CHAPTER-3: DEBT INSTRUMENTS

Introduction
Debt instruments are fundamental components of the financial market, representing a vital
avenue for borrowing and lending capital. These instruments encompass various forms such
as bonds, loans, and Treasury bills, serving as vehicles through which entities acquire funds
from investors or financial institutions. Unlike equity instruments that confer ownership in a
company, debt instruments involve a contractual obligation for the borrower to repay the
principal amount along with agreed-upon interest within a specified time frame.
Debt instruments are often perceived as more conservative investments due to their fixed-income
nature, offering predictable returns through interest payments. Investors seeking stable income
streams or capital preservation often turn to debt instruments as a way to diversify their
portfolios and manage risk effectively. Understanding the intricacies of debt instruments is
crucial for investors, financial institutions, and governments alike, as they play a significant role
in shaping economic activities, capital markets, and overall financial stability.
Types of Debt Security
Debt securities are financial instruments that represent a loan made by an investor to a borrower,
typically a corporation or government. These securities are essential for raising capital and come
with various features, maturities, and risk levels. The most common types of debt securities
include:

1. Bond

Bonds are the most common type of fixed-income security, providing a steady interest income
stream over a specified period. Both corporations and governments issue bonds to raise capital
for various purposes. Bonds are seen as safer investments compared to stocks, but they generally
offer lower returns as they lack growth potential.
Bonds are long-term debt instruments issued by corporations and governments to finance
operations or specific projects. Corporations pay interest and principal from earnings, whereas
governments use tax revenue or project-generated income to meet their bond obligations.
Key Concepts:

 Coupon Rate: The interest rate paid on bonds, typically at regular intervals. Investors
receive interest payments based on the bond’s coupon rate.
 Indenture: The legal agreement between the issuer and bondholders that specifies the
terms of the bond, including payment schedules, collateral, and procedures for default.
 Secured Bonds: Backed by assets, such as real estate or equipment, offering more
security for investors.
 Unsecured Bonds (Debentures): Rely solely on the creditworthiness of the issuer,
without any collateral backing.

The below diagram shows a typical conventional or ordinary bond

Purposes of Bonds
Capital Raising: Bonds serve as a crucial tool for organizations to secure funding for a variety
of purposes, including financing new projects, expanding operations, or managing day-to-day
expenses. By issuing bonds, companies and governments can access substantial capital from a
wide range of investors.
Portfolio Diversification: Investing in bonds allows investors to diversify their portfolios, which
can help mitigate overall risk. Bonds typically have different risk and return profiles compared to
equities, making them an essential component for balancing investment strategies.
Income Generation: Bonds provide a reliable source of income through regular interest
payments, appealing particularly to income-seeking investors. This fixed income stream makes
bonds an attractive option for those looking to achieve stable cash flow while preserving capital
Types of Bonds
There are several key types of bonds, each serving different purposes and appealing to various
investors:

 Government Bonds: Issued by national governments to finance public projects or

manage budget deficits. These bonds are typically low-risk due to government backing.
For example, U.S. Treasury Bonds are widely considered one of the safest investments.
  Corporate Bonds: Issued by corporations to raise capital. These can vary in risk,
from investment-grade bonds (low risk) to junk bonds (high risk). Companies use
corporate bonds to fund expansion, acquisitions, or debt refinancing.
 Municipal Bonds: Issued by local governments to finance public projects such as
schools, roads, or infrastructure. Municipal bonds often offer tax advantages, with
interest being exempt from federal taxes.
 Zero-Coupon Bonds: These bonds do not pay periodic interest but are issued at a
discount to face value, with investors receiving the full face value at maturity. They are
ideal for long-term investors seeking capital appreciation.
 Convertible Bonds: Bonds that can be converted into a specified number of the issuer’s
common stock under certain conditions, offering the potential for higher returns if the
company’s stock price rises.

Each type of bond has unique characteristics, risk levels, and potential returns, making them
essential instruments in both corporate finance and individual investment strategies.
2. Treasury Securities
Treasury securities are debt instruments issued by governments, including the Ethiopian Federal
Government. Funds raised by issuing treasury securities are used to finance various
governmental activities, such as managing public debt or financing budget deficits. These
securities are regarded as some of the safest investments available, as they are backed by the full
faith and credit of the issuing government. Treasury securities come in a variety of maturities,
catering to different investment needs, ranging from short-term instruments to long-term
commitments. This diverse range allows investors to choose options that align with their
financial goals and risk tolerance, making Treasury securities an attractive choice for those
seeking stability and security in their investment portfolios.
Types of Treasury Securities:

 Treasury Bills (T-Bills): are short-term debt securities with maturities of one year or
less. They are sold at a discount to their face value and redeemed at full value upon
maturity. This makes T-Bills an attractive investment option for those seeking low-risk,
short-term financing. The issuance process typically involves periodic auctions where
investors, including individuals, banks, and institutional investors, can submit bids for T-
bills. These auctions can be competitive or non-competitive; in competitive bidding,
investors specify the yield they are willing to accept, while in non-competitive bidding,
they agree to accept the yield determined by the auction. In Ethiopia, Treasury bills (T-
bills) are issued with various maturities to cater to the needs of different investors and to
manage the government’s short-term funding requirements. The types of maturities for T-
bills typically include:

 28-day T-bills: These are the shortest maturity options and are often used for very short-
term funding needs.
 91-day T-bills: These T-bills have a maturity of approximately three months and are
popular among investors looking for short-term investment opportunities.
 182-day T-bills: With a maturity of about six months, these are suitable for investors
seeking a slightly longer-term investment while still maintaining liquidity.
  364-day T-bills: These T-bills mature in one year and are attractive to investors who want
to lock in their funds for a longer period while benefiting from the security of
government-backed securities.

The different maturities allow investors to choose options that align with their investment goals
and liquidity preferences while providing the government with flexibility in managing its cash
flow and financing requirements.

 Commercial Paper: Commercial paper is a short-term, unsecured debt instrument issued

by corporations to address immediate financial needs. Typically sold at a discount to its
face value, it has a fixed maturity of less than one year, making it a flexible and cost-
effective financing option.

Purposes of Commercial Paper:

 Working Capital: Used by companies to manage day-to-day operations, such as payroll

or inventory purchases.
 Flexibility: Provides short-term funding without the need for collateral, allowing
corporations to address temporary cash flow needs quickly.

 Supplemental Funding: Commercial paper can supplement other forms of financing,

such as bank loans or lines of credit, to meet short-term funding requirements.

Types of Commercial Paper:

 Financial Commercial Paper: Issued by financial institutions to raise liquidity.

 Non-Financial Commercial Paper: Issued by corporations to fund their short-term
obligations.

For instance, imagine Company A issues commercial paper with a maturity of 90 days to raise
funds for its upcoming operational expenses. Investors who purchase this commercial paper
provide Company A with the necessary funds, and in return, they receive the face value of the
paper at maturity. Company A benefits by accessing quick and cost-effective financing to
support its day-to-day activities without having to pledge collateral.
3. Inter-bank Money Market
Interbank loans are short-term loans that banks extend to one another to manage liquidity and
meet reserve requirements. Typically transacted in the money market at a specific interest rate,
these loans allow banks to maintain cash reserves and navigate daily fluctuations in deposits and
withdrawals. By facilitating liquidity and supporting the overall stability of the banking sector,
interbank lending plays a crucial role in ensuring the efficient functioning of financial systems.
For instance, if Dashen Bank in Ethiopia faces a temporary liquidity shortfall due to unexpected
withdrawals, it may seek an interbank loan from Zemen Bank. Zemen Bank can provide the loan
at a set interest rate, enabling Dashen Bank to meet its cash flow needs without liquidating
assets. This arrangement not only supports Dashen Bank’s operations but also allows Zemen
Bank to earn interest on the loan, demonstrating how interbank loans enhance stability and
liquidity in the banking system
4. Repurchase agreement (Repos)
A repurchase agreement, or repo, is a short-term borrowing mechanism where one party sells
securities to another with the agreement to repurchase them at a later date, typically at a higher
price. This transaction serves as a way for the seller to obtain immediate cash while providing
the buyer with collateral.
For example, if a financial institution holds Treasury Bills issued by the Ethiopian Federal
Government but needs short-term liquidity, it may enter into a repo agreement. In this scenario,
the institution sells the Treasury Bills to a bank and agrees to repurchase them the following day
at a slightly higher price. This arrangement allows the institution to access cash quickly while the
bank earns a return on the transaction, secured by the low-risk Treasury Bills. Repos, therefore,
play a crucial role in enhancing liquidity within the financial system.

Interactive exercise3
1. What characteristic distinguishes a zero-coupon bond from other types of bonds?

It pays interest periodically

It is sold at a discount to face value and pays no periodic interest

It can be converted into the issuing company's stock

It is secured by physical assets

2. What is the primary purpose of issuing bonds by corporations?

To gain ownership in another company

To raise capital for business activities

To avoid paying taxes

To purchase stocks in foreign markets

3. In the context of bonds, what is meant by the term "coupon rate"?

The percentage of the bond's face value that is paid annually as interest

The rate at which the bond can be converted into stock

The fee charged by the issuer to underwrite the bond

 The discount rate applied at the time of bond issuance
4. Which of the following statements is true about municipal bonds?

They are issued only by federal governments.

Interest earned on municipal bonds is typically taxable at regional level but on the federal level

Municipal bonds are used to finance public projects and usually have tax-exempt interest

They are considered to be riskier than corporate bonds

5. Which of the following types of bonds involves low-risk

Corporate Bonds

High-Yield Bonds

Government Bonds

Zero-Coupon Bonds
 No Type Questions Given Answer Correct Answer Result

The percentage of
In the context of The percentage of
the bond's face
bonds, what is the bond's face
1 value that is paid Correct
meant by the term value that is paid
annually as
"coupon rate"? annually as interest
interest

What
characteristic It is sold at a It is sold at a
distinguishes a discount to face discount to face
2 Correct
zero-coupon bond value and pays no value and pays no
from other types periodic interest periodic interest
of bonds?

Which of the
following types of Government
3 Government Bonds Correct
bonds involves Bonds
low-risk

What is the
To raise capital
primary purpose To raise capital for
4 for business Correct
of issuing bonds business activities
activities
by corporations?

Municipal bonds
Which of the Municipal bonds
are used to
following are used to finance
finance public
5 statements is true public projects and Correct
projects and
about municipal usually have tax-
usually have tax-
bonds? exempt interest
exempt interest

Purpose and Participants of the Debt Market

The debt market serves a crucial role for both issuers and investors. Governments,
municipalities, and corporations issue debt to fund long-term projects or meet operational needs,
while investors purchase debt securities to earn predictable returns with lower risk compared to
equities.
Participants:

 Issuers: Federal and local governments, corporations.

 Investors: Households, financial institutions, pension funds.
The debt market helps fuel economic growth by providing the capital needed for infrastructure,
development, and business expansion. Efficiently functioning debt markets are essential for
financial stability.
Financial Institutions Participation in Bond Markets
Commercial Banks and Savings – Purchase bonds for their asset portfolio
& Loan Associations (S&Ls) – Sometimes issues bonds as a source of secondary capital
Finance Companies – Commonly issues bonds as a source of long-term funds
– Use funds received from the sale of shares to purchase
Mutula Funds
bonds
– Facilitate bond trading by matching up buyers and
Brokerage Firms
sellers of bonds in the secondary market
– Place newly issued bonds for governments and
corporations.
Investment Banking firms – They may place the bonds and assume the risk of market
price uncertainty or place the bonds on a best-efforts basis in
which they do not guarantee a price for the issuer.
Insurance Companies – Purchase bonds for their asset portfolio
Pension Funds – Purchase bonds for their asset portfolio
– Issue bonds to raise funds for public projects
Government Entities
– Purchase bonds as part of their investment strategy
– Issue corporate bonds to raise capital for expansion or
Corporations operations
– Invest in bonds as part of asset management strategies
– Purchase bonds for personal investment portfolios
Retail Investors
– Use bonds as a means of saving and generating income

Chapter Key Points

 Debt instruments represent a loan made by an investor to a borrower, typically a corporation or

government, with the obligation to repay the borrowed amount plus interest over time.
 Bonds are the most common type of fixed-income security, paying periodic interest and returning the
principal at maturity. Bonds can be government-issued, corporate, municipal, zero-coupon, or
convertible.
 Treasury securities, such as T-bills, T-notes, and T-bonds, are considered among the safest
investments, backed by the U.S. government.
 Commercial paper is a short-term, unsecured debt instrument issued by corporations to meet
immediate funding needs.
 Loan agreements formalize the terms of a loan, providing clarity and security for both the borrower
and lender.
  Interbank loan is a short-term loan made between banks to manage liquidity and meet reserve
requirements.
 Repo- is a short-term borrowing arrangement in which one party sells securities to another
with the agreement to repurchase them later at a higher price.

SELF ASSESSMENT QUESTIONS

1. Convertible bonds can be converted into what?

Cash

Preferred shares

A predetermined number of the issuer's common stock shares

Bonds of another corporation

2. In a repurchase agreement (repo), what does the seller typically do?

Issues new stocks

Sells securities to obtain cash and agrees to repurchase them later

Borrows money without collateral

Provides long-term loans to businesses

3. What are Treasury securities primarily used for?

To secure private investments

To finance government operations and manage the national debt

To provide consumer loans

To raise capital for corporations

4. What is one of the main differences between institutional investors and retail investors when investing in
fixed income securities?

Institutional investors cannot invest in fixed income securities

Retail investors have greater negotiating power than institutional investors

The motivations and consideration of interest rates may differ due to the scale and financial capabilities.

There are no differences; both invest in exactly the same manner

5. What is the main appeal of debt instruments for investors?

They provide ownership in a company.

They offer predictable returns through interest payments.

They allow investors to share in the company's profits.

They have higher growth potential than stocks.

6. What is the main purpose of interbank loans?

To invest in government bonds

To manage liquidity and meet reserve requirements

To fund long-term corporate projects

To provide loans to individuals

7. What is the main purpose of commercial paper for corporations?

To secure long-term financing for business expansion

To raise funds for operational expenses and immediate financial obligations

To issue stock to investors

To repay existing long-term debts

8. In a secured loan agreement, what does the borrower typically provide?

A personal guarantee

Detailed financial statements

Collateral

Stock options
9. Which of the following best describes commercial paper?

A secured loan issued by banks

A short-term, unsecured debt instrument

A long-term bond

A government-issued security
10. Which of the following is NOT a feature of Treasury Bills (T-Bills)?

They are sold at a discount to their face value

They offer long-term investment opportunities

They are backed by the full faith and credit of the government

They are typically issued through periodic auctions

Types of bonds in detail

Bonds are debt instruments issued by governments, municipalities, corporations, and other
entities to raise capital. They come in various types, each with unique features, risks, and
benefits. Below is a detailed overview of the major types of bonds:

1. Government Bonds

Issued by national governments, these are considered some of the safest investments because
they are backed by the government's ability to tax and print money.

Types:

 Treasury Bonds (T-Bonds):

o Issued by the U.S. government.
o Maturities range from 10 to 30 years.
 o Pay semi-annual interest (coupon payments).
o Considered virtually risk-free.
 Treasury Notes (T-Notes):
o Maturities range from 2 to 10 years.
o Pay semi-annual interest.
 Treasury Bills (T-Bills):
o Short-term bonds with maturities of less than one year.
o Sold at a discount and mature at face value (zero-coupon bonds).
 Inflation-Protected Securities (TIPS):
o Principal and interest payments adjust with inflation.
o Protects investors from inflation risk.
 Savings Bonds:
o Non-marketable bonds issued to individual investors.
o Examples: Series EE and Series I bonds (inflation-linked).

Key Features:

 Low risk of default.

 Interest is typically exempt from state and local taxes (but subject to federal taxes).
 Highly liquid.

2. Municipal Bonds (Munies)

Issued by state, local governments, or municipal entities to fund public projects like schools,
highways, and infrastructure.

Types:

 General Obligation Bonds (GO Bonds):

o Backed by the full faith and credit of the issuer.
o Repaid through taxes.
 Revenue Bonds:
o Repaid from revenue generated by the project they fund (e.g., toll roads, utilities).
 Private Activity Bonds:
o Fund projects for private entities that serve a public purpose (e.g., airports,
affordable housing).

Key Features:

 Interest is often exempt from federal, state, and local taxes.

 Lower yields compared to taxable bonds.
 Generally low default risk, but credit risk varies by issuer.
3. Corporate Bonds

Issued by companies to raise capital for business operations, expansion, or acquisitions.

Types:

 Investment-Grade Bonds:
o Issued by financially stable companies with low default risk.
o Lower yields compared to high-yield bonds.
 High-Yield Bonds (Junk Bonds):
o Issued by companies with lower credit ratings.
o Higher risk of default but offer higher yields.
 Convertible Bonds:
o Can be converted into a predetermined number of the issuer's shares.
o Offers potential for capital appreciation.
 Callable Bonds:
o Can be redeemed by the issuer before maturity.
o Typically offer higher yields to compensate for call risk.
 Puttable Bonds:
o Allow bondholders to sell the bond back to the issuer before maturity.

Key Features:

 Higher yields compared to government bonds.

 Subject to credit risk (default risk varies by issuer).
 Interest is taxable at the federal and state levels.

4. Zero-Coupon Bonds

Bonds that do not pay periodic interest. Instead, they are sold at a deep discount and mature at
face value.

Key Features:

 No periodic interest payments.

 Return comes from the difference between the purchase price and face value.
 Often issued by governments and corporations.
 Subject to interest rate risk and inflation risk.
5. Agency Bonds

Issued by government-sponsored enterprises (GSEs) or federal agencies, such as Fannie Mae,

Freddie Mac, or the Federal Home Loan Bank.

Key Features:

 Not directly backed by the U.S. government but considered low-risk.

 Offer slightly higher yields than Treasury bonds.
 Interest is typically subject to federal taxes but exempt from state and local taxes.

6. Supranational Bonds

Issued by international organizations like the World Bank, International Monetary Fund (IMF),
or Asian Development Bank.

Key Features:

 Used to fund global development projects.

 Generally low risk.
 Offer competitive yields.

7. Emerging Market Bonds

Issued by governments or corporations in developing countries.

Key Features:

 Higher yields due to higher risk (political instability, currency risk, etc.).
 Subject to credit risk and currency risk.
 Can be volatile but offer diversification benefits.

8. Green Bonds

Issued to fund environmentally friendly projects, such as renewable energy or clean water
initiatives.

Key Features:

 Proceeds are earmarked for green projects.

  Often issued by governments, municipalities, or corporations.
 Growing in popularity due to increased focus on sustainability.

9. Sovereign Bonds

Issued by national governments in foreign currencies.

Key Features:

 Used to attract foreign investment.

 Subject to currency risk and political risk.
 Examples: U.S. Treasury bonds issued in foreign markets.

10. Floating Rate Bonds

Bonds with variable interest rates that adjust periodically based on a benchmark rate (e.g.,
LIBOR or SOFR).

Key Features:

 Interest payments fluctuate with market rates.

 Protects investors from interest rate risk.
 Often issued by corporations and governments.

11. Perpetual Bonds

Bonds with no maturity date. They pay interest indefinitely.

Key Features:

 Rare and typically issued by governments or financial institutions.

 Higher risk due to lack of maturity date.
 Offer steady income but are sensitive to interest rate changes.

12. Catastrophe Bonds (Cat Bonds)

High-yield bonds issued by insurance companies to raise funds for covering large-scale disasters
(e.g., hurricanes, earthquakes).
Key Features:

 High risk: If a specified catastrophe occurs, investors may lose principal.

 High returns to compensate for risk.
 Used for risk diversification in portfolios.

13. Foreign Bonds

Bonds issued by a foreign entity in a domestic market and denominated in the domestic currency.

Examples:

 Yankee Bonds: Issued in the U.S. by foreign entities.

 Samurai Bonds: Issued in Japan by foreign entities.
 Bulldog Bonds: Issued in the U.K. by foreign entities.

Key Features:

 Subject to currency risk and political risk.

 Offer diversification benefits.

14. War Bonds

Historically issued by governments to finance military operations during wars.

Key Features:

 Rare in modern times.

 Often marketed as patriotic investments.

Summary Table:

Type of Bond Issuer Risk Level Key Features

Government
National Governments Low Safe, tax advantages, liquid
Bonds
Low-
Municipal Bonds State/Local Governments Tax-exempt, funds public projects
Medium
Medium-
Corporate Bonds Companies Higher yields, credit risk
High
 Type of Bond Issuer Risk Level Key Features
Zero-Coupon No periodic interest, sold at
Governments/Corporations Medium
Bonds discount
Slightly higher yields than
Agency Bonds GSEs/Federal Agencies Low
Treasuries
Emerging Market
Developing Countries High High yields, high risk
Bonds
Low- Funds environmentally friendly
Green Bonds Governments/Corporations
Medium projects
Floating Rate
Governments/Corporations Medium Interest adjusts with market rates
Bonds
Perpetual Bonds Governments/Institutions High No maturity date, steady income
Catastrophe High risk, high return, linked to
Insurance Companies High
Bonds disasters
Medium- Currency risk, diversification
Foreign Bonds Foreign Entities
High benefits

Each type of bond serves different investment goals, risk tolerances, and tax considerations.
Investors should carefully evaluate their objectives and the specific features of each bond before
investing.

NoTypeQuestionsGiven AnswerCorrect AnswerResult1

Convertible bonds can be converted into what?
A predetermined number of the issuer's common stock shares
A predetermined number of the issuer's common stock shares
Correct 2
In a repurchase agreement (repo), what does the seller typically do?
Sells securities to obtain cash and agrees to repurchase them later
Sells securities to obtain cash and agrees to repurchase them later
Correct 3
What are Treasury securities primarily used for?
To finance government operations and manage the national debt
To finance government operations and manage the national debt
Correct 4
What is one of the main differences between institutional investors and retail investors when investing in fixed
income securities?
The motivations and consideration of interest rates may differ due to the scale and financial capabilities.
The motivations and consideration of interest rates may differ due to the scale and financial capabilities.
Correct 5
What is the main appeal of debt instruments for investors?
They offer predictable returns through interest payments.
They offer predictable returns through interest payments.
Correct 6
What is the main purpose of interbank loans?
To manage liquidity and meet reserve requirements
To manage liquidity and meet reserve requirements
Correct 7
What is the main purpose of commercial paper for corporations?
To raise funds for operational expenses and immediate financial obligations
To raise funds for operational expenses and immediate financial obligations
Correct 8
In a secured loan agreement, what does the borrower typically provide?
Collateral
Collateral
Correct 9
Which of the following best describes commercial paper?
A short-term, unsecured debt instrument
A short-term, unsecured debt instrument
Correct 10
Which of the following is NOT a feature of Treasury Bills (T-Bills)?
They offer long-term investment opportunities
They offer long-term investment opportunities
Correct