DEBT MARKET

(BOND VALUATION)
GROUP 4

CHARACTERISTICS
OF DEBT MARKET
&
INSTRUMENTS

JOSE, ALYSSA ASHLEY DC. BSAIS 2D-MAS 2

CONTENTS 1 Debt Market

Characteristics of
2
Debt Market
Debt Market
3 Instruments
Characteristic
4 Corporate Bond
DEBT MARKET

• Often called as bond market or credit

market
• Financial market used to raise funds for
long-term purposes
Participants in Debt Market
• Issuers are entities which issue debt securities.
• Investors are entities which invest in debt securities.
• Managers or dealers which arrange, structure market and
distribute issues of debt securities.
• Agent and trustees are entities which provide agency
and trustee services.
• Trading Infrastructure which provide trading
infrastructure systems and services.
CHARACTERISTICS OF DEBT MARKET

• Primary and Secondary Market

• Predictability
• Easier Planning
• Retain Control
 BOND

• Most common type of debt instrument

• Long-term debt instrument
• Major issuers are the government and
corporations or firms
 CHARACTERISTICS OF
BOND
• Residual Maturity – as time passes, the residual maturity
of any bond shortens.
• Coupon– bond pays a fixed rate of interest, normally
made in two installments.
• Par – known as redemption value is also the price at
which bonds are first issued
DEBT MARKET INSTRUMENTS CHARACTERISTIC

Treasury Bonds (Goverment)

and Corporate Bonds (Firms)
Treasury Bonds (Government)

• or T-bonds
• debt securities offered by the government
that have maturities greater than 20 years.
CORPORATE BOND
(FIRMS)
• Long-term debt instrument issued by
firms or corporation that seek to raise
money for variety of reasons
• A debt obligation or IOUs by firms
(issuer) to a bondholder (lender)
• Coupon interest rate
Legal Aspects of Corporate Bonds

• Bond Indenture

• Trustee
Bond Indenture

• is a legal document or binding contract

between the corporation or firm and the
bondholder
• Standard Provision
• Restrictive Provision
• Standard Provision focuses on the
ways of record-keeping and general
provisions.

• Restrictive Provision place a certain aid

to the bondholders in combating the
borrower risks.
(Sinking-fund requirement & Security Interest)
Trustee

• a paid individual, corporation or

commercial bank trust department
that acts as the third party to a
bond indenture.
• a type of agent on behalf of the
bondholders.
Cost of Bonds to the Issuer

• Impact of Bond Maturity

• Impact of Offering Size
• Impact of Issuer’s Risk
• Impact of the Cost of Money
General Features of a Bond Issue

• Conversion Feature
• Call Feature
• Stock Purchase Warrants
• Conversion Feature allows the bondholder
the right to transform bond into common
stock.
• Call Feature allows issuer of bond to
repurchase the issued bonds at a call price
before bond reaches its date of maturity.
• Stock Purchase Warrants instrument that
gives the holders the right to purchase a
number of shares of the issuer’s common
stock at a specified time.
 TYPES OF
BONDS

KATHERINE JOY C. MICLAT

OBJECTIVES
*UNDERSTAND BOND RATING
*LEARN ABOUT TRADITIONAL
BONDS
*LEARN ABOUT CONTEMPORARY
BONDS
*COMPARE DIFFERENT TYPES OF
BONDS
 ▫ - is a grade given to a bond
by a rating service that
indicates its credit quality.
The rating takes into

BOND consideration a bond issuer's

financial strength or its
RATING ability to pay a bond's
principal and interest in a
timely fashion.
WHY CONSIDER BOND
RATING?
Moody’s and Standard & Poor’s Bond Ratings
COMMON TYPES OF
BONDS
 Basic types of
bonds that are
TRADITIONAL customary and
BONDS have been
established for a
long time
CONTEMPORARY
These bonds are
BONDS newer and more
innovative
TRADITIONAL TYPES OF
BONDS
1. SECURED BONDS
- Bonds that are secured by
corporate assets.
-Can be called “Senior Security
Bond” due to higher level of priority
claim
1. SECURED BONDS
Collateralize assets, such as:
Property Equipment Another Income
Stream
WHY COLLATERIZE
BONDS?
1. SECURED BONDS
a. Mortgage Bonds- Secured by
real-estate or buildings
* Note that number of mortgages
can be issued against the same
collateral.
 ▫ Priority of lender’s claim:
Claim is on proceeds from
sale of mortgaged assets; if
not fully satisfied, the lender
becomes a general creditor.
MORTGAGE The first-mortgage claim
must be fully satisfied before
BONDS distribution of proceeds to
second mortgage holders, and
so on.
1. SECURED BONDS
b. Collateral Trust Bonds- Backed
by stocks and bonds the issuer
owns
 ▫ Priority of lender’s
claim: Claim is on
proceeds from stock
COLLATERAL and (or) bond; if not
TRUST fully satisfied, the
lender becomes a
BONDS general creditor
 Definition of Term
General Creditor-One who is or has become owed
of an uncollateralized debt.
- As a general creditor, you have to stand in line
after creditors such as the Internal Revenue
Service and the banks.
 1. SECURED BONDS
c. Equipment Trust Certificates-
Backed by equipment bond
issuer uses
- also known as “rolling stock
bonds”

Note: Cannot be issued by equipment manufacturer, only

by equipment users.
 Definition of Term
Rolling Stocks-Any of various readily movable
transportation equipment such as automobiles,
locomotives, railroad cars, and trucks.
 ▫ Priority of lender’s
claim: Claim is on
proceeds from stock
EQUIPMENT and (or) bond; if not
TRUST fully satisfied, the
lender becomes a
CERTIFICATES general creditor
2. UNSECURED BONDS
-are not secured by a specific
asset, but rather by "the full
faith and credit" of the issuer.
2. UNSECURED BONDS
a. Debentures- have no collateral
backing; rely on the creditworthiness
and reputation of the issuer for support.
*Both corporations and governments
frequently issue debentures to raise
capital or funds
 ▫ Priority of
lender’s claim:
Claims are the
DEBENTURES same of any
general creditor.
2. UNSECURED BONDS
b. Subordinated Debentures- most
junior to debts but senior to stocks;
represents unsecured debt with a claim
to assets that ranks behind all debt
senior to these debentures.
 ▫ Priority of
lender’s claim:
Claim is that of
SUBORDINATED general creditor
DEBENTURES but not as good as
a senior debt
claim.
2. UNSECURED BONDS

c. Income Bonds- Payment of

interest is required only when
earnings are available.
 ▫ Priority of
lender’s claim:
Claim is that of a
INCOME general creditor
BONDS
 ▫ Priority of lender’s
claim: Are not in
default when interest
payments are missed,
INCOME because they are
BONDS contingent only on
earnings being
available.
 Definition of Term
• Default- occurs when the bond issuer fails to make
interest or principal payment within the specified
period. This problem is often solved by restructuring
an agreement between the issuing country and its
bondholders
• Contingent – entirely depended on a something
CONTEMPORARY TYPES
OF BONDS
1. Zero- (or low-) Coupon
Bonds
2. Junk Bonds
 Can be broken down into two...

a. Fallen Angels – This is a bond that was once

investment grade but has since been reduced to
junk-bond status because of the issuing
company's poor credit quality.
 Can be broken down into two...
b. Rising Stars – The opposite of a fallen angel,
this is a bond with a rating that has been
increased because of the issuing company's
improving credit quality. A rising star may still be
a junk bond, but it's on its way to being
investment quality.
3. Floating Rate Bonds
4. Extendible Notes
5. Putable Bonds
 “
▫ Note: The claims of lenders (that is, bondholders) against
issuers of each of these types of bonds vary, depending on
the bonds’ other features. Each of these bonds can be
unsecured or secured.
INTERNATIONAL BOND
ISSUES
INTERNATIONAL BONDS
a. Eurobond- A bond issued by an
international borrower and sold to
investors in countries with
currencies other than the currency
in which the bond is denominated.
INTERNATIONAL BONDS
b. Foreign Bond- is issued by a
foreign corporation or government
and is denominated in the investor’s
home currency and sold in the
investor’s home market.
OTHER TYPES OF BONDS
OTHER TYPES OF BONDS
•Convertible Bonds
•Deferred Interest Bonds
•Guaranteed Bonds
•Variable Rate Bond
•Zero Coupon Convertible Bonds
OTHER TYPES OF BONDS
•Convertible Bonds
•Deferred Interest Bonds
•Guaranteed Bonds
•Variable Rate Bond
•Zero Coupon Convertible Bonds
 Basic Bond
Fundamentals and
Valuation
NIGOS, JULIE ANN D.
MAS 2- FINANCIAL MANAGEMENT

ALLPPT.com _ Free PowerPoint Templates, Diagrams and Charts

Valuation Fundamentals
• Valuation is the process that links risk and return to
determine the worth of an asset.
• There are three key inputs to the valuation process:
1. Cash Flows(returns)
2. Timing
3. A measure of risk, which determines the
required return
Basic Valuation Model
• The Value of any asset at time zeroV0, can be expressed as
Bond Valuation: Bond Fundamentals

• Bonds are long-term debt instruments used by

business and government to raise large sums of money,
typically from a diverse group of lenders.
• Most corporate bonds pay interest semiannually
(every 6 months) at a stated coupon interest rate, have an initial
maturity of 10 to 30 years, and have a par value, or face value,
of $1,000 that must be repaid at maturity.
Bond Valuation: Basic Bond
Valuation
The basic model for the value, B0, of a bond is given by Equation 6.5.

Where
B0 = value of the bond at time zero
I = annual interest paid in dollars
n = number of years to maturity
M = par value in dollars
rd = required return on the bond
Example:

• Tim Sanchez wishes to determine the current value of the Mills

Company bond. Assuming that interest on the Mills Company
bond issue is paid annually and that the required return is equal to the
bond’s coupon interest rate, I = $100, rd = 10%, M = $1,000
and n = 10 years. The computations involved in finding the bond value
are depicted graphically on the following time line.
Discounted models
The general formula for estimating the fair price of a bond is:
P = C/(1+r) +C/(1+r)2 + C/(1+r)3 +. . .+ C/(1 + r)n + B/(1+r)n
EXAMPLE:
A bond pays a coupon of 4 Euro every six months, and 100 Euro
will be repaid at maturity. There are two years to maturity and
the next coupon is due in six months. The redemption yield on
similar bonds is 6% p.a. Estimate the fair price of the bond.
An interest rate of 6% p.a. indicates a rate of 3% per six month
period.
Answer:
P = 4/(1,03) + 4/(1,03)2 + 4/(1,03)3 +4/(1,03)4 + 100/(1,03)4
P = 3, 88 + 3, 77 + 3, .66 + 3, 55 + 88.85 = 103, 71 Euro
Bond Valuation:
Bond Value Behavior
In practice, the value of a bond in the marketplace is rarely equal to
its par value.
- Whenever the required return on a bond differs from the bond`s
coupon interest rate, the bond`s value will differ
from its par value.
- The required return is likely to differ from the coupon
interest rate because either (1) economic conditions have changed,
causing a shift in the basic cost of long-term funds, or (2) the firm`s
risk has changed.
- Increases in the basic cost of long-term funds or in risk will raise
the required return; decreases in the cost of funds or in risk will
lower the required return.
TABLE 6.6 Bond Values for Various Required Returns (Mills
Company’s 10% Coupon Interest Rate, 10-Year Maturity, $1,000 Par,
January 1, 2013, Issue Date, Paying Annual Interest
FIGURE 6.4 Bond Values and Required
Returns
Bond Valuation:
Bond Value Behavior
• Interest rate risk is the chance that interest rates will
change and thereby change the required return and
bond value.
• Rising rates, which results in decreasing bond values,
are of greatest concern.
• The shorter the amount of time until a bond`s maturity,
the less responsive is its market value to a given
change in the required return.
FIGURE 6.5 Time to Maturity and Bond
Values
 Duration
For a non-callable security, duration is the weighted
average time until a bond’s cash flows are received.
Duration is not limited to bond analysis. It can be determined for
any cash flow stream.
Duration is a direct measure of interest rate risk. The higher it is,

the higher is the risk.

Thinking of duration as a measure of time can be misleading if the

life or the payments of the bond are uncertain.

Macaulay’s duration
• Macaulay duration is the time-value-of- money- weighted, averag
number of years necessary to recover the initial cost of the
security.

N
Ct

t 1 1  R 
t
t
D
where D = duration P
where D = duration
CCt t == cast
cast flow
flow at
attime
time tt
RR == yield
yieldto
tomaturity
maturity(per
(perperiod)
period)
PP == current
current price
priceofof bond
bond
NN == number
numberof of periods
periodsuntil
until maturity
maturity
tt == period
period inin which
whichcash
cashflow
flow is
isreceived
received
Chua’s closed-form duration is less
cumbersome because it has no
summation requirement.

  1  R  N 1   1  R   RN  FN
C t  

R 1  R 1  R
2 N N

D  
P
where FF ==face
where facevalue
value(par
(par value)
value) of
of the
the bond
bond
and all
and all other
other variables
variablesare
areas
aspreviously
previouslydefined.
defined.
 Modified duration measures the percentage
change in bond value associated with a one-
point change in interest rates.

dP 1  1  C1 2C 2 NC N  1
      N 

dR P  1  R    1  R   1  R 
1 2
1  R  P
DMacaulay
Dmodified 
1+ R
2

Bond Convexity
Convexity measures the difference between the actual price
and that predicted by duration, i.e. the inaccuracy of duration
The more convex the bond price-YTM curve, the greater is

the convexity.

Convexity = ( d2P / dy2) x ( 1/P ) x (1 / 2 ) to y2,

Bond Convexity
Price forecasting accuracy is enhanced by incorporating
the effects of convexity.
Suppose a bond has a 15-year life, an 11% coupon, and a
price of 93%. Macaulay duration = 7.42, yield-to-maturity =
12.00%, modified duration = 7.00, convexity = 97.71.
If YTM rises to 12.50%, new price= 89.95%
Actual price change = - 3.28%
Price change predicted by duration = - 3.50%
 Price change predicted by duration and
convexity = - 3.38%
Bond Convexity

bond price
yield to maturity
• No matter what happens to interest rates, the bond with
he greater convexity fares better. It dominates the
competing investment
BOND PRICE AND YIELD TO
MATURITY
YIELD TO MATURITY
Is the estimated annual rate
of return for a bond
assuming that the investor
holds the asset until
maturity date and reinvests
the payments at the same
rate.
•Yield to maturity (YTM)
= [(Face value/Present
value)1/Time period]-1.
•If the YTM is less than the bond’s
coupon rate, then the market value of
the bond is greater than par value
( premium bond).

• If a bond’s coupon rate is less than

its YTM, then the bond is selling at a
discount. If a bond’s coupon rate is
equal to its YTM, then the bond is
selling at par.
VARIANTS of YTM

•Yield to call
•Yield to put
•Yield to worst
 Yield to call
when a bond is callable (can be repurchased by the issuer before the maturity),
the market looks also to the Yield to call, which is the same calculation of the
YTM, but assumes that the bond will be called, so the cash flow is shortened.
 Yield to put

same as yield to call, but when the bond holder has the option to
sell the bond back to the issuer at a fixed price on specified date.
 Yield to worst

when a bond is callable, puttable, exchangeable, or has other features, the

yield to worst is the lowest yield of yield to maturity, yield to call, yield to put,
and others.
 COUPON RATE

Is the annual income in investor can expect to receive

while holding a particular bond.
• If a bond’s coupon rate is less
than its YTM, then the bond is
selling at a discount.
• If a bond’s coupon rate is more
than its YTM, then the bond is
selling at a premium.
• If a bond’s coupon rate is equal to
its YTM, then the bond is selling at
par
 BOND PRICE
Can be summarized as the sum of the present value of the par value repaid at
the maturity and the present value of coupon payments.
PRESENT VALUE of an Annuity

Is the value of stream of payments, discounted by the interest rate to

account for the payments being made at various moments in the future.
 DISCOUNT RATE
The interest rate used to discount future cash flows of a financial instrument;
the annual interest rate used to decrease the amounts of future cash flow to
yield their present value.
Where:
F = face value, iF = contractual interest rate,
C = F * iF = coupon payment (periodic interest
payment), N = number of payments, i = market
interest rate, or required yield, or observed /
appropriate yield to maturity, M = value at
maturity, usually equals face value, and P =
market price of bond.
 Money
Market
Securities
Carlos Daniel Natividad
Money Market
Securities
-highly liquid (short-term debt securities)

-are IOUs issued by governments,

financial institutions, and large
corporations.
Money Market Instruments

• Banker’s Acceptances (BAs)

• Treasury Bills (TBs)

• Commercial Paper

• Negotiable Certificates of Deposit (NCDs)

Treasury Bills
Treasury Bills
NV= nominal value

D= discount

d= discount rate

nsm= number of days from sale to maturity

P= purchase price
Example: Calculate the discount of
Treasury bills if the nominal value is
P1,000,000, the discount rate is 5%, and
maturity is 90 days.
Discount = NV x d x (n/360)
Discount = 1,000,000 x 0.05 x (90/360)
= 1,000,000 x 0.05 x 0.25
= P 12,500
Example: Calculate the issue price of
Treasury bills if the nominal value is
P1,000,000, the discount rate is 5%, and
maturity is 90 days.

Price (P) = NV – discount

P = 1,000,000 – 12,500 = P 987,500

Example: Calculate the issue price of Treasury
bills if the nominal value is P1,000,000, the
discount rate is 5%, and maturity is 90 days.

Given: FV= P1,000,000

nsm= 90 days

Discount rate= 5%
Example: Calculate the rate of return on bills
Given: FV = 1,000,000
Discount (D) = P12,500
Price(P)= P987,500
nsm = 90 days
r=?
R = (12,500 / 987,500) x ( 360/90)
= 0.012658 x 4
=.0506 or 5.06%
Commercial
Paper
Commercial Paper
A business entity issues a commercial paper worth P1,000,000, which will be
redeemable after completion of 100 days. If the discount is 1% and other charges
worth P15,000 were applicable. Find out the rate of interest on this commercial
paper.

Given:
Face Value = P1,000,000
Discount rate= 1%
Discount & Other Charges = P15,000
 
Solution:
Net Amount Realized= Face Value-(Discount and Other Charges)
Net Amount Realized= 1,000,000-[(1% of 1,000,000)+15,000]
= 1,000,000- (10,000+ 15,000)
= 1,000,000-25,000
= P975,000
Rate of Interest
Given: Face Value = P1,000,000
Net Amount Realized = 975,000
Maturity Period = 100
Rate of Interest= [(FV-Net Amount Realized)/Net Amount Realized]×(360/Maturity
Period)

Rate of Interest= [(1,000,000-975,000)/975,000]×(360/100)

Rate of Interest= (.025641)x(3.6)

=.0923 or 9.23%
 Bankers
Acceptance
Bankers Acceptance

A BA (bank acceptance) is issued at 12%.   The

nominal amount of the BA is P1 million and it is
issued for 90 days.Find the discount
Discount = N x nsm/365 x d/100
=P1,000,000 x .12 x 90/365
              = P29,589
If, in the case above, the original investor now sells the
BA at a discount rate of 11% when there are still 60 days
left to redemption, the proceeds (also called the
consideration that the buyer would pay) will be calculated
N =1,000,000
as follows.
nsm = 60 days
d = 11%

Proceeds = N - (N x d x nsm/365
       = P1,000,000 - (P1,000,000 x .11 x 60/365)
= P 981,918
Certificate of
Deposit
Certificate of Deposit

MV = maturity value

N  = nominal amount of the certificate (amount deposited)

r  = Interest rate

n  = period of the instrument in days

Calculations:
A deposit of P1,000,000 is made on March 1 for 90 days, and interest
paid on the amount is 15%, the maturity value is calculated as
follows:
Nominal amount P1 000 000

Interest for period (P1 000 000 x15% x 90/365)    +P 36 986

MV P1 036 986
If the holder sells this instrument to another party
on 31 March at a yield of 14% , proceeds of the
sale are calculated as follows:

MV =P1 036 986

n =60

r =14%

Proceeds = MV / [1 + (n/365 x r)]

= P1 036 986 / [1 + (60/365 x.14)
               = P1,013,658
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