Chapter 6

Capital Market
Bond Market
Money vs. Capital Markets
 Use maturity of claim:
Debt Instruments Common Stock &
Preferred Stock

Maturity 1 Maturity greater

year or less than 1 year

Money Market Capital Market

 A market for long-term debt and equity is

called a capital market helping in capital
formation.
 Capital Markets
 The market for trading equities and intermediate and long-
term debt (those that mature in more than one year).
 Consist of bond (debt) market and stock (equity) market
 Issuers (e.g. governments and corporations) raise money
for long-term investments
 Three main instruments: bonds, stocks and mortgages
 Provide an alternative to investment in assets such as real
estates
 Largest purchasers are individuals and households
 The size of a nation’s capital markets is directly proportional
to the size of its economy.
Capital Markets
 Capital markets are massive in scope exceeding
$80 trillion with the fastest growing segment in
stocks
Instruments 1990 2016 Annual
($ billions) ($ billions) Growth Rate
(%)
Treasury notes and bonds $4,070 $22,220 8.0%

Corporate bonds 1,588 9,261 7.3%

Corporate stocks (at 3,333 36,835 10.1%

market value)
Mortgages 3,808 13,464 5.2%

Total $12,799 $81,780 7.7%

Capital Market Instruments
 Capital markets bring together borrowers and suppliers of
long-term funds
 (1) Bonds: debt securities that obligate the issuers to make
coupon (interest) payments at specified intervals and par
(face) value of the security at maturity to the holders.
Governments and corporations are key issuers
 (2) Stocks: equity securities issued only by corporations
that entitle the holder to the residual claims on their income
and net worth representing shares of ownership.
Individuals hold around half of the value of stocks. Pension
funds, mutual funds and insurance companies hold the rest
 (3) Mortgages: long-term loan (i.e. a maturity of 5 or more
years) to households/firms to purchase house/land, where
the real estates serves as collateral.
Bond Markets

 Capital markets are markets for equity (stock) and

debt (bond) instruments with original issue
maturities of more than one year
 Bonds are long-term debt obligations issued by
corporations and government units
 Bond markets are markets in which bonds are
issued and traded
 Treasury notes (T-notes) and bonds (T-bonds)
 Municipal bonds
 Corporate bonds
Government of Canada Treasury
Notes and Bonds
 Treasury notes and bonds (T-notes and T-
bonds) are issued by the Bank of Canada to
finance the national debt and other government
expenditures
 Newly issued Treasuries are called ‘on the run’ and older
Treasuries are called ‘off the run.’
 The annual federal deficit is equal to annual
expenditures (G) less taxes (T) received
 The national debt (ND) is the sum of historical
N
annual federal deficits: NDt   (Gt  Tt )
t 1
Treasury Notes and Bonds

 Default risk free: backed by the full faith and credit of

the government
 Low returns: low interest rates (yields to maturity)
reflect low default risk
 Interest rate risk: because of their long maturity, T-
notes and T-bonds experience wider price fluctuations
than money market securities when interest rates
change
 Liquidity risk: older issued T-bonds and T-notes trade
less frequently than newly issued T-bonds and T-notes
Treasury Notes and Bonds

 T-notes have original maturities from over 1 to 10 years

 T-bonds have original maturities from over 10 years
 Issued in minimum denominations (multiples) of $100
 May be either fixed principal or inflation-indexed
 Principal value used to determine the coupon on inflation-indexed
bonds is adjusted to reflect inflation (measured by the CPI)
 In other words, the semiannual coupon payments and the final principal
payment of inflation-indexed bonds are based on the inflation-adjusted
principal value of the security
 Trade in very active secondary markets
 Prices are quoted as percentages of $100 face value, while
coupon rates are usually fixed
Sample Treasury Bond Quote

$1,000 par Treasury Bond

Maturity Coupon Bid Ask Chg Ask Yld
11/15/2045 3.000 107.6563 107.6865 0.0938 2.624

 Maturity mo/yr: Month and year, the bond matures November

15, 2045, but it may be callable before that time.
 Coupon: Coupon rate of 3% or $30.00 per year but paid
semiannually ($1,000 face).
 Bid: The closing price per $100 of par the dealer will pay to
buy the bond; the seller would receive this price from selling
to the dealer. In this case, 107.6563% of $1,000 or $1,076.56.
Sample Treasury Bond Quote

Maturity Coupon Bid Ask Chg Ask Yld

11/15/2045 3.000 107.6563 107.6865 0.0938 2.624

 Ask: The closing price per $100 of par the dealer requires to
sell the bond; the buyer would pay this price to the dealer. In
this case, 107.6865% of $1,000 or $1,076.87.
 Chg: The change from the prior closing ASK price. In this
case, the ASK price increased 0.0938 from the prior quoted
closing ask price
 Ask Yld = Promised compound yield rate if purchased at the
Ask price. In this case, the yield is 2.624%
Stripped Treasury Bonds
 Bank of Canada does not issue STRIPs directly to investors.
Instead, financial institutions or dealers do.
 Bonds are formed when FIs “strip” coupons off regular bonds and
sell the cash-flows separately, creating zero-coupon bonds that
pay no coupons, selling at deep discounts and repay face value
at maturity
 Important advantage is free of reinvestment risk and to be used
to immunize against interest rate risk
 Tend to be very sensitive to changes in interest rates because
there are no coupon payments to reduce the impact of interest
rate changes
 Being available in at least 16 countries around the world
 Bank-issued GICs are often viewed as comparable products
Example
PV of STRIPS components for a 3-year Treasury note
with a 6% coupon, a 5.8% YTM, and a $10,000 face
value is $10,076.67, assuming semi-annual
compounding.CUSIP
Maturity Cash Flow at PV of Cash Flow
(in years) Maturity at 5.8%
0.5 1 $300 $291.66
1.0 2 $300 $283.55
1.5 3 $300 $275.67
2.0 4 $300 $268.01
2.5 5 $300 $260.56
3.0 6 $300 $253.32
3.0 7 $10,000 $8,443.90
Σ=$10,076.67
Provincial & Municipal
Government Bonds
 Provincial and municipal governments also issue
bonds to finance expenditures on schools, roads,
and other large programs
 Provincials and municipals are denominated in
either domestic currency or foreign currencies
(mostly in USD) and are mainly held by pension
plans (e.g. CPP) and foreigners
 Guaranteed by provincial governments, there are
also long-term bonds issued by various government
agencies to assist municipalities to finance items as
mortgages, farm loans or power-generating
equipment
Reference: Treasury Note and
Bond Yields
 Prices quoted in the financial press (i.e., “clean
prices”) are calculated as:

Vb = the present value of the bond

M = the par (i.e., face) value of the bond
INT = annual interest payment = par value * coupon rate
N = the number of years until the bond matures
m = the number of times per year interest is paid
rb = interest rate used to discount cash flows on the bond
Accrued Interest

 Accrued interest must be paid by the buyer of a

bond to the seller of a bond if the bond is purchased
between interest payment dates.
 It is the portion of the coupon payment accrued between
the last coupon payment and the settlement day

 The price of the T-bond or T-note with accrued

interest is called the full price or the dirty price,
while the price without accounting for accrued
interest is the clean price.
Accrued Interest

 Accrued interest on T-notes and T-bonds is

calculated as:
INT Actual number of days since last coupon payment
Accrued interest  
2 Actual number of days in coupon period

 The full (or dirty) price of a T-note or T-bond is the

sum of the clean price (Vb) and the accrued interest
Example: Accrued Interest
 Given: a fictitious 8% corporate bond, with a principal value
of $200,000, matures on March 15, 2025.
 The bond is purchased on Tues, May 9, 2018 (i.e.
transaction date) and settlement date (i.e. Friday, May 12,
2018) is the third business day after purchase.
 Interest is paid every Mar 15 and every Sept 15 until
maturity
 Days involved = 16 (in March) + 30 (in April) + 9 (in May) =
55 days
 Accrued interest = (Par Amount)×(Coupon Rate)×(Time
Period)= ($200,000)(0.08)(55/365) = $2,410.96 owed to a
seller or payable by a purchaser
Example: Accrued Interest
 You buy a 6% coupon $1,000 par T-bond 59 days after the last
coupon payment. Settlement occurs in two days. You become
the owner 61 days after the last coupon payment (59+2), and
there are 121 days remaining until the next coupon payment.
The bond’s clean price quote is 120.59375. What is the full or
dirty price (sometimes called the invoice price)?
$60 61
Accrued Interest    $10.05
2 (121  61)

 The clean price is 120.59375% of $1,000 or $1,205.9375.

 Thus, the dirty price is $1,205.9375 + $10.05 = $1,215.9875.
Real Return Bonds
 Real Return Bonds (RRBs) are Government of Canada
bonds that pay you a rate of return that is adjusted for
inflation. They were introduced in 1991
 Unlike regular (nominal) bonds, this feature assures that
your purchasing power is maintained regardless of the
future rate of inflation.
 RRBs pay interest semi-annually based on an inflation-
adjusted principal, and at maturity they repay the principal
in inflation-adjusted dollars.
 Have a lower coupon (e.g. 1.5% - 4.25%) than traditional
bonds due to the safety of government issues
 You can buy RRBs for as little as $1,000 with laddered
maturities through most securities dealers.
Example: RRBs
 A real return bond is issued with a coupon of 3% and an initial principal of
$1,000.
 Assuming inflation is 1% after six months since issuance, the bond’s
principal is then increased to $1,010 = (1,000) × (101%).
 Six months later, the bond will pay a coupon interest of $15.15 =
(1,010)(0.03/2).
 If inflation rises to 3% by year end, the principal is adjusted to $1,030
 By then, another interest payment of $15.45 = (1,030)(0.03/2)
 The principal is repeatedly adjusted with the on-going inflation
 Final payment = principal + inflation compensation
 With an inflation rate of 2% every six months over 10 years, the principal will
rise to $1,485.95 = (1,000)(1+0.02)20.
 RRBs can be difficult to understand, particularly because of the ongoing
inflation-adjustments to their interest payments and market price, but also
because of the way in which they are taxed.
Corporate Bonds
 Many variations of interest rates, terms, repayment
provisions, seniority of claims in case of liquidation,
collateral, and risk
 Corporate issues are not traded as actively as government
issues
 Trade OTC – only a few bonds are listed on exchanges
 In Canada, coupons are typically paid semi-annually
 Sold in relatively large offerings underwritten by securities
firms
 Major bond investors are financial institutions, pension funds
and mutual funds
 Bond quotes are typically given in percent of par
Corporate Bonds
 Bonds – long-term debt instruments issued with an
indenture agreement
 Quote for a regular corporate bond:
Issue Coupon Maturity Bid Ask Yield
Date
XYZ Co. 7.0% 1 June/20 100.75 101.25 6.76%
 Extendibles: 1 June 20/24
 Retractables: 1 June 20/18
 With maturity greater than ten years
 More risky than money market securities
 Fixed-income securities have a specified payment
schedule
 Dates and amount of interest and principal payments are known
in advance
Corporate Notes
 Long-term debt securities are created without
an indenture agreement
 Structured Notes
 Amount of interest and principal to be paid is
based on specified market conditions
 Issuers use structure notes to reduce their risk
 Buy a structured note issued by a highly-rated
security firm to bypass the imposed restrictions
 Exchange-Traded Notes
 Issuers promise to pay a return based on the
performance of a specific debt index
The Trading Process for
Corporate Bonds
 Primary sales either occur through a public sale or
a private placement)
 Secondary markets
 The exchange market (e.g., TSX bonds)
 The over-the-counter (OTC) market
 Bond ratings
 The three major bond rating agencies are Moody’s,
Standard & Poor’s (S&P), and Fitch Ratings
 Bonds are rated by perceived default risk
 Bonds may be either investment or speculative (i.e.,
junk) grade
Bond Credit Rating: S&P and DBRS
Rating Description
Investment-Grade
AAA Highest credit quality, maximum safety
AA Superior, high credit quality
A Satisfactory, upper-medium credit quality
BBB Adequate, lower-medium credit quality
Speculative-Grade
BB Speculative, low credit quality
B Highly speculative, very low credit quality
Extremely Speculative-
Grade
CCC/CC/C Very highly speculative, extremely low credit
quality, high risk
D In default
Bond Market Indexes
 Serve similar functions as the stock index since
1970s and managed by major investment banks
 E.g. Scotia Capital Universe Bond Index
 Reflect both the monthly capital gain and loss on
bonds plus any interest (coupon) income earned
gauging performance of the bond market as a whole
 Changes in values of bond indexes can be used by
bond traders to evaluate changes in the investment
attractiveness of bonds of different types and
maturities
Bond Market Participants

 The major issuers of debt market securities are federal,

state and local governments, as well as corporations
 The major purchasers of capital market securities are
households, businesses, government units, and foreign
investors
 Financial firms (e.g., banks, insurance companies,
and mutual funds) are the major suppliers of funds for
municipal and corporate bonds
 Foreign investors and financial firms are the major
suppliers of funds for Treasury securities (including T-
bills, T-notes, and T-bonds)
Bond Market Securities Held by
Various Market Participants
International Aspects of Bond
Markets
 Motivations for international bond investing
 Potentially higher returns
 Better diversification
 Additional complexities in international bond
investing
 Higher risk; political risks higher and potential for
capital flight in lesser developed markets
 Greek crisis in Europe is an example
 Lower recourse in the event of non-repayment
 Foreign exchange rate movements can significantly
impact returns
International Aspects of Bond
Markets
 International bond markets involve unregistered bonds
that are internationally syndicated, offered
simultaneously to investors in several countries, and
issued outside of the jurisdiction of any single country
 Eurobonds are long-term bonds issued outside the
country of the currency in which they are denominated
 E.g., dollar-denominated bonds issued in Europe or Asia
 Foreign bonds are long-term bonds issued outside of
the issuer’s home country and usually denominated in
the currency of the country in which they are issued
 E.g., Japanese company issues a dollar-denominated public
bond rather than a yen-denominated bond in the U.S.
 Sovereign bonds are government-issued debt
Example
 Firms may seek to raise funds outside their
domestic markets.
Issuer Issued in Currency of Categories
Issue
Canadian Canada CAD$ Domestic bonds
Canadian Japan YEN¥ Foreign bonds
(Samurai bonds)
Canadian France USD$ Euro bonds
(Eurodollar
bonds)
Canadian European CAD$ Euro bonds
market (Euro-Canadian
dollar bonds)
Canadian US USD$ Foreign bonds
(Yankee bonds)
International Debt Securities
Issued, 1994 - 2015