BOND MARKETS
Learning Objectives
1.Understand the basic concepts of bond markets; importance of issuing bonds and types of entities
issue bonds.
2. To understand detailed steps required by National Regulations on issuing bonds.
3. Differentiate between various types and its set of basic properties.
4. Be equipped and knowledgeable on assessing and comparing the risk levels of different bonds.
5. Empower investors and market participants with strategies to mitigate risks, protect investments,
and promote stability and confidence within the bond market.
6. Help understand the different bond indexes and how to benchmark the performance of bond
investments, track market trends, and make informed decisions.
Topic Outline
● What are Bonds?
Define as contract, agreement, or guarantee. All these terms are applicable to the
securities known as bonds.
● Why Issue Bonds?
The principal reason for issuing bonds is to diversify sources of funding.
● Specific Financial Management Strategies
○ Minimising financing costs. To leverage the use of borrowed money and enable profit
making businesses to expand and earn more profit than they could, using only the
funds invested by the shareholders.
○ Matching revenue and expenses. To offer a bridge that links the repayment of
borrowings for projects to anticipated revenue.
○ Promoting inter-generational equity. To offer a means of requiring future taxpayers to
pay for the benefits they enjoy, rather than putting the burden on current taxpayers.
○ Controlling risk. To insulate the parent corporation or government from
responsibility if the bond payments are not made as required.
○ Avoiding short-term financial constraints. To help avoid painful steps that might
otherwise be necessary owing to a lack of cash.
● Issuers of Bonds
○ National governments. This includes strong incentives to pay on time in order to
retain access to credit markets, and it has extraordinary ability to print money and to
take control of foreign currency reserves that can be employed to make payments for
bonds.
○ Lower levels of government. This includes the government at the sub-national level
that’s called semi-sovereigns. Semi-sovereigns are generally riskier than sovereigns
because unlike national governments, it has no power to print money or take control
of foreign exchange.
○ Corporations. This issue corporate bonds by a business enterprise, whether owned by
private investors or by a government.
○ Securitisation vehicles. This issue is an asset-backed security type of bonds on which
the required payments will be made out of the income generated by specific assets,
such as mortgage loans or future sales.
● Issuing bonds
○ Underwriters and dealers. Issuers sell bonds to the public by underwritten single
investment banking firms or by a group of them, referred to as syndicate.
○ Swaps. Issuers make use of interest-rate swaps to obtain their desired financing
schedule.
○ Setting the interest rate. Issuers determine interest rate on a bond issue through a
variety of methods which includes the most common, the underwriter setting the rate
based on market rates on the day of issuance.
○ Selling direct. Issuers often practically rely on new technology to sell their bonds
directly to investors over the internet, without the intermediation of underwriters or
dealers.
○ Secondary dealing. This is where corporate bonds trade on stock exchanges and
brokers for buyers and sellers meet face-to-face. Vast majority occurs in the over-the-
counter market, directly between an investor and a bond dealer.
○ Electronic trading. This is where the number of different securities is small and
liquidity - the amount available for investment - is high.
○ Settlement. This applies to Central banks who have made considerable efforts to
shorten the time between execution of a trade and the exchange of money and
payment.
● Types of Bonds
○ Straight bonds. Also known as debentures. The basic fixed income statement, obliges
the issuer to regular, fixed interest as well as principal repayment upon maturity.
○ Callable bonds. The issuer has the option to redeem these bonds before the maturity
date, providing flexibility but exposing investors to reinvestment risk.
○ Non-refundable bonds. These may be called only if the issuer is able to generate the
funds internally, from sales or taxes
○ Putable bonds. Putable bonds give the investor the right to sell the bonds back to the
issuer at par value on designated dates.
○ Perpetual debentures. Also known as irredeemable debentures, are bonds that last
forever unless the holder sells them back.
○ Zero-coupon bonds. Do not pay periodic interest, instead, they are issued at less than
par value and are redeemed at par value, with the difference serving as an interest
payment.
○ STRIPS. Separately Registered Interest and Principal of Securities turn the payments
associated with a bond into separate securities, one for each payment involved.
○ Convertible bonds. It has a conversion value, which is simply the price of the common
shares for which it may be traded.
○ Adjustable bonds. A bond whose interest rate is adjusted periodically according to a
predetermined formula
○ Structured securities. Bonds that have options attached. Callable, putable and
convertible bonds are simple examples of structured securities.
● Properties of bonds
○ Maturity. The maturity of a bond, which determines when the principal is repaid,
influences both the risk and return for investors, and requires careful debt
management planning for issuers.
○ Coupon. The coupon of a bond, which is the fixed annual interest rate paid as a
percentage of the bond's original price, provides a consistent return for investors
regardless of changes in the bond's market value after issuance.
○ Current yield. Discuss the current yield of a bond, which is the interest rate based on
its current market price, calculated by dividing the annual coupon by the bond's
current price.
Formula: Current Yield = Annual Dollar Coupon Interest / Current Price
Example: If an investor buys a 6% coupon rate bond (with a par value of 1,000) for a
discount of 900, the investor earns an annual interest income of (1,000 × 6%), or 60.
The current yield is (60) / (900), or 6.67%. The 60 in annual interest is fixed,
regardless of the price paid for the bond.
○ Yield to maturity. Discuss the yield to maturity of a bond, which shows the total annual
return if the bond is held until maturity, including interest and any gain or loss.
○ Duration. Discuss the duration of a bond, which indicates how soon half of the bond's
payments are received, with higher yields usually resulting in shorter durations.
● Ratings of risk. Bond ratings, which assess default risk and influence bond prices and yields,
with lower ratings leading to higher yields and increased risk.
● Interpreting the price of a bond. Bond prices as a percentage of their original value, how
they change, and how non-government bonds are priced against benchmarks.
● Interest rates and bond prices. How changes in interest rates affect bond prices, with bond
prices move inversely to interest rates and how the impact varies with the bond’s duration.
Formula: Price Change = Duration x Value x Change in Yield
Example: If you hold a bond with a 6% coupon rate and market interest rates rise to 8%, the
bond's price will fall. For example, if the bond was initially priced at 1,000 when market rates
were also 6%, its price would drop to approximately 833.30 to reflect the higher market rates.
This demonstrates the inverse relationship between bond prices and interest rates.
● Inflation and returns on bonds. How inflation affects bond returns by showing the
difference between nominal and real interest rates and how expected inflation impacts bond
yields and prices.
● Exchange rates and bond prices and returns. How exchange rate changes affect
international bond investments, showing how fluctuations in currency values can impact
returns and bond prices.
● The yield curve. The yield curve, which shows interest rates for different loan terms and
how its shape indicates interest rate trends and economic conditions.
● Spreads. A spread is the difference in interest rates between two bonds. It’s often compared
to a common standard, like a government bond, to see which bond offers better value.
Example: If a government bond offers a yield of 2% and a corporate bond offers 5%, the bond
spread is 3%. This spread reflects the additional return investors demand for taking on more
risk with the corporate bond.
● Enhancing security. An issuer frequently takes steps to reduce the risk bondholders must
bear in order to sell its bonds at lower interest rate.
There are three common ways of doing this: (COBOSI)
○ Covenants. Legally binding promises made at the time a bond is issued.
○ Bond insurance. Provides investors with greater security and can lead to more
favorable borrowing conditions for issuers.
○ Sinking funds. Help issuers systematically prepare for debt repayment while
providing investors with added confidence in the issuer’s financial stability.
● Repurchase agreements. Is a contract in which a seller, usually a securities dealer such as
an investment bank, agrees to sell bonds in return for a cash loan, but promises to repurchase
the bonds at a specific date and price.
Illustration: Bank A sells 5,000,000 worth government bonds to Bank B on January 1 with
an agreement to repurchase them after 7 days. The repo rate is 2% annualized. How much
will be the repurchasing price if Bank A repurchases the bonds on january 8?
Interest= Principal×Repo Rate×Term/Days in a Year
5,000,000 x 2% x 7/360= 1,944.44
Repo Price= Principal + Interest
5,000,000 + 1,944.44= 5,001,944.44
● High-yield debt – or junk. One of the most important bond-market developments in recent
years is the issuance of debt by entities with weak credit ratings. Such bonds are called high-
yield debt or below-investment-grade debt. They are better known to the public as junk
bonds.
● International markets. The issuance of bonds outside the issuer’s home country can occur
in two different ways:
○ Foreign bonds. Issued outside the issuer’s home country and are denominated in the
currency of the country where they are issued.
○ Eurobonds. Denominated in neither the currency of the issuer’s home country nor that
of the country of issue, and are generally subject to less regulation.
● Emerging-market bonds. A fixed income debt that is issued by countries with developing
economies as well as by corporations within those nations and it includes local and hard
currency.
● Bond indexes
○ 1. Benchmark. Tracks the performance of a bond issue that is deemed an appropriate
benchmark for an entire category of bonds.
○ 2. Weighted. Measures the total return of an identifiable group of bonds.
● Index shortcomings
○ Inconsistency. The inconsistency in bond tracking arises because bonds mature, are
called, or become inactive, which means that no index can consistently track the same
bonds over time.
○ Uncertain Pricing. Bond measures are less precise than stock measures because many
bonds trade infrequently, making it hard to get accurate prices. This often means
using estimates instead of actual transaction data.
○ Disqualification. A bond may be dropped from an index if it ceases to meet the criteria
for inclusion, particularly if it is upgraded or downgraded by ratings agencies.
○ Poor Diversification. Poor diversification in some indexes can lead to undiversified
portfolios, which can result in significant losses if a heavily weighted issuer faces
problems.
● Credit default swaps. A contract in which two parties agree to exchange the risk that a
borrower will default on its bonds or loans.
