Capital Markets

Introduction – Purpose of Capital Markets

• In the capital markets, the motive of firms issuing or buying securities is very
different than in the money markets. In the money markets, firms are
warehousing idle funds until needed for some business activity or borrowing
temporarily until cash is collected. Firms buy capital goods such as plant and
equipment to produce some product to earn a profit. Most of these
investments are central to the firm’s core business activities.
• Capital goods normally have a long economic life, ranging from a few years
to 30 years or more. Capital assets usually are not highly marketable.
• Most firms attempt to finance capital goods with long-term debt or equity to
lock in their borrowing cost for the life of the project and to eliminate the
problems associated with periodically refinancing assets.
• A firm buys a plant with an expected economic life of 15 years. Because
short-term rates are typically lower than long-term rates, at first glance,
short-term financing may look like a real deal. However, if interest rates rise
dramatically, the firm may find its borrowing cost skyrocketing as it has to
refinance its short-term debt.
• However, if long-term securities such as bonds are used, the cost of funds is
known for the life of the asset and there should be fewer refinancing
problems.
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 Introduction – Capital Market Participants s
• Capital markets bring together borrowers and suppliers of long-term funds.
The market also allows investors who hold previously issued securities to
trade those securities for cash in the secondary capital markets.
• The largest net purchasers of capital market securities are households.
Financial institutions are a distant second because their net position (assets
minus liabilities) is small, which in turn is because of their role as financial
intermediaries. However, their asset and liability holdings are the largest of
any capital market participant. That is, they purchase funds from individuals
and others, and then issue their own securities in exchange.
• Individuals and households may invest directly in the capital markets but,
more than likely, they purchase stocks and bonds through financial
institutions such as commercial banks, insurance companies, mutual funds,
and pension funds.

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Introduction – Capital Market Participants s

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 Introduction
• Equity (stocks) and debt (notes, bonds, and mortgages) instruments with
maturities of more than one year trade in capital markets.
• Bond is a negotiable debt investment certificate that ensures fixed income for
a defined period of time generally issued by a company or government
agency.
• A bond investor offers money to the issuer and in return, the issuer promises
to repay the amount equal to bond value at a fixed interest rate (at a specified
maturity date) over the life of the bond. However the interest on bonds is
usually paid (semi-annually) every six months.
• Bonds are generally used by companies and foreign governments to fund
multiple projects as well as activities. 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). 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. 5
 Introduction - Features of Bonds
• Bonds have a number of different features, mentioned factors play a role in
determining the value of a bond.
• Face Value/Par Value
• The face value (also called as the par value) is the quantity of money a
holder will receive back once a bond matures. A newly issued bond
generally sells at the par value.
• What makes other people more confused is that the par value isn’t the price
of the bond. A bond's price wavers all through its life in reaction to a number
of variables. When a bond trades at a price higher the face value, it is
thought to be selling at a premium. When a bond sells lower than face
value, it is thought to be selling at a discount.
• Coupon (The Interest Rate)
• Coupon is the quantity of money the bondholder receives as interest
payments. It is usually expressed as a percentage of the par value. It’s
referred to as “coupon” because sometimes these bonds have a physical
presence which one can tear off and redeem back for interest. Though, this
was a more common thing in the past, these days the records are
electronically managed.
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 Introduction - Features of Bonds
• If a bond pays a coupon of 10% and its par value is Rs.10,000 its interest
would be Rs.1000 annually. Rates that remains fixed as a percentage of the
par value, are considered as Fixed-rate bond. Another possibility is flexible
interest payment, referred to as floating-rate bond where interest rate is tied
up to market rates through an index, for example the rate on Treasury bills.
• One might presume investors will pay more for a high coupon than for a low
coupon. All things being equivalent, a lower coupon suggests that price of
the bond will fluctuate more.
• Maturity
• Maturity is the date on which the principal amount of a note, draft,
acceptance bond or other debt instruments becomes due and is reimbursed
back to the investor and thereafter the interest payments stops. It is also
regarded as the termination date on which an installment loan must be paid
in full. Maturities can range from as low as 3 years to as long as 30 years.
• A bond that matures in three years is much more anticipated and therefore
less risky than a bond that matures in 30 years. Thus, in general, the longer
the duration to maturity, the higher the interest rate. Also, all things being
comparable, a longer term bond will alter more than a shorter term bond.

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 Types of Bonds
• In the financial market of Pakistan, bonds are either issued by the
Government or Corporate entities.
Government Bonds
• Government bond is a debt security loaned by a government to
assist government spending, most often issued in the country’s local
interest.
• The various types of Government bonds issued by the Govt. of
Pakistan:
• Pakistan Investment Bonds
• US Special Dollar Bonds
• WAPDA Bonds
• National Saving Bonds
• Sukuk

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 Types of Bonds
Corporate Bonds
•Corporate Bond is a debt security which is issued by company and sold
to investors to meet its financial requirements. Commonly known as
Term Finance Certificate (TFC).
•Corporate Bonds are normally issued for a specified time period with an
assurance to return the principal amount of the bond money including
interest to the bondholder.
•When someone buys a bond, he/she is lending money to the company
that issued it. The company ensures to return the money, on a
specified maturity date.
•Till that time, it also pays a stated rate of return, which usually occurs
semiannually. The interest payments collected from corporate bonds
are taxable. Unlike shares, bonds do not provide an ownership interest
in the issuing company.

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 Corporate Bonds
• Are long-term bonds issued by corporations. The minimum denomination on
publicly traded corporate bonds (which, in contrast to privately placed
corporate bonds, require SEC registration) is $1,000, and coupon-paying
corporate bonds generally pay interest semi annually.
• 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. As described below, these 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 dividends paid to equity
holders.
• By legally documenting the rights and obligations of all parties involved in a
bond issue, 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 as bond repayments are
overseen by a trustee (frequently a bank trust department) who is appointed
as the bond holders’ representative or “monitor.” The signature of a trustee
on the bond is a guarantee of the bond’s authenticity.
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 Corporate Bonds
• The indenture usually specifies the security or assets to which bondholders have
prior claim in the event of default. Mortgage bonds pledge land and buildings;
equipment trust certificates pledge specific industrial equipment or rolling stock,
such as railroad cars, trucks, or airplanes; and collateral trust bonds are secured
by stocks and bonds issued by other corporations or governmental units.
• If no assets are pledged, the bonds are secured only by the firm’s potential to
generate cash flows and are called debentures. Bond contracts that pledge
assets in the event of default have lower yields than similar bonds that are
unsecured.
• Corporate bonds can differ in ways other than security. The debentures can be
senior debt, giving the bondholders first priority to the firm’s assets (after
secured claims are satisfied) in the event of default, or subordinated (junior)
debt, in which bondholders’ claims to the company’s assets rank behind senior
debt.
• Many corporate bonds have sinking fund provisions, and most have call
provisions. A sinking fund provision requires that the bond issuer provide funds
to a trustee to retire a specific dollar amount (face amount) of bonds each year.
The trustee may retire the bonds either by purchasing them in the open market
or by calling them if a call provision is present.

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 Corporate Bonds
• It is important to notice the distinction between a sinking fund provision and
a call provision. With a sinking fund provision, the issuer must retire a
portion of the bond as promised in the bond indenture.

• In contrast, a call provision is an option that grants the issuer the right to
retire bonds before their maturity. Most security issues with sinking funds
have call provisions because that guarantees the issuer the ability to retire
bonds as they come due under the sinking fund retirement schedule.
• Convertible bonds are bonds that can be converted into shares of
common stock at the discretion of the bondholder. This feature permits the
bondholder to share in the good fortune of the firm if the stock price rises
above a certain level.
• If the market value of the stock the bondholder receives at conversion
exceeds the market value of the bond’s future expected cash flows, it is to
the bondholder’s advantage to exchange the bonds for stock, thus making a
profit.
• As a result, convertibility is an attractive feature to bondholders because it
gives them an option for additional profits that is not available with
nonconvertible bonds.
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 Corporate Bonds – Listed on PSX
(Example)
Symbol Name Launched Maturity Next Coupon Frequency Tenor

Engro Polymer & Chemicals

EPCLSC January 11, 2019 July 11, 2026 January 11, 2023 3 Month(s) 7.5
Ltd.(SUKUK)

TPLSC TPL Corp Limited.(SUKUK) June 23, 2022 June 23, 2027 December 23, 2022 3 Month(s) 5

SBLTFC Samba Bank Limited (TFC) March 01, 2021 March 01, 2031 March 01, 2023 6 Month(s) 10

CNERGYSC Cnergyico PK Limited.(SUKUK) January 18, 2017 January 18, 2023 January 18, 2023 3 Month(s) 5

UBLTFC5 United Bank Limited(TFC-5) January 29, 2019 January 29, 2044 January 29, 2023 3 Month(s) 25

Jahangir Siddiqui & Co.

JSTFC11 March 06, 2018 September 06, 2023 March 06, 2023 6 Month(s) 5
Limited-TFC11

SNBLTFC3 Soneri Bank Limited(TFC3) December 06, 2018 December 06, 2043 December 06, 2022 6 Month(s) 25

KFTFC1 KASHF Foundation September 30, 2019 September 30, 2023 December 31, 2022 3 Month(s) 4

AGSILSC Agha Steel Industries Ltd.(SUKUK) October 09, 2018 October 09, 2025 January 09, 2023 3 Month(s) 6

PESC1 Pakistan Energy SUKUK-1 March 01, 2019 March 01, 2029 March 01, 2023 6 Month(s) 10

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 Parties Involved in a Bond
• The bond market can essentially be broken down into three important key
players or groups.
1. Issuer:
• The issuer is responsible for selling bonds in the bond market to fund the
operations of the organizations. This part of the market usually comprises of
governments, banks and corporations, out of which the major one is the
government, which uses the bond market to in funding a country's operations.
Other issuers consist of banks and corporate entities which issue bonds to
fund their operations.
2. Trustee:
• A trustee of a trust deed is responsible for securing any issue of a bond. The
trustee can be an individual person, member of board, a company or a bank
appointed with the approval of the SECP. A trustee in the case of Bonds is
basically a holding service who has the power of administration for managing
dealings related to bonds.
• They are trusted to make decisions in the beneficiary’s best interest. The
primary role of a trustee is to take possession of the trust property in
accordance with the provisions of the trust deed and exercise due diligence
to ensure compliance by the issuer with the provisions of the trust deed. 14
 Parties Involved in a Bond
3. Investor
•The final player in the bond market is the one who buys the debt that is
being issued in the market. It can be an individual or a group who
commits money to investment products with the expectancy of financial
return. Commonly, the primary concern of an investor is to reduce risk
while maximizing return, as opposed to a risk-taker, who is willing to
accept an advanced level of risk in the hopes of collecting
higher-than-average profits.

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 Parties Involved in a Bond
BOND TRUSTEE (DEBENTURE TRUSTEE)
•Bond trustee is a financial institution having trust powers and
responsible for transfer, registration or payments of bonds. Examples
are commercial banks or trust company given powers by a bond issuer
to enforce the terms of bonds indenture.
•An indenture is a contract between a bond issuer and a bond holder. A
bond trustee ensures interest payments are made as planned and on
time as well as protects the interests of the bondholders in cases of
default issues.
•Also guarantees that the re-payment terms and legal obligations of the
security are being properly met.
•Debenture trustee is responsible to monitor compliance of the issuer
with covenants of a debt security. If this role is not adequately and
responsibly played, it can cause a loss to the bondholders and lead to
loss of investor confidence in general.

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 Costs Associated with the Investment in Bonds
• When you buy a bond, you are eligible to the percentage of a
coupon payment due from the trade settling date till the next
payment date for coupon.
• The previous owner of the bond is entitled to the percentage of that
coupon payment from last coupon payment date up till the trade
settlement date.

• Costs are predictable and unavoidable part of investing. Primarily,

the cost associated with investing in bonds is the commission
paid to the brokers on buying and selling bonds.

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 Terms of the Bond Contract
• A bond is a contractual obligation of a borrower to make periodic cash
payments to a lender over a given number of years. A bond constitutes
debt, so there is a borrower and a lender. In the parlance of Wall Street, the
borrower is referred to as the bond issuer. The lender is referred to as the
investor, or the bondholder.
• The bond consists of two types of contractual cash flows. First, on maturity,
the lender is paid the original sum borrowed, which is called the principal,
face value, or par value, of the bond. Note that these three terms are
interchangeable.
• Second, the borrower or issuer must make periodic interest payments to the
bondholders. These interest payments are called the coupon payments
(C). The magnitude of the coupon payments is determined by the coupon
rate (c), which is the amount of coupon payments received in a year stated
as a percentage of the face value (F). For example, if a bond pays $80 of
coupon interest annually and the face value is $1,000, the coupon rate is:
c = C/F
= $80/$1,000
= 8%

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 Terms of the Bond Contract
• To determine the timing of the cash flows we need to know the
term-to-maturity (or maturity) of the bond, which is the number of years
over which the bond contract extends. For example, a bond with 3 years to
maturity and paying annual coupon payments has three coupon payments.
The principal amount is repaid at maturity. Thus, a bond with a coupon rate
of 8 percent and a face value of $1,000 has $80 coupon payments at the
end of each of the 3 years and a principal payment of $1,000 at maturity.
• It is important to keep in mind that for most bonds the coupon rate, the par
value, and the term-to-maturity are fixed over the life of the bond contract.
• Coupon rates are typically set at or near the market rate of interest or yield
on similar bonds available in the market. A similar bond is one that is a
close substitute, nearly identical in maturity and risk.
• The coupon rate and the market rate of interest may differ. The coupon rate
is fixed throughout the life of a bond. The yield on a bond varies with
changes in the supply and demand for credit or with changes in the issuer’s
risk.

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 Par, Premium and Discount Bonds
• A bond is a contractual obligation of a borrower to make periodic cash payments to a
lender over a given number of years. A bond constitutes debt, so there is a borrower
and a lender. In the parlance of Wall Street, the borrower is referred to as the bond
issuer. The lender is referred to as the investor, or the bondholder.

• One of the properties of the bond formula is that whenever a bond’s coupon rate is
equal to the market rate of interest on similar bonds (the bond’s yield), the bond
always sells at par. We call such bonds par bonds because they sell at par value.
• For example, consider a 3-year bond with a face value of $1,000 and an annual
coupon rate of 5 percent when the yield or market rate of interest on similar bonds is
5 percent. The bond’s price is $ 1,000, i.e., sell at par.
• If the market rate of interest immediately rises to 8 percent. What is the price of the
bond? Is it below, above, or at par?
• For i to equal 8 percent, the price of the bond declines to $922.69. The bond sells
below par; such bonds are called discount bonds. Whenever the market rate of
interest on similar bonds is above a bond’s coupon rate, a bond sells at a discount.
The reason is the fixed nature of a bond’s coupon.
• If the interest rate on similar bonds were to fall to 2 percent, the price of our bond
would rise to $1,086.52. The bond sells above par; such bonds are called premium
bonds. Whenever the market rate of interest is below a bond’s coupon rate, a bond
sells at a premium. The premium price adjusts the bond’s yield to 2 percent, which is
the market yield that similar bonds are offering.
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 Zero Coupon Bonds
• Zero coupon bonds have no coupon payment but promise a single
payment at maturity. The interest paid to the holder is the difference
between the price paid for the security and the amount received on maturity
(or price received when sold).

• Common examples of zero coupon securities are U.S. Treasury bills and
U.S. savings bonds, or MTB (in Pakistan, i.e., T-Bills).

• Generally, most money market instruments (securities with maturities of less

than 1 year) are sold on a discount basis (issued at a price less than face
value), meaning that the entire return on the security comes from the
difference between the purchase price and the face value.

• In addition, some corporations have issued zero coupon bonds.

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 Bond Prices & Yields
• Bond prices and yields vary inversely. Specifically, as the market
rate of interest (or yield) rises, a bond’s market price declines; or as
the market rate of interest (or yield) declines, a bond’s market price
rises.

• This inverse relationship exists because the coupon rate or interest

rate on a bond is fixed at the time the bond is issued. For example,
when market interest rates rise, the only way to increase a bond’s
yield to be equal to the market rate of interest is to reduce the
bond’s price because the rate of interest the bond pays is fixed for
the life of the bond contract. The investor in such a bond is “paid”
the additional interest as a capital gain.

• Likewise, if market interest rates decline, the only way to reduce a

bond’s yield to the market rate is to increase the bond’s price.

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 Interest Rate Risk & Duration
Interest Rate Risk
•Interest rate risk is the risk related to changes in interest rates that cause a
bond’s total return to differ from the promised yield or yield-to-maturity.
•Interest rate risk comprises two different but closely related risks:
(1) price risk and (2) reinvestment risk.
•Price risk is defined by the first bond property, namely, bond prices and bond
yields are inversely related. Increases in interest rates lead to capital losses
that cause total returns to decline. Conversely, decreases in interest rates lead
to capital gains that cause total returns to rise. These fluctuations in total return
caused by capital gains and losses constitute price risk.
•Reinvestment risk is a trickier concept. Remember, when we calculated
yield-to-maturity, we noted that the bond pricing formula assumes that all
coupon payments are reinvested at the bond’s yield-to-maturity. Given that
interest rates fluctuate, it is unlikely that an investor will reinvest all coupon
payments at the promised yield. If, for example, interest rates increase over the
life of a bond, coupons will be reinvested at higher yields, increasing
reinvestment income.
•The increase in reinvestment income increases the total return of the bond. If
interest rates decline, the converse is true. The change in a bond’s total return
caused by changing coupon reinvestment rates is what constitutes
reinvestment risk. 23
 Interest Rate Risk & Duration
Duration
•It is important for investors and financial institutions to be able to
evaluate the effect of interest rate risk on their bond investments.
•How can we measure interest rate risk? The problem we have is that
bond price volatility varies directly with maturity and inversely with
coupon rate.
•A good measure of interest rate risk should account for both effects
simultaneously. A measure of interest rate risk (or bond price volatility)
that considers both coupon rate and maturity is duration.

•Duration is a weighted average of the number of years until each of the

bond’s cash flows is received.

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 End

Capital Markets