Chapter 4:

BOND MARKETS IN FINANCIAL MARKETS

Overview of Topics Covered

Discusses how bond markets in financial market works and why it matters, explain the
features and other important concepts.

Learning objectives
1. Define bond markets in financial markets
2. Understand the concept of bond markets in financial markets
3. Explain who are the issuers, types and concepts.
4. Discuss the instruments and the evolving market of bonds.

I. INTRODUCTION TO BOND MARKETS

A. Brief History of Bond Market

・Middle Ages: Bonds were a natural outgrowth of the loans that early bankers provided to
finance wars.
・1157: The earliest known bond was issued by the Bank of Venice to fund a war with
Constantinople.
・2005: In the United States, the largest single market, over $400 billion worth of bonds change
hands on an average day, and the value of outstanding bonds in March 2005 exceeded $13
trillion.
・Late 1970’s: bond markets have changed dramatically over the past two decades.

B. Definition of Bond Markets

Part of financial market in which participants can issue new debt or buy and sell debt
securities.

The word “bond” means contract, agreement, or guarantee. All these terms are applicable to
the securities known as bonds.

An investor who purchases a bond is lending money to the issuer, and the bond represents
the issuer’s contractual promise to pay interest and repay principal according to specified
terms.

A short-term bond is often called a note.

C. Importance in the Financial System

Bonds are never an issuer’s only source of credit. The principal reason for issuing bonds is
to diversify sources of funding. The amount any bank will lend to a single borrower is limited.

Bonds also help issuers carry out specific financial-management strategies.

II. ISSUERS OF BONDS

∙National Governments
Bonds backed by the full faith and credit of national governments are called sovereigns.
These are generally considered the most secure type of bond.

∙Lower Levels of Government

Bonds issued by a government at the subnational level, such as a city, a province or a state,
are called semi-sovereigns.
Semi-sovereigns are generally riskier than sovereigns because a city, unlike a national
 government, has no power to print money or to take control of foreign exchange.

∙Corporations
Corporate bonds are issued by a business enterprise, whether owned by private investors
or
by a government. Large firms may have many debt issues outstanding at a given time.
∙Securitization Vehicle
An asset-backed security is a type of bond on which the required payments will be made out
of the income generated by specific assets, such as mortgage loans or future sales.

III. TYPES AND PROPERTIES OF BONDS

A. Types of Bonds
∙Straight Bonds
The basic fixed-income investment.
A bond that yields interest on a regular basis.

∙Callable Bonds
A debt security that, at the issuer's discretion, may be redeemed early before to
maturity.
Worth less than an identical bond that is non-callable.

∙Non-refundable Bonds
A bond issue that cannot be redeemed for a stated period of time.
These may be called only if the issuer is able to generate the funds internally, from
sales or taxes.

∙Puttable Bonds
Gives the investor the right to sell the bonds back to the issuer at par value on
designated dates.
Worth more than an identical bond that is not puttable.

∙Perpetual Debentures
Bonds that will last forever, unless the holder agrees to sell them back to the issuer.
Also known as irredeemable debentures.

∙Zero-Coupon Bonds
Bonds that do not pay periodic interest.
Designed to eliminate reinvestment risk.

∙STRIPS
Are an innovation related to zero coupon bonds.
Turn the payments associated with a bond into separate securities, one for each
payment involved.
 ∙Convertible Bonds
May be exchanged for another security, usually the issuer’s common shares.
Convertibles often come with hard call protection, which prohibits the issuer from
calling the bonds before the conversion date.

∙Adjustable Bonds
The interest rate on a floating-rate bond can change frequently, usually depending
on short term interest rates.
Adjustable Bonds means bonds the interest rate on which is not fixed to maturity.

∙Structured Securities
Bonds that have options attached to them are called structured securities.

B. Properties of Bonds
∙Maturity
This is the date on which the bond issuer will have repaid all the principal and will
redeem the bond.
The number of years to maturity is the term.

∙Coupon
This is the stated annual interest rate as a percentage of the price at issuance.
Once a bond has been issued, its coupon never changes.

∙Current Yield
Current yield is the effective interest rate for a bond at its current market price.
If the price has fallen since the bond was issued, the current yield will be greater
than the coupon; if the price has risen, the yield will be less than the coupon.

Formula:
Annual dollar coupon interest / Current price

∙Yield to Maturity
This is the annual rate the bondholder will receive if the bond is held to maturity.
Includes the value of any capital gain or loss the bondholder will enjoy when the
bond is redeemed.

∙Duration
This is a number expressing how quickly the investor will receive half of the total
payment due over the bond’s remaining life, with an adjustment for the fact that
payments in the distant future are worth less than payments due soon.

∙Ratings of Risk
Ratings are extremely important in setting bond prices.
All the ratings agencies emphasize that they rate only the probability of default, not
the probability that the issuer will experience financial distress or that the price of
its bonds will fall.

IV. FOUNDATIONAL CONCEPTS

∙ Interest Rates and Bond Prices
Interest rates and Bond prices have an inverse relationship.
The change of interest rates relies on the bond’s duration.

Formula:
Price change = duration x value x change in yield

∙Interpreting the Price of a Bond

The bond's price is typically quoted as a percentage of the issue price, typically
reported as 100.
Government bond interest rates are unstable due to repurchase expectations, making
them an unstable benchmark in some countries.
 ∙The Yield Curve
The yield curve is a graph that shows the relationship between bond yields and
maturities.
The yield curve shows different borrowing rates across different maturities, which
range from short-term to long-term.

∙Rating of Risk
The investigation of the issuer’s capacity to serve the bonds including financial
strength and the intended use of bonds.
After investigating an agency issues a rating that represents its estimated default
risk.

V. MARKET STRUCTURE AND KEY PLAYERS

∙Issuing Bonds
Offer document, prospectus or official statement which lays out the issuer’s
Financial situation.
Security given to bondholders in case of non-payments.
∙Underwriters and Dealers
Underwriters are responsible for arranging the proportion of the bonds and
marketing it to potential investors.
Dealers often have exclusive rights to participate in the government's bond auction
and subsequently resell the bonds to investors.

∙Secondary Dealing
Investors buy and sell a bond in the over-the-counter market.
Bonds are traded between the investors and dealers.

VI. TRADING AND MARKET OPERATIONS

∙ Electronic Trading
Screen-based bond trading system, some belonging to a single dealer
and others bringing many dealers together.
∙Settlement
The execution of a trade and the exchange of money and payment. The shorter the
settlement time, the lower is the risk that a bank or securities firm will be harmed
by the collapse of another firm with which it has traded.
∙Spreads
The difference between the current yields of two bonds.

VII. ADVANCE CONCEPTS AND STRATEGIES

∙ Inflation and Returns on Bonds
Interest rates can be thought of as having two separate components. The first is
recompense for inflation, the change in prices that is expected to occur during the
term of borrowing. The second is the payment the bond investor exacts for the use
of its money after taking inflation into account.
 ∙ High-Yield Debt or Junk
Better known to the public as junk bonds. One of the most important bond-market
developments in recent years is the issuance of debt by entities with weak credit
ratings. Such bonds are called high-yield debt or below-investment-grade debt.
∙ Credit Default Swaps
a relatively new type of contract that allows investors to express a view on the
creditworthiness of a particular company or sector without actually owning the
underlying bonds.
∙ Enhancing Securities
1. Covenants- legally binding promises made at the time a bond is issued.
2. Bond Insurance- frequently sought by issuers with unimpressive credit ratings.
3. Sinking fund- ensure that the issuer arranges to retire some of its debt, on a
prearranged schedule, prior to maturity.
∙ Repurchasing Agreements
A contract in which a seller, usually a securities dealer such as an investment bank,
agrees to sell bonds in return for a cash loan but promises to repurchase the bonds
at a specific date and price.

VIII. INTERNATIONAL AND SPECIALIZED MARKETS

∙ International Market
These markets facilitate the trading of corporate, government, and financial institution
 bonds outside their home countries.
Has a significant amount of global debt held by foreign investors.
 Foreign Bonds
・Are bonds issued by a foreign entity in a domestic market and are

・Denominated in the currency of the country where they are issued

 Eurobonds
・Are denominated in neither the currency of the issuer’s home country nor that
of the country of issue and are generally subject to less regulation.
∙Emerging-Market Bonds
Are bonds issued by governments and companies in developing countries.
These bonds typically have below-investment-grade ratings and exhibit high price
volatility.
∙Bond Indexes and Index Shortcomings
 Benchmark
Used to measure and compare the performance of a bond portfolio or other
investments.
Investors use benchmarks to evaluate the returns of their own investments against
the broader market.
 Maturity
Maturity refers to the date when a bond must be fully repaid by the issuer to the
investor.
Maturity of a bond is the point in time when the bond’s principal is due, and the
bond contract ends
 Inconsistency
Inconsistency in a bond index happens because bonds mature, are called, or stop
being traded, making it impossible to track the exact same set of bonds over time.
It refers to the issue where an index cannot continuously monitor the same bonds
since they may exit the market or no longer be actively traded.
 Uncertain Pricing
Uncertain pricing occurs when the price of bonds in an index cannot be easily
determined due to infrequent trading, forcing estimations instead of actual prices.
It refers to the challenge of accurately calculating bond prices in an index when
recent trade data isn't available, making the index less precise.
 Disqualification
Disqualification happens when a bond is removed from an index because it no
longer meets the required criteria.
 Poor Diversification
Happens when an index relies heavily on a few issuers, forcing fund managers to
buy lots of bonds from the same source.
This can lead to big losses if that issuer defaults, as seen with Russia in 1998.
∙ Exchange Rates and Bond Prices and Return
Exchange rates can impact bond prices, especially for international investors.
If a currency strengthens, the value of bonds in that currency can rise for foreign
investors, and if it weakens, the bond’s value can fall.
IX. SPECIALIZED INSTRUMENTS
∙ SWAPS
Issuers make use of interest-rate swaps to obtain the financing schedule they desire.
Issuers chooses to sell a bond and simultaneously purchase another bond with the
proceeds from the sale to take advantage of the current market.
∙Bond Futures
Contracts allow investors to receive payment if an interest rate is above or below a
specified level on the contract’s expiration date.
Contractual obligation for the contract holder to buy or sell a bond on a specified date
at a predetermined price.

X. THE EVOLVING MARKET

∙ The Changing Nature of the Market
Investors previously valued all their bonds at the original purchase price holding them
on a long term until they were sold.

Many investors now actively trade bonds to take advantage of price differences, since
computers have made it possible for traders to spot price differences quickly.
∙No more Coupons
Bond purchasers were given certificates as proof of their ownership and often come
with coupons attached, one for each interest payment due on the bonds.

Bearer bonds, which are not registered in a particular name may be sold by whoever
has physical possession of it.

∙Selling Direct
New technology has made it easy for the issuers to sell their bonds directly to investors
over the internet, without the intermediation of underwriters or dealers.
This is likely to lead to a lower cost to the issuers, and to reduce the profits of
investment
banks and brokers that underwrite and sell bonds.

REFERENCE:
https://www.rba.gov.au/education/resources/explainers/the-balance-of-
payments.html#:~:text=The%20balance%20of%20payments%20summarises,payments%20(like
%20foreign%20aid)