Financial

Markets

Course Material No. 5:

DEBT SECURITIES MARKET

Lawrence Zyril D. Lizardo, CPA, MAcc

Course Instructor
2 FINANCIAL INSTRUMENTS • NU LAGUNA

Debt Securities Market

5
LEARNING OUTCOMES

After studying the material, you should be able to:

• Identify different types of bonds

• Select the bond or debt security investments that will yield
higher value
Unit Outline

RESOURCES NEEDED

For this lesson, you would need the following resources:

• Power point presentation 5

• Financial Market Book
MANAGING CREDIT RISK IN MONEY MARKET • NU LAGUNA 3

TABLE OF CONTENTS

Starting Point
Pretest 3
Before you start, try answering the following Make it Real
questions. 4
1. What are bonds? Debt Securities Market
5
_________________________________________
2. What are the different types of bonds – Give 2 and Post Test
explain its nature. 9
________________________________________
9 Instructor
10

Debt Securities
Market
 4 FINANCIAL INSTRUMENTS • NU LAGUNA

Give a brief summary of your understanding of what debt securities are

and their importance to the businesses and to the economy.
 MANAGING CREDIT RISK IN MONEY MARKET • NU LAGUNA 5

Debt Securities Market

Overview:

Debt Securities Market is the type of financial market in the form of debt transactions between
demanders and suppliers of funds. Debt instrument is legally enforceable evidence of a financial debt and the
promise of timely repayment of principal, plus any interest. Debt security is a debt instrument however not all
debt instruments are debt securities. Debt securities are different from equity securities as equity securities
represent claims on earnings and assets of a corporation, while debt securities are investment into debt
instruments. The characteristics of a regular bond are coupon rate, maturity date and current price.

Bond Valuation in Practice essentially is calculating the present value of a bond's expected future
coupon payments. The theoretical fair value of a bond is calculated by discounting the present value of its
coupon payments by an appropriate discount rate. The discount rate used is the yield to maturity, which is the
rate of return that an investor will get if s/he reinvested every coupon payment from the bond at a fixed interest
rate until the bond matures. It takes into account the price of a bond, par value, coupon rate, and time to
maturity. Discount rate used normally is the risk free or default free rate plus the risk premium, if applicable.
There are 2 approaches in Bond Valuation for option-free bonds: traditional approach and arbitrage free
valuation approach. There are 2 approaches in Bond Valuation for bonds with embedded options: lattice model
and Monte Carlo Simulation

Debt market or debt securities market is the financial market where the debt instruments or securities are
transacted by suppliers and demanders of funds. This is the:
• Money market for short term debts
• Capital market for long term debts, like equity in the stock market

A debt instrument is a paper or electronic obligation that enables the issuing party to raise funds by promising
to repay a lender in accordance with terms of a contract. Types of debt instruments include notes, bonds,
debentures, certificates, mortgages, leases or other agreements between a lender and a borrower. These
instruments provide a way for market participants to easily transfer the ownership of debt obligations from one
party to another.

A debt instrument is legally enforceable evidence of a financial debt and the promise of timely repayment of
the principal, plus any interest. The importance of a debt instrument is twofold.
• First, it makes the repayment of debt legally enforceable.
• Second, it increases the transferability of the obligation, giving it increased liquidity and giving creditors
a means of trading these obligations on the market.
Without debt instruments acting as a means of facilitating trading, debt would only be an obligation from one
party to another. However, when a debt instrument is used as a trading means, debt obligations can be moved
from one party to another quickly and efficiently.

Types of Debt Instruments

Debt instruments can be either long-term obligations or short-term obligations. Short-term debt instruments,
both personal and corporate, come in the form of obligations expected to be repaid within one calendar year.
Long-term debt instruments are obligations due in one year or more, normally repaid through periodic
installment payments.

➢ Short-Term Debt Instruments

6 FINANCIAL INSTRUMENTS • NU LAGUNA

In corporate finance, short-term debt usually comes in the form of revolving lines of credit, loans that
cover networking capital needs and Treasury bills. If for example, a corporation looks to cover six
months of rent with a loan while it tries to raise venture funding, the loan is considered a short-term
debt instrument.

➢ Long-Term Debt Instruments

Long-term debt instruments in personal finance are usually mortgage payments or car loans. For
example, if an individual consumer takes out a 30-year mortgage for Php 500,000, the mortgage
agreement between the borrower and the mortgage bank is the long-term debt instrument.

Debt Security

Debt security refers to a debt instrument, such as a government bond, corporate bond, certificate of deposit
(CD), municipal bond or preferred stock, that can be bought or sold between two parties and has basic terms
defined, such as notional amount (amount borrowed), interest rate, and maturity and renewal date. It also
includes collateralized securities, such as collateralized debt obligations (CDOs), collateralized mortgage
obligations (CMOs), mortgage-backed securities issued by the Government National Mortgage Association
(GNMAs) and zero-coupon securities.

Types of Debt Securities

➢ Money market debt securities. Money market securities are debt securities with maturities of less
than one year. Money market securities of most interest to individual investors are treasury bills (T-bills) and
certificates of deposit (CDs).

➢ Capital market debt securities. Capital market debt securities are debt securities with maturities of
longer than one year. Examples are notes, bonds, and mortgage-backed securities

Basic terms of a debt security

➢ Notional (estimated/theoretical) amount or amount borrowed

➢ Interest rate
➢ Maturity and renewal date

Debt Security vs Debt Instrument

What is the difference between debt security and debt instrument?

Debt security
➢ refers to money borrowed that must be repaid and has a fixed amount, a maturity date and interest rate.
➢ Can be bought or sold between two parties
➢ Some are discounted in the original market price.
➢ Examples are treasury bills, bonds, preferred stock and commercial paper.

Debt instrument
➢ Can be paper or electronic form; a tool that an entity can utilize to raise capital
➢ Gives market participants the option to transfer the ownership of the debt obligation from one party
to another
➢ Primary focuses on debt capital raised by institutional entities.
MANAGING CREDIT RISK IN MONEY MARKET • NU LAGUNA 7

➢ Examples are bonds, debentures (unsecured loans), leases, certificates, bills of exchange and promissory
notes, credit cards, loans, credit lines

The Bond Market

Debt market or Debt securities market is also known as bond market is a financial market in which the
participants are provided with the issuance and trading of debt securities. The bond market primarily
includes government-issued securities and corporate debt securities, facilitating the transfer of capital
from savers to the issuers or organizations requiring capital for government projects, business
expansions and ongoing operations. In the bond market, participants can issue new debt in the market
called the primary market or trade debt securities in the market called the secondary market. These
products are typically in the form of bonds, but they may also come in the form of bills and notes. The
goal of the bond market is to provide long-term financial aid and funding for public and private projects
and expenditures.

Types of Bond Markets

➢ Corporate Bond.

Corporations provide corporate bonds to raise money for different reasons, such as financing ongoing
operations or expanding businesses. The term "corporate bond" is usually used for longer-term debt
instruments that provide a maturity of at least one year.

➢ Government Bonds.

National governments issue government bonds and entice buyers by providing the face value on the
agreed maturity date with periodic interest payments.

➢ Municipal Bonds.
Local governments and their agencies, states, cities, special-purpose districts, public utility districts,
school districts, publicly owned airports and seaports, and other government-owned entities issue
municipal bonds to fund their projects.

➢ Mortgage Bonds.

Pooled mortgages on real estate properties provide mortgage bonds. Mortgage bonds are locked in by
the pledge of particular assets. They pay monthly, quarterly or semi-annual interest.

➢ Asset-backed bonds.

Also known as asset-backed security (ABS), asset-back bond is a financial security collateralized by a
pool of assets such as loans, leases, credit card debt, royalties or receivables.

➢ Collateralized Debt Obligation (CDO).

CDO is a structured financial product that pools together cash flow-generating assets and repackages
this asset pool into discrete tranches that can be sold to investors.

Characteristics of Bonds

The characteristics of a regular bond include:

8 FINANCIAL INSTRUMENTS • NU LAGUNA

➢ Coupon rate.

Some bonds have an interest rate, also known as the coupon rate, which is paid to bondholders semi-
annually. The coupon rate is the fixed return that an investor earns periodically until it matures.

➢ Maturity date.

All bonds have maturity dates, some short-term, others long-term. When the bond matures, the bond
issuer repays the investor the full face value of the bond. For corporate bonds, the face value of a bond
is usually Php 1,000 and for government bonds, face value is Php 10,000. The face value is not
necessarily the invested principal or purchase price of the bond

➢ Current or Market Price.

Depending on the level of interest rate in the environment, the investor may purchase a bond at par,
below par, or above par. For example, if interest rates increase, the value of a bond will decrease since
the coupon rate will be lower than the interest rate in the economy. When this occurs, the bond will
trade at a discount, that is, below par. However, the bondholder will be paid the full face value of the
bond at maturity even though he purchased it for less than the par value.

Bond Valuation

Bond valuation is a technique for determining the theoretical fair value of a particular bond. Bond
valuation includes calculating the present value of the bond's future interest payments, also known as
its cash flow, and the bond's value upon maturity, also known as its face value or par value. Because a
bond's par value and interest payments are fixed, an investor uses bond valuation to determine what
rate of return is required for a bond investment to be worthwhile. Eq 5.1 describe the formula to value
a bond.

To illustrate, suppose a 10-year 10% bond with a par value of Php1,000 is traded in the market. The
similar debt instrument is expecting 9% returns in the market. How much is the value of the bonds?

Using Eq 5.1 the bond is valued at Php 1,064. The value is higher than par and issued on a premium
because the market offers a lower return as compared the guaranteed returns of 10%.

This principle simply states that the bonds can be resold at Php1,064 since this is perceived by the
market to be better off that what is available to everyone else.
MANAGING CREDIT RISK IN MONEY MARKET • NU LAGUNA 9

A zero-coupon bond makes no annual or semi-annual coupon payments for the duration of the bond.
Instead, it is sold at a deep discount to par when issued. The difference between the purchase 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 present value of the face value.

Following our example above, if the bond paid no coupons to investors, its value will simply be the
present value of the face value of the bonds i.e. Php422.41. Under both calculations, a coupon paying
bond is more valuable than a zero-coupon bond.

Valuation for a Non-Treasury bond (Adding Risk Premium)

The above valuation assumes a default free rate and thus for a non-Treasury bond, a risk premium has
to be added to the base interest rate (the Treasury rate). The risk premium is the same regardless of
when a cash flow is to be received. This risk premium is also called constant credit spread. So, for the
above, assuming the appropriate risk premium / credit spread is 100 bps equivalent to 1%, the discount
rate to be used should be 6% i.e. 5% the risk free interest rate (the Treasury rate) + 1% risk premium.

Approaches in Valuation

The above formula can be adjusted based on the approaches in valuation. There are at least 2
approaches in valuation of bonds. Below are approaches which assumed option-free bonds.

o Traditional approach – where valuation is to discount every cash flow of a bond by the same
interest rate or discount rate for each period.

o Arbitrage Free Valuation approach – this value the bond as a package of cash flows, with each
cash flow viewed as a zero-coupon bond and each cash flow discounted at its unique discount
rate

Valuation of Bonds with Embedded Options

There are two models:

a. The lattice model which is used to value callable bonds and putable bonds
b. The Monte Carlo simulation model which is used to value mortgage-backed securities and certain
types of asset-backed securities.

POST-TEST

True or False

1. Financial market is a forum or market that enables suppliers and demanders of funds to make
transactions.
2. Debt can be short term or long term that is why it can be within capital market definition if short
term, while in money market if long term.
3. Debt market or Debt Securities Market is the financial market where the debt instruments or
securities are transacted by suppliers and demanders of funds.
4. A debt instrument is a paper or electronic obligation that enables the issuing party to raise funds by
promising to repay a lender in accordance with terms of a contract.
10 FINANCIAL INSTRUMENTS • NU LAGUNA

5. Types of debt instruments include notes, bonds, debentures, certificates, mortgages, leases or other
agreements between a lender and a borrower.
6. The importance of a debt instrument is twofold. First, it makes the repayment of debt legally
enforceable. Second, it increases the transferability of the obligation, giving it increased liquidity and
giving creditors a means of trading these obligations on the market.
7. Without debt instruments acting as a means of facilitating trading, debt would only be an obligation
from one party to another.
8. Long-term debt instruments are obligations due in one year or more, normally repaid through
periodic installment payments.
9. Short-term debt instruments, both personal and corporate, come in the form of obligations expected
to be repaid within one calendar year.
10. In corporate finance, short-term debt usually comes in the form of revolving lines of credit, loans
that cover networking capital needs and Treasury bills.
11. Long-term debt instruments in personal finance are usually mortgage payments or car loans.
12. Debt security refers to a debt instrument, such as a government bond, corporate bond, certificate of
deposit (CD), municipal bond or preferred stock, that can be bought or sold between two parties and
has basic terms defined, such as notional amount (amount borrowed), interest rate, and maturity and
renewal date.
13. The interest rate on a debt security is largely determined by the perceived repayment ability of the
borrower; higher risks of payment default almost always lead to higher interest rates to borrow
capital.
14. Also known as fixed-income securities, most debt securities are traded over the counter.
15. Debt securities, sometimes referred to as fixed-income securities, include money market securities
and capital market debt securities such as notes, bonds, and mortgage backed securities.
16. Money market securities are debt securities with maturities of less than one year. Money market
securities of most interest to individual investors are treasury bills (T-bills) and certificates of deposit
(CDs).
17. Capital market debt securities are debt securities with maturities of longer than one year. Examples
are notes, bonds, and mortgage-backed securities.
18. Usually Financial Instruments and Financial Securities are interchangeably used, and these are indeed
similar.
19. All financial instruments are financial securities.
20. A security is a fungible, negotiable financial instrument that holds some type of monetary value.

INSTRUCTOR

I am Lawrence Zyril D. Lizardo. I am a CPA since 2011. I finished my

Master in Accountancy in December 2018.

Currently, a managing partner of Lizardo, Natanauan CPAs and Co.