CHAPTER 3:

BOND MARKETS

Dr. LINH DUY NGUYEN

FACULTY OF FINANCE
BANKING UNIVERSITY OF HCMC
 CONTENTS
2

I. Introduction
II. Types of bond
III. Bond yields and risk in investing bond
IV. Issuance in the primary market
V. Transactions in the secondary market
 I. INTRODUCTION
3

 Bonds are securities that represent a debt owed by the issuer to

the investor. Bonds obligate the issuer to pay a specified amount
at a given date, generally with periodic interest payments.
 The par, face, or maturity value of the bond (they all mean the
same thing) is the amount that the issuer must pay at maturity.
 The coupon rate is the rate of interest that the issuer must pay,
and this periodic interest payment is often called the coupon
payment. This rate is usually fixed for the duration of the bond
and does not fluctuate with market interest rates.
 If the repayment terms of a bond are not met, the holder of a bond
has a claim on the assets of the issuer.
I. INTRODUCTION
4
I. INTRODUCTION
5
6
I. INTRODUCTION
7
I. INTRODUCTION
8
 CHARACTERISTICS OF BONDS
9

 Be a debt security, representing the lenders' rights

(bondholders) to the borrower (issuer).
 The interest payments are fixed (except for floating-rate
bonds) and do not depend on firms’ performance
 The interest payments are a tax deduction on the borrower's
income tax return.
 Have a maturity, and face value will be repaid to the
bondholder upon maturity.
 In case of bankruptcy, insolvency or liquidation,
bondholders receive payment before common stock
shareholders.
 II. TYPES OF BOND
11

1. By issuers
2. By coupon structure
3. By embedded options
4. By bond rating
5. By location
6. By collateral
 1. BY ISSUERS
12

 Government bonds
 Municipal bonds
 Corporate bonds
 1. BY ISSUERS
13

 Government bonds
A government bond is a debt security issued by a
government to support government spending and
obligations.
 Government bonds issued by national governments
are often considered low-risk investments since the
issuing government backs them.
 1. BY ISSUERS
14

 Municipal bonds
 Municipal bonds are securities issued by local, county, and
state governments.
 The proceeds from these bonds are used to finance public
interest projects, such as schools, utilities, and
transportation systems.
 Interest earned on municipal bonds that are issued to pay
for essential public projects are exempt from federal
taxation.
 1. BY ISSUERS
15

 Corporate bonds
 Corporate bonds are bonds issued by corporations.
 The degree of risk varies widely among different bond
issues because the risk of default depends on the
company’s health, which can be affected by a number
of variables.
 The interest rate on corporate bonds varies with the
level of risk.
 2. BY COUPON STRUCTURE
16

 Coupon bonds
 A coupon bond includes attached coupons and pays periodic
(typically annual or semi-annual) interest payments during
its lifetime and its par value at maturity.
 Zero-coupon bonds
 A zero-coupon bond (also discount bond) does not make
periodic interest payments but instead trades at discounts.
When the bond reaches maturity, its investor receives its par
(or face) value
 The difference between the purchase price of a zero-coupon
bond and the par value indicates the investor's return.
 3. BY EMBEDDED OPTIONS
17

 Convertible bonds
 Callable bonds
 Putable bonds
 Floating-rate bonds
 Conventional bonds
 3. BY EMBEDDED OPTIONS
18

 Convertible bonds
 A convertible bond is a type of bond that provides a holder
with a right to convert the bond into a specified number of
common stock in the issuing firm.
 This right benefits bondholders, so the holders obtain a lower
yield relative to that of a straight/conventional bond.
 A convertible bond has two values:
 The value of straight bond: equals the market value of the bond
 The value of conversion: equals the market value of shares, which
can be converted from each bond
 The conversion ratio – also called the conversion premium –
determines how many shares can be converted from each bond.
 3. BY EMBEDDED OPTIONS
19

 Convertible bonds
 Ex: A convertible bond has a conversion ratio of 25:1 (means
one bond can be exchanged for 25 shares of stock), a par value
of $1,000. The market price of this bond is $1,130 and that of
the stock in the issuing firm is $45. The issuing firm want to
repurchases this bond with the price of $1,070. Which option
will you choose?
 A) Covert this bond and sell the stocks in the market
 B) Sell this bond to the issuing firm
 C) Sell this bond in the market
 3. BY EMBEDDED OPTIONS
20

 Callable bonds
A callable bond is a debt security that can be redeemed
early by the issuer before its maturity at the issuer's
discretion.
 A callable bond allows companies to pay off their debt
early and benefit from favourable interest rate drops.
 A callable bond benefits the issuer, and so investors of
these bonds are compensated with a more attractive
interest rate than on otherwise similar non-callable bonds.
 3. BY EMBEDDED OPTIONS
21

 Putable bonds
A putable bond is a debt instrument with an embedded
option that gives bondholders the right to demand early
repayment of the principal from the issuer.
 If interest rates rise after bond purchase, the future value
of coupon payments will become less valuable. Therefore,
investors sell bonds back to the issuer and may lend
proceeds elsewhere at a higher rate.
 Bondholders are ready to pay for such protection by
accepting a lower yield relative to that of a straight bond.
 3. BY EMBEDDED OPTIONS
22

 Floating-rate bonds
 A floating-rate bond is a bond whose interest rate is adjusted
periodically according to a predetermined formula;
 Its interest rate usually equal to a money market reference rate,
like LIBOR, plus a quoted. The spread is a rate that remains
constant.
 A typical coupon would look like 3 months USD LIBOR
+0.20%.
 3. BY EMBEDDED OPTIONS
23

 Conventional bonds
 A conventional bond or a straight bond does not have any
embedded option.
 This bond has only a specified face value, interest payment
frequency, interest rate, and maturity date.
 4. BY BOND RATING
24

 The bond credit rating represents the credit worthiness of

corporate or government bonds. The ratings are published
by credit rating agencies (such as Standard & Poor’s,
Moody’s and Fitch) and used by investment professionals to
assess the likelihood the debt will be repaid.
 Bonds with a rating of BBB- or Baa3 or a higher level are
called investment-grade bonds and bonds that have a rating
lower than BB or Ba are called junk bonds (also called
high-yield bonds) because they have an elevated risk of
default and hence higher yields.
 Moody's S&P Fitch
Rating description
Long-term Short-term Long-term Short-term Long-term Short-term
Aaa AAA AAA Prime
Aa1 AA+ AA+
A-1+ F1+
Aa2 AA AA High grade
P-1
Aa3 AA− AA−
A1 A+ A+ Investment-
A-1 F1
A2 A A Upper medium grade grade

A3 A− A−
P-2 A-2 F2
Baa1 BBB+ BBB+
Baa2 BBB BBB Lower medium grade
P-3 A-3 F3
Baa3 BBB− BBB−
Ba1 BB+ BB+
Non-investment
Ba2 BB BB grade
speculative
Ba3 BB− BB−
B B
B1 B+ B+
B2 B B Highly speculative
Non-
B3 B− B− investment
Caa1 CCC+ Substantial risks grade

Extremely
Caa2 Not prime CCC AKA high-
speculative
yield bonds

Caa3 CCC− C CCC C

Default imminent AKA junk
with little prospect for bonds
CC recovery
Ca
C
C DDD
D / DD / In default
/
D

25
 5. BY LOCATION
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 Domestic bonds
 Foreign bonds
 Euro bonds
 5. BY LOCATION
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 Domestic bonds
 A domestic bond is an obligation of a domestic issuer,
denominated in domestic currency, and sold and traded in
the domestic market.
 E.g., a British company issues debt in the United Kingdom
with the principal and interest payments based or
denominated in British pounds.
 5. BY LOCATION
28

 Foreign bonds
 Foreign bonds are sold in a foreign country and are
denominated in that country’s currency. E.g., a British
company issues debt in the United States with the
principal and interest payments denominated in dollars.
 Eurobonds
 Eurobonds are bond issued by a non-resident and
denominated in a currency other than that of the country in
which it is sold. E.g., a British company issues debt in the
United States with the principal and interest payments
denominated in British Pound.
 6. BY COLLATERAL
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 Secured bonds
 Secured bonds are those that are collateralized by assets, such as
property, equipment (especially for airlines, railroads, and
transportation companies), or by another income stream. Mortgage-
backed securities (MBS) are an example of a single bond-type
secured by both the physical assets of the borrowers.
 Unsecured bonds
 Unsecured bonds are not secured by a specific asset, but rather by
"the full faith and credit" of the issuer. In other words, the investor
has the issuer’s promise to repay but has no claim on specific
collateral.
 III. BOND YIELDS AND RISK IN INVESTING BOND
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1. Bond yields
2. Main risk in investing bond
3. Bond valuation

TS. Nguyễn Duy Linh

 1. BOND YIELDS
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A. Nominal yield
B. Current yield
C. Promised yield to maturity (YTM)

 Nominal and current yields are mainly descriptive and

contribute little to investment decision making

TS. Nguyễn Duy Linh

 A. NOMINAL YIELD
32

 Nominal yield
 Be the coupon rate of a particular issue, e.g., a bond with an 8
percent coupon rate has an 8 percent nominal yield.
 This provides a convenient way of describing the coupon
characteristics of an issue.

TS. Nguyễn Duy Linh

 B. CURRENT YIELD
33

 This yield measures the current income from the bond as a

percentage of its price:
CY=
MP

 C is the fixed annual coupon

 MP0 is the bond’s current market price

 It is important to income-oriented investors (e.g., retirees)

who want current cash flow from their investment
portfolios.
 Current yield has little use for investors who are interested
in total return because it excludes the important capital gain
or loss component.
TS. Nguyễn Duy Linh
 C. PROMISED YIELD TO MATURITY
34

 The yield to maturity (YTM) is defined as the interest rate

that makes the present value of a bond’s payments equal to
its price.
 This interest rate is often interpreted as a measure of the
average rate of return that will be earned on a bond if:
 The investor holds the bond to maturity

 The investor reinvests all the interim cash flows at the

computed YTM rate

TS. Nguyễn Duy Linh

 C. PROMISED YIELD TO MATURITY
35

 Computing the promised yield to maturity

−
= +
+
1+ 1+ ~
+
2

 YTM for a zero-coupon bond

= = −1
1+

TS. Nguyễn Duy Linh

 C. PROMISED YIELD TO MATURITY
36

 Example 1: You buy an 8% coupon, 20-year bond with the

price of $900, face value = $1,000. Calculate a semi-annual
promised YTM and an annual promised YTM.
 Example 2: A zero coupon bond maturing in 10 years with a
maturity value of $1,000 selling for $311.80. Calculate a
semi-annual promised YTM and an annual promised YTM.
 Example 3: Suppose an 8% coupon, 30-year bond is selling
at $1,276.76. What average rate of return would be earned
by an investor purchasing the bond at this price?

TS. Nguyễn Duy Linh

37
 C. PROMISED YIELD TO MATURITY
39

 Premium Bonds:
Coupon rate > Current yield > YTM

 Discount Bonds:
Coupon rate < Current yield < YTM

 Far value = Market price

Coupon rate = Current yield = YTM

TS. Nguyễn Duy Linh

 2. MAIN RISKS IN INVESTING BOND
40

A. Interest rate risk

B. Reinvestment risk
C. Credit (default) risk
D. Inflation risk
E. Liquidity risk
F. Exchange rate risk

TS. Nguyễn Duy Linh

 A. INTEREST RATE RISK
41

 Interest rate risk is the riskiness of an asset’s return that

results from interest-rate changes. In particular, bond prices
and yields are inversely related.
 As interest rates rise or fall, bondholders experience capital
losses or gains. These gains or losses make fixed-income
investments risky, even if the coupon and principal
payments are guaranteed.
 Interest rate risk increases for bonds with longer maturities
and lower coupon payments, and decreases for bonds with
shorter maturities and higher coupon payments.

TS. Nguyễn Duy Linh

 B. REINVESTMENT RISK
42

 Reinvestment risk is the component of interest rate risk due

to the uncertainty of the rate at which coupon payments/the
proceeds from the short-term bond will be reinvested.
 Reinvestment risk is related to interest rate risk but has the
opposite effect on a bond's performance.
 Reinvestment risk increases for bonds with longer
maturities and higher coupon payments, and decreases for
bonds with shorter maturities and lower coupon rates.

TS. Nguyễn Duy Linh

 C. CREDIT RISK
43

 Credit (default) risk occurs when the issuer of the bond is

unable or unwilling to make interest payments when
promised or to pay off the face value when the bond
matures.
 Bond default risk is measured by Moody’s Investor
Services, Standard & Poor’s Corporation, and Fitch
Investors Service.

TS. Nguyễn Duy Linh

 D. INFLATION RISK
44

 Inflation risk occurs when the increase in inflation reduces

the purchasing power of a bond’s future coupons and
principal.
 Inflation may lead to higher interest rates which is negative
for bond prices.
 Inflation Linked Bonds are structured to protect investors
from the risk of inflation. The coupon stream and the
principal (or nominal) increase in line with the rate of
inflation and therefore, investors are protected from the
threat of inflation.

TS. Nguyễn Duy Linh

 E. LIQUIDITY RISK
45

 This is the risk that investors may have difficulty finding a

buyer when they want to sell and may be forced to sell at a
significant discount to market value.
 The more liquid an asset is, the more desirable it is (higher
demand), holding everything else constant.
 Bonds that trade frequently and in large amounts, such as
Treasury securities, usually have less liquidity risk than
bonds which trade less frequently.
 Liquidity risk becomes a smaller factor in overall return as
the holding period lengthens.

TS. Nguyễn Duy Linh

 F. EXCHANGE RATE RISK/CURRENCY RISK
46

 An investor is exposed to currency risk if a bond is

denominated in a currency other than his home currency.
Exchange rate risk arises from uncertainty in exchange rate
fluctuations.

 We can assess the magnitude of exchange rate risk by

examining historical rates of change in various exchange
rates and their correlations.

TS. Nguyễn Duy Linh

 3. BOND VALUATION
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A. Valuing a coupon bond

B. Valuing a zero-coupon bond (discount bond)
C. Valuing a perpetual bond

TS. Nguyễn Duy Linh

 V. BOND VALUATION
48

 General rule: The value of a financial asset is the present

value of the cash flows the asset is expected to provide.

0 1 2 3 …. n

C C C C C+F
 V. BOND VALUATION
49

 The process of valuation includes the following steps:

 Calculate the expected cash flow created by the asset (CF)
 Estimate the discount rate (r)

 Calculate the present value (P0)

= + +. . . +
(1 + ) (1 + ) (1 + )
 A. VALUING A COUPON BOND
50

 The value of a coupon bond is the present value of the interest

payments plus the present value of the principal payment:
 The interest payments are paid annually
1
= + = 1− +
(1 + ) (1 + ) (1 + ) (1 + )

 The interest payments are paid semi-annually

= 2 +
/2 1
= 1− +
1+
2 1+
2 /2 (1 + /2) (1 + /2)

• C: the annual coupon payment • i: the prevailing yield to maturity

• n: the number of years to maturity for this bond issue
• F: the par (face) value of the bond
TS. Nguyễn Duy Linh
 VALUING A COUPON BOND
51

 Example: Let’s calculate the value of an 8.5% coupon bond

that matures in 5 years with a par value of $100,000 in the
following cases:
 A) Semi-annual compounding, assuming the YTM for this bond is:
 8%
 8.5%
 10%

 B) Annual compounding, assuming the YTM for this bond is:

 8%
 8.5%
 10%

TS. Nguyễn Duy Linh

52
53
 VALUING A COUPON BOND
THE PRICE-YIELD CURVE
55

The Price-Yield Curve for a 20-Year, 8% Coupon Bond

Price
2,500

1,985
2,000

1,547
1,500
1,231

1,000
1,000 828
699
600
523
500

- YTM
0% 2% 4% 6% 8% 10% 12% 14% 16% 18%

TS. Nguyễn Duy Linh

 B. VALUING A ZERO-COUPON BOND
58

 The value of a zero-coupon bond is present value of the

principal payment:
 The interest payments are paid annually
=
(1 + )

 The interest payments are paid semi-annually =

(1 + /2)

• n: the number of years to maturity • i: the prevailing yield to maturity

• F: the par (face) value of the bond for this bond issue

TS. Nguyễn Duy Linh

 B. VALUING A ZERO-COUPON BOND
59

 Ex: Let’s calculate the value of a zero-coupon bond that

matures in 5 years with a par value of $100,000 in the
following cases:
 A) Semi-annual compounding, assuming the YTM for this
bond is: 8%; 8.5%; 10%
 B) Annual compounding, assuming the YTM for this bond
is: 8%; 8.5%; 10%

TS. Nguyễn Duy Linh

60
61
 B. VALUING A ZERO-COUPON BOND
63

 Ex: A zero-coupon bond has a par value of $1,000,000 and

matures in 5 years.
a) Calculate the price of the bond if YTM = 15%

b) How much is the expected return rate if an investor buy

this bond at $500,000?

TS. Nguyễn Duy Linh

64
 C. VALUING A PERPETUAL BOND
65

 Perpetual bonds are fixed income securities which are not

redeemable, i.e., they do not have a maturity date.

 The value of a perpetual bond is the coupon amount

which divided by the discount rate.

TS. Nguyễn Duy Linh

 EXAMPLE
66

A bond has following characteristics:

 FACE VALUE : 100.000 USD
 COUPON RATE : 10%
 ISSUED DATE : 09/05/2006
 MATURITY DATE : 09/05/2016
 TERM : 10 YEARS
 FREQUENCY : ANNUAL
 PRICE :110.000 USD
 Prevailing Rate : 9%
Should we buy it? Why or why not?

Chương 3: Thị trường trái phiếu

67
 IV. ISSUANCE IN THE PRIMARY MARKET
68

 Bidding procedures for government bonds

A. Method
B. Determination of purchasing price
C. Examples
 A. METHOD
69

 The competitive bid:

 Fixed-rate tender
 Variable-rate tender

 Combination of competitive bid and non-competitive

bid
 Fixed-rate tender

 Variable-rate tender
 B. DETERMINATION OF PURCHASING PRICE
70

 For a discount bond

 Purchasing price: =
1+
G : The price of a T-bill
MG : The par value of a bond
Ls : Bid-winning interest rate (%/year)
n : Term to mautiry (year)

 At maturity: T = par value

 B. DETERMINATION OF PURCHASING PRICE
71

 For a coupond bond whose coupon rate has not been specified
 Purchasing price: G = Par value

 Periodic interest payment: L = MG × Ls / k

L : Interest payment
k : Number of interest payments per year

 At maturity: T = Par value + L

 B. DETERMINATION OF PURCHASING PRICE
72

 For a coupond bond whose coupon rate has ALREADY

been specified
 Purchasing price:
× 1 MG
= 1 − +
Ls 1 + 1 +

 Lt: the nominal rate (coupon rate)

 Ls: Bid-winning interest rate

 Periodic interest payment: L = MG × Lt

 At maturity: T = Par value + L
 C. EXAMPLES
73

 MOF issues government bonds to mobilize VND 380 billion

for investment projects
 Type of the bond : Coupon;
 Par value : VND 1.000.000;
 Coupon rate : 9%/year;
 Maturity : 10 years;
 Number of interest payments per year: 2
 Bid method : The competitive bid (Fixed-rate tender)
 There are 10 members who join the auction:
 Submitted Submitted
Member interest rate Volume
(%) (VND billion)
1 9.50 50
2 9.20 60
3 9.00 80
4 8.50 70
5 8.50 90
6 8.00 100
7 7.00 50
8 7.00 40
9 6.00 60
10 5.00 50
Game Theory 74
 C. EXAMPLES
75

 Let’s calculate:
a) Bid-winning interest rate and bid-winning volume for
each member
b) Does member 1 win the auction?
c) Assuming that member 10 sell these bonds to investor X
after the 2-year holding period. The expected return rate
of X is 7.0%. Let’s calculate the price of the bond
76
77
 V. TRANSACTIONS IN THE SECONDARY MARKET
79

 The Viet Nam bond market consists of two market

segments:
 the OTC market and
 the exchange market

 Traditionally, most bonds were traded in the OTC market

bilaterally by phone or some other measure.
 More than 90% of all bonds issued in Viet Nam are
government-sector bonds.
80
 V. TRANSACTIONS IN THE SECONDARY MARKET
81

 Corporate bonds listed on HNX and HOSE are traded on

these two exchanges, although trading volumes and values
are still very small compared with those of unlisted bonds.
Unlisted corporate bonds are traded in the OTC market.
 Government bonds—comprising central government
bonds, government-guaranteed bonds, and municipal
bonds—and foreign-currency-denominated bonds are
listed and traded in the specialized government bond
market, which is operated by HNX.
82