered investment grade if it falls
to BB+ status. The lowest rating, D, indicates that the bond is in default. That means the issuer is
delinquent in making interest payments and principal repayments to its bondholders.
• In general, Moody's assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, with WR and NR as
withdrawn and not rated, respectively. Standard & Poor's and Fitch assign bond credit ratings of AAA,
AA, A, BBB, BB, B, CCC, CC, C, and D, with the latter denoting a bond issuer in default.
• The agencies rate bonds at the time they are issued. They periodically re-evaluate bonds and their
issuers to see if they should change the ratings. Bond ratings are important because they affect the
interest rates that companies and government agencies pay on their issued bonds.

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Bond Market Participants
Bond markets bring together suppliers and demanders of long-term funds.
The major issuers of debt market securities are central governments, local
governments, and corporations.
The major purchasers of capital market securities are households, businesses,
government units, and foreign investors.

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International Aspects of Bond Markets
• The international bond market is a market for bonds that are traded beyond national
boundaries. They pull together investors from different countries.
• The bonds which are traded in international bond markets are called international bonds.
• International bond markets are those markets that trade bonds that are underwritten by an
international syndicate, offer bonds to investors in different countries, issue bonds outside the
jurisdiction of any single country, and offer bonds in unregistered form.
• Normally, though not always, these bonds are issued in the issuer’s domestic currency.
• In fact, it depends on where the subscription is expected.
• In such a situation, the issuer may issue bonds denominated in US Dollar or Euro.
• Also, international bonds like most other types of bonds, attract interest payments at regular
intervals and the investor gets the principal amount back upon maturity of the bond.
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International Bond Market has three Classifications
1. Foreign Bonds. In foreign bonds, the issuer is from one country but he issues the bonds in some
other country. The issuer issues these bonds in the local currency of the country where he is
issuing bonds. An example of a foreign bond will be a US company issuing bonds to raise capital in
India. The US company will issue the bonds in Indian Rupee. As a result, Indian investors will not be
subject to the ups and downs of the foreign exchange market. They will invest in Indian Rupee, earn
interest in Indian Rupee, and will get their principal back in Indian Rupee. An Indian company or can
also issue bonds in India in Indian Rupee. But these bonds will be called Domestic Bonds. So, for a
bond to classify as Foreign Bond, it must come from a foreign issuer.

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International Bond Market has three Classifications…
2. Euro Bond. In Euro Bond, a foreign entity issues a bond in the domestic market. The
issuer issues bond in a currency which is not the domestic currency of that country. So, a
Eurobond in US currency can be issued in any country other than the US. If a US company
issues bonds in Japan in Pound sterling, it will also be an example of a Eurobond.
Eurobond is a result of unfavourable tax regimes of the 1960s in the US. This led to the US
companies issuing bonds in US dollars outside of the USA. Here, the investors will be
subject to ups and downs in the foreign exchange rate.
3. Global Bonds. Apart from foreign bonds and euro bonds, some companies, though
rarely, issue global bonds. In global bonds, bonds are issued in multiple countries at a go
and often in multiple currencies. Usually, large multinational corporations issue global
bonds.

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Key Features of International Bond Market
• Participants in the international bond market include Governments, traders, institutional
investors, and individuals. However, bonds in the international bond market are less liquid.
And for this reason, institutional investors such as pension funds, mutual funds, etc hold a
chunk of them.
• In international bonds, credit rating agencies rate foreign bonds but not Euro bonds.
Hence, the entity issuing Eurobond must command considerable credibility to attract
investors.
• Foreign bonds must observe the rules and regulations of the country of issue, like
domestic bonds of that country. Eurobonds, however, are not subject to any particular
country’s regulations.
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Advantages of Participation in International Bond Markets
• Diversification: Investment in international bonds provides the benefit of diversification. Diversification
decreases the risk of a major loss for the investors. This happens because your returns from an
international bond (mostly) will not be subject to negative events in your home economy. So, for
example, if your home country witnesses heavy floods, your investment in some foreign country is safe
from any negative impact of this event.
• Increased Exposure: Investment in the international bond market provides a great opportunity for
those who seek exposure to foreign economies. So, if you are expecting the British economy to perform
well in the coming years, you can invest in British bonds through the international bond market. This will
enable you to make money out of the foreign economy’s performance.
• Higher Returns: International bond markets usually offer a higher rate of interest than domestic bonds.
The reason is that they are riskier for investors coming from some other country. Hence, investment in
the international bond market can potentially boost the returns of your portfolio.
• Hedging: If you are prone to a falling US Dollar and making losses out of it, you can invest in
international bonds as a hedge. By investing in bond issues of that country whose currency is stronger
and is gaining, you can make up for the losses.
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Disadvantages of Participation in International Bond Markets
• Increased Risk: While investments in International Bond Market provide diversification, it has its
own risks. A sudden political uproar can be one factor for high risk. The economic instability of
the other country can also lead to losses for the investors.
• Exchange Rate Volatility: In some types of international bonds, issuers issue bonds in the non-
domestic currency of the investor. This makes the investor subject to fluctuations in the
exchange rate of that currency. For example, upon maturity, the issuer will pay in the bond’s
original currency. But the same amount may convert into a lesser amount in the domestic
exchange rate of the investor.
• Lack of liquidity: Bonds in International bond markets do not enjoy much liquidity. If an investor
wants to cash his investment, he can easily do so in the case of domestic bonds as finding the
buyer for a domestic bond will be easy. But to find a buyer for an international bond can be quite
difficult as very few people invest in international bonds. Hence, bonds in international bond
markets lack relative liquidity.

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Bond Markets in Tanzania
There are two types of bond markets in Tanzania:
1. Treasury Bond Markets – where the government issues the T-bonds to the market
through the Central Bank of Tanzania, Bank of Tanzania. The bond maturities in this
market range from 2 to 25 years, as shown here below:
Bond Maturity Coupon Rate Bond Coupon Rate Bond Coupon Rate
Maturity Maturity
2 – year 7.60% 5-year 8.60% 7-year 9.48%
10-year 10.25% 15-year 11.15% 20-year 12.10%
25-year 12.56%

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Bond Markets in Tanzania…
2. Corporate Bond Markets – corporations issue corporate bonds in primary markets and
are traded in the secondary market at Dar Es Salaam Stock Exchange.
• A Corporate Bond is a bond issued by company/ an enterprise “A borrower” to investors
“Lenders” from the general public.
• When a company issues a bond it divides it into small proportions that are sold at a price
called the face value.
• The Company will promise investors payment of some interests on the borrowed amount;
interests will be paid annually or semi-annually.
• Investors are also promised repayment of the borrowed amount after the bond matures.

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Bond Markets in Tanzania…
At the time of writing these notes, May 2022, DSE had only four (4) registered corporate
bonds with the following details:
Bond No. ISIN Coupon Tenure Issue Date Maturity Issued
Rate Date Amount
X1 XX 15.56% 6 year Dec. 2015 Dec. 2021 14.96 bn
bond
X2 XX 10.0% 3 year July 2019 July 2022 83.35bn
bond
X3 XX 11.79% 5 year June 2018 June 2023 12.52 bn
bond
X4 XX 13.4607% 5 year June 2019 June 2024 9.18 bn
bond
Total 120.01 bn
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Summary
• This topic looked at the domestic and international bond markets.
• Three types of bonds, T-notes and bonds, municipal bonds, and corporate bonds, available
to long-term investors were discussed.
• The international bond markets were also discussed.
• Finally, we discussed the Bond Markets in Tanzania

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Reviewed Questions
1. What are capital markets and how do bond markets fit into the definition of capital markets?
2. A municipal bond you are considering as an investment currently pays a 6.75% annual rate of
return.
(i) Calculate the tax equivalent rate of return if your marginal tax rate is 28%.
(ii) Calculate the tax equivalent rate of return if your marginal tax rate is 21%.
3. What is the difference between bearer bonds and registered bonds?
4. What is a convertible bond? Is a convertible bond more or less attractive to a bond holder
than a non-convertible bond?
5. What is a callable bond? Is a call provision more or less attractive to a bond holder than a
non-callable bond?
6. What is the difference between a Eurobond and a foreign bond?
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