Bond markets

BOND MARKETS
Presented by:
Maksudul Huq Chowdhury

Background of Bonds
A bond is a long term fixed denomination debt security issued
by a corporate entity or government or any other authorized
agency of the government which are authorized to raise funds
through issuance of bond. A bond is issued for a limited time
with a certain rate of interest to be paid over the principal
amount outstanding. A bond is managed and terminated as per
the covenants (term and conditions mentioned in the bond
indenture (statement of contractual agreements on the part of
the borrowing company).

Background of Bonds
From the above definition we may find the following basic
features of a bond:
 A bond is a long term debt instrument.
 It has a fixed monetary denomination – or face value.
 The bond is a mortgage debt instrument.
 It has a fixed or finite maturity period when the bond shall be
terminated.
Cont…..

Background of Bonds
 Interest is paid at a fixed rate, which is charged on the principal
amount outstanding at the time of payment.
 Interest paid in general semi annually.
 The bond has an indenture where all the terms and conditions
for management and termination of the bond are mentioned.
 The bond indenture is a legal agreement on the part of the
borrowing company to the lender.
Cont…..

Specific features of a Bond
In addition to the basic features mentioned above, most bonds
are issued with some specific features to suit the needs of the
issuer. However, such features are not common to all bonds.
Some of these additional features are also observed in case of
most of the bonds in different forms. These are:

Trustees
Instrumental credit arrangements in most of the cases includes
provisions for one trustee to oversee the interest of the lenders
(investors in the securities) so that the borrower company can
not violate the terms and conditions mentioned in the
indenture and thus minimize the risk of default. Most often, the
trustee is an institution or person who is perceived to be
acceptable to the general investors. The trustee oversees the
activities of the bond issuer to ensure that it is performing as per
the terms and conditions laid down in bond indenture. In
Bangladesh ICB works as the trustee for most of the bonds
issued so far by the different firm.

Trustees
They perform 3 functions namely:
i. Ensure that indenture and other documents are properly
prepared and implemented
ii. Monitor that the firm is performing in compliance with the
indentures term and conditions and
iii. Take necessary actions if the firm is not performing in
compliance with the indenture.
Cont…..

Protective covenants
All most of all types of lending agreement include a set of
protective covenants in favour of the lenders. These covenants
can be general covenants like restriction on further borrowings,
restriction on secondary mortgage, restriction on dividend
payments in certain situations and also the requirements for
maintaining certain debt equity ratio, requirements for
insurance and normal wear and tear for the mortgaged assets
etc.

Repayment Procedure
The repayment of borrowed funds can be made in any of the
following ways:
 Flat of fully amortized payment: under this procedure, the
borrowed fund along with the interest is repaid in equal
periodic payments. Every installment includes interest on the
unpaid balance plus some part of the principal loan.

Repayment Procedure
 Balloon Payment: Under this payment plan the early stage
repayments include the interest and a small segment of the
principal. The major segment of principal is repaid at later stage
and so the volume of installment becomes larger like a balloon.
This payment procedure is also known as semi amortized
payments.
 Terminal Payment: Under this payment procedure, the
interest is paid periodically but the principal is repaid at the end
of maturity or through other form of retirements of debt.
Cont…..

Termination or Retirement of a Bond
 Most bonds have finite life. A bond is terminated or retired on
or before that date. A bond can be terminated in any of the
following ways:
 Termination at Maturity: Normally a bond is terminated at
the time of maturity. This repayment can be made by repaying
the principal amount borrowed. This is the normal process of
termination of a bond.

 Termination by Conversion: A bond can be subject to
termination by conversion into common stock of the firm. Most
often, this conversion into common stock takes place at the time
of maturity period. The conversion is done in any of the
following approaches to be declared in the bond indenture.
1. A fixed percentage of the bond will be converted into a
predetermined number of common stock. In this case the bond
will be something like a stock warrant whose value will be equal
to the market price of the underlying security.
Cont…..

 For example, Faith 11 (BD) Ltd issued some Tk. 2000 10-years
bonds. The bonds were convertible into 15 Tk.100 common stock
of the firm for 80% of its value, which is Tk. 1600. The balance
of Tk. 400 was payable in cash. Now if the price of stock of Faith
11 (BD) Ltd goes up to Tk. 120 each, the market value of the bond
should be 15 * tk. 120 + Tk. 400 = Tk. 1800 + Tk. 400 = Tk. 2200.
If the stock price goes further up to Tk. 150 each, the bond price
will be Tk. 2250 + Tk. 400 = Tk. 2650. In the same way, if the
stock price decline, the bond price will also decline.
Cont…..

2. Another approach is to declare that a fixed percentage of the
face value (par value) of the bond will be converted into
common stock of the firm at a price to be prevailing at the time
of conversion. The number of common stock to be converted
into remains an undefined number. The number will depend on
the market price of the common stock prevailing at the time of
conversion. Since the bond holders can not gain from this type
of conversion provisions, the bond price remain the same as any
other form of bonds with same risk class.
Cont…..

 For example, in the above case if 80% of Faith 11 (BD) Ltd bonds
were converted (80% of Tk. 2000 or Tk. 1600 in this example)
into the common stocks of the firm, then the bond holders
would have received stocks of the firm in as per the market price
of the stock at the time of conversion. Therefore, if the market
price is Tk. 120 per share, the bond holders will receive
(1600/120) 13 share of the firm plus Tk. 440 [Tk. 400 + (Tk. 1600
– Tk. 120*13)] in cash.
Cont…..

 Termination by Gradual withdrawal: A debt instrument’s
total retirement can take long time. Total repayment most often
is made at the end of bond life. However, in some cases, it can
take time as long as a number of years. This type of gradual
retirement can take place in a number of ways. For this purpose,
the bond issuing firm needs a sinking fund provision. Under
sinking fund provision, the borrowing firm is required to set
aside a certain part of its net profit after tax in a fund created for
regular partial retirement of the outstanding loan. The sinking
fund provision also allows the firm to develop necessary funds at
the time of maturity if a single repayment is planned. The serial
bond allows the issuing company to retire certain number of
outstanding bonds every year.
Cont…..

Thus by the time of maturity only a few number of bonds will
remain outstanding.
1. Gradual retirement of Bond: Under this method issuer
withdraws the bond gradually adopting a systematic
retirement plan. Most often Gradual retirement is made by
 Buying back, a fixed (predetermined) number of bonds from the
open market every year and retire the same.
Cont…..

 The bond issuer repays the total amount of a fixed number of
bonds every year through the serial numbers of the bonds (serial
bond). For this purpose, the bond issuer declares in advance which
number of bonds will be retired when. The investor can also plan
what type of maturity they want to invest into their money.
 Gradually repaying a fixed (predetermined) portion of outstanding
amount along with the interest payments. This provision applies for
all the bonds altogether.
Cont…..

2. Call Provision: Under the call provision, the outstanding
bonds can be called back by the issuing company before the
maturity period. In this case, the bond holders receive certain
premium price over the face value of the bond. The issuing
company can call back an outstanding bond after the expiry of
a minimum waiting period. After this date, the bond issuer
retains the right to call back the bond at any time it finds
convenient but has to pay call premium on it.
Cont…..

3. Replacement of Bond: The convertibility features coupled
with call provision enables the issuing company a provision
to convert the bonds outstanding into the stock of the
company. Thus through conversion, the bond holders
become shareholder as per market price of the bond and the
stock at the time of conversion. An outstanding long-term
debt can also be retired and replaced by issuing a new debt.
This is done if the market interest rate comes down to a level
too low, in comparison to that of the outstanding bond’s
interest rate. In this case, if the firm can issue a new bond
and uses the proceeds to repay the existing loan, the firm can
minimize its long-term cost of debt. The replacement
approach can be ensured only when the outstanding bond
has a call provision.
Cont…..

Institutional Participation in Bond Markets
All types of financial institutions participate in bond
markets. Commercial banks, savings institutions and
finance companies commonly issue bonds in order to
raise capital to support their operations. Commercial
banks, savings institutions, bond mutual funds,
insurance companies and pension funds are investors
in the bond market. Financial institutions dominate
the bond market in that they purchase a large
proportion of bonds issued.

Cont…..
Reasons for participation of Financial Institutions in bond markets:
Financial
Institution
Reasons for participation
Commercial banks  Purchase bonds for their asset portfolio
 Sometimes issue bonds as a source of
secondary capital.
Finance
Companies
 Commonly issue bonds as a source of long-
term funds.
Mutual funds  Use funds received from the sale of shares to
purchase bonds. Some bond mutual funds
specialize in particular types of bonds, while
other invest in all type.

Cont…..
Brokerage firms  Facilitate bond trading by matching up
buyers and sellers of bonds in the secondary
market.
Investment
banking firm
 Place newly issued bonds for government
and corporations. 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.

Types of Bonds
A. On the basis of issuer, bonds may be categorized into 3
major categories:
1. Treasury and Agency bonds
2. Municipal Bonds and
3. Corporate Bonds

Types of Bonds
 1. Treasury and Agency bonds: This types of bonds issued by
government to financed government expenditures in the form of
Treasury notes and Treasury bonds. The key difference between
a note and a bond is that note maturities are less than 10 years
whereas bond maturities are more than 10 years. Investors in
Treasury notes and bonds receive semiannual interest payments
from the Treasury.
Cont…..

Types of Bonds
 2. Municipal Bonds:
 3. Corporate Bonds: Corporate bonds are long-term debt
securities, issued by corporations that promise the owner
coupon payments (interest) usually on a semiannual basis.
Cont…..

Types of Bonds
B. On the basis of Variability of Coupon:
1. Zero Coupon Bonds: Zero Coupon Bonds are issued at a
discount to their face value and at the time of maturity, the
principal/face value is repaid to the holders. No interest
(coupon) is paid to the holders and hence, there are no cash
inflows in zero coupon bonds. The difference between issue
price (discounted price) and redeemable price (face value) itself
acts as interest to holders.
Cont…..

Types of Bonds
2. Floating Rate Bonds: In some bonds, fixed coupon rate to be
provided to the holders is not specified. Instead, the coupon
rate keeps fluctuating from time to time, with reference to a
benchmark rate. Such types of bonds are referred to as Floating
Rate Bonds. These bonds are known as Inverse Floaters and are
common in developed markets.
Cont…..

Types of Bonds
3. Junk Bonds: Corporate bonds that are perceived to have very
high risk are referred to as Junk bonds. The primary investors in
junk bonds are mutual funds, life insurance companies and
pension funds. In addition, many institutional investors
continue to invest in junk bonds because the yields offered on
these bonds are so much higher than yields on safer debt
securities.
Cont…..

Types of Bonds
C. On the Basis of Variability of Maturity:
1. Callable Bonds: These securities have provisions allowing the
issuer to redeem the issue prior to the scheduled maturity date.
2. Puttable Bonds: The holder of a puttable bond has the right (but
not an obligation) to seek redemption (sell) from the issuer at
any time before the maturity date. The holder may exercise put
option in part or in full.
Cont…..

Types of Bonds
3. Convertible Bonds: The holder of a convertible bond has the
option to convert the bond into equity (in the same value as of
the bond) of the issuing firm (borrowing firm) on pre-specified
terms. This results in an automatic redemption of the bond
before the maturity date.
Cont…..

Types of Bonds
D. On the basis of Principal Repayment:
1. Amortizing Bonds: Amortizing Bonds are those types of bonds
in which the borrower (issuer) repays the principal along with
the coupon over the life of the bond. For example - auto loans,
home loans, consumer loans, etc.
2. Bonds with Sinking Fund Provisions: Bonds with Sinking Fund
Provisions have a provision as per which the issuer is required to
retire some amount of outstanding bonds every year. The issuer
has following options for doing so: i. By buying from the market,
ii. By creating a separate fund which calls the bonds on behalf of
the issuer
Cont…..

Why are bonds risky
Default
risk
Inflation
risk
Interest
rate risk

Why are bonds risky
Default
risk
Risk that the issuer fails to make promised
payments on time
Zero for government debt
Other issuers: corporate, municipal, foreign
have some default risk
Greater default risk means a greater yield
Cont…..

Why are bonds risky
Inflation
risk
Most bonds promise fixed interest payments
Inflation erodes the real value of these
payments
Future inflation is unknown
Larger for longer term bonds
Cont…..

Why are bonds risky
Interest
rate risk
Changing interest rates change the value
(price) of a bond in the opposite direction.
All bonds have interest rate risk
But it is larger for the long term bonds
Cont…..

Types of bond market
The Securities Industry and Financial Markets Association classify
the broader bond market into five specific bond markets.
1. Corporate
2. Government & Agency.
3. Municipal.
4. Mortgage Backed, Asset Backed, and Collateralized Debt
Obligation
5. Funding

Corporate bond market of Bangladesh
The issues of developing a corporate bond market that is
currently near non-existent in Bangladesh. The two major
sources of financing are the banks and capital market. Equity
financing from capital markets through issuing new shares is
lenient whereas debt financing through issuing corporate bonds
is almost nonexistent.

Reasons for Non-existence of Corporate Bond Market
1. High interest rate is a barrier to the corporate bond market.
Government still borrows through various national savings
schemes at high interest rates and banks collect deposits at
quite high interest rates in competition with government
securities.
2. Absence of secondary bond market is a major reason for non-
existence of corporate bond market in Bangladesh. They mean
that secondary organized market which includes OTC market,
and private placement market for corporate bonds.

Reasons for Non-existence of Corporate Bond Market
3. Lack of awareness and education deter to attract right issuers and
investors in the corporate bond market.
4. Lack of knowledge-based trading even for government bonds is
an important reason for inactive corporate bond market.
5. Lack of innovative products has kept the market unattractive.
Securities bearing zero and fixed coupons, and bonds following
Islamic shariah only are available currently in Bangladesh. Bonds
like Treasury Inflation Protected Securities (TIPS), Islamic Bonds
(SUKUK Bond), High-Yield Bonds (HYB), and Deep Discount
Bonds may help formation of corporate bonds market in
Bangladesh.
Cont…..

Cost of bond issuance in Bangladesh bond market
To issue new bonds in Bangladesh is very much formal which
includes huge amount of oversubscription fees. It greatly affects
the issuance of bond in Bangladesh. The following is a list of
considering factor.
1. Securities and Exchange Commission registration.
2. Publication of prospectus
3. Printing of prospectus and application
Cont…..

Cost of bond issuance in Bangladesh bond market
4. Certificate, post issue, postage
5. Listing fees
6. Issue manager or underwriter
7. Trustee fee
8. Credit rating, bankers, legal and audit
9. Central depository fee
Cont…..

Problems of bond market of Bangladesh
1. Absence of Market-determined Interest Rate
2. Regulatory Reform
3. Lack of Benchmark Bonds
4. Unbundled Pension and Insurance Funds
5. High Yielding Government Instruments Hindering Private Sector
Bond Issue
6. Poor Marketability
7. High Time to Market for Time Consuming and Complicated
Administrative Process

Problems of bond market of Bangladesh
8. Undefined Economic Benefits
9. Investor’s Reluctance to Maintain Bond Portfolio
10. Conservative Policy of Investors
11. Lack of Awareness Program for Investors
12.Adverse Perception by Market Participant of Settlement Risk
13.Lack of Intermediaries with Expertise in Debt Products
14. Political Instability
15.Poor Disclosure of Accounting Information
16. Dominance of Banking System
17.Financial Sector Vulnerability for Huge Non-Performing Loans
Cont…..

Valuation of Bonds
General Valuation:
The following comments are valid for all kind of assets.
 Book Value
 Stated value from the firm’s Balance Sheet
 Market Value
 The price for the asset at any given time--determined by
supply and demand in the marketplace. Asset can be bought
or sold at this price.

Valuation of Bonds
 Intrinsic Value
 Present value of the asset’s expected cash flow
 Investor estimates cash flows
 Investor determines required rate based on risk of asset and
market conditions.
In a perfect market where all investors have the same
expectations & risk aversion: Market Value = Intrinsic Value
Cont…..

Bond Terminology
 Par Value
 Also called the Face Value
 Coupon Interest Rate
 Borrowers (firms) typically make periodic payments to the
bondholders. Coupon rate is the percent of face value paid
every year.
 Maturity
 Time at which the maturity value (Par Value) is paid to the
bondholder.

Bond Valuation Model
 Bond Valuation is an application of Present Value.
 The Value of the bond is the present value of all the cash flows
the investor receives as a result of holding the bond.

 3 Cash Flows
 Amount that is paid to purchase the bond (PV)
 Periodic Interest Payments made to the bondholders (PMT)
 Payment of maturity value at end of Bond’s life.
Cont…..

 Other Terminology
 Time frame for cash flows (N) = Bond’s Maturity
 Interest Rate for Time Value is the rate at which future cash
flows are being discounted to present.
Cont…..

Relationships between Coupon Rate, Required
Return, and Bond Price
 Zero-Coupon Bonds
 No periodic coupon
 Pays face value at maturity
 Trade at discount from face value
 No reinvestment risk
 Considerable price risk

Discount bonds are bonds priced below face value;
premium bonds above face value
 Discounted bond
 Coupon < Market rates
 Rates have increased since issuance
 Adverse risks factors that may have occurred
 Price risk—depends on maturity
 Default risk may have increased
 Fisher effect of higher expected inflation

Discount bonds are bonds priced below face value;
premium bonds above face value
 Premium bond
 Coupon > Market
 Rates decreased since issuance
 Favorable risk experience
 Price risk—depends on maturity
 Default risk might have decreased as economic activity has
increased
 Low inflation expectations
Cont…..

Bond Maturity and Price Variability
 Long-term bond prices are more sensitive to given changes in
market rates than short-term bonds
 Changes in rates compounded many times for later coupon and
maturity value, impacting price (PV) significantly
 Short-term securities have smaller price movements
Cont…..

Explaining Bond Price Movements
 The price of a bond should reflect the present value of future cash
flows discounted at a required rate of return
 The required return on a bond is primarily determined by
 Prevailing risk-free rate
 Risk premium

 Factors that affect the risk-free rate
 Changes in returns on real investment
 Financial investment an alternative to real investment
 Opportunity cost of financial investment is the returns
available from real investment
 Government deficits/surplus position
Cont…..

 Inflationary expectations
 Consumer price index
 Federal Reserve monetary policy position
 Oil prices and other commodity prices
 Exchange rate movements
Cont…..

 Factors that affect the credit or default risk premium
 Strong economic growth
 High level of cash flows
 Investors bid up bond prices; lower default premium
 Weak economic growth
 Lower profits and cash flows
 Impact on specific industries varied
 Investors flee from risky bonds to Treasury bonds
 Bond prices fall; default premiums increase
Cont…..

Bond markets

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to Bond markets

Similar to Bond markets (20)

More from Maksudul Huq Chowdhury

More from Maksudul Huq Chowdhury (16)

Recently uploaded

Recently uploaded (20)

Bond markets