Bond Market Overview

Bond Market Overview

  • Bond market is a financial market for issuance and trading of debt securities. Participants can issue new debt in the primary market or trade debt securities in the secondary market.
  • Types of bonds and their issuance contexts are covered in subsequent sections.

Common Characteristics of Bonds

  • Maturity date: the date specified in the bond when payment of face value is made by the issuer.
  • Face value (par value): amount borrowed by the issuer to be paid at maturity.
  • Coupon payment: fixed interest payment each year until maturity.
  • Coupon rate: rate stated in the bond used to compute annual interest payment.

Other Characteristics of Bonds
1) Call provision

  • Gives issuer the right to redeem the bond at a call price before maturity.
  • Exercise of call: issuer can call if right is exercisable and call protection has expired.
  • Investor impact: if market rates decline, issuer may call, forcing reinvestment at lower rates; this is detrimental to long-term investors.
    2) Put provision
  • Gives bond holder the right to require issuer to repurchase the bond at a put price before maturity.
    3) Convertible features
  • Gives bondholders the right to convert the bond into a number of common shares at a predetermined price.
    4) Warrants
  • Gives bondholders the option to buy shares at a predetermined price, rather than converting the bond.

Parties in Bond Issuance

  • Bondholders (investors): provide loans to the issuer in exchange for bonds.
  • Issuer: can be a government or a corporation.
  • Government bonds: often called treasury or government bonds.
  • Corporate bonds: issued by corporations.
  • Default premium: additional yield on corporate bonds to compensate for credit/default risk.
  • Default risk: the risk issuer may not meet obligations.
  • Default premium represents the extra return demanded for credit risk.

Bond Types by Issuer and Structure

  • Corporate bonds: issued by corporations to raise money for operations or expansion; typically longer-term debt (≥1 year).
  • Government bonds: issued by national governments.
  • Municipal bonds: issued by local governments and agencies (states, districts, utility districts, school districts, etc.).
  • Mortgage bonds: pooled mortgages secured by real estate assets; interest paid monthly/quarterly/semi-annually.
  • Asset-backed bonds: collateralized by a pool of assets (loans, leases, credit card debt, royalties, receivables).
  • Sustainability bonds: finance environmental or social initiatives; align with core bond components.

Core Components and Examples

  • Pooled mortgages create mortgage bonds; assets pledged to secure payments.
  • Asset-backed bonds are backed by a pool of assets (e.g., loans, leases, receivables).
  • Sustainability bonds finance environmental/social initiatives and must conform to core components: (1) Purpose, (2) Project evaluation and selection, (3) Proceeds management, (4) Progress reporting and utilization.

Four Factors Affecting Bond Valuation
1) Coupon rate (stated rate)
2) Discount rate (effective yield)
3) Years until maturity or call
4) Face value (par value)

Bond Valuation: Conceptual Framework

  • Bond valuation determines the theoretical fair value of a bond by discounting expected cash inflows.
  • Cash inflows consist of coupon payments and the face value at maturity.

Non-Zero Coupon Bond Valuation (Example Formula)

  • Let CP be the annual coupon payment, D the discount rate, N the years to maturity, and FV the face value.
  • Present value of bond (BV):
    $$BV = rac{CP}{(1+D)^1} + rac{CP}{(1+D)^2} + \