BM2213

BONDS

Issuer of Bonds

A bond is a long-term contract under which a borrower agrees to pay interest and principal payments on specific
dates to the bondholders. Bonds are issued by corporations and government agencies looking for long-term
debt capital (Brigham & Houston, 2022). In straightforward terms, a bond is an obligation by the borrower (bond
issuer) to pay the lender (bondholder) a specific amount of money in the future. Like stocks, bonds are issued
to raise funds. If a company, for example, needs money to expand the business or payout loans, it can choose
to issue either stocks or bonds to raise capital (Jonas, 2017).

Illustration: On January 4, 20CY, McRamos Food Products borrowed P170,000,000 by issuing P170,000,000
bonds. Assume that McRamos sold 170,000 individual bonds for P1,000 each. It could have sold one (1)
P170,000,000 bond, 17 bonds each with a P10,000,000 face value, or any other combination that totaled
P170,000,000. In any event, McRamos received the P170,000,000; in exchange, it promised to make annual
interest payments and repay the P170,000,000 on specified maturity date.

Technically, bonds refer to debt instruments with maturities of 10 years or more. Most people use the term
“bonds” loosely to refer to almost any debt instrument, regardless of maturity (Jonas, 2017).

By Maturity Period
• Bill – A fixed-income instrument that matures in one (1) year or less. A common example is the short-term
debt obligation of governments, usually called Treasury Bills or T-Bills.
• Note – A debt obligation that matures between two (2) and 10 years. An example is the government’s
Treasury Note or T-Notes.
• Bond – A fixed-income instrument that matures in 10 years or more.

By the Issuer
• Treasury securities – A fixed-income instrument issued by the national government through its Treasury
Department. Depending on the maturity period, these may be Treasury Bills (T-Bills), Treasury Notes (T-
Notes), or Treasury Bonds (T-Bonds).
• Government agencies can also issue bonds to raise funds.
o Examples of these agencies in the US include:
- Government National Mortgage Association (GNMA); and
- Government-sponsored enterprises like the Federal National Mortgage Association, Federal Home
Loan Bank Corporation, and Student Loan Marketing Association.
o Pag-IBIG or the Home Development Mutual Fund also issues bonds to raise needed capital in the
Philippines.
- General Obligation Bond – Municipal bonds backed by the full taxing power of the municipality.
- Revenue Bonds – Bonds issued by the municipality to finance a government project whose interest
and principal payments depend on that project's income. Examples are Puerto Princesa Green
Bonds, Boracay-Aklan Provincial Bonds, and Tagaytay City Tourism Bonds.
• Corporate bond – A bond issued by a business entity. Corporations use bonds as an alternative to stocks
in raising capital. Philippine companies that regularly issue corporate bonds include Ayala Corporation,
Globe Telecom, JG Summit Corporation, and Filinvest Land.

By Interest Coupon Structure

• Zero-coupon bond – A bond that does not pay any interest rate. Since investors don’t receive interest
payments, the only way to earn is to buy these bonds at huge discounts so they can profit afterward when
the bonds are redeemed at their par value.
• Accrual bond – A bond with a stated interest rate but is not paid until maturity. Investors don’t receive
interest before maturity but accrue and compound and are paid during maturity.
• Step-up bond – A bond that pays an initial interest rate for the period and a higher rate after that period.
For example, a 10-year maturity bond may offer 5% fixed interest for the first four (4) years, then 7% starting
on the 5th year.

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 1 of 9
 BM2213

• Floating-rate bond – A bond whose coupon rate is linked to a benchmark rate. This benchmark rate may
be the country’s inflation rate, the London Interbank Offered Rate (LIBOR), or other rates. For example, a
floating-rate bond that pays a coupon rate of 2% plus the inflation rate will pay 5% if the inflation rate is 3%.
If the interest rate is 5%, the bond will pay 7%.

Key Characteristics of Bonds (Lumen, 2019)

Par Value

Par value is the amount of money a holder will get back once a bond matures; a bond can be sold at par, at a
premium, or discount.
- When a bond trades at a price above the face value, it is said to be selling at a premium.
- When a bond sells below face value, it is said to be selling at a discount.
- A bond’s price fluctuates throughout its life in response to several variables, including interest rates and
time to maturity.
- Pull to par is the effect in which the price of a bond converges to par value as time passes. At maturity, the
price of a debt instrument in good standing should equal its par (or face value). This effect is also called the
“reduction of maturity.” It results from the difference between the market interest rate and the nominal yield
on the bond.

Coupon Interest Rate

The coupon rate is the interest the bondholder will receive per payment, expressed as a percentage of the par
value (Lumen, 2019).
- The name “coupon” arose because, in the past, paper bond certificates were issued that had coupons
attached to them, one for each interest payment. On the due dates, the bondholder would hand in the
coupon to a bank in exchange for the interest payment.
- Coupon interest rate is usually fixed throughout the life of the bond. It can also vary with a money market
index.
- Not all bonds have coupons. Zero-coupon bonds are those that pay no coupons and thus have a coupon
rate of 0%. Such bonds make only one (1) payment – the face value payment on the maturity date. Usually,
to compensate the bondholder for the time value of money, the price of a zero-coupon bond will always be
less than its face value on any date before the maturity date. The bondholder receives the full principal
amount on the redemption date.

Illustration: Assume a bond with a par value of P1,000 pays P100 interest each year. The bond’s coupon
𝑃100
payment is P100, so its coupon interest rate is 𝑃1,000 = 10%. The P100 is the annual income that an investor
receives when investing in a bond.

Maturity Date

Maturity date refers to the final payment date of a loan or other financial instruments, at which point the principal
(and all remaining interest) is due to be paid.
- The issuer must repay the nominal amount on the maturity date. If all due payments have been made, the
issuer has no further obligations to the bondholders after the maturity date.
- The length of time until the maturity date is referred as the term or tenor, or maturity of a bond.
- The maturity can be any length of time, although debt securities with a term of less than one (1) year are
generally designated money market instruments rather than bonds. Most bonds have a term of up to 30
years. Some bonds have been issued with terms of 50 years or more; historically, there have been some
issues with no maturity date (irredeemable).

Typically, the maturity of a bond is fixed. However, it is important to note that bonds are sometimes “callable,”
meaning that the debt issuer can pay back the principal at any time. In this case, the maturity date is the day
when the bond is called. Thus, investors should inquire, before buying any fixed-income securities, whether the
bond is callable or not. Bonds can also be puttable, meaning that the holder has the right, but not the obligation,

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 2 of 9
 BM2213

to demand early repayment of the principal. Similarly, the maturity date, if applicable, is the date as the bond is
redeemed.

Illustration: If the bonds were issued on January 4, 2x16, and will mature on January 3, 2x31, the maturity of
the bonds is 15 years from when it was issued.

Most bonds have an original maturity (the maturity at the time the bond is issued) ranging from 10 to 40 years,
but any maturity is legally permissible. Of course, the effective maturity of a bond declines each year after it has
been issued. Thus, the illustration’s bonds had a 15-year original maturity. But in 2x17, a year later, they will
have a 14-year maturity; a year after that, they will have a 13-year maturity; and so on (Brigham & Houston,
2022).

Call Provisions

A callable bond (also called a redeemable bond) allows the issuer to retain the privilege of redeeming the bond
at some point before it reaches its maturity date. In other words, on the call date*, the issuer has the right, but
not the obligation, to buy back the bonds from the bondholders at a defined call price. Technically speaking, the
bonds are not bought and held by the issuer. They are instead canceled immediately.

*Call dates are the dates on which callable bonds can be redeemed early.

- If interest rates in the market have gone down by the time of the call date, the issuer will be able to refinance
its debt at a cheaper level and so will be incentivized to call the bonds it originally issued.
- Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a
premium known as the call premium.
- Price of callable bond = Price of straight bond – Price of call option. The price of a callable bond is always
lower than that of a straight bond* because the call option adds value to an issuer.

*A straight bond has no embedded options (call or put options).

The issuer has an option for which it pays in the form of a higher coupon rate. If interest rates in the market
have gone down by the time of the call date, the issuer will be able to refinance its debt at a cheaper level. The
issuer will be incentivized to call the bonds it originally issued. Another way to look at this interplay is that as
interest rates go down, the price of the bonds goes up. Therefore, it is advantageous to repurchase the bonds
at par value. With a callable bond, investors benefit from a higher coupon than they would have had with a
straight, non-callable bond. On the other hand, if interest rates fall, the bonds will likely be called, and they can
only invest at a lower rate.

Illustration: A call premium, often equal to one (1) year’s interest, on a 10-year bond with a 10% annual coupon
and a par value of P1,000 might be P100, which means that the issuer would have to pay investors P1,100 (the
par value plus the call premium) if it wanted to call the bonds.

In most cases, the provisions in the bond contract are set so that the call premium declines over time as the
bonds approach maturity. Also, although some bonds are immediately callable, in most cases, bonds are often
not callable until several years after the issue, generally five (5) to 10 years. It is known as a deferred call, and
such bonds are said to have call protection (Brigham & Houston, 2022).

Sinking Funds

In modern finance, a sinking fund is a method by which an organization sets aside money over time to retire its
indebtedness by repaying or purchasing outstanding loans and securities held against the entity. More
specifically, it is a fund into which money can be deposited so that preferred stock, debentures, or stocks can
be retired over time. Sinking funds can also be used to set aside money to replace capital equipment as it
becomes obsolete.

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 3 of 9
 BM2213

Sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired
periodically. The entire bond issue can be liquidated by the maturity date. Issuers may either pay to trustees,
which in turn call randomly selected bonds in the issue, or purchase bonds in an open market, then return them
to trustees.

A sinking fund may operate in one or more of the following ways:

• The firm may repurchase a fraction of the outstanding bonds in the open market each year.
• The firm may repurchase a fraction of outstanding bonds at a special call price associated with the sinking
fund provision (they are callable bonds).
• The firm has the option to repurchase the bonds at either the market price or the sinking fund price,
whichever is lower. The firm can only repurchase a limited fraction of the bond issue at the sinking fund
price. At best, some indentures allow firms to use a doubling option, which allows the repurchase of double
the required number of bonds at the sinking fund price.
• A less common provision is to call for periodic payments to a trustee, with the payments invested so that
the accumulated sum can be used for the retirement of the entire issue at maturity. Instead of the debt
amortizing over the life, the debt remains outstanding, and a matching asset accrues. Thus, the balance
sheet consists of Asset = Sinking fund, Liability = Bonds.

For the creditors, the fund reduces the risk the organization will default when the principal is due: it reduces
credit risk. However, if the bonds are callable, this comes at a cost to creditors. Because the organization has
an option on the bonds, the firm will buy back discount bonds (selling below par) at their market price while
exercising its option to buy back premium bonds (selling above par) at par. Therefore, if interest rates fall and
bond prices rise, a firm will benefit from the sinking fund provision that enables it to repurchase its bonds at
below-market prices. In this case, the firm’s gain is the bondholder’s loss – thus, callable bonds will typically be
issued at a higher coupon rate, reflecting the option's value.

Illustration: Suppose a company issued P100,000,000 of 20-year bonds, and it is required to call 5% of the
issue, or P5,000,000 of bonds, each year. In most cases, the issuer can handle the sinking fund requirement in
either of two (2) ways:
1. It can call for redemption of the required P5,000,000 of bonds at par value. The bonds are numbered serially,
and a lottery administered by the trustee would determine those called for redemption.
2. The company can buy the required number of bonds on the open market.

The firm will choose the least-cost method. If interest rates have fallen since the bond was issued, the bond will
sell for more than its par value. In this case, the firm will use the call option. However, if interest rates have
risen, the bonds will sell below par so the firm can buy the P5,000,000 par value of bonds in the open market
for less than P5,000,000. Note that a call for sinking fund purposes differs from a refunding call because most
sinking fund calls require no call premium. However, only a small percentage of the issue is normally callable
in a given year (Brigham & Houston, 2022).

Other Features

Other important features of bonds include yield, market price, and putability.
- The yield is the rate of return received from investing in the bond. It usually refers either to the current yield,
which is simply the annual interest payment divided by the current market price of the bond (often the clean
price), or to the yield to maturity or redemption yield. Yield to maturity is a more useful measure of the bond's
return, considering the current market price, the amount and timing of all remaining coupon payments, and
the repayment due on maturity.
- The market price of a tradeable bond will be influenced by the amounts, currency, timing of the interest
payments and capital repayment due, the quality of the bond, and the available redemption yield of other
comparable bonds that can be traded in the markets. The price can be quoted as clean or dirty. “Dirty” refers
to the actual price to be paid, while “clean” includes an adjustment for accrued interest. The issue price at
which investors buy the bonds when they are first issued will typically be approximately equal to the nominal
amount. The net proceeds the issuer receives are thus the issue price, less issuance fees. The market price
of the bond will vary over its life: it may trade at a premium (above par, usually because market interest

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 4 of 9
 BM2213

rates have fallen since issue) or at a discount (below par, if market rates have risen or there is a high
probability of default on the bond).
- Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the
put dates. These are referred to as retractable or putable bonds. Put dates are the dates on which putable
bonds can be redeemed early. This type of bond protects investors: if interest rates rise after a 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 than a straight bond. A death put is an optional redemption
feature on a debt instrument allowing the beneficiary of the estate of a deceased bondholder to put (sell)
the bond (back to the issuer) at face value in the event of the bondholder’s death or legal incapacitation.

Bond Valuation

The value of any financial asset—a stock, a bond, a lease, or even a physical asset such as an apartment
building or a piece of machinery—is the present value of the cash flows the asset is expected to produce. The
cash flows for a standard coupon-bearing bond consist of interest payments during the bond’s 10%, 15-year life
plus the amount borrowed (generally the par value) when the bond matures. In the case of a floating-rate bond,
the interest payments vary over time. There are no interest payments for zero-coupon bonds, so the only cash
flow is the face amount when the bond matures. For a “regular” bond with a fixed coupon, here is the situation:

Where:
𝑟𝑑 = The market rate of interest on the bond. It is the discount rate used to calculate the present value
of the cash flows, which is also the bond’s price.
N = The number of years before the bond matures. N declines over time after the bond has been issued.
INT = Interest paid each year = Coupon rate x par value
M = The par, or maturity, value of the bond.

Illustration: Redrawing the timeline, the numerical valued for all variables are shown, except the bond’s value,
𝑉𝐵 .

The following general equation can be solved to find the value of any bond:
𝑁
′
𝐼𝑁𝑇 𝐼𝑁𝑇 𝐼𝑁𝑇 𝑀 𝐼𝑁𝑇 𝑀
𝐵𝑜𝑛𝑑 𝑠 𝑉𝑎𝑙𝑢𝑒 = 𝑉𝐵 = 1
+ 2
+ ⋯+ 𝑁
+ 𝑁
=∑ 𝑡
+
(1 + 𝑟𝑑 ) (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 )𝑁
𝑡=1

Inserting the values:

15
𝑃100 𝑃1,000
𝑉𝐵 = ∑ 𝑡
+
(1.10) (1.10)15
𝑡=1

The cash flows consist of an annuity of N years plus a lump sum payment at the end of Year N.

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 5 of 9
 BM2213

Each cash flow can be discounted to the present and sum those PVs to find the bond’s value. However, this
procedure is not very efficient, especially when the bond has many years to maturity.

Spreadsheets can also be used to solve for the bond’s value. The PV of this bond can be calculated using
Excel’s PV function:

=PV(rate,nper,pmt,[fv],[type])

Using the above illustration: =PV(0.1,15,100,1000) = -1,000. It gives the bond’s value as P1,000. Note that type
is left blank because cash flows occur at year-end.

Whenever the bond’s market, or going rate, 𝑟𝑑 , is equal to its coupon rate. A fixed-rate bond will sell at its par
value. Usually, the coupon rate is set at the going rate in the market the day a bond is issued, causing it to sell
at par initially. The coupon rate remains fixed after the bond is issued, but interest rates in the market move up
and down. For example, if the market interest rate on the illustration’s bond increased to 15% immediately after
it was issued, it would recalculate the price with the new market interest rate as follows: =PV(0.15,15,100,1000)
= -707.63. The bond’s price would fall to P707.63, well below par, as a result of the increase in interest rates.
Whenever the going interest rate rises above the coupon rate, a fixed-rate bond’s price will fall below its par
value, called a discount bond.

On the other hand, bond prices rise when market interest rates fall. For example, if the market interest rate on
the illustration’s bond decreased to 5% immediately after it was issued, it would once again recalculate its price
as follows: =PV(0.05,15,100,1000) = -1,518.98. In this case, the price rises to P1,518.98. Generally, whenever
the going interest rate falls below the coupon rate, a fixed-rate bond’s price will rise above its par value; this
type of bond is called a premium bond.

In summary:
• 𝑟𝑑 = coupon rate, fixed-rate bond sells at par; hence, it is a par bond.
• 𝑟𝑑 > coupon rate, fixed-rate bond sells below par; hence, it is a discount bond.
• 𝑟𝑑 < coupon rate, fixed-rate bond sells above par; hence, it is a premium bond.

Bond Yields

Bond yield is the return an investor realizes on a bond. The bond yield can be defined in different ways. As the
simplest definition, it is setting the bond yield equal to its coupon rate. The current yield is a function of the
bond's price and its coupon or interest payment, which will be more accurate than the coupon yield if the bond's
price is different than its face value. More complex calculations of a bond's yield will account for the time value
of money and compounding interest payments. These calculations include yield to maturity (YTM), bond
equivalent yield (BEY), and effective annual yield (EAY) (Hayes, Bond Yield, 2022).

Yield to Maturity (YTM)

A bond's yield to maturity (YTM) is equal to the interest rate, which makes the present value of a bond's future
cash flows equal its current price. These cash flows include all the coupon payments and their maturity value.
Solving for YTM is a trial and error process that can be done on a financial calculator with the following formula
(Hayes, Bond Yield, 2022):
𝑇
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠𝑡
𝑃𝑟𝑖𝑐𝑒 = ∑
(1 + 𝑌𝑇𝑀)𝑡
𝑡−1

Illustration: Suppose you were offered a 14-year, 10% annual coupon, P1,000 par value bond at a price of
P1,494.93.

𝐼𝑁𝑇 𝐼𝑁𝑇 𝐼𝑁𝑇 𝑀

𝑉𝐵 = 1
+ 2
+⋯+ 𝑁
+
(1 + 𝑟𝑑 ) (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 ) (1 + 𝑟𝑑 )𝑁

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 6 of 9
 BM2213

100 100 1,000

𝑃1,494.93 = +⋯+ +
(1 + 𝑟𝑑 )1 (1 + 𝑟𝑑 )14 (1 + 𝑟𝑑 )14

The value for 𝑟𝑑 can be substituted until the value found ‘works’ and force the sum of the PVs in the equation to
equal P1,494.93. However, finding 𝑟𝑑 = 𝑌𝑇𝑀 by trial and error would be a tedious, time-consuming process.
This equation can be calculated using a financial calculator and a spreadsheet.

Financial calculator: Simply enter N = 4, PV = -1494.93, PMT = 100, and FV = 100; then press the I/YR key.
5% will appear as the answer.

Spreadsheet: YTM can be computed using the RATE function in Excel. Simply type =RATE(nper,pmt,pv,[fv],
[type], [guess]); = RATE(14,100,-1494.93,1000). It gives the YTM as 5%. Note that there is no need to specify
a value for type (because the cash flows occur at the end of the year) or guess.

Bond Equivalent Yield (BEY)

Bond yields are generally quoted as a bond equivalent yield (BEY), which adjusts because most bonds pay
their annual coupon in two (2) semi-annual payments. In the previous examples, the bonds' cash flows were
annual, so the YTM equals the BEY. However, if the coupon payments were made every six (6) months, the
semi-annual YTM would be 5.979% (Hayes, Bond Yield, 2022).

The BEY is a simple annualized version of the semi-annual YTM and is calculated by multiplying the YTM by
two. In this example, the BEY of a bond that pays semi-annual coupon payments of P50 would be 11.958%
(5.979% x 2 = 11.958%). The BEY does not account for the time value of money for the adjustment from a semi-
annual YTM to an annual rate.

Effective Annual Yield (EAY)

Investors can find a more precise annual yield once they know the BEY for a bond if they account for the time
value of money in the calculation. Effective annual yield is a measure of annual return on investment that
considers the compounding of interest. In the case of a semi-annual coupon payment, the effective annual yield
(EAY) would be calculated as follows:
1 + 𝑌𝑇𝑀 2
𝐸𝐴𝑌 = ( ) −1
2

If an investor knows that the semi-annual YTM was 5.979%, then he or she could use the previous formula to
find the EAY of 12.32%. Because the extra compounding period is included, the EAY will be higher than the
BEY (Hayes, Bond Yield, 2022).

Changes in Bond Values over Time

When a coupon bond is issued, the coupon is generally set at a level that causes the bond’s market price to
equal its par value. If a lower coupon were set, investors would not be willing to pay P1,000 for the bond; but if
a higher coupon were set, investors would clamor for it and bid its price up over P1,000. Investment bankers
can judge the coupon rate that will cause a bond to sell at its P1,000 par value.

A bond that has just been issued is known as a new issue. Once it has been issued, it is called an outstanding
bond or a seasoned issue. Newly issued bonds generally sell at prices very close to par, but the prices of
outstanding bonds can vary widely from par. Except for floating-rate bonds, coupon payments are constant; so
when economic conditions change, a bond with a P100 coupon that sold at its P1,000 par value when it was
issued will sell for more or less than P1,000 thereafter.

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 7 of 9
 BM2213

Assessing a Bond’s Riskiness

The following are the factors that impact the riskiness of a bond.

Price Risk

As mentioned, interest rates fluctuate over time, and when they rise, the value of outstanding bonds declines.
This risk of a decline in bond values due to an increase in interest rates is called price risk (or interest rate risk).

Price risk is higher on bonds with long maturities than bonds that mature soon. It follows because the longer the
maturity, the longer before the bond will be paid off, and the bondholder can replace it with another bond with a
higher coupon (Brigham & Houston, 2022).

Illustration: Below shows how the value of a 1-year bond with a 10% annual coupon fluctuates with changes in
𝑟𝑑 and then comparing those changes with changes on a 15-year bond. The 1-year bond’s values at different
interest rates are shown below:

Value of a 1-year bond at 5% =PV(0.05,1,100,1000) -1,047.62

Value of a 1-year bond at 10% =PV(0.1,1,100,1000) -1,000.00
Value of a 1-year bond at 15% =PV(0.15,1,100,1000) -956.52

For bonds with similar coupons, this differential interest rate sensitivity always holds true: the longer a bond’s
maturity, the more its price changes in response to a given change in interest rates. Thus, even if the risk of
default on two (2) bonds is exactly the same, the one with the longer maturity is typically exposed to more risk
from rising interest rates (Brigham & Houston, 2022).

Reinvestment Risk

An increase in interest rates hurts bondholders because it leads to a decline in the current value of a bond
portfolio. As well as a decrease in interest rates also hurts bondholders because if interest rates fall, long-term
investors will suffer a reduction in income (Brigham & Houston, 2022).

Illustration: Consider a retiree with a bond portfolio who lives off his income. On average, the bonds in the
portfolio have coupon rates of 10%. Now suppose interest rates decline to 5%. Many of the bonds will mature
or be called. As this occurs, the bondholder will have to replace 10% bonds with 5% bonds. Thus, the retiree
will suffer a reduction in income.

The risk of an income decline due to a drop in interest rates is called reinvestment risk. Reinvestment risk is
high on callable bonds. It is also high on short-term bonds because the shorter the bond’s maturity, the fewer
the years before the relatively high old coupon bonds will be replaced with the new low-coupon issues. Thus,
retirees whose primary holdings are short-term bonds or other debt securities will be hurt badly by a decline in
rates, but holders of non-callable long-term bonds will continue to enjoy the old high rates (Brigham & Houston,
2022).

Default Risk

Potential default is another significant risk that bondholders face. If the issuer defaults, investors will receive
less than the promised return. Recall that quoted interest rate includes a default risk premium: the higher the
probability of default, the higher the premium and thus the yield to maturity. The default risk on Treasuries is
zero, but this risk is substantial for lower-grade corporate and municipal bonds (Brigham & Houston, 2022).

Illustration: Suppose two (2) bonds have the same promised cash flows—their coupon rates, maturities, liquidity,
and inflation exposures are identical—but one has more default risk than the other. Investors will naturally pay
more for the one with less chance of default. As a result, bonds with higher default risk have higher market

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 8 of 9
 BM2213

rates: 𝑟𝑑 = 𝑟 ∗ + 𝐼𝑃 + 𝐷𝑅𝑃 + 𝐿𝑃 + 𝑀𝑅𝑃. If a bond’s default risk changes, 𝑟𝑑 and thus the price will be affected.
Thus, if the default risk increases, the price will fall and the yield to maturity (VTM = 𝑟𝑑 ) will increase.

Bond Markets

The bond market, often called the debt market or credit market, is a financial marketplace where investors can
trade in government-issued and corporate-issued debt securities. Governments typically issue bonds to raise
capital to pay debts or fund infrastructural improvements. Publicly-traded companies issue bonds when they
need to finance business expansion projects or maintain ongoing operations (Hayes, Bond Market, 2022).

The bond market is broadly segmented into two (2) different silos: the primary and secondary markets. The
primary market is frequently referred to as the "new issues" market, in which transactions strictly occur between
bond issuers and bond buyers.

The primary market yields the creation of brand-new debt securities that have not previously been offered to
the public. In the secondary market, securities that have already been sold in the primary market are then bought
and sold at later dates. Investors can purchase these bonds from a broker, who acts as an intermediary between
the buying and selling parties. These secondary market issues may be packaged in the form of pension funds,
mutual funds, and life insurance policies, among many other product structures. (Hayes, Bond Market, 2022).

References:
Brigham, E. F., & Houston, J. F. (2022). Fundamentals of Financial Management. Boston, United States of
America: Cengage Learning.
Hayes, A. (2022). Bond Market. Retrieved from Investopedia:
https://www.investopedia.com/terms/b/bondmarket.asp
Hayes, A. (2022). Bond Yield. Retrieved from Investopedia: https://www.investopedia.com/terms/b/bond-
yield.asp
Jonas, J. R. (2017). Easy Guide for Filipinos: How to Invest in Bonds. Retrieved from PinoyMoneyTalk:
https://www.pinoymoneytalk.com/philippine-bonds-101/
Lumen. (2019). Key Characteristics of Bonds. Retrieved from Boundless Finance:
https://courses.lumenlearning.com/boundless-finance/chapter/key-characteristics-of-bonds/

07 Handout 1 *Property of STI

 student.feedback@sti.edu Page 9 of 9