Introduction to Bond Market (1)

8/4/2019 Introduction to Bond Market (1)

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G N KHALSA

GLOBAL CAPITAL MARKETS


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BONDS

A bond is a debt security

In which the authorized issuer owes the holders adebt and is obliged to repay the principal andinterest (the coupon) at a later date, termedmaturity.

Financial contracts that pledge to repay aspecified or fixed amount of money, with interestpaid to the lenders upon maturity of the contract


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Bond Issuer

1. Purpose to raise short and long term

funding for their business and development

activities.Government Bonds issued are

basically risk free

The risk of default is fully guaranteed by the

Government known as Malaysian Government

Securities (MGS).


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Bond Issuer

Bonds issued by private entities or companies:

Purpose to help finance their ongoing business

activities.an alternative instrument to issue of

equity or preference shares. to increase of financial leverage (used borrowed

funds to improve its return on investment)

an incentive of tax deductible (helps to reduce the

amount of tax on the company profits)


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Bond Issuer

Bonds issued by private entities Or companies consistof debentures, secured (mortgaged) bond) andconvertible bonds:-

a. Debenture. usually unsecured in the sense that there areno liens or pledges on specific assets.

it is however, secured by all properties not otherwise pledged. Inthe case of bankruptcy debenture holders are considered generalcreditors.

The advantage of debentures to the issuer is they leave specificassets burden free, and thereby leave them open for subsequentfinancing, an alternative instrument to issue of equity orpreference shares.


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Investing in Bond

An attractive investments because:

Pay holders fixed interest income (couponpayment) Paid out on quarterly or half yearly

Percentage of paid out is determined in advance. Paid out is base on a percentage of amount of

bond.

Produce Capital GainsSold prior its maturity atmore than purchase price

Held to maturity


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Why Invest in Bonds?

Most financial planners and fund managers view bonds as being lessrisky than shares but yielding more returns than fixed deposits. It isless risky than shares because it provides:a fixed income from thecoupons and

the return of the principal is as stable as the issuer of the bonds.

Bonds issued by stable governments of economically strong countriesare considered the least risky. In general, it is in a nations interest thatbonds issued by its government pay their coupons and pay the

principal sum upon maturity, so that the credibility of the governmentremains strong and

it can continue to raise capital through the future issuance of bonds.


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When the stock market is bearish, Bonds provide an

alternative avenue for corporations to raise capital. A mature bond market plays an important role in

stabilising the overall financial system of a country.

In many developed countries, the market capitalisation

of the bond markets are larger than that of the stockmarkets. In Malaysia, the securities laws have beenamended to facilitate the development of the bondmarket which has been growing from strength tostrength.

Over the past 10 years, the bond market has grownsubstantially both in terms of trading activities in thesecondary market and in terms of market liquidity


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How a Bond is Traded ?


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Primary Markets

Primary Market: When the issuer(government or corporations or institutions)

first offers new issues, that first trading isdone at theprimary market.

this means is that the issuer is able to raise

funds for its use and the money raised fromthe sale of the bonds come directly to theissuer.


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Secondary Market

Secondary Market Subsequently, the bonds boughtfrom the issuer can be bought and sold among otherinvestors, and this is referred to as the secondarymarket.

The secondary market provides liquidity to theindividuals or institutions that have acquired thebonds, which are now able to sell off the bonds beforethe maturity date, should they wish to do so. The trading of bonds in the secondary market creates a

market pricing of the bonds that depends on the supplyand demand of the bonds, and

prevailing interest rates, among other factors.


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The secondary market plays an

important role

Investors purchasing bonds at the primary

market know there is an avenue to sell-off

their bonds.

The secondary markets provide a gauge for

issuers to price their primary issues.


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Bonds are medium to long-term debt

instrumentsAdvantages

Investor receives periodic

fixed interest income,irrespective of whether thecompany issuing the bondsis doing well or not.

Bondholders have a prior

right over ordinaryshareholders on distributionof earnings and on claims inthe event of bankruptcy.

Disadvantages

As the income (coupons)derived from bonds is fixed,

the investor does not get paidmore even if business isbooming as in the case ofordinary shareholders whomay be given higher dividends.

Bondholders have no voting

rights and are not owners ofthe company whileshareholders have a right tovote at general meetings.


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Basic Types of Bonds

Irredeemable

PerpetualBond

War Bond

Redeemable

Zero Coupon

Coupon Paying


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Irredeemable

Do not mature

No maturity date Issuer is bound to make

eitherPerpetuity payments, ore.g. War Bond or

Perpetual BondPerpetual Bond India

Converted into another form of security


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Redeemable Bond

A. Maturity

1. Length of the time until loan contract or agreement expires

i. Date the debt will cease to exist

ii. Issuer will redeem the bond

iii. Issuer are committed to meet their obligations over thisperiod

i. Short Term 1 to 5 years

ii. Intermediate term 5 to 12 years

iii. Long Term > 12 years


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1) Par Value

1 The amount that the borrower promises to

pay before the end of the term to maturity.

2 Known as principal, redemption value, face value

& maturity value.


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2) Coupon

The interest rate that the issuer pays to the bond holders.

This rate is fixed throughout the life of the bond.

It can also vary with a money market index, such asKLIBOR, or it can be even more exotic.

The name coupon originates from the fact that in the

past, physical bonds were issued which had couponsattached to them.

On coupon dates the bond holder would give the couponto a bank in exchange for the interest payment.


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3) Coupon Dates

Dates on which the issuer pays the coupon to the

bond holders. In Malaysia, most bonds are either

semi-annual or annual. In the U.S., most bonds are semi-annual, which

means that they pay a coupon every six months.

In Europe, most bonds are annual and pay onlyone coupon a year.


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5) Indenture

A contract between an issuer of bonds and the

bondholder statingthe time period before

repayment, amount of interest paid,

if the bond is convertible (and if so, at what price

or what ratio), if the bond is callable and the amount of money

that is to be repaid.


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6) Covenants

A document specifying the rights of bond holders. A clause

in a loan agreement written to protect the lender's claim by

keeping the borrower's financial position approximately the

same as it was at the time the loan agreement was made.Essentially, covenants spell out what the borrower may do

and must do in order to satisfy the terms of the loan.

E.g., the borrower may be prohibited from issuing more debt

by using certain assets as collateral. Likewise, the borrower may be required to issue reports to

bondholders on certain dates called protective covenant,

restrictive covenant.


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7) Optionality

A bond may contain an embedded option;

that is, it grants option like features to the

buyer or issuer.


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8) Sinking fund provision of the

corporate bond indenture

requires a certain portion of the issue to beretired periodically.

The entire bond issue can be liquidated by thematurity date.

If that is not the case, then the remainder iscalled balloon maturity. Issuers may either pay to trustees, which in turn call

randomly selected bonds in the issue, or,

alternatively, purchase bonds in open market, thenreturn them to trustees


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9) An Exchangeable Bond

Is a straight bond with an imbedded option to

exchange the bond for the stock of a companyother than the issuer (usually a subsidiary orcompany in which the issuer owns a stake) atsome future date and under prescribedconditions. An exchangeable bond is different from a

convertible bond. A convertible bond gives the holderthe option to convert bond into shares of the issuer.


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10) Zero Coupon Bond

A debt security that doesn't pay interest (a

coupon) but is traded at a deep discount,

rendering profit at maturity when the bond isredeemed for its full face value.

Also known as an accrual bond.


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11) Coupon Bond

For example, a $1,000 bond with a coupon of 7%

will pay you $70 a year. The reason it's called a

"coupon" is because some bonds literally havecoupons attached to them.

Holders receive interest by stripping off the

coupons and redeeming them.

This is less common today as more records are

kept electronically.


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Types of InternationalBond Market


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1) Fixed Rate Bond

Is a bond with a fixed coupon (interest) rate.

A fixed rate bond is a long term debt paperthat carries a predetermined interest rate.

The interest rate is known as coupon rate and

interest is payable at specified dates before

bond maturity.


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2) Floating rate notes (FRNs)

Bonds that have a variable coupon, equal to a moneymarket reference rate, like LIBOR or federal funds rate,plus a spread. The spread is a rate that remains constant.

Almost all FRNs have quarterly coupons, i.e. they pay outinterest every three months, though counter examples doexist.

At the beginning of each coupon period, the coupon is

calculated by taking the fixing of the reference rate for thatday and adding the spread.

A typical coupon would look like 3 months USD LIBOR+0.20%.


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3) High yield bond

Is a bond that is rated below investment grade

at the time of purchase.

These bonds have a higher risk of default or other

adverse credit events, but typically pay higher

yields than better quality bonds in order to make

them attractive to investors.


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4) Inflation-indexed bonds (also

known as linkers)

Bonds where the principal is indexed to inflation, and thuspurports to cut out the inflation risk. The first knowninflation-indexed bond was issued by the Massachusetts

Bay Company in 1780. The market has grown dramatically since the British

government began issuing inflation-linked Gilts in 1981.

Today, the asset class comprises over $500 Billion of theinternational debt market.

The market primarily consists of sovereign debt, withprivately issued inflation-linked bonds constituting a smallportion of the market.


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5) Asset Backed Security

It is bond or a note that is based on pools of assets, or collateralizedby the cash flows from a specified pool of underlying assets.

Assets are pooled to make otherwise minor and uneconomicalinvestments worthwhile, while also reducing risk by diversifying the

underlying assets. Securitization makes these assets available for investment to a

broader set of investors.

These asset pools can be made of any type of receivable from thecommon, like credit card payments, auto loans, and mortgages, oresoteric cash flows such as aircraft leases, royalty payments andmovie revenues.

Typically, the securitized assets might be highly illiquid and privatein nature.


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6) Subordinated bond

Bond that has a lower priority than other bonds of theissuer in case of liquidation during bankruptcy. In case of liquidation, there is a hierarchy of creditors. First the

liquidator is paid, then government taxes, and so on.

The first bond holders in line to be paid are those holding whatis called senior bonds.

After they have been paid, the subordinated bond holders arepaid.

As a result, the risk is higher.

Subordinated bonds usually have a lower credit rating thansenior bonds. The main examples of subordinated bonds can befound in bonds issued by banks, and asset-backed securities.


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7) Bearer bond

It is an official certificate issued without a namedholder.

The person who has the paper certificate can claim the

value of the bond. Often they are registered by a number to prevent

counterfeiting, but may be traded like cash.

Bearer bonds are very risky because they can be lost

or stolen. Especially after federal income tax began in the United

States, bearer bonds were seen as an opportunity toconceal income or assets.


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8) Lottery Bonds

Issued by France, Belgium and the other major nations of Europe.

They are government bonds and only issued by a government.

Outwardly, lottery bonds resemble ordinary fixed rate bonds, theyhave a fixed, though usually long, tenor and pay regular coupons.

The serial number is the incentive for the purchaser to buy thebond.

However there is a further complication; occasional bonds willreceive a bonus.

A small number of bonds are redeemed for an amount greater

than their face value. Hence the holder of that particular bond will have won the

lottery.


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9) Bear bond

It is a bond issued in Russian roubles by a

Russian entity in the Russian market.


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THANK YOU

Documents

Introduction to Bond Market (1)