Financial Markets

Prepared by: Ms. Ida

Bond Markets
Prepared by: Ms. Ida
 Any long term promissory note
issued by the firm. A bond
What are certificate is the tangible evidence
BONDS? of debt issued by a corporation or a
governmental body and represents a
loan made by investors to the issuer.
 The most prevalent example of the
interest only loan with investors
receiving exactly the same two sets
What are of cash flows;
BONDS? 1. the periodic interest payments,
and
2. the principal (par value or face
value) returned at maturity.
 Trading Process for Corporate Bonds

The initial or primary sale of corporate bond issues occurs

either through a public offering, using an investment bank
serving as a security underwriter or through a private
placement to a small group of investors (often financial
institutions). Generally, when a firm issues bonds to the
public, many investment banks are interested in underwriting
the bonds. The bonds can generally be sold in a national
market.
 Trading Process for Corporate Bonds

Most often, corporate bonds are offered publicly through investment

banking firms as underwriters. Normally, the investment bank facilitates
this transaction using a firm commitment underwriting. The investment
bank guarantees the firm a price for newly issued bonds by buying the
whole issue at a fixed price (the bid price) from the bond-issuing firm at a
discount from par. The investment bank then seeks to resell these
securities to investors at a higher price (the offer price).
 Trading Process for Corporate Bonds

Sell Bonds Sell Bonds

Underwriter
Corporation Investors
(Investment Bank)

Pays Bid Price Pays Bid Price

Firm Commitment Underwriting of a Corporate Bond Issue

 Trading Process for Corporate Bonds

Other arrangements can be as follows:

1. Competitive Sale

The investment Bank can purchase the bonds through competitive

bidding against other investment banks or by directly negotiating with
the issuer.
 Trading Process for Corporate Bonds

Other arrangements can be as follows:

2. Negotiated Sale

With a negotiated sale, a single investment bank obtains the

exclusive right to originate, underwrite and distribute the new bonds
through a one-on-one negotiation process. With a negotiated sale,
the investment bank provides the organization and advising services
to the issuers.
 Trading Process for Corporate Bonds

Other arrangements can be as follows:

3. Best Efforts Underwriting Basis

In their arrangement, the underwriter does not guarantee a firm price

to the issuer. The investment bank incurs no risk of mispricing the
security since it simply seeks to sell the securities at the best market
price it can get for the issuing firm.
Advantages of using Bonds

1. Long-term debt is generally less expensive than

other forms of financing because
a. Investors view debt as a relatively safe
investment alternative and demand a lower rate
of return, and
b. Interest expenses are tax deductible.
Advantages of using Bonds

2. Bondholders do not participate in extraordinary

profits; the payments are limited to interest.
3. Bondholders do not have voting rights.
4. Floatation costs of bonds are generally lower than
those of ordinary (common) equity shares.
Disadvantages of using Bonds

1. Debt (other than income bonds) results in interest

payments that, if not met, can force the firm into
bankruptcy.
2. Debt (other than income bonds) produces fixed
charges, increasing the firm’s financial leverage.
Although this may not be a disadvantage to all
firms, it certainly is for some firms with unstable
earnings streams.
Disadvantages of using Bonds

3. Debt must be repaid at maturity and thus at some

point involves a major cash outflow.
4. The typically restrictive nature of indenture
covenants may limit the firm’s future financial
flexibility.
As of September, 2019 the following are bond issuances by the government business
firms in the Philippines secured by Bond Funds and part of the Investment Portfolio of
Mutual Funds.

ALFM Peso Bonds RCBC “Sustainability” Bonds

Grepalife Bonds Robinsons Bank

Philam Bonds Fixed Rate Corporate Bonds

Philequity Peso Bonds PH Samurai Bonds

Sun Life Prosperity Bonds Ayala Land Inc. (PH) Bonds

Bond Features and Prices
The various features of corporate bonds and some of the terminology associated with bonds follow:

Par Value The face value of the bond that is returned to the bondholder at maturity.

Coupon Interest The % of the par value of the bond that will be paid out annually in the form of
Rate interest. Formula is: Stated interest payment divided the Par value.

Maturity The length of time until the bond issuer returns the par value to the bondholder and
terminates the bond.

Indenture The agreement between the firm issuing the bonds and the bond trustee who
represents the bondholders. It provides the specific terms of the loan agreement,
including the description of the bonds, the rights of the bondholders, the rights of
the issuing firm and the responsibilities of the trustees.

Current Yield This refers to the ratio of the annual interest payment to the bond’s market price.

Yield to This refers to the bond’s internal rate of return. It is the discount rate that equates
Maturity the present value of the interest and principal payments with the current market
price of the bond.
 Formula is:

Annual Interest Principal Payment - Price of the Bond

+
Approximat Payment Number of Years to Maturity
e Yield:
0.6 (Price of the Bond) + 0.4 (Principal Payment)
 Illustrative Problem:

Par value of bond: Php 1,000 What is the bond’s approximate

Interest rate: 10% yield to maturity?
Term: 10 years
Current price: Php 900

Annual Interest Principal Payment - Price of the Bond

+
Approximat Payment Number of Years to Maturity
e Yield:
0.6 (Price of the Bond) + 0.4 (Principal Payment)
 Illustrative Problem:

Par value of bond: Php 1,000 What is the bond’s approximate

Interest rate: 10% yield to maturity?
Term: 10 years
Current price: Php 900

Approximat
e Yield: = 11.70%
 Credit Quality Risk
Credit Quality Risk is the chance that the bond issuer will not be able to
make timely payments.
Bond ratings involve a judgement about the future risk potential of the
bond provided by rating agencies such a as Moody’s, Standard and
Poor’s and Fitch IBCA, Inc. Dominion Bond Rating Services. Bond ratings
are favorably affected by:
A. A low utilization of financial leverage; The poorer the bond
B. Profitable operations; rating, the higher the
C. A low variability of past earnings; rate of return
D. Large firm size; demanded in the
E. Little use of subordinated debt. capital markets.
 Credit Quality Risk
The bond credit ratings agencies assign similar rating based on detailed
analyses of issuers’ financial condition, general economic and credit
market conditions, and the economic value of any underlying collateral.
The agencies conduct general economic analyses of companies’
business and analyze firm’s specific financial situations. A single company
of instance may carry several outstanding bond issues and if these issues
feature fundamental differences, then they may have different credit level
risks. High quality corporate bonds are considered investment grade,
while higher credit risk bonds are speculative, also called junk bonds and
high-yield bonds.
TYPES OF BONDS

A. Unsecured Long-term Bonds

Debentures
These are unsecured long-term debt and backed only by the
reputation and financial stability of the corporation. Because these
bonds are unsecured, the earning ability of the issuing corporation is
of great concern to the bondholder. To provide some protection to the
bondholder, the issuing firm may be prohibited from issuing future
secured long-term debt that would create additional encumbrance of
assets. To the issuing firm, debentures will allow it to incur
indebtedness and still preserve some future borrowing power.
TYPES OF BONDS

A. Unsecured Long-term Bonds

Subordinated Debentures
Claims of bondholders of subordinated debentures are honored only
after the claims of secured debt and unsubordinated debentures have
been satisfied.
TYPES OF BONDS

A. Unsecured Long-term Bonds

Income Bonds
An income bond requires interest payments only if earned and non-
payment of interest does not lead to bankruptcy. Usually issued
during the reorganization of a firm facing financial difficulties, these
bonds have longer maturity and unpaid interest is generally allowed
to accumulate for some period of time and must be paid prior to the
payment of any dividends to stockholders.
TYPES OF BONDS

B. Secured Long-term Bonds

Mortgage Bonds
A mortgage bond is a bond secured by a lien on real property.
Typically, the market value of the real property is greater than that of
the mortgage bond issued. This provides the mortgage bondholders
with a margin of safety in the event that the market value of the
secured property declines. Should the issuing firm fail to pay the
bonds at maturity; the trustees can foreclosure or sell the mortgaged
property and use the proceeds to pay the bondholders.
TYPES OF BONDS

B. Secured Long-term Bonds

Mortgage Bonds can further be subclassified as follows:
a) First Mortgage Bonds
The first mortgage bonds have the senior claim on the secured
assets if the same property has been pledged on more than one
mortgage bond.
b) Second Mortgage Bonds
These bonds have the second claim on assets and are paid only
after the claims of the first mortgage bonds have been satisfied.
TYPES OF BONDS

B. Secured Long-term Bonds

Mortgage Bonds can further be subclassified as follows:
c) Blanket or General Mortgage Bonds
All the assets of the firm are used as security for this type of bonds.
d) Closed-end Mortgage Bonds
The close-end mortgage bonds forbid the further use of the pledged
assets security for other bonds. This protects the bondholders from
dilution of their claims on the assets by any future mortgage bonds.
TYPES OF BONDS

B. Secured Long-term Bonds

Mortgage Bonds can further be subclassified as follows:
e) Open-end Mortgage Bonds
These bonds allow the issuance of additional mortgage bonds
using the same secured assets as security. However, a restriction
may be placed upon the borrower, requiring that additional
assets should be added to the secured property if new debt is
issued.
TYPES OF BONDS

B. Secured Long-term Bonds

Mortgage Bonds can further be subclassified as follows:
f) Limited Open-end Mortgage Bonds
These bonds allow the issuance of additional bonds up to a
limited amount at the same priority level using the already
mortgaged assets as security.
OTHER TYPES OF BONDS

1. Floating Rate or Variable Rate Bonds

A floating rate bond is one in which the interest payment changes
with market conditions. In periods of unstable interest rates this type
of debt offering becomes appealing to issuers and investors. To the
issuers like banks and finance companies, whose revenues go up
when interest rates rise and decline as interest rates fall, this type of
debt eliminates some of the risk and variability in earnings that
accompany interest rate swings. To the investor, it eliminates major
swings in the market value of the debt that would otherwise have
occurred if interest rates had changed.
OTHER TYPES OF BONDS

1. Floating Rate or Variable Rate Bonds

A common feature of all the floating rate bonds is that an attempt is
being made to counter uncertainty by allowing the interest rate to
float [e.g., interest rates may be adjusted quarterly at 3% above the
three-month London Interbank Offered Rate (LIBOR)]. In this way
a change in cash inflows to the firm may be offset by an adjustment
in interest payments.
OTHER TYPES OF BONDS

2. Junk or Low-Rated Bonds

Junk or low rated bonds are bonds rated BB or below. The major
participants of this market are new firms that do not have an
established record of performance, although in recent years junk
bonds have been increasingly issued to finance corporate buyouts.
Since junk bonds are of speculative grade, they carry a coupon rate
of between 3 to 5 percent more than AAA grade long-term debt. As a
result, there is now an active market for these new debt instruments.
OTHER TYPES OF BONDS

2. Junk or Low-Rated Bonds

Because of the acceptance of junk or low-rated bonds, many new
firms without established performance records now have a viable
financing alternative to secure financing through a public offering,
rather than being forced to rely on more-costly commercial bank
loans.
OTHER TYPES OF BONDS

3. Eurobonds
These are bonds payable or denominated in the borrower's currency,
but sold outside the country of the borrower, usually by an
international syndicate of investment bankers. This market is
denominated by bonds stated in U.S. dollars.

The Eurobond is usually sold by an international syndicate of

investment bankers and includes bonds sold by companies in
Switzerland, Japan, Netherlands, Germany, the United States and
Britain, to name the most popular countries.
OTHER TYPES OF BONDS

3. Eurobonds
An example might be a bond of a U.S. company payable in dollars and
sold in London, Paris, Tokyo or Frankfurt.

Eurobonds are also referred to as bonds issued in Europe by an American

company and pay interest and principal to the lender in U.S. dollars.

The use of Eurobonds by U.S. firms to raise funds has fluctuated

dramatically with the relative interest rates an abundance or lack of funds
in the European markets dictating the degree to which they are used.
OTHER TYPES OF BONDS

4. Treasury Bonds
Treasury bonds carry the "full-faith-and-credit" backing of the
government and investors consider them among the safest fixed-
income investments in the world. The BSP sells Treasury securities
through public auctions usually to finance the government's budget
deficit. When the deficit is large, more bonds come to auction. In
addition, the BSP uses Treasury securities to implement monetary
policy.
 Bond markets refer to the financial
markets where the issuance, buying,
What is the and selling of debt securities like
BOND bonds occur. The other names
MARKET? include debt markets, fixed-income
markets, and credit markets.
 It is a platform for companies and
governments to raise capital by
What is the issuing debt instruments like bonds.
BOND Companies issue bonds commonly
MARKET? to finance operations and large-
scale projects.
 At the same time, the
government issues bonds intending
What is the to finance government spending or
BOND expenditure, including
infrastructure spending and debt
MARKET? repayment. One example is the
Treasury securities market.
 Bond markets are boon to corporate
and government bodies since it
What is the helps them raise capital easily and
BOND flexibly. Primarily, it allows
MARKET? companies to obtain capital without
causing equity dilution.
 In addition, using the debt
instruments to obtain capital
reduces the cost of capital since the
What is the interest expense associated with
BOND such instruments is tax-deductible.
MARKET? Altogether, companies can build an
optimal capital structure and are a
place to trade debt securities.
 Inflationary phenomena have an
impact on debt markets. Bond prices
fall when interest rates rise, and vice
versa. Stock market rallies and
What is the companies outperforming the market
BOND are common when the economy is
booming, and investors will be more
MARKET? interested in stocks than debt
instruments, causing investment to
shift from the debt market to the
stock market.
 Simultaneously, during a bear
market or stock market collapse,
What is the investors will shift their investments
BOND to bonds, which are a safe haven in
MARKET? comparison to stocks in a volatile or
bear market.
Bond Market
CORPORATE BONDS

Characteristics of Corporate Bonds

Remember that while bonds are a corporation's promise to repay with
interest, stocks represent ownership of a corporation. Since stockholders
have the power to hire and fire the executives of a corporation, those
executives may pay more attention to the interests of stockholders than
they do those of bondholders. To more closely align the interests of
bondholders and executives, many bonds carry with them bond
covenants, which either tell management what to do or place
restrictions on what management can do.
CORPORATE BONDS

Characteristics of Corporate Bonds

Bond covenants: A portion of a bond agreement that specifies what the
borrower (the bond issuer) may or may not do during the life of the
bond.

Most often bond covenants are "financial covenants" that specify, for
example, that management must maintain a stated leverage ratio, or a
debt-to-equity ratio, within a given range. These types of ratios are
designed to make sure that management does not overload the
corporation with debt.
CORPORATE BONDS

Characteristics of Corporate Bonds

Covenants can also be "nonfinancial," such as requiring management to
provide financial information to bondholders, placing restrictions on the
selling of assets, and/or making sure the assets of the company have
adequate levels of insurance.

In general, bonds with covenants have lower interest rates because the
restrictions on what management can and cannot do makes the firm
more stable and the bonds less risky.
CORPORATE BONDS

Characteristics of Corporate Bonds

When a corporation issues a long-term bond, it may wish to pay off all
or part of the bond early, before it reaches its maturity date. To allow the
issuer of a bond to pay off its bond early or recall it, the bond must have
a call provision. The call provision of a bond stipulates under what
conditions the issuer can buy back the bond or pay it off early. Bonds
with call provisions usually have multiple call dates and stated prices of
the buyback.
CORPORATE BONDS

Characteristics of Corporate Bonds

Call provision: A clause in a bond contract that allows the issuer of the
bond the right to buy back all or part of the bond issued before the
bond's maturity date.
CORPORATE BONDS

Characteristics of Corporate Bonds

The call provision of a bond might state that a bond due June 1, 2030, is
callable on June 1, 2017, at a price of 105% of par. The indenture, or
bond contract, usually includes a table of call dates and prices. The call
price is normally higher than the face value of the bond, but it decreases
the closer the bond comes to its maturity date. For example, the issuer
may offer 105% of the face value if it calls the bond after 4 years, but it
may offer only 102% if it calls the bond in 10 years because it is closer
to the bond's maturity date.
CORPORATE BONDS

Characteristics of Corporate Bonds

Indenture: A legal contract between the bond issuer and the bond
holder or purchaser. The contract lays out the legal requirements of the
borrower or bond issuer.
CORPORATE BONDS

Characteristics of Corporate Bonds

Sometimes the early buyback of bonds is required under the terms of a
sinking fund. A sinking fund is a pool of money a corporation sets aside
to help repay a bond issue. Sinking funds are often created to help
ensure the bond issuer can repay the face value of the bonds they issue.

Sinking fund: A pool of money set aside for the repayment of a bond.
CORPORATE BONDS

Characteristics of Corporate Bonds

For example, suppose Fred's Beer Company sells a 10-year bond with a
$10,000 face value and a coupon rate of 5%. The issuer has to pay
bondholders $250 twice a year for the next 10 years, which may not be
much of a financial strain for Fred's. But at the end of 10 years Fred's
has to repay the $10,000 face value, which might cause some cash flow
problems for Fred's, especially if the company is in a poor financial
condition when the bond matures. The company may be in fine shape
today, but how many beers will they be selling 10 years from now?
CORPORATE BONDS

Characteristics of Corporate Bonds

To reduce the risk of being short on cash 10 years from now, the
company may create a sinking fund for repurchasing a portion of the
existing bonds, say, every year. By repaying a portion of its debt each
year, the company will face a much smaller payout when the bonds
mature. Sinking fund provisions usually allow an issuer to repurchase
their bonds periodically and at a specific price, usually at par or the
prevailing market price.
CORPORATE BONDS

Characteristics of Corporate Bonds

A sinking fund might sound a lot like a call provision, but they are
different. Sinking funds usually limit how many of the bonds the issuer
can buy back early, whereas call provisions often allow the issuer to pay
off all the bonds it issues. Also, sinking fund buyback prices are usually
lower than call provision buyback prices, so the holder of a bond from a
company with a sinking fund actually stands to lose more money should
a sinking fund provision result in the early payoff of their bond.
CORPORATE BONDS

Characteristics of Corporate Bonds

Some bonds can be converted into shares of common stock at some
point in the future at an agreed-upon price. Although convertible bonds
generally have a lower yield than nonconvertible bonds with the same
characteristics, convertible bonds allow a bondholder to share in the
success of the economic growth of the firm. From an issuer's point of
view, convertible bonds are beneficial because they require lower
interest payments than nonconvertible bonds. The downside to the issuer
is, if the firm is successful in the future, this success will have to be
shared with bondholders as they convert their bonds to common stock.
CORPORATE BONDS

Characteristics of Corporate Bonds

Convertible bonds: A bond where the bondholder can convert the bond
into a specified number of shares of stock of the firm that issued the bond.

While bonds have many different characteristics, one of the most

important distinguishing features of a bond is the potential for default.
Bond buyers are very concerned about default risk. Yet properly
evaluating default risk is a difficult thing to do. Next we examine one of
the most controversial methods used to evaluate default risk: the bond
rating system.
GOVERNMENT BONDS

Government and Agency Bonds

Because of the very low level of default risk, government debt-including
Treasury notes and Treasury bonds-pay relatively low interest rates
compared with other bonds in the market. But this is not to say these
government bonds are risk free. Because of their longer maturity dates,
when interest rates change, Treasury notes and bonds have bigger
swings in their market prices than do Treasury bills or other short-term
debt. Thus government bonds have price risk, even if their default risk is
almost zero.
GOVERNMENT BONDS

Government and Agency Bonds

Government agencies would sell bonds in the market and use the proceeds
to buy mortgages from the financial institutions that wrote them. The
agencies then would pool these mortgages together and sell slices of the
pooled mortgages to a wide variety of investors.

Since investors believed these government agencies had the full backing of
the government, the agencies could borrow funds in the market at a
relatively low interest rate. Even though these rates were generally higher
than Treasury bill rates, the agency bonds were often viewed as almost
perfectly default risk-free
CORPORATE BONDS

Municipal Bonds
There are two types of municipal bonds: general obligation bonds and
revenue bonds. As the name suggests, the proceeds from general
obligation bonds are used by the issuing government for general
expenses and are not targeted for a specific project. Most general
obligation bonds must be approved by taxpayers because future taxes
will be used to repay the debt plus interest.
General obligation bond: A bond issued and backed by a state or local
municipality to raise funds that will be used for a variety of public
works projects.
CORPORATE BONDS

Municipal Bonds
Revenue bonds, on the other hand, are repaid in part using the cash flow
from a particular cash-generating project.
Revenue bond: A bond issued and backed by a state or local
municipality to raise funds that will be used for a specific income-
generating project.
CORPORATE BONDS

Municipal Bonds
Federal Income Tax Exemption of Muni Bonds
Since the muni bond pays a higher rate than the equivalent tax-free rate,
the saver will choose the muni bond, ceteris paribus.
Thus, when comparing bonds with taxable interest payments with tax-
free bonds such as muni bonds, investors cannot simply compare rates
of return. Instead, investors must be certain that they are comparing
equivalent tax-free rates of return; otherwise they may be making
inefficient use of their resources.
CORPORATE BONDS

Municipal Bonds
Default Risks with Muni Bonds
Although muni bonds are issued by state and local governments, they
are not risk-free promises to repay. General obligation bonds are usually
viewed as having a lower default risk than revenue bonds. This is
because revenue bonds depend on a specific source of revenue for
repayment. If that specific source or project does not perform as
planned, then repayment of the bond can become doubtful.
 END :)

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