The Bond Market

Types of Bonds
1. Treasury Notes & Bonds
2. Treasury Inflation Protected Securities
(TIPS)
3. Treasury STRIPS
4. Agency Bonds
5. Municipal Bonds
6. Corporate Bonds
I. Treasury Notes & Bonds
1. To finance national debt or
1. SUN & ORI => Financing APBN’s Deficit
2. Treasury notes original maturity 1 to 10 years,
Treasury Bonds original maturity 10 to 30 years.
3. Free Risk, Government can always print money to
pay off debt if necessary.
4. Low Interest rate, because no risk
5. In Indonesia : ORI, Sukuk Ritel, SBR (Saving Bond
Ritel), Sukuk Negara Tabungan
Type Maturity
Treasury Bill Less than 1 year
Treasury Note 1 to 10 years
Treasury Bond 10 to 30 years
II. Treasury Inflation Protected Securities (TIPS)

1. Not affected by inflation.

2. Interest rate doesnt change during the term of security, Paid
twice a year (Fixed Rate) & coupon rate determined via
auction process
3. principal value of TIPS adjusts up and down based on
inflation as measured by the Consumer Price Index (CPI). The
rate of return investors receive reflects the adjusted
principal.in case of deflation, principal value of TIPS is
adjusted downward.
4. Can be used by retirees who want to hold a very low risk
portfolio
1. First year in first semester, investor will receive coupon payment $30
as usual

FV Investor
3%
$ 1,000 Receive
Coupon
$30

2. First year, in second semesrter, suddenly CPI increase 4%, so the FV

will be adjusted based on the increase of CPI

FV 3% Investor
$ 1,040 Coupon Receive
$31.2

3. Second year, in first semesrter, CPI fall 2%, so the FV will be

adjusted based on the decrease of CPI

FV
3% Investor
$
Coupon Receive
1,019.2
$30 .57
III. Treasury STRIPS
 Interest payment & principal becomes a
separate zero-coupon security.
 Each component has own identifying number

& can be held or traded separately

 Zero coupon securities, because the only time

an investor receives a payment, is when it

matures.
 Effective for immunizing portfolio against

interest rate risk.

 Interest
Payment Common Bonds
Anually 5
Years
Face
Value

STRIPS, Principal & Interest

Payment trade separately
Interest Interest
Face Paymen Paymen
Value , tV t III
Maturity Interest Interest
5 years Paymen Paymen
Zero Coupon t IV tI
Bond, Sell at
Interest
Discount
Paymen
t II
IV.Agency Bonds
1. Government-sponsored enterprise (GSEs)
2. Low risk
3. Issue bonds to raise funds for national
interest purpose.
V.Municipal Bonds
 Issued by local, county, and state governments
 Used to finance public interest projects such as
school, utilities & transportation systems.
 Tax-free
 Risk : Not Default-free,because local government
cant print money & default rates are higher during
the weak economy.
 Two types :
1. General obligation bonds (Full faith of credit)
2. Revenue bonds
1. Industrial Development Bond => to stimulate local
businesses following great depression.
Municipal Bonds Calculation
 A tax-free municipal bond = a tax of
corporate bond x ( 1 – Marginal Tax Rate)
VI.Corporate Bonds
 Typically have a face value of $1,000,
although some have a face value of $5,000 or
$10,000
 Pay interest semi-annually
 Sinking fund
 Callable or call provision
 Can be bearer bonds or registered bonds
Characteristics of Corporate Bonds
 Registered Bonds
─ Replaced “bearer” bonds
─ The firms (issuer) required to report to the IRS
the name of the person who receives interest
income.
 Restrictive Covenants
─ May limit dividends, new debt, ratios, etc.
Characteristics of Corporate Bonds
 Call Provisions, wich states that the issuer has the right to force the
holder to sell the bond back,
 Why call provisions?
1. If interest rate fall, the bond price will rise, if the price rise
above the call price, firm (isssuer) will call the bond
2. Allow issuer to buyback based on sinking fund’s term
3. Allow to retire a bond issue if the covenants of the issue
restrict the firm from some activity
4. Have a possibility to alter its capital structure
 Conversion
─ Some debt may be converted to equity (common stock)
─ One way firms avoid sending a negative signal to the
market.
Types of
Corporate Bonds
 Secured Bonds, are ones with collateral attached
─ Mortgage bonds (a building)
─ Equipment trust certificates ( tangible non real esatate)
 Unsecured Bonds
─ Debentures (creditworthiness of the issuer)
─ Subordinated debentures (similar to debentures except they
have a lower priority claim)
─ Variable-rate bonds (interest rate is tied to another market
interest rate)
 Junk Bonds
─ Debt that is rated below BBB
─ Often, trusts and insurance companies are not permitted to
invest in junk debt
Financial Guarantees for Bonds
 Some debt issuers purchase financial
guarantees to lower the risk of their debt.
 The guarantee provides for timely
payment of interest and principal, and are
usually backed by large insurance
companies.
 Credit Default Swap provides insurance
against default.
Bond Pricing Equation
C = Coupon Payment
r = Interest Rate
t = time. If annually t =n , if semi annually t = n x 2
FV / Par Value
 Coupont Rate = Coupon Payment / Face
Value (Par Value)