BOND MARKETS

 Facilitates the flow of long- term debt from surplus units to deficit units.

Bonds- are long term debt securities that are issued by government agencies or corporations.
Parties involved: Issuer (debtor) and bondholder (creditor)
Issuer of bond is obligated to pay interest periodically (annually or semiannually) and the par
value at maturity.
Requirement: An issuer must be able to show that its future cash flows will be sufficient to enable it to make
its coupon and principal payments to bondholders
Types of Bonds
 Type of issuer
1. Treasury bonds- issued by the government;
T-Bills (1 year or less) VS T- Notes (<10 years) VS T- bonds (10 years or more)
2. Corporate bonds- issued by corporation
Bond Indenture- legal document specifying the rights and obligations of both the
issuing firm and the bondholders. Designed to address all matters related to the bond
issue (collateral, payment dates, default provisions, call provisions among others)
Characteristics of Corporate Bonds
 Sinking- fund provision- a requirement that the firm retire a certain amount of the
bond issue each year.
 Protective covenants- place restrictions on the issuing firm that are designed to
protect bondholders from being exposed to increasing risk during the investment
period. E.g. Amount of dividends, corporate officer’s salary, amount of additional
debt the firm can issue
 Call provision- requires the firm to pay a price above par value when it calls its
bonds (call premium).
Is it advantageous to bondholders if the issuer decides to call (buy back)
the bonds?
 Bond collateral- usually mortgage on real property (land & buildings)
o First mortgage bond- first claim on the specified assets
o Chattel mortgage bonds- secured by personal property
o Debentures- unsecured ( backed only by the general credit of the issuing
firm)
 o Subordinated debentures- owners receive nothing until the claims of
mortgage bonds and regular debenture owners and secured short- term
creditors have been satisfied.
How Corporate Bonds Finance Restructuring?
 Finance leverage buyout (LBO) - involves the use of debt to purchase shares and
take a company private.
 Revise Capital Structure- instead of issuing new shares, corporations opt to issue
bonds.
 Ownership Structure
1. Bearer bonds- require the owner to chip coupons attached to the bond and send them
to the issuer to receive coupon payments.
2. Registered bonds- require the issuer to maintain records of who owns the bond and
automatically send coupon payments to the owners.
 Characteristics
1. Callable & Putable Bonds- callable: can be redeemed at the issuer’s discretion prior to
the specified maturity (redemption) date; putable: can be sold back to the issuer on
specified dates, prior to redemption dates.
2. Convertible bonds- usually a corporate bonds issued with the option for holders to
convert into some other assets on specified terms at a future date (equity).
3. Floating Rate Notes (FRNs) - corporate bond where the coupons can be adjusted at
pre- determined intervals.
4. Foreign Bonds- corporate bonds issued in the country of denomination, by a firm based
outside the country.
5. Index- linked bonds- corporate bonds where the coupon can be adjusted to high and
variable rates of inflation—both the value and the coupon of an index- linked bond are
uprated each year in line with lagged changes in a specified price index (Consumer
Price Index).
 Inflation- indexed Treasury Bonds/ Treasury Inflation- Protected Securities (TIPS)
- the coupon rate offered is lower than the rate on typical treasury bonds- but the
principal value is increased by the amount of the inflation rate (every 6 months)

6. Junk bonds- corporate bonds whose issuers are regarded by bond credit rating agencies
as being of high risk.
7. Strips- Stripping refers to the breaking up of a bond into its component coupon
payments and its maturity value.
*Stripped Treasury bonds- the cash flow are commonly transformed (stripped)
by securities firms into separate securities.
Strips are not issued by the Treasury but instead are created and sold by
various financial institutions.
8. Federal Agency Bonds- government bonds issued to ensure that there is sufficient
financing for homeowners who wish to obtain mortgages.
9. Low- and Zero- coupon bonds- issued at a deep discount from par value.

Bond Yields
From the issuer’s perspective- cost of financing
Yield to maturity- annualized yield that is paid by the issuer over the life of the bond.
- Annualized discount rate that equates the future coupon and the
principal payment to the initial proceeds received from the bond
offering.
- YTM= Coupon + ((Face Value- Issue Price)/ Yield to maturity))
(Issue Price x 60%) + (Face Value x 40%)
Example: Consider an investor who can purchase bonds with 10 years until maturity, a par value of
P1, 000, and an 8% annualized coupon rate for 936. The yield to maturity on the bonds is:
YTM= Coupon + ((Face Value- Issue Price)/ Yield to maturity))
(Issue Price x 60%) + (Face Value x 40%)
= _80 + ((1000- 936)/ 10)) _____ = ____86.40___
(936 x 60%) + (1000 x 40%) 561.6 + 400
= 86.40/ 961.60
= 8.99%

From the investor’s perspective

YTM= issued and hold until maturity.
Holding period return= return from their investment over a particular holding period.
= Coupon Payments + (Selling Price- Purchase Price)
Purchase Price
BOND VALUATION
 Appropriate price reflects the present value of the cash flows to be generated by the bond in
the form of periodic interest payments and the principal payment to be provided at maturity.
Formula:

 NPV=PV of I + PV of P

*Bond Price fluctuate inversely with interest rates*

 Expectation theory- if market rate rise (increase), people prefer to hold the NEW, higher yielding
issues than existing bond. Existing bonds will be sold and their prices will fall.
 Risk.

Sensitivity of Bond Prices to Interest Rate Movements

 Indicate the potential damage to their bond holdings in response to changes in interest rates
(Therefore, in the required return on the bonds)
 Methods to assess the sensitivity of bonds
1. Bond Price Elasticity
2. Bond Duration

1. Bond Price Elasticity

 The price sensitivity of any particular bond is greater for declining interest rates than for rising
interest rates.
 The bond price elasticity is negative in all cases, reflecting the inverse relationship bet interest
rate movement and bond prices.

2. Bond Duration/ Macaulay’s Duration

 Measurement of the life of the bonds on a present value basis.
 The longer a bond’s duration, the greater its sensitivity to interest rate changes.
 The lower the coupon rate, the greater the price volatility
 Two bonds have the same maturity, assuming no call option, the one with lower coupon
will be more volatile.
 Two bonds with same coupon rate, the one with the longer maturity will be more volatile.
Modified Duration estimate the percentage change in the bond’s price in response to a 1% point change
in bond yields.

Bond Convexity a more complete formula to estimate the percentage change in price on response to a
change in yield.

For relatively large changes in the bond yield, the bond price adjustment as estimated by modified
duration is less accurate. The larger the change in the bond yield, the larger the error from estimating the
change in bond price in response the change in yield.