Addis Ababa University

College of Business and Economics

School of Commerce

The Bond Market

Section 4,Group 2

30 November 2022
 The Bond Market

Prepared By:
Name
ID.No.
Sagni Berhanu GSE/1803/14

Samson Alemayehu GSE/1013/14

Semhal Legesse GSE/2091/14
Senait Girma GSE/2996/14
Senait Kebede GDE/4599/14
 Capital Market
• Purpose of Capital Market- Firms and individuals use the capital markets
for long term investments unlike money market.
• Capital Market Participants -The primary issuers of capital market
securities are federal and local governments and corporations.
-The federal & State(Local) government issues long-term
notes and bonds to fund the national debt and finance capital projects
respectively.
- Corporations issue both bonds and stock.
 Capital Market
• Capital Market Trading-
- Occurs in either the primary market or the secondary Market.
- The primary market is where new issues of stocks and bonds are introduced.
- When firms sell securities for the very first time, the issue is an initial public
offering (IPO).
- A secondary market is where the sale of previously issued securities takes
place.
What is a bond?

• 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.
• A bond is a fixed-income instrument that represents a loan made by an
investor to a borrower.
Characteristics of a Bond

• The coupon rate is the rate of interest the bond issuer will pay on the face value of
the bond, expressed as a percentage.
• Coupon dates are the dates on which the bond issuer will make interest payments.
• The par, face, or maturity value of the bond is the amount that the issuer must pay
at maturity.
• The maturity date is the date on which the bond will mature and the bond issuer
will pay the bondholder the face value.
• The issue price is the price at which the bond issuer originally sells the bonds.
What is The Bond Market?

• The bond market also known as debt market or credit market, is a financial
market where participants can issue new debt (primary market) or buy and
sell debt securities known (secondary market).
• The primary market is frequently referred to as the "new issues" market
• In the secondary market, securities that have already been sold in the
primary market are then bought and sold at later dates.
 Types of Bonds

• Corporate Bonds
• Municipal Bonds
• Treasury Bonds
• Agency Bonds
Corporate Bonds

• A corporate bond is a type of debt security that is issued by a firm and sold
to investors.
• Companies issue corporate bonds to raise money for reasons such as:
- Financing current operations,
- Expanding product lanes
- Opening up new manufacturing facilities etc.
Corporate Bonds continued…

• Corporate bonds are typically classified as either investment grade or else high-yield (junk)
• An investment-grade rating signifies a high-quality bond that presents a relatively low risk
of default.
• Junk bonds are bonds that carry a higher risk of default.
• The bond indenture is a contract that states the lender’s rights and privileges
and the borrower’s obligations.
• Most corporate bonds have a face value of $1,000 and pay interest semiannually (twice per
year).
Corporate Bonds continued…
Characteristics of Corporate Bonds

1.Restrictive Covenants:
• Managers are more interested in protecting stockholders than they are in protecting
bondholders.
• Since bondholders cannot look to managers for protection when the firm gets into
trouble, they must include rules and restrictions on managers designed to protect the
bondholders’ interests.
• Usually limit the amount of dividends the firm can pay
• Limit the ability of the firm to issue additional debt.
• Other financial policies, such as the firm’s involvement in mergers, may also be
restricted.
Restrictive covenants are included in the bond indenture
 Characteristics of Corporate Bonds
Continued…
2. Call Provisions
• The issuer has the right to force the holder to sell the bond back.
• The call provision usually requires a waiting period between the time the bond is initially issued
and the time when it can be called.
• To make it possible for them to buy back their bonds according to the terms of the sinking fund.
• A sinking fund is a requirement in the bond indenture that the firm pay off a portion
of the bond issue each year.
• The other reason firms usually issue only callable bonds is that firms may have to retire a bond
issue if the covenants of the issue restrict the firm from some activity(like additional borrowing)
that it feels is in the best interest of stockholders.
• Finally, a firm may choose to call bonds if it wishes to alter its capital structure.
Characteristics of Corporate Bonds
Continued…
3. Conversion
• Some bonds can be converted into shares of common stock.
• The conversion from the bond to stock can be done at certain times during
the bond's life and is usually at the discretion of the bondholder.
• It is a hybrid security with debt- and equity-like features.
• The conversion ratio will be such that the price of the stock must rise
substantially before conversion is likely to occur.
Types of Corporate Bonds

A.Secured Bonds
• A secured bond is a type of investment in debt that is secured by a specific asset owned by
the issuer.
• If the issuer defaults on the bond, the title to the asset is transferred to the bondholders.
• Secured bonds are seen as less risky
• Types of secured bonds include:
- Mortgage Bonds
- Equipment trust certificates
Types of Corporate Bonds Continued…

• Mortgage bonds are used to finance a specific project. ( For example, a

building may be the collateral for bonds issued for its construction)
• Equipment trust certificates are bonds secured by tangible non-real-estate
property, such as heavy equipment or airplanes.
• These bonds are backed by a security making them less risky. As a result,
they will have a lower interest rate.
Types of Corporate Bonds Continued…

B. Unsecured Bonds
• Unsecured bonds, also called debentures, are not backed by equipment,
revenue, or mortgages on real estate.
• Debentures are long-term unsecured bonds that are backed only by the
general creditworthiness of the issuer.
• It is a funding option for companies with solid finances that want to avoid
issuing shares and diluting their equity.
• In the event of default, the bondholders must go to court to seize assets.
Types of Corporate Bonds Continued…

C. Junk Bonds
• Junk bonds, also known as high-yield bonds, are bonds that are rated below investment grade.
• Junk bonds carry a higher risk of default than other bonds, but they pay higher returns to make
them attractive to investors.
• Speculative-grade bonds are often called junk bonds

• Main issuers of such bonds are capital-intensive companies with high debt ratios or young
companies that have yet to establish a strong credit rating.
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.
• Municipal bonds that are issued to pay for essential public projects are exempt from federal taxation
• We can use the following equation to determine what tax-free rate of interest is equivalent to a
taxable rate:
Equivalent tax-free rate taxable interest rate 11 marginal tax rate2

• Municipal bonds come in two main categories.

- General Obligation (GO) bond
- Revenue bond
Municipal Bonds Continued…

• A General Obligation bond (GO bond) is a municipal bond backed solely by

the credit and taxing power of the issuing jurisdiction.
• GO bonds are issued with the belief that a municipality will be able to repay
its debt obligation through taxation
Municipal Bonds Continued…

• A revenue bond is a category of municipal bond supported by the revenue

from a specific project
• Unlike GO bonds, revenue bonds are project-specific and are not funded by
taxpayers.
Uses of Municipal Bonds

• Municipal bonds are bonds that are issued by municipal governments typically to fund
municipal projects, such as:
- Construction of schools
- Construction of libraries
- Construction of infrastructure (roads, bridges, public transit)
- Funding police departments
- Funding fire departments etc.
Risks with Municipal Bonds

• Although municipal bonds are fairly safe bonds with little default risk, they
are not backed by the federal government and can default.
• Municipal bonds typically carry a call provision. A call provision allows the
issuer to redeem the bond before the maturity date.
Treasury Bonds

• Treasury bond (or T-Bond) is a long-term government debt security issued

by the U.S. Treasury Department with a fixed rate of return.
• Maturity periods range from 20 to 30 years.
• The U.S. Treasury issues notes and bonds to finance the national debt.
• Treasury bonds can be purchased directly from the U.S. Treasury or through
a bank, broker, or mutual fund company.
Treasury Bonds

• Investments in T-bonds are motivated by the need for a steady, predictable

return on investment.
• Treasury bonds are part of U.S. Treasury securities, which include Treasury
bills and Treasury notes.
The Mechanics of Treasury Bonds

• Treasury bonds are initially purchased during monthly Treasury auctions and are issued
for periods between 20 to 30 years and are virtually risk-free because of the U.S
government guarantee.
• The bond price is largely influenced by the level of interest rates and the yield to maturity
• Treasury bonds are issued in electronic format only. The last paper format T-bonds
matured in 2016.
• T-bond holders do not pay local or state income tax on interest earned, but the same
interest is taxable by the federal government.
Agency Bonds

• Agency bonds, also known as agency debt, is the debt issued by a

government-sponsored enterprise (GSE) or a federal agency.
• An agency bond is a security issued by a government-sponsored enterprise
or by a federal government department other than the U.S. Treasury.
Mechanics of Agency Debt Market

• Agency bond is typically issued through broker-dealers.

• They buy agency debt wholesale at a discount, then sell the debt to
investors in the secondary market at a higher price.
• Like Treasury securities, federal government agency bonds are backed by
the full faith and credit of the U.S. government.
Characteristics of Agency Bonds

• Low risk: Agency bonds are considered very safe and typically come with
high credit ratings.
• Higher return: They provide higher returns relative to treasuries, which are
considered risk-free.
• Highly liquid: They are actively traded and hence, are highly liquid.
Advantages of Agency Bonds

Low risk and higher returns:

• Agency debt is considered to come with low default risk even when it is not
backed up by the government.
• It provides higher returns relative to treasuries, which are considered default-free
High liquidity:
• Agency debt is actively traded and can be bought or sold without a high
transaction cost.
Disadvantages of Agency Bonds

Inflation risk and costs:

• Returns from holding agency debt are reduced in a high inflation environment or if the
transaction costs are too high.
Complexity:
• Agency debt is offered in a variety of structures, with some being more complex than
others.
• It is difficult to analyze different structures and decide if agency debt is suitable for one’s
portfolio.
Bond Yield

• Bond yield is the return an investor realizes on a bond and can be derived in
different ways.
• The current yield depends on the bond's price and its coupon, or interest
payment.
• Formula to calculate Current yield –
Where ic = Current yield
c= Price of Coupon bond
P= yearly coupon payment
Current Yield Calculation Example
Yield to Maturity

• Yield to maturity (YTM) is the total return anticipated on a bond if the bond
is held until it matures.
• Considered a long-term bond yield but is expressed as an annual rate.
• Yield to maturity is similar to current yield, which divides annual cash
inflows from a bond by the market price of that bond to determine how
much money one would make by buying a bond and holding it for one year.
Yield to Maturity Continued…

• YTM calculation assumes that all coupon payments are reinvested at the
same rate as the bond's current yield and take into account the bond's
current market price, par value, coupon interest rate, and term to maturity.
• The complex process of determining yield to maturity means it is often
difficult to calculate a precise YTM value.
• One can approximate YTM by using a bond yield table or a financial
calculator.
 Finding the Value of Coupon Bonds

• In Summary, below is the steps how to find the value of a security:

1. Identify the cash flows that result from owning the security
2. Determine the discount rate required to compensate the investor for
holding the security.
3. Find the present value of the cash flows estimated in step 1 using the discount rate
determined in step 2.
 Finding the Price of Semiannual Bonds

• To adjust the cash flows for semiannual payments, divide the coupon
payment by 2 since only half of the annual payment is paid each six months.
• Similarly, to find the interest rate effective during one-half of the year, the
market interest rate must be divided by 2.
• The final adjustment is to double the number of periods because there will
be two periods per year
Formula for value of a security
Example for Price of Semiannual Bonds
Advantages and Disadvantages of Bond Markets

Pros
• Tend to be less risky and less volatile than stocks.
• Bondholders have preference over shareholders in the event of bankruptcy.
• The corporate and government bond markets are among the most liquid
and active in the world.
• Wide universe of issuers and bond types to choose from.
Advantages and Disadvantages of Bond
Markets Continued…

Cons
• Lower risk translates to lower return, on average.
• Buying bonds directly may be less accessible for ordinary investors.
• Exposure to both credit (default) risk as well as interest rate risk.
THANK YOU