Chapter 8 : Capital Market - Bond Market

Mr. Al Mannaei
Money Market
• Short-term Securities.
• High liquidity.
• Low Interest rate (yield).
• Low Risk.
Capital Market
• Long-term Securities (more than a year).
• Issued by Governments and Corporations.
• Lower liquidity relative to Money Market securities.
• Higher Interest rate (yield) relative to MM Securities.
• Higher Risk relative to MM Securities.
• Negotiable (Tradable).
Capital Market
• Reason for issuance :
– Make or Rise Capital ( ex. Initial Public Offering
IPO )
– Finance long-term projects.
– Issuer : Borrowing for long-term.
– Investor : Investing for long-term
 Capital Market
• Buying and selling equity and debt
instruments.

• Link between suppliers of capitals and

borrowers. 

• Include primary and secondary markets.

Issuers & Investors
• Major Issuers (borrowers)
– Large corporations - bonds and stock
– Governments - federal, state, and local bonds.

• Major Investors
– Households (directly or indirectly through
financial intermediaries).
– Foreign investors.
U.S. Government Issues and Agency Securities

1. U.S. Treasury Notes and Bonds

– Debt security.
– Fixed interest (Yield).
– T-Note : one to ten years.
– T-Bond : Ten and more.
– Pay Coupons.
– Sold through competitive bid or non-competitive.
• Mini example: US Gov. offer $1,000,000 on competitive
bid.
– Investor A offer 1.5%.
– Investor B offer 1.7%
– Who should win the deal ?!

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 2.Treasury Inflation Protection Securities (TIPS).

• What is inflation ?!
• You buy a car for BD 10,000
• Next year your friend buy a similar car for
BD10,500.
• Calculate the inflation rate ?!
• Is high inflation rate good ?!
Treasury Inflation Protection Securities (TIPS).

• Investments & inflation !

• You invest BD 10,000 in a bond that pay
3% coupon. After a year the inflation rise
by 3%.

• Clearly, you are losing the interest

because of inflation!
Treasury Inflation Protection Securities (TIPS).

• A treasury security that is linked to inflation rate.

– Where face value (par) adjusted according to inflation
rate.
• Their Interest is not effected by inflation.
• Interest on TIPS is paid semiannually.
• Minimum denomination is $1,000.
• Issued by governments.
 Example 1
Sara bought a TIPS with original principal of
$1000,10% semi-annual coupon If the inflation rate is 3%,
Calculate her coupon? and TIPS ?
 Example 2
• An investor bought a TIPS with original principal of
$100,000, 3% annual coupon rate compounded semi-
annual and 10 years maturity.
• If the semiannual inflation rate during the first 6
months is 1%, Calculate first coupon payment ?
TIPS are used for
1. Protect investments against inflation.
2. The yield on TIPS provides a direct measure
for real interest rate. Therefore expected
inflation can be calculate through
subtracting the yield on TIPS from the yield
of comparable security.
Example : yield on 5 –year TIPS= 1.10%.yield
on 5-year Treasury note =3.49%
Expected inflation = 3.49-1.10= 2.39%

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 3. Separate Trading of Registered Interest and Principal (STRIP).

A bank bought a bond for par issued by US Gov. with 3

years maturity , the coupon rate is 6% , paid annually ?
– How many payments the bank will receive ?
– How much the bank will receive as an interest each year ?
– Which coupon is facing higher risk ?!
– What if the bank decided to sell the coupon of the second year ?!

Year 1 Year 2 Year 3

(Maturity)

.
 3. Separate Trading of Registered Interest and
Principal (STRIP).

• Simply, investor buy a bond then sell the

payments separately.
• STRIP consist from to component coupons +
principle
• Each payment sold at discount.
• Each payment considered as zero bond.
 Example 2
Suppose that KFH decides to purchase a bond and
convert it into a STRIP. The bond has the following
characteristics:
– Maturity of 4 years.
– Coupon rate of 8% (semi-annual).
– Face value of $1000.
•How many separate securities can be created ?
•Calculate the face value of each zero-bond?
 Municipal Bond (munis)
• A debt security.
• Issued by a state, municipality or local
government.
• To finance its capital expenditures.
• Exempt from federal taxes.
– Does Municipal Bond = Government Bond ?!
– Does municipal bond considered as risk-free ?!
– Corporate bond vs. municipal bond yield ?!
1.General Obligation Bond (GO)

• No collateral (not backed with an assets).

• Backed by taxation OR revenue from projects.
• If issuer defaulted, the obligation will be paid by
tax.
• Issuer use GO bond to finance basic services to
the community such as
–
–
–
2. Revenue Bonds
• No collateral.
• Secured by project revenue.
• Revenue bond used to finance project that make revenue
such as :
–
–
–
Municipal Bond
3. Industrial Development Bonds
(IDB) - Public financing of private
business.
4. Mortgage-backed bonds:
– Issued by city housing authorities.
– To finance homes for low and moderate income
people.
– These bonds are tax exempt.
– Issuer use them to borrow funds at low interest
and then make low interest mortgage loans.
Municipal Bond
4. Mortgage-backed bonds (MBS)
Why MBS is important ?!

Ministry of
Citizens Housing CBB
Example
• An Investor considering the following bonds,
Tax rate 30%, which bond should investor choose ?
AA AA
Municipal Corporate
4% 6%

Bond AA Municipal AA
Corporate
Pre-tax * 6%
After Tax 4%

* Assumed
Example ( continue )

What is the Tax rate increase to 40% ?

Now , which investor will choose ?!
AA AA
Municipal Corporate
4% 6%

Bond AA Municipal AA
Corporate
Pre-Tax 6%
After Tax 4%
Example ( continue )

What is the Tax rate increase to 40% ?

AA AA
Municipal Corporate
4% 6%

Bond AA Municipal AA
Corporate
Pre-tax 6.67% 6%
After Tax 4% 3.6%
Result : As tax rate increase then municipal will generate higher
after tax yield than taxable securities and vice versa.
 Types of ownership record
• Bearer Bonds
– Very old fashion!

– Holder = owner.
• Because name is not documented on the bond.

– Coupons representing interest payments are

likely to be physically attached to the
security.

– Negotiable.  

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Types of ownership record

Registered Bonds.
–Name is recorded.

–Physical (form) or electronically.

–Payments send by mail or credited to bank

account directly.
Maturity
• Term bonds :
– Bonds from the same issue that share the
same maturity dates.

– Most corporate bonds are term bonds.

• Serial bonds
– Bonds in the same date of issuance mature on
different dates.

– Most municipal bonds are serial issues (state and

local government issues).
 Maturity

Term bonds: from the same issue that share the

same maturity dates.

Serial bonds: Bonds in the same date of issuance mature on

different dates.
Indenture vs. Debentures Bonds

Bonds

Debenture
Indenture s
1.Equipment 1.Senior debt
trust certificates
2.Subordinated
2. Collateral debt
bonds

Which of the above bonds facing lower risk ?

Indenture Bonds
Equipment trust certificates
•Debt security.
•Issued by corporation.
•Secured by the equipment or physical assets.

Gulf Air BISB

•What if gulf air Defaulted ?!

 Indenture Bonds
Collateral trust bonds
•Debt security.
•Issued by Corporation or Government.
•Secured by the financial assets (stocks or bonds).

Gulf Air BISB

•What if gulf air Defaulted ?!

Debentures
1.Senior debt
In case of default, giving the bondholders
first priority to firm’s assets after the
secured claims.

2.Subordinated debt
Bondholder’s claims to the company’s
assets rank behind the senior debt.
Investors in Corporate Bonds
• Why investor invest in Corporate bonds ?
– Long-term investment horizon.
– Liquidity not always needed - hold to maturity.
– Safety - investment grade. ( low risk )
– Tax considerations.
Investor in Corporate bond
• Major investors include:
– Pension funds ( retirement funds ).
– Life insurance company.
– Foreign Investors.
Primary Market for Corporate Bonds

• Primary Markets
1.Public Sale :
Competitive sale : Sold on public auction market
to underwriter that offer the lowest interest rate.

Negotiated sale : Like competitive but investment

banker provides the origination and advising
services
Primary Market for Corporate Bonds

• 2.Private placement : Sold to limited

numbers of buyers ( < 35 ) .
– Avoid registration and disclosure requirements
– When interest rate is high or economic
condition is unstable , Private placement
increase .
Junk Bonds
• Also known as “ High yielding bonds” or “ Speculative
bonds”
• High Yield bonds ( 3-4% higher than Government
securities )
• High Risk.
• Rated “BB” or lower
• When investor buy Junk Bonds ?
 Thank you
End of Chapter 8
Thursday Solving problems & Exercises

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