LESSON: BOND MARKET

BOND
A bond is a debt investment in which an investor loans money to an entity which borrows the funds for a
defined period of time at a fixed interest rate.

Bonds are long-term debt securities that are issued by the government agencies and corporations. They
have interest payments which occur annually or semi-annually. Par value is paid at maturity which is
normally between a period of 10 years and 30 years.

BOND MARKET
A place where debt securities are issued and traded.

Issuer:
● Commercial Banks
○ Commercial banks are financial institutions that accept deposits, offer checking account
services, and make various loans. They also have products like savings accounts for
individuals and small businesses as well as certificates of deposit.
○ BDO Private Bank, Inc.; Philippine Veterans Bank; Robinsons Bank Corp.
● Finance Companies
○ A Financing Company is a corporation which is primarily organized for the purpose of
extending credit facilities to consumers and to industrial, commercial, or agricultural
enterprises, by direct lending or by discounting or factoring commercial papers or
accounts receivable, or by buying and selling contracts, leases, chattel mortgages, or
other evidences of indebtedness, or by financial leasing of movable and immovable
property.
○ PAGASA PHILIPPINES FINANCE CORPORATION (FORMERLY: PAGASA
PHILIPPINES LENDING COMPANY, INC.)
● Savings Institutions
○ Savings institutions, sometimes called thrift institutions, are banks that serve a local
community. They take the deposits of local residents and lend the money back in the
form of consumer loans, mortgages, and small business loans.
○ Bataan Development Bank; Bataan Savings and Loan Bank; BPI Direct BanKo, Inc. ( a
subsidiary of BPI)

Investors:
● Commercial Banks
● Savings Institution
● Bond Mutual Funds
○ A bond fund is simply a mutual fund that invests solely in bonds. For many investors, a
bond fund is a more efficient way of investing in bonds than buying individual bond
securities.
 ● Insurance Companies
○ A business that provides coverage, in the form of compensation resulting from loss,
damages, injury, treatment or hardship in exchange for premium payments. The company
calculates the risk of occurrence then determines the cost to replace (pay for) the loss to
determine the premium amount.

● Pension Funds
○ Pension funds are investment pools that pay for workers' retirements. Funds are paid for
by either employees, employers, or both.

TREASURY BONDS
The Bureau of Treasury commonly issues treasury bills, treasury notes and treasury bonds to finance the
government expenditure.

Many governments of different countries want to use a fiscal policy of spending more money than it
receives from taxes. These treasury bonds are issued by the Treasury Department of each government. It
is attractive to investors because treasury bonds are free from credit risk.

The treasury announces the plans for an auction including the date, amount of funds it needs and the date
of the maturity of the bonds.

Bond dealers serve as intermediaries in the secondary markets by matching up the buyers and sellers of
treasury bonds. They set an ask price and wait for the bidding. These dealers gain profit from the spread
of ask price and bid price

SAVINGS BOND
● Savings bonds have higher attractiveness for lower price of bonds. Savings bonds have 30 years
of maturity. The money can be redeemed any time after 12 months of issue and there is a penalty

FEDERAL AGENCY BONDS

These bonds are issued by federal agencies and use proceeds to purchase mortgages in the secondary
market. Main objective of issuing these bonds is to ensure sufficient finance for owners who wish to
obtain a mortgage.

MUNICIPAL BONDS
A municipal bond is a bond issued by the Government or state or local government.
 MUNICIPAL BONDS

GENERAL OBLIGATION BONDS REVENUE BONDS

Payments on general obligation bonds Payments on revenue bonds are

are generated by municipal generated by revenues of project
government’s ability to tax.

CALL PROVISIONS
Most municipal bonds contain a call provision which allows the user to repurchase the bonds at a
specified price before the bonds mature.

CREDIT RISKS OF MUNICIPAL BONDS

● Both types of municipal bonds are subject to some degree of credit risk.
● Sometimes government has to spend more than the budget deficit
● But there is a risk that they might not be able to pay the premium. In this case the investors want
a higher risk premium.
● Again, due to little disclosure of the economy in the state there lies a risk in investing in
municipal bonds.
RATINGS OF MUNICIPAL BONDS
● Due to risk of defaults, investors commonly monitor the rating of municipal bonds.
● The higher the rating, the less the issuer has to pay to risk premium.
● This enables the issuer to issue the municipal bonds at a higher price.

INSURANCE AGAINST CREDIT RISK OF MUNICIPAL BONDS

● Some municipal bonds are insured to protect against default.
● The issuer pays for this protection money to issue the bond at a higher price.

VARIABLE RATES OF MUNICIPAL BONDS

● Variable rate municipal bonds have a floating interest rate that is based on the benchmark interest
rate.
● In this case the coupon payment adjusts the movement in the benchmark
● But under some certain conditions variable rates can be converted to a fix rate.

TAX ADVANTAGE OF MUNICIPAL BONDS

● The interest income is exempt from federal taxes
● The interest income earned on bonds that are issued by a municipality within a particular state is
normally exempt from the income tax of that state.
TRADING AND QUOTATIONS OF MUNICIPAL BONDS
● There are hundreds of bond dealers that can accommodate investors' requests to buy or sell
municipal bonds in the secondary market.
● Investors who expect that they will not hold a bond until maturity should only consider bonds that
feature active secondary market trading.

YIELD OFFERED ON MUNICIPAL BONDS

The yield offered by a municipal bond differs from the yield on a treasury bond with the same maturity
for three reasons.
● The municipal bond must pay a risk premium to compensate for the possibility of default risk.
● The municipal bonds must pay a slight premium to compensate for being less liquid than treasury
bonds with the same maturity.
● The income earned from municipal bonds is exempt from federal taxes.

CORPORATE BONDS
Long term debt securities issued by corporation that promises the investor coupon payments on a
semiannual basis
● Bonds maturity is typically between 10 to 30 years but corporations may issue bonds more than
this period.
● Bonds have tax advantages for issuer

CORPORATE BOND OFFERINGS

⮚ Public offerings:
o Whenever a corporation plans to issue bonds, it hires a security firm to underwrite bonds.
The bonds underwriter assesses the circumstances and determines to set a price for the
bond. Before placing in the market, the proposal must be registered by Securities and
Exchange Commission (SEC). After approval the underwriter will distribute the
prospectus to other security firms to help the bonds to place in the market.
⮚ Private placements
o Small firms borrow relatively small amounts of funds by private placement rather than
Public offering. A private placement does not have to be registered with the Security and
Exchange Commission but has to disclose all financial data to the investors. Generally
institutional investors are the main buyer of the private placement.

CREDIT RISK OF CORPORATE BOND

Corporation bonds are subject to the risk of default. So, there is a risk premium in yield that is paid by the
corporation. Risk level depends on the economic situation.
▪ Bond ratings as a measure of credit risk: rating agencies rate the corporate bonds. Higher
rated bonds can be placed at higher prices because of the lower credit risk.
o Example: Coca-Cola and IBM issued bonds in 2012 at a yield of less than 2%
▪ Junk bond: corporate bonds that have higher risk are called junk bonds. Junk bonds offer
high yields that contain a risk premium for higher risk.
SECONDARY MARKET FOR CORPORATE BONDS
▪ Dealer role in secondary market:
o This market is served by dealers and they can play a broker role by matching up
buyers and sellers. They also have inventory of bonds. Dealers commonly handle
large transactions.
▪ Liquidity in secondary market
o Bonds issued by large and well-known corporations in large volume are highly liquid
and small corporations in small volume are less liquid. So small corporation may
have to accept a discounted price to attract investors

ELECTRONIC BOND NETWORKS

This is a platform for institutional investors who wish to buy and sell bonds in the secondary market.
Because of these platforms institutional investors can easily know the ensuring bond to be sold/bought in
the market. Main reason to establish the platform is to reduce the transaction cost.

Types of order through broker:

▪ Market order
▪ Limit order

Trading online: popularity in trading online is increasing because of transparency. In this way investors
can know the spread of bid and ask. The online service charges a standard fee for every trade.

CHARACTERISTICS OF CORPORATE BONDS

▪ Sinking-fund provision
o A requirement that the firm retire a certain amount of the bond issued each year.
This provision is considered to be an advantage to the remaining bond holder
because it reduces the payments necessary at maturity
▪ Protective covenants
o Bond indentures normally place restrictions on the issuing firm that are designed
to protect bond holders from being exposed to increasing risk during the
investment period. It is an agreement between the issuer & the holder of a bond,
requiring or forbidding certain actions of the issuer
▪ Call provisions
o A call provision is a provision on a bond that allows the original issuer to
repurchase and retire the bonds.
▪ Bond collateral
o Bonds can be secured by collateral and by the nature of that collateral. Usually,
the collateral is a mortgage on real property. A first mortgage bond is secured
by personal property. Bonds unsecured by specific property are called
debentures. Subordinated debentures have claims against the firm’s assets that
are junior to the claims of both mortgage bonds and regular debentures.
▪ Low-and zero-coupon bonds
 o Long term debt securities that are issued at deep discount from par value. To the
issuing firm, these bonds have the advantage of requiring low or no cash outflow
during their life.
▪ Variable-rate bonds
o Long term debt securities with a coupon rate that is periodically adjusted. Most
of these bonds tie their coupon rate to the London Interbank offer rate (LIBOR),
the rate at which banks lends funds to each other on an international basis. The
rate is adjusted every three months.
▪ Convertibility
o A convertible bond allows investors to exchange the bond for the stated number
of shares of the firm’s common stock. This conversion offers investors the
potential for high returns. Investors are therefore willing to accept a lower rate of
interest on these bonds, which allows the firm to obtain financing at lower cost.

HOW CORPORATE BONDS FINANCE RESTRUCTURING

▪ Using bonds to finance a leverage buy out
o Leverage Buy-out (LBO) involves the use of debt to purchase shares and make the
company private
o To cover large amount of debt payments, the owner might sell off some assets of the firm
for the cash
o If improved operating performance, firms engaged in LBO will go public
▪ Using bonds to revise capital structure
o Issuance of bonds to change capital restructure when they have sufficient of cash
flow
o Debt is cheaper than equity
o Debt for equity swap (issuing bonds to repurchase existing stock)