The Bond Market

Chapter 12
Financial Markets and Institutions, Mishkin & Eakins
9th Global Edition
Chapter Preview
• Bond and its types
• Risks involved in bond investment
• Types and characteristics of corporate bonds
• Bond valuation
• YTM and current yield
What is a bond?
• A bond is a financial instrument that allows a government or
corporation to borrow money from investors.
• It is typically issued at a set rate of interest over a specific
period of time – from the date the bond is issued to its
maturity date.
• The interest rate (or coupon) that is paid for this loan is
determined by a variety of factors, such as the
creditworthiness of the issuer and the prevailing rate of
interest offered in the market at that point in time.
What is a bond?
• Provided you buy a bond for the same price as its par
value/face value, your investment return will be the value of
the coupon payments you received, and the face value after
maturity.
• If you decide to sell your bond in the market prior to its
maturity date you may also have a gain or loss based on
whether the bond was worth more or less than the face value.
 Types of Bonds
• Treasury Notes and Bonds
The Treasury issues notes and bonds to finance the national debt. The
difference between a note and a bond is that notes have an original maturity
of 1 to 10 years while bonds have an original maturity of 10 to 30 years.
• The prices of Treasury notes, bonds, and bills are quoted as a percentage of
$100 face value.
• Treasury bonds have very low interest rates because they have no default
risk. But they have interest rate risk.
 …Types of bonds: Treasury bonds
• Bangladesh Government Treasury Bonds (BGTB) of 2, 5, 10, 15 and 20 years
maturities. BGTBs are sold through auctions. Only Primary Dealers (PD) can
submit bids in the auctions. Other institutions and individuals can submit bids
in auction but through the PDs.
• At present 20 banks are performing as Primary Dealer.
• Individuals may also buy or sell government securities in secondary market
over the counter (OTC)/Trader Work Station (TWS) of MI module.
• To buy or sell bonds investors need to open Business Partner Identification
(BP ID) in favor of their individual/institutional customers in Market
Infrastructure (MI) Module of Bangladesh Bank.
 …Types of bonds: Corporate Bonds
• When large corporations need to borrow funds for long periods of time,
they may issue bonds.
• Most corporate bonds have a face value of $1,000 and pay interest
semiannually (twice per year). Most are also callable, meaning that the
issuer may redeem the bonds prior to maturity after a specified date.
• The bond indenture is a contract that states the lender’s rights and
privileges and the borrower’s obligations. Any collateral offered as
security to the bondholders is also described in the indenture.
 …Types of bonds: Corporate Bonds
• Corporate bonds carry more risk than government bonds because
corporations can’t raise taxes to pay for their bond issues.
• The degree of risk varies widely among different bond issues because
the risk of default depends on the company’s health. The interest rate on
corporate bonds varies with the level of risk.
• Corporate/T-Bonds that do not make regular coupon payments to their
owners are referred to as zero-coupon bonds.
• These bonds are issued at a discount from their par values and will repay
the full par value at their maturity date.
Risks involved in bond investment
• Although the stock market is generally considered more volatile,
bonds carry their own forms of risk. The most significant ones are
interest-rate risk and credit quality risk (default risk).
• Generally, the higher the risk the larger the yield, or return, to the
investor. For example, Government, backed by the credit worthiness
of the government, pay lower returns than bonds issued by
corporations with a less creditworthy reputation.
• When you accept high yields and low credit quality, you risk seeing
the bond issuer default on their bond obligations.
• The biggest risk of a bond investment is if the issuer goes bankrupt,
the loan may not get paid back at all.
…Risks involved in bond investment
• A bond can be bought and sold in the open market, similar to a stock.
When the bond matures, the borrower repays you the original purchase
price of your bond.
• Prior to the bond’s maturity, its market value will vary as interest rates
in the economy rise or fall. For example, suppose you hold a bond of
$1,000 par value with 5% coupon.
• If interest rates rise to 7%, the value of your bond will be worth less
because investors want new bonds paying more; therefore, your bond
will depreciate, losing resale value.
• If interest rates fall to 3%, your bond becomes more valuable than
those issued after yours; this means the bond value has appreciated
and you could sell it at a premium.
…Risks involved in bond investment

• When interest rates rise, bond prices

generally fall. This means that bonds —
particularly longer-term bonds — are highly
susceptible in economic climates with
rising interest rates.
• If your investment portfolio is heavily
weighted with bonds and you try to sell
bonds before it matures when interest rate is
high, you would lose some of your original
investment.
Types of Corporate Bonds
• A variety of corporate bonds are available. They are usually
distinguished by the type of collateral that secures the bond and
by the order in which the bond is paid off if the firm defaults.
• Secured Bonds Secured bonds are ones with collateral attached.
Mortgage bonds are used to finance a specific project. For
example, a building may be the collateral for bonds issued for its
construction.
• In the event that the firm fails to make payments as promised,
mortgage bondholders have the right to liquidate the property in
order to be paid. Because these bonds have specific property
pledged as collateral, they are less risky than comparable
unsecured bonds. As a result, they will have a lower interest rate.
 …Types of Corporate Bonds
• Unsecured Bonds: Debentures are long-term unsecured bonds that are
backed only by the general creditworthiness of the issuer.
• No specific collateral is pledged to repay the debt. In the event of default,
the bondholders must go to court to seize assets.
• Debentures usually have an attached contract that spells
out the terms of the bond and the responsibilities of management.
• The contract attached to the debenture is called an indenture. Debentures
have lower priority than secured bonds if the firm defaults. As a result,
they will have a higher interest rate than otherwise comparable secured
bonds.
…Types of Corporate Bonds
• Junk Bonds: All bonds are rated by various credit-rating agencies
according to their default risk.
• The rating companies study the issuer’s financial characteristics and
make a judgment about the issuer’s possibility of default.
• A bond with a rating of AAA has the highest grade possible. Bonds at
or above Moody’s Baa or Standard and Poor’s BBB rating are
considered to be of investment grade.
• Those rated below this level are usually considered as speculative.
Speculative-grade bonds are often called junk bonds.
Bond Rating:
Investment Grade Bond
Characteristics of corporate bonds
• Restrictive Covenants As managers are monitored by the
stockholders they will be 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. These
are known as restrictive covenants.
• They usually limit the amount of dividends the firm can pay (so
to conserve cash for interest payments to bondholders) and the
ability of the firm to issue additional debt.
…Characteristics of corporate bonds
• Call Provisions Most corporate indentures include a call provision,
which states that 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.
• The price bondholders are paid for the bond is usually set at the
bond’s par price or slightly higher (usually by one year’s interest
cost). For example, a 10% coupon rate $1,000 bond may have a call
price of $1,100.
• Because bondholders do not generally like call provisions, callable
bonds must have a higher yield than comparable noncallable bonds.
Reasons for including call provision
• If interest rates fall, the price of the bond will rise. If rates
fall enough, the price will rise above the call price, and the
firm will call the bond.
• Suppose that a firm needed to borrow additional funds to
expand its storage facilities. If the firm’s bonds carried a
restriction against adding debt, the firm would have to retire
its existing bonds before issuing new bonds or taking out a
loan to build the new warehouse.
• Finally, a firm may choose to call bonds if it wishes to alter
its capital structure. A maturing firm with excess cash flow
may wish to reduce its debt load if few attractive investment
opportunities are available.
…Characteristics of corporate bonds
• Conversion Some bonds can be converted into common stock. This feature
permits bondholders to share in the firm’s good fortunes if the stock price
rises.
• Most convertible bonds will state that the bond can be converted into a certain
number of common shares at the discretion of the bondholder.
• Issuing convertible bonds is one way firms avoid sending a negative signal to
the market. In the presence of asymmetric information between corporate
insiders and investors, when a firm chooses to issue stock, the market usually
interprets this action as indicating that the stock price is relatively high or that
it is going to fall in the future.
• If managers believe that the firm will perform well in the future, they can,
instead, issue convertible bonds. If the managers are correct and the stock
price rises, the bondholders will convert to stock at a relatively high price.
Alternatively, bondholders have the option not to convert if managers turn out
to be wrong about the company’s future.
Bond valuation
• We value securities by discounting their future cash flows to
today by obtaining its present value.
• Valuation of a security involves two tasks:
• Forecast its future cash flow
• Determine its discount rate (the required rate of return)
• The future cash flows from a bond are known (coupons +
principal), as long as there is no default.
• The key for bond valuation then is to determine its discount rate
or rate of return required for a bond investment to be worthwhile.
Zero coupon bond valuation
• A zero-coupon bond makes no annual or semi-annual coupon
payments over the duration of the bond. Instead, it is sold at a discount
to par when issued.
• The difference between the purchases price and par value is the
investor’s interest earned on the bond.
• To calculate the value of a zero-coupon, we only need to find the PV
of the face value.
• Example: Consider a zero coupon bond. What is the value of a 5-year
zero coupon bond (based on annual discounting) if the discount rate is
12%?
Coupon bond valuation
• The PV of expected cash flows is added to the PV of the face value of
bond, as shown in the following formula:

• Note that most bonds semi-annual coupon payments. In that case, the
modified formula will be:

• Where,
Coupon bond valuation
• Example: What would be you be willing to pay right now for a bond
which pays annual coupon of 6.5% per year for 3 years, has a face
value of $1,000. Assume that similar 3-year bonds offer a return of
5.1%.
•
YTM and Current yield
• If you buy a bond and hold it until it matures, you will earn
the yield to maturity. This represents the most accurate
measure of the yield from holding a bond.
• The YTM is calculated as follows:
…YTM and Current yield
• YTM approximation formula:

• Example: What is the YTM on a 20 year bond with a current price of

$900 if the coupon rate is 8% paid semi-annually:
…YTM and Current yield
• The Current Yield measures the annual return to an investor based on
the current price.

• For example, a 10% coupon bond which is currently selling at $1150

would have a current yield of: