Economics 122

FINANCIAL ECONOMI CS (DE BT S ECURITIES 1)

M. DE BUQUE - G ONZ ALES
AY2014 -201 5

SOURCE: BODIE ET AL. (2009), ROSS ET AL., LO (2008)

Debt securities (fixed-income)
 Money market securities – short-  Bonds – longer-term debt
term, marketable, liquid, low risk instruments
o Treasury bills o Treasury notes
o Certificates of deposit (CDs) o Treasury bonds
o Commercial paper (CP) o Corporate bonds
o Bankers’  acceptances o International bonds
o RPs and RRPs o Mortgage-backed securities
o Eurodollars
o Federal funds
o Brokers’  calls
o LIBOR market
Market Participants
 Issuers  Intermediaries  Investors
o Government o Dealers o Government
o Corporations o Rating agencies o Pension funds
o Financial o Credit enhancers o Insurance
institutions o Liquidity enhancers companies
o Supranationals o Mutual funds
Bond characteristics
 Bonds are debt.
 Bond issuers are borrowers.
 Bond holders are creditors.
 The contract between the issuer and the holder is called an indenture.
 The indenture gives the coupon rate, maturity date, and par value (face value,
nominal value, or principal).
Bond characteristics
 Face or par value is typically $1000.
o This is the principal paid at maturity.
 The coupon rate determines the interest payment.
o Interest is usually paid semiannually.
o Interest  payments  are  called  “coupon  payments.”
o The coupon rate can be zero.
 Called risk-free securities even though they may be exposed to default/credit
risk, inflation risk, and liquidity risk.
Bond characteristics
 Note maturity is 1 to 10 years.
 Bond maturity is over 10 years.
 Prices are quoted as a percentage of par value (e.g. 96:09 or 96 9/32 = 96.281,
price = 96.281% of par or $962.81 for the $1k par value security)
Corporate bonds
 Secured bonds – have specific collateral backing them in the event of firm
bankruptcy
 Unsecured bonds – called debentures, these have no collateral
Corporate bonds
Corporate bonds with options attached
 Callable bonds – give the firm the option to repurchase the bond from the
holder at a stipulated call price before maturity date. (Benefit to firm.)
o Ex. Callable bond with call price at 110% of par value (i.e., at $1,100)
o Higher coupon rates and promised yields to maturity than non-callable bonds.
Why?
 Convertible bonds – give the bondholder the option to convert each bond into
a stipulated number of shares of the  firm’s  stock.  (Benefit  to  bondholder.)  
o Ex. Bond convertible into 40 shares, issued at par. When would it be profitable to
convert?
o Lower coupon rates and promised yields to maturity than non-callable bonds.
Why?
Corporate bonds
 Puttable bonds – extendable instruments; gives the bondholder the
option to retire or extend the bond at the call date (in contrast to callable
bonds).
o When would it benefit the bondholder to extend the bond?
 When coupon rate > market rate.
 Floating rate bonds or floaters – these have an adjustable coupon rate
(and hence coupon payments), though these are tied to some measure
of the current market rate (e.g., Treasury bills).
o Major risk: They do not adjust to changes in the financial condition of the
firm (i.e., the yield spread is fixed over the life of the security).
Preferred stock
 Strictly speaking, considered to be equity, but often included in the fixed-
income universe. Has features similar to both equity and debt.
 Like bonds:
o Dividends are paid in perpetuity.
o No voting power regarding management of the company.
 Like equity:
o Nonpayment of dividends does not mean bankruptcy.
o The firm retains discretion to make the dividend payments to the preferred
stockholders.
o It has no contractual obligation to pay those dividends (usually cumulative, where
unpaid dividends cumulate and must be paid in full before any dividends may be
paid to holders of common stock).
Preferred stock
 Middle of the line in priority of claims.
o Preferred stock ranks after bonds but before common stock in terms of the
priority of its claims to the assets of the firm in the event of corporate
bankruptcy. Order:
-Gov't, Debtors, Suppliers

 No tax break. -Preferred Stockholders

-Common Stockholders

o Preferred stock payments treated as dividends rather than interest, therefore

not tax-deductible expenses for the firm.
International bonds
 Foreign bonds – issued by a borrower from a country other than the one in
which the bond is sold (bond denominated in the currency of the country
where it is marketed)
o Ex. Yankee bonds ($), Samurai bonds (¥), bulldog bonds (£)
 Eurobonds – issued in the currency of one country but sold in other national
markets
o Eurodollar bonds ($-denominated bonds sold outside the US and not regulated by
US federal agencies)
o Euroyen bonds (¥-denominated bonds sold outside Japan)
o Eurosterling bonds (£-denominated bonds sold outside the UK Japan)
Corporate bonds
Innovations in the bond market
 Inverse Floaters – similar to floaters, except that the coupon rate in these
bonds falls when the general level of interest rates rise
o Double whammy when interest rates rise. Why?
 The price of the bond would fall because of the rise in market rates,
and additionally, because its coupon payments would fall.
Corporate bonds
Innovations in the bond market
 Asset-Backed Bonds – income from a specified group of assets is used to
service the debt (e.g., mortgages, auto or credit card loans)
o Other ex. Disney bonds with coupon rates tied to the financial
performance of some Disney films; David Bowie bonds with coupon
payments  tied  to  royalties  of  the  rock  star’s  albums.
Corporate bonds
Innovations in the bond market (continued)
 Catastrophe Bonds – a  way  to  transfer  “catastrophe  risk”  from  the  firm  to  
the capital markets; higher coupon rates than normal, but bondholders
need to give up all or part of their investments in the event of a
catastrophe.
o Ex. Japan earthquake bonds, Swiss hailstorm bonds
Corporate bonds
Innovations in the bond market (continued)
 Indexed Bonds
oEx.20-year bonds issued by Mexico with payments that depended on
the price of oil
oTreasury Inflation Protected Securities (TIPS) in the US where par value
is tied to the general level of prices, hence coupon payments as well as
the final repayment increase in direct proportion to the CPI).
 Therefore, the interest rate on these bonds is a risk-free real rate.
 Principal and Interest Payments for a Treasury Inflation
Protected Security (4% coupon rate)

For the 1st year (2% inflation):

 nominal return = (interest + price appreciation)/initial price =
($20 + $40.8)/$1000 = 6.08%
 real return = (1 + nominal return)/(1 + inflation) - 1 =
(1 + .0608)/(1 + .02) -1 = 4%

14-17
Some Local Flavor
 Money market instruments
 Treasuries
 International bonds
 Corporates
Money market instruments
Repurchase Agreements (RPs) and Reverse RPs
 Dealers in government securities (GS) use repos or RPs as a form of short-term, usually
overnight, borrowing
 Sells GS to an investor on an overnight basis, with an agreement to buy back those
securities the next day at a slightly higher price (the increase in price is the overnight
interest)
 The dealer thus takes out a 1-day loan from the investor (the securities serve as collateral)
 Considered very safe in terms of credit risk because the loans are backed by GS
 Term repo: An identical transaction except that the term of the implicit loan can be 30
days or more
 Reverse repo (RRP): Mirror image of the repo (dealer finds an investor holding GS and
buys them, agreeing to sell them back at a specified higher price on a future date)
Money market instruments
Reverse repos (RRPs), in the context of the BSP
 Describes  transactions  from  the  counterparty’s  point  of  view,  where  
BSP sells GS to banks (mops up liquidity) on agreement to buy them
back  (essentially  borrowing,  but  called  “matched  sales”)
 Together with SDAs, RRPs are the main monetary tools of the BSP
(available in overnight and term which is up to a month 14/30 days)
 (sort of)

Money market instruments

Special deposit accounts (SDAs)
 Introduced by the BSP in 1998
 Put into greater use as a monetary tool in 2006
 Opened to trust entities of banks in mid-2007
 Now  the  BSP’s  most  potent  liquidity-mopping instrument
 Tenors range from a week to a month
 Yields the equivalent of the policy rate plus a premium *NO LONGER TRUE that SDA
Yield = Policy Rate + Premium
Treasuries
Philippine Treasury notes
 The completion by the national government (NG) of its foreign debt restructuring in
1992 enabled it to increase its offering of T-notes
 In 1991–1994, NG issued floating rate T-notes (FRTNs) that were benchmarked to the
91-day T-Bill
 However, this meant variable interest and volatility, creating two problems: (i) costly
and short-term servicing, and (ii) absence of stable benchmark
 NG introduced fixed rate T-notes (FXTNs) in 1994, regularly issued beginning1995
 Eventually, NG issued up to 25-year T-bonds, forming nucleus of the bond market
International bonds
ROPs (Philippine global papers)
 Biggest issuers in the Philippines of foreign currency-denominated bonds and
notes are the national government and the BSP
 The NG actively issued in the international capital market beginning 1999 to
finance its fiscal deficit (ballooned in the early to mid-2000s) GMA expanded VAT during
2004 elections

 FX requirements of the National Power Corp. also contributed to the rise in

debt issuances during the period
International bonds
GFIs and GOCCs also issued internationally during the period:
 Ex. DBP, NPC, PNOC, PSALM, MWSS
 These normally carry a spread over comparable ROPs
Corporate bonds
Philippine corporate bonds
 Note: Majority of fixed income investments in the Philippines are in
government securities
 Corporate bonds issued by top corporations :
o Ayala Corp.
o San Miguel Corp.
o SM
o PLDT
 As it is elsewhere, risks associated with corporate bonds are higher than
with government issuances, and can be expected to give higher returns
 Found at:
Fixed Income Summary Philippine Debt Exchange (PDEx)

As of Mar. 10, 2015 04:30 PM

Fixed Income Summary