Group 5

(Hinlo and Jimenez)

Bond Market

Capital Markets
- Markets that trade debt (bonds and mortgages) and equity (stocks) instruments
with maturities of more than one year.
Bonds
- long-term debt obligations issued by corporations and government units.
- Proceeds from a bond issue are used to raise funds to support long-term
operations of the issuer
Bond markets
- markets in which bonds are issued and traded
- used to assist in the transfer of funds from individuals, corporations, and
government units with excess funds to corporations and government units in need
of long-term debt funding
Why do people buy bonds?
Investors buy bonds because:
- They provide a predictable income stream. Typically, bonds pay interest twice a
year.
- If the bonds are held to maturity, bondholders get back the entire principal, so
bonds are a way to preserve capital while investing.
- Bonds can help offset exposure to more volatile stock holdings.
Companies, governments and municipalities issue bonds to get money for various things,
which may include:
- Providing operating cash flow
- Financing debt
- Funding capital investments in schools, highways, hospitals, and other projects
Bond Characteristics
a. Face Value – (also known as the par value) of a bond is the price at which the
bond is sold to investors when first issued; it is also the price at which the bond is
redeemed at maturity.
b. Coupon Rate – The periodic interest payments promised to bond holders are
computed as a fixed percentage of the bond’s face value; this percentage is known
as the coupon rate.
c. Coupon – dollar value of the periodic interest payment promised to bondholders;
this equals the coupon rate times the face value of the bond.
Example: if a bond issuer promises to pay an annual coupon rate of 5% to bond
holders and the face value of the bond is $1,000, the bond holders are being promised
a coupon payment of (0.05) ($1,000) = $50 per year.
d. Maturity – the length of time until the principal is scheduled to be repaid. In the
U.S., a bond’s maturity usually does not exceed 30 years. Occasionally a bond is
issued with a much longer maturity.
Example: the Walt Disney Company issued a 100-year bond in 1993. There have
also been a few instances of bonds with an infinite maturity; these bonds are known
as consols. With a consol, interest is paid forever, but the principal is never repaid.
e. Call Provisions – Many bonds contain a provision that enables the issuer to buy
the bond back from the bondholder at a pre-specified price prior to maturity. This
price is known as the call price. A bond containing a call provision is said to be
callable. This provision enables issuers to reduce their interest costs if rates fall
after a bond is issued, since existing bonds can then be replaced with lower
yielding bonds. Since a call provision is disadvantageous to the bond holder, the
bond will offer a higher yield than an otherwise identical bond with no call provision.
A call provision is known as an embedded option, since it can’t be bought or sold
separately from the bond.
f. Put Provisions – enables the buyer to sell the bond back to the issuer at a pre-
specified price prior to maturity. This price is known as the put price. A bond
containing such a provision is said to be putable. This provision enables bond
holders to benefit from rising interest rates since the bond can be sold and the
proceeds reinvested at a higher yield than the original bond. Since a put provision
is advantageous to the bond holder, the bond will offer a lower yield than an
otherwise identical bond with no put provision.
g. Sinking Fund Provisions – requires the issuer to repurchase a fixed percentage
of the outstanding bonds each year, regardless of the level of interest rates. A
sinking fund reduces the possibility of default; default occurs when a bond issuer
is unable to make promised payments in a timely manner. Since a sinking fund
reduces credit risk to bond holders, these bonds can be offered with a lower yield
than an otherwise identical bond with no sinking fund.
Pricing Bonds (source https://www.graduatetutor.com/corporate-finance-tutoring/yields-bond-
valuation-pricing/)

Bond’s Price = the present value of its expected future cash flows
Rate of Interest used to discount the bond’s cash flows is known as the yield to maturity
a. Pricing Coupon Bonds
Where,
C = the periodic coupon payment
y = the yield to maturity (YTM)
F = the bond’s par or face value
t = time
T = the number of periods until the bond’s maturity date

Example: bond has a face value of $1,000, a coupon rate of 4% and a maturity of four
years. The bond makes annual coupon payments. If the yield to maturity is 4%,
These results show the following important relationship:
• if y > coupon rate, P < face value
• if y = coupon rate, P = face value
• if y < coupon rate, P > face value
These results also demonstrate that there is an inverse relationship between yields and
bond prices:
• when yields rise, bond prices fall
• when yields fall, bond prices rise

b. Adjusting for Semi-Annual Coupons - bond that makes semi-annual coupon

payments
Adjustments made to the pricing formula:
• the coupon payment is cut in half
• the yield is cut in half
• the number of periods is doubled
Example: A bond has a face value of $1,000, a coupon rate of 8% and a maturity of two
years. The bond makes semi-annual coupon payments, and the yield to maturity is 6%.
The semi-annual coupon is $40, the semi-annual yield is 3%, and the number of semi-
annual periods is four.

The bond’s price = = 38.83 + 37.70 + 36.61 + 924.03 = $1,037.17

c. Pricing Zero Coupon Bonds
Zero Coupon Bonds – does not make any coupon payments; instead, it is sold to
investors at a discount from face value.
Pricing formula for a zero-coupon bond

Example: A one-year zero-coupon bond is issued with a face value of $1,000. The
discount rate for this bond is 8%. What is the market price of this bond?

Three Common Types of Bonds

1. Treasury notes, bills and bonds,
 2. Municipal bonds, and
3. Corporate bonds.
Bond Market Securities
In this section, we look at the bond market securities issued by each of these
groups: Treasury notes and bonds, municipal bonds, and corporate bonds.
Treasury notes and bonds (T-notes and T-bonds)
- Long-term securities issued by the U.S. Treasury to finance the national debt and
other federal government expenditures.
- considered to be risk-free because the “full faith and credit” of the U.S. government
backs them.
Full Faith and Credit
- The Full Faith and Credit Clause ensures that states honor the court judgments of
other states.
- For example, I'm involved in a car accident in America. As a result, America’s court
grants me $1,000 in damages. But the defendant or the person who ran into me
lives in Florida and refuses to pay me.

a. What are Treasury Bills?

- a short-term debt obligation backed by the U.S. Treasury Department with a
maturity of one year or less.
- T-Bills are peso-denominated short-term fixed income securities issued by the
Republic of the Philippines through its Bureau of Treasury
- Original tenors are 91, 182 and 364 days. All maturity dates traditionally fall on a
Wednesday (unless said day is a holiday). Computation of selling price is based
on number of days remaining till the maturity of a series.
Example:
Suppose you could buy a 91-day T-bill at an asked price of $98 per $100 face
value and you could sell to the dealer at a bid price of $97.95 per $100 face value. What
are the quotation conventions on this bill and how is the yield calculated? What is the best
measure of the yield on a T-bill?
Answer:
(𝐹−𝑃)
𝑃
Bond Yield Equivalent = 𝑡

𝑤ℎ𝑒𝑟𝑒 𝐹 = 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 𝑃 = 𝑃𝑟𝑖𝑐𝑒 𝑃𝑎𝑖𝑑 𝑡 = 𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑦𝑒𝑎𝑟

 (100 − 98)
Bond Yield Equivalent = 98
91
365
= 0.8186
= 8.186%
(𝐹 − 𝑃 )
Discount Rate = 𝐹
𝑥
360
𝑤ℎ𝑒𝑟𝑒 𝐹 = 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒 𝑃 = 𝑃𝑟𝑖𝑐𝑒 𝑃𝑎𝑖𝑑 𝑡 = 𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑦𝑒𝑎𝑟 x= days of maturity

(100 − 98)
Discount Rate = 100
91
360
= 0.8111
= 8.11%
𝑞𝑢𝑜𝑡𝑒𝑑 𝑟𝑎𝑡𝑒 𝑛
Effective Annual Rate = ( 1 + ) −1
𝑛
0.08186 365/91
=(1+ ) −1
365/91
= .0844 𝑜𝑟 8.44%

Note: Discount rate will always be lower than the ask yield based on the B.Y.E formula
because F appears in the denominator of the discount rate formula while P is in the
denominator of the B.Y.E. formula (and F>P as long as yields are positive). In addition,
360<365 in the year part of the formulas and those numbers wind up in the numerator the
best measure of yield earned when buying a T-bill is the B.Y.E since it uses P as the base
rather than F (and because 365 is correct).
Why does the discount rate calculation exist?
- it is a shorthand calculation that was easier beforehand calculators existed. It
allowed people to translate price into yield quickly.
Source: https://www.pnb.com.ph/index.php/investment-opportunities/treasury-bill
https://pesolab.com/how-to-start-investing-in-philippine-treasury-bills/
b. What are Notes? https://www.youtube.com/watch?v=1Ipz95Vqd8Q
- debt security that offers a fixed interest rate and a maturity date that ranges
between one and 10 years
- the government sells treasury notes to help fund its debt.
Example:
Wang Yibo deposit Php 1000 into a savings account paying 2.5% annual interest
that matures in 5 years. How much money will you have (principal plus interest) at the
end of the 5-year term? A = is the amount of money in the account at the end of the year
Simple Interest Over Time (the account balance including principal plus interest)

𝑟 𝑃0 = is the principal (starting amount)

𝐴 = 𝑃0 ( 1 + ( ) 𝑘𝑡)
𝑘
r= is the annual interest yield in decimal form
0.025
𝐴 = 1000 ( 1 + ( ) 1 ∗ 5) k=is the number of periods over which the interest is paid during
1
the year
𝐴 = 1000 ( 1 + 0.25 ∗ 5)
t=is the number of years the principal remains invested in the
𝐴 = 1125 account

Note that when the interest is paid once at the end of the year,
the formula is A=P0(1+r)

c. What are Bonds?

· Long-term securities that typically mature in 30 years and pay interest every six
months
Example:
Park Seo Joon invests Php 20,000 at 6% simple interest for 8 year. How much is
in the account at the end of the 8 years period?
Simple Interest Over Time
𝑟
𝐴 = 𝑃0 ( 1 + ( ) 𝑘𝑡)
𝑘
0.06
𝐴 = 20,000 ( 1 + ( ) 1 ∗ 8)
1
𝐴 = 20,000 ( 1 + 0.6 ∗ 8)
𝐴 = 29,600
Municipal Bonds
 - called “munis,” are debt securities issued by states, cities, counties and other
government entities

Type of Minus
1. General obligation bonds.
- These bonds are not secured by any
assets; instead, they are backed by the
“full faith and credit” of the issuer, which
has the power to tax residents to pay
bondholders.
- municipal debt issue that is secured by a
broad government pledge to use its tax
revenues to repay the bond holders.
- GO bonds are considered safe
investments. It is common that such bonds receive strong ratings from credit rating
agencies.
Example: A municipality decides to launch a new project, but it lacks sufficient
capital to finance the initiative. In such a case, the municipality can issue general
obligation bonds. Investors who purchase the bonds provide capital to the
municipality. In return, the investors are entitled to a portion of the municipality’s
revenues generated from the project, as well as tax revenues. The revenue
streams allow the municipality to honor both the interest and principal payments of
the bonds.
Source: https://investinganswers.com/dictionary/g/general-obligation-bond
2. Revenue bonds
- class of municipal bond issued to fund public projects which then repay investors
from the income created by that project
For example, a revenue bond may be issued to finance an extension of a state highway.
To help pay off the interest and principal on that bond, tolls collected from the use of the
highway may be pledged as collateral.
Note: If revenue from the project is insufficient to pay interest and retire the bonds on
maturity as promised maybe because motorists are reluctant to use the highway and pay
the tolls general tax revenues may not be used to meet these payments. Instead, the
revenue bond goes into default and bond holders are not paid. Thus, revenue bonds are
generally riskier than GO bonds and Revenue bonds are project-specific and are not
funded by taxpayers
Corporate Bonds
- Long-term bonds issued by corporations
- debt securities issued by private and public corporations.
- offer higher yields than government bonds because they usually come with
a higher probability of default, making them riskier.
Corporate Bonds Valuation
- it is dependent on the present value of future expected cash flows,
discounted at a risk-adjusted rate
How to Value a Corporate Bond?
- A common way to visualize the valuation of corporate bonds is through a
probability tree. (Probability Tree Method)

Example of a corporate bond:

✓ 3-year maturity
✓ $1,000 face value
✓ 5% coupon rate ($50 coupon payments paid annually)
✓ 60 payout ratio ($600 default payout)
✓ 10 probability of default
✓ 5% risk-adjusted discount rate
First Step: Find the expected value at each period.
How to Compute?
- Done by Adding the product of the default payout and the probability of
default (P) with the product of the promised payment (coupon payments
and repayment of principal) and the probability of not defaulting (1-P)
See the Illustration for more easier interpretation:
Second Step: Calculate the bond’s price
d = risk-adjusted discount rate

How to Calculate a Corporate Bond’s Yield?

based on Problem

source: https://corporatefinanceinstitute.com/resources/knowledge/valuation/corporate-
bond-valuation/
-
BOND MARKET PARTICIPANTS
1. Bond Issuers
- The issuers sell bonds or other debt instruments in the bond market to fund
the operations of their organizations. This area of the market is mostly made
up of governments, banks, and corporations. The biggest of these issuers
is the government, which uses the bond market to fund a country's
operations, such as social programs and other necessary expenses. Banks
are also key issuers in the bond market and they can range from local banks
 up to supranational banks such as the European Investment Bank, which
issues debt in the bond market. The final major issuer in the bond market is
the corporate bond market, which issues debt to finance corporate
operations.
2. Bond Underwriters
- The underwriting segment of the bond market is traditionally made up of
investment banks and other financial institutions that help the issuer to sell
the bonds in the market. In general, selling debt is not as easy as just taking
it to the market. In most cases, millions (if not billions) of dollars are being
transacted in one offering. As a result, a lot of work needs to be done—such
as creating a prospectus and other legal documents—in order to sell the
issue.
- In general, the need for underwriters is greatest for the corporate debt
market because there are more risks associated with this type of debt.
3. Bond Purchasers
- The final players in the market are those who buy the debt that is being
issued in the market. They basically include every group mentioned as well
as any other type of investor, including the individual. Governments play
one of the largest roles in the market because they borrow and lend money
to other governments and banks.
- Furthermore, governments often purchase debt from other countries if they
have excess reserves of that country's money as a result of trade between
countries. For example, China and Japan are major holders of U.S.
government debt.
COMPARISON OF BOND MARKET SECURITIES
US Treasury and Municipal Bonds
- Treasury bonds and municipal bonds are low-risk types of securities. The
federal government issues treasury bonds, while local and state
governments issue municipal bonds. When you purchase a treasury or
municipal bond, you are lending money to the government for a set period
of time. In return, you receive income, typically with some tax benefits.
- The Bureau of the Public Debt, a federal department, issues treasury bonds
to provide funds to operate the federal government and to cover the federal
debt. Meanwhile, municipal bonds are used to fund local and state public
projects, such as roads, schools and other infrastructure.
US Treasury and Corporate Bonds
- The most attractive aspect of a corporate bond is the yield. Because few
corporations have the credibility of the U.S. government, their bonds are
considered riskier.
- the U.S. government continues to operate through good times and bad. To
compensate for the added risk, corporations offer higher rates of return on
their bonds.
- Corporate bond investors can benefit from ratings upgrades on these bonds
that can positively affect the interest rate and return on their investments.
Treasury bonds can be attractive to those who want to have a guaranteed
return on their investment and avoid default risk. The interest earned on
Treasury bonds is also tax-free at the local and state levels.
Municipal Bonds and Corporate Bonds
- Corporate bonds are those issued by large companies to raise capital for
things like market research, development, and expansion. As an investor,
you can make money by collecting those interest payments for as long as
you hold your bonds. However, those interest payments will be subject to
taxes. This means that if you buy corporate bonds paying $800 in interest
annually and your effective tax rate is 25%, you'll lose $200 of that income
to taxes.
- Municipal bonds are those issued by localities to fund public projects like
roadways, hospital systems, and schools. Municipal bonds come in two
varieties: general obligation and revenue.Example, If you buy bonds issued
by your home state, you won't pay state or local taxes, either. This means
that if you buy municipal bonds issued by your home state paying $800
interest annually, you'll get to keep that $800 in full.
INTERNATIONAL ASPECTS OF BOND MARKETS
International bond markets are those markets that trade bonds that are
underwritten by an international syndicate, offer bonds to investors in different countries,
issue bonds outside the jurisdiction of any single country, and offer bonds in unregistered
form.
International bonds classified into three main groups:
1. Eurobonds,
2. Foreign bonds, and
3. Domestic bonds.
Eurobonds
 - debt issued and traded in countries other than the country in which the
bond’s currency or value is denominated in. These bonds are often issued
in a currency that is not the domestic currency of the issuer.
- Issued by companies on the European continent, or in the European Union,
but they can trade in non-European countries, too.
- Euromarkets is the trading place of Eurobonds, Eurocurrency, Euro notes,
Euro commercial Papers, and Euro equity. It is commonly an offshore
market.
Example: Company XYZ is headquartered in the United States. Company XYZ decides
to go to Australia to issue bonds denominated in Canadian dollars. In many cases, an
issuer sells its Eurobonds in a number of international markets. Company XYZ might sell
its Canadian dollar-denominated bonds in Japan and Canada too.
Foreign Bonds
- Bonds are issued by foreign borrowers
Special characteristics of the foreign bond markets are
• Issuers of bonds are usually governments and private sector utilities.
• It is a standard practice to underwrite and organize underwriting the risks.
• Issues are generally pledged by the retail and the institutional investors.
Example: Foreign bonds issued in the United States are called Yankee bonds, foreign
bonds issued in Japan are called Samurai bonds, and foreign bonds issued in the United
Kingdom are called Bulldog bonds.
Domestic bonds
- dealt in local basis and domestic borrowers issue the local bonds. Domestic
bonds are bought and sold in local currency
Example: A British company issues debt in the United Kingdom with the principal and
interest payments based or denominated in British pounds.