Bangalore

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Part-02A
Bond & Bond Markets: An Introduction
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What is debt?
It is a financial claim.
Who issues it?
The borrower of funds
For whom it is a liability
Who holds it?
The lender of funds
For whom it is an asset
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Difference between debt and equity?
Debt does not confer ownership rights
It is merely an IOU
A promise to pay interest at periodic intervals
And to repay the principal at a pre-specified maturity
date.
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It usually has a finite life span
Perpetual debt is rare
The interest payments are contractual
obligations
Borrowers are required to make payments irrespective
of their financial performance
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Interest payments to be made before any
dividends for equity holders.
In the event of liquidation
The claims of debt holders must be settled first
Only then can equity holders be paid.

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Bonds and debentures are termed as Fixed
Income Securities
Once the rate of interest is set at the onset of
the period for which it is due
It is not a function of the profitability of the firm
Failure to pay the promised interest will
tantamount to default
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Bonds may be secured or unsecured
Unsecured debt securities are termed as
Debentures in the US
Unsecured means no specific assets have been
earmarked as collateral
Secured debt requires the firm to earmark
specific assets as collateral
Secured debt holders enjoy priority from the
standpoint of payments
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Debt securities may be negotiable or non-
negotiable
Negotiable securities can be traded in the
secondary market
Can be endorsed by one party in favor of another
Examples of non-negotiable debt securities
National savings certificates
Conventional Time or Fixed deposits
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The most basic form of a bond is called the
Plain Vanilla version.






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This is true for all securities, not just for bonds.
More complicated versions are said to have
`Bells and Whistles attached.

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These bonds are slightly different
The interest rate does not remain fixed
It varies each period based on the reference rate
Short-term reference rate maturity < 1 year
Floating rate bonds
Longer-term reference rate
Variable or adjustable rate bonds
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Convertible bonds can be converted to shares
of stock
Callable bonds can be prematurely retired by
the issuer
Putable bonds can be prematurely
surrendered by the holders
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It is the principal value
Amount payable by the borrower to the last
holder at maturity.
Amount on which the periodic interest payments
are calculated.
A.K.A as
Par Value
Redemption Value
Maturity Value
Principal Value
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It is the time remaining in the life of the
bond.
The length of time for which interest has to be
paid as promised.
The the length of time after which the face value
will be repaid.
A.K.A as
Maturity
Term
Tenor


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The periodic interest payment that has to be
made by the borrower.
The coupon rate multiplied by the face value
gives the rupee/dollar value of the coupon.
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Most bonds pays coupons on a semi-annual basis.
True in UK/US/Australia/Japan
In European and Eurobond markets annual
payments are the norm
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In earlier days bonds were accompanied by a
booklet of post-dated coupons
Each coupon could be detached and redeemed
on the corresponding coupon payment date
Even today bearer bonds come with coupons
The bearer certificate number is mentioned on
the coupon
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Bond with a face value of $1000.
The coupon rate is 8% per annum paid semi-
annually.
So the bond holder will receive
1000 x 0.08
___ = $40 every six months.
2


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The rate of return if an investor buys the
bond at the prevailing price and holds it
till maturity.
In order to get the YTM, two conditions
must be satisfied.
The bond must be held till maturity.
All coupon payments received before maturity
must be reinvested at the YTM.
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At any point in time the YTM may be
Greater than
Less than or
Equal to the Coupon Rate
YTM is the IRR of a bond
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Bonds involve pure cash flows
So only ONE REAL POSITIVE YTM
Solution to a Non-Linear equation
Solved iteratively
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A holder gets a stream of contractually
promised payments.
The value of the bond is the value of this stream
of cash flows.
Cash flows arising at different points in time
cannot be added
Cash flows have to be discounted
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It is a chicken and egg story
If we know the yield that is required we can
quote a price
Once we acquire the asset at a certain price, we
can work out the corresponding yield.

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A bond will pay identical coupons every
period
And will repay the face value at maturity.
The periodic cash flows constitute
an annuity.
The terminal face value is a lump
sum payment.
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Bond pays a semi-annual coupon of $C/2,
and has a face value of $M.
Assume there are N coupons left
And that we are standing on a coupon
date.
We are assuming that the next coupon is exactly
six months away.
The required annual yield is y
Implies that the semi-annual yield is y/2.
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The present value of the coupon stream is:
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The present value of the face value is:
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So the price of the bond is:
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IBM has issued a bond with a face value of
$1,000.
The coupon is 8% per year to be paid on July
15 and January 15 every year.
Today is 15 July 2013 and that the bond
matures on 15 January 2033.
The required yield is 10% per annum.
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JJ 01/15
FA 01/15
MS 01/15
AO 01/15
MN 01/15
JD 01/15
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In the example the price is less than the
face value
Such a bond is called a Discount Bond
It is trading at a discount from the face value.
The reason is that
The yield is greater than the coupon
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If the yield were to equal the coupon
The bond would sell at PAR
Such bonds are called PAR Bonds
If the yield is less than the coupon
The price will exceed the face value.
Such bonds are called Premium Bonds
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As we move from one coupon date to the
next, if the YTM were to remain constant
Par bonds would continue to trade at PAR
Premium bonds will steadily decline in price
Discount bonds will steadily increase in price
This is called the Pull to Par Effect
At maturity ALL BONDS WILL TRADE AT PAR
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As we approach maturity the number of
coupons reduces
The contribution of coupons to price reduces
The contribution of the PV of the face value
increases
For premium bonds the first effect dominates
Thus the price steadily declines
For discount bonds the second effect
dominates
Thus the price steadily increases

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A plain vanilla or Bullet Bond pays the entire
face value at maturity in a lump sum
Amortizing bonds pay the principal in
installments
The first payment occurs before maturity
The last payment is made at maturity

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Consider a 5 year amortizing bond with a
face value of $1,000 and an annual coupon of
8%.
The annual cash flows are depicted below

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Time Cash Flow
1 80
2 80
3 330
4 310
5 540
The first two cash flows represent interest on
a principal of $1,000
The third cash flow is interest on $1,000 plus
a principal payment of $250
The outstanding principal is $750
The fourth cash flow is interest on $750 plus
a principal payment of $250
The outstanding principal is $500
The final cash flow is interest on $500 plus
the remaining principal of $500

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Some companies issue such bonds because
the assets being funded have a similar cash
flow profile
Second the coupon on such a bond may be
lower than that of a bullet bond
In the case of a bullet bond the entire principal
is due at a single point in time
There is greater default risk

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Plain Vanilla bonds pay coupon every
period and repay the face value at
maturity.
A Zero Coupon Bond does not pay any
coupon interest.
Issued at a discount from the face value
Repays the principal at maturity.
Face Value Price, constitutes the interest
for the buyer.
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Microsoft is issuing zeroes with 5 years to
maturity and a face value of $10,000.
The required yield is 10% per annum
What should be the price?
Price is the PV of the face value
In practice we discount on a semi-annual basis
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This is to facilitate comparisons with
conventional bonds

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A zero coupon bond can never sell at a
premium
It will always trade at a discount prior to
maturity
At maturity it will trade at par
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If held to maturity a ZCB will always give rise
to a capital gain
If sold prior to maturity there may be a
capital gain or a capital loss
Consider a bond with 10 years to maturity
The YTM at the time of purchase was 10%
The cost was $376.90
A year later it is sold at a YTM of 12%
The corresponding price is $350.35

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For bonds with a given maturity ZCBs have
the highest price sensitivity
Bullish speculators anticipating a rate decline
will fancy such bonds
Investors seeking a locked in return over a
long-term such as Pension Funds
Like such bonds
There is an assured return if held till maturity
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A newly established issuer
Or an issuer with a relatively virgin product
or service
Or a restructured company due to a merger
or following a bankruptcy
Will be perceived as more risky
Investors will demand a high coupon
Such firms are unlikely to have high earnings
Revenues will peak only after the
product/service is established
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They can ill afford high coupons
They may consider a step-up coupon bond
Where the coupon increases as the bond ages
Assume a company can issue a plain vanilla
at a coupon of 8% with a maturity of 5 years
Instead it may opt for a bond
With a coupon of 6% for the first three years
And a coupon of 10% for the last two years
This is a Deferred Interest Security
Provides the issuer with breathing room in the
earlier years
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These pay coupons in the form of additional
securities and not cash
This offers the issuer time to prepare for cash
outlays
They are used as Mezzanine Finance
They rank between senior debt and equity in the
capital structure
Investors take more risk as compared to buyers
of regular bonds but get higher returns
Issuers can conserve cash in earlier years when it
is at a premium
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Fully backed by the federal government of
the issuing nation.
Consequently they are virtually devoid of
credit risk or the risk of default.
The yield on such securities is a benchmark
for setting rates on other kinds of debt.
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Treasury securities are issued
To finance expenses in excess of current
revenues
To pay interest on debt accumulated in earlier
years due to deficits in those years
To repay past debt issues that are currently
maturing
The US Treasuries market
Is the largest bond market in the world
Is the most liquid bond market in the world
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The Treasury issues three categories of
marketable securities.
T-bills are discount securities
They are zero coupon securities
T-notes and T-bonds are sold at face value and
pay interest periodically.
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T-bills are issued with a original time to
maturity of one year or less.
They are Money market instruments.
They have maturities of either 1, 3, 6, or 12
months at the time of issue.
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T-notes and T-bonds have a time to maturity
exceeding one year at the time of issue.
They are capital market instruments.
T-notes have maturities ranging from 1-10 years
T-bonds have an original maturity in excess of 10
years, extending up to 30 years.
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An issue may be followed later by a further
issue
With the same remaining time to maturity and
the same coupon
The issuance of further tranches is termed as a
Re-opening.
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Six months ago a 10-year note was issued
with a coupon of 8% per annum.
Today if a note with 9 years to maturity
and a coupon of 8% issued it will add to the
pool that is already trading in the market
Thus it is a re-opening of an existing issue

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Who is a primary dealer?
A PD is a dealer who is authorized to deal
directly with the Central Bank of the country
In the US, a PD is a bank or securities broker-
dealer that directly deals with the FRBNY
Importance of FRBNY
In India a PD deals directly with the RBI
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The Treasury sells bills, notes, and bonds by
way of a competitive auction process.
Most of the treasury securities are bought by
primary dealers.
Individual investors submit non-competitive bids
and participate on a much smaller scale.
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Bids may be:
Competitive
Indicate price & quantity or yield & quantity
Non-competitive
Indicate only quantity
Small investors and individuals
generally submit non-competitive bids
A non-competitive bidder may not bid for more than
$5MM worth of securities in a bill or bond auction

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Primary dealers bid for their accounts and
on behalf of their clients
They usually submit large competitive
bids
Bids indicate the maximum price that the bidder
is prepared to pay if it is a price based auction
Or the minimum yield that the bidder is
prepared to accept if it is a yield based auction
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The Treasury will net out the total
amount of non-competitive bids
The balance will be allocated to competitive
bidders.
There are two ways in which securities
can be allotted
The multiple price/yield auction mechanism
French Auctions
The uniform price/yield auction mechanism
Dutch Auctions
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Assume that the Treasury is offering 25
billion dollars worth of T-bonds.
2 billion dollars worth of non-competitive bids
have been received.
So 23 billion dollars worth of bonds are available
to be offered to the competitive bidders.
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There are six competitive bidders who have
submitted the following yields.
The bids have been arranged in ascending order
of yield.
In a price based auction the bids would have
been arranged in descending order of price.
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Bidder Bid Yield Bid
Amount
Aggregate
Amount
Alpha 5.370 3.0 bn 3.0 bn
Beta 5.372 5.0 bn 8.0 bn
Gamma 5.373 4.0 bn 12 bn
Delta 5.375 8.0 bn 20 bn
Charlie 5.375 12.0 bn 32 bn
Tango 5.380 3.0 bn 35 bn
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The aggregate demand equals the amount on
offer at a yield of 5.375.
A multiple yield auction will lead to the
following allocation.
Alpha will get 3 bn at a yield of 5.370
Beta will get 5 bn at 5.372
Gamma will get 4 bn at 5.373
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At a yield of 5.375 we have only 11 bn left to
allocate.
There is a demand of 20 bn at this yield
8 bn from Delta and 12 bn from Charlie.
Thus we will allocate 11/20 = 55% to each
bidder at this yield
There will be pro-rata allocation
0.55 of 8 bn or 4.40 bn will go to Delta
0.55 of 12 bn or 6.6 bn will go to Charlie
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The highest accepted yield is called the Stop
Yield or High Yield
In this case it is 5.375
The ratio of bids received to the amount
awarded is known as the bid to cover ratio
The higher the ratio the stronger is the auction
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The second type of auction is called a
uniform price/yield auction.
Aggregate demand is equal to the supply at a
yield of 5.375%.
Thus everyone who bid less will be allotted
the quantities sought at this yield.
The two bidders at 5.375 will also be
awarded at this yield but on a pro-rata basis.
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Those who bid more than 5.375 will get
nothing and are said to be shutout of the
auction.
Since 1999 the U.S. Treasury has been
conducting only uniform yield auctions.
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WI stands for When, As, and If Issued
The when issued market is a market for
forward trading of a bond
Which has been announced but not yet issued
Trades take place from the date of
announcement until the actual issue date
Helps bidders to gauge the markets interest
before the actual auction

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WI trading has ramifications for the bidding
strategies of market participants
Traders can take both long and short
positions
Settlement is scheduled for the issue date
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It has a bearing on the outcome of the
auction
It affects the strategy used by a bidder because
it has an impact on his prior position
Bidders who are long in the WI market enter the
auction with a Long Position
Those who are short in the WI market enter the
auction with a short position
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The WI market helps in price discovery
It provides important information on
The strength of demand for the security
And on the disparity of bidders views
This help potential bidders to formulate their
strategies
At times a dealer may believe that he has
very important private information
If so he may not participate in the WI market and
will directly enter the auction with bids based on
his knowledge
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On or before the date of the auction the
issues trade on a yield basis
The actual price can be established only after
the coupon is set
Starting with the day after the auction
Securities are quoted on a price basis because
the coupon is known
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In a coupon roll a dealer will purchase the
most recently issued security from a client
And simultaneously sell the same amount of
the recently announced new security
The first leg with settle on the following day
The second leg is a forward contract
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There can be a Reverse Roll
The dealer will sell the most recent issue for
next day settlement
And buy the newly announced security for
forward settlement
The forward leg in a Roll/Reverse Roll is a WI
trade
It will settle on the new issue settlement date
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The roll is the spread between the yield on
the new security and that on the outstanding
issue in the same maturity segment
A GIVE in the Roll means that
The WI security provides a higher yield than the
outstanding issue
A Take in the Roll means that
The WI security provides a lower yield
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Dealers use rolls to position themselves for
the coming auction
Assume that the dealer is short in the
outstanding issue
Either because he expects the market to decline
Or he has to accommodate clients
In such a situation he may do a roll
This will close out his existing short position
And will create a short position in the to-be-
issued security
This gives him an incentive to bid more aggressively
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On March 17 20XX the Treasury announced
the auction of a 2-year note
The auction was scheduled for March 24
The settlement date was March 31
Trading of the roll began as soon as the issue
was announced
A Give of 5 bp means that the dealer proposes to
buy the current issue at the prevailing yield
And sell the new issue at a yield that is 5 bp
more
A Take of 5 bp means that the dealer proposes to
sell the new issue at a yield that is 5bp lower
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The roll achieves the following
He acquires the outstanding issue for next day
settlement
He sells the to be issued security, with the same
par value for forward delivery on 31 March
The customer is rolling over the investment
from the current issue to the new issue
This extends the maturity of the investment by
one month
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The client can invest the funds received till
the new issue settles
However he loses the accrued interest that
he would have earned had he held on to the
issue
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The Treasury per se does not issue zero
coupon securities.
But zero coupon securities can be created
which are backed by conventional bonds
Take a large quantity of a T-note or bond and
separate all the cash flows from each other
Sell the entitlement to each cash flow
separately.
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Take the case of a two-year T-note.
It can be separated into five zero coupon
securities maturing after:
6 months
12 months
18 months
24 months
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Earlier investment banks used to buy bonds
from the Treasury and separate the cash
flows
Each cash flow was then sold separately as a zero
coupon bond.
Such issues are called trademarks.
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The issue of trademarks has now ceased.
Because investment banks can now create
such instruments
In concert with the Treasury itself.
These ZCBs are known as STRIPS
Separate Trading of Registered Interest and
Principal of Securities.
These are not issued or sold by the Treasury
The market is made by investment banks.
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What is the motivation to create such
products?
In practice arbitrage is possible when a
coupon security is purchased at a price
That is lower than what could be obtained by
selling each cash flow separately.
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Coupon stripping reflects a case of financial
engineering
Creating a risk-return profile that is not
otherwise available
An investment bank would buy a large
quantity of a Treasury security
The securities would be placed with an SPV
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The SPV is a single-purpose dedicated trust
It has the powers to own the bonds and
collect payments
It cannot sell or lend the bonds
It cannot write options on the bonds
Or use them as collateral for borrowing
The SPV is empowered to issue zero coupon
bonds
Where each security represents the ownership of
a single cash flow from the mother bond
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Assume that 100MM USD of 15 year bonds
with a coupon of 8% are placed with the SPV
The SPV can issue 6M, 12M, 18M, extending up to
14 year zeroes with a total face value of 4MM
USD each
And 15 year zeroes with a total face value of
104MM

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Merrill Lynch pioneered the concept by
introducing TIGRS
Treasury Investment Growth Receipts
Salomon followed with CATS
Certificates of accrual on Treasury securities
Lehman came up with LIONS
Lehman Investment Opportunity Notes
These are known as Animal Products
This segment of the market was termed as the
Zoo


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The Treasury launched this program in 1985
to facilitate the stripping of designated
securities.
All new T-bonds and notes with a maturity of 10
years or more are eligible.
The zeroes created in the process are direct
obligations of the U.S. government.
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The mechanism is as follows.
A dealer who owns a bond or note can ask the
FRB where it is held
To replace it with an equivalent set of STRIPS
representing each payment as a separate security.
Each of these securities can be traded independently
of others.
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In 1987 the Treasury started to allow dealers
to reverse the process
This is called STRIPS RECONSTUTUTION
If a dealer owns STRIPS representing all the
coupon and principal payments of a bond
The FED can on request convert these holdings into a
single position in the corresponding bond
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Each coupon and principal cash flow from a
Treasury security is assigned a CUSIP
The mother bond is also assigned a CUSIP
The stripped coupons are known as C-STRIPS
The stripped principal is known as P-STRIPS
Supply of a C-STRIP increases over time
because a C-STRIP maturing on a day like 15 FEB
2020 will have the same CUSIP irrespective of
which mother bond it has come from
The original coupon rate is irrelevant

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P-STRIPS always correspond to the original
security
They have a unique CUSIP
Their supply is fixed at the time of issuance
In practice the prices of long-dated P-STRIPS
are a bit higher than those of C-STRIPS with
the same maturity date
One reason is that P-STRIPS are more liquid due
to greater availability
A $100 face value bond with a coupon of 8% will
generate C-STRIPS with a face value of $4 but P-
STRIPS with a face value of $100
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Another reason why P-STRIPS are in higher
demand is that they allow reconstitution
activities more easily
Assume that the sum of the STRIPS is cheaper than
the mother bond
If a dealer already has the P-STRIPS only the C-STRIPS
need to be acquired
However if he owns some of the C-STRIPS he needs to
acquire the P-STRIPS and the remaining C-STRIPS
The facility to reconstitute when profitable is priced
into the P-STRIPS
Note: Buy and hold investors will prefer C-STRIPS
since they are priced lower and give a higher yield
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For Plain Vanilla bonds the specified
coupon rate is valid for the life of the
bond.
In the case of Floaters the rate is reset at
the beginning of every period
The rate will vary directly with the
benchmark
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The rate on a Floater is specified as LIBOR
+ 50 b.p.
The spread is positive.
If it were specified as LIBOR 30b.p.
The spread will be negative
If LIBOR rises, the rate will increase,
whereas if LIBOR falls it will decrease
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In the case of a default risk-free floater the
price will reset to par on a coupon date
It may sell at a premium or discount between
coupon dates
Consider a floater with a coupon = 5-year T-
Bond rate
Assume there are two periods left to maturity

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The price at the end of the first coupon period will
be given by
c
T-1
is the coupon one period before maturity
y
T-1
is the YTM one period before maturity
On a coupon reset date the YTM = coupon
Because we have assumed there is no default risk
Any change in the required yield as reflected in
the prevailing YTM
Will also be reflected in the coupon being set
If coupon = yield, the bond should sell at par
Thus P
T-1
= M
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Once again at T-2: c
T-2
= y
T-2
and P
T-2
= M
This logic can be applied to a bond with any
time remaining till maturity
However between two coupon dates the
price may not be equal to par
Consider the valuation at T-2+k
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Although c
T-2
was set at T-2 and is equal to
y
T-2
y
T-2+k
is determined at T-2+k and will reflect the
yield prevailing at that time.
Thus y
T-2+k
need not equal c
T-2
and may be
higher or lower
Hence between two coupon dates, a floater may
sell at a premium or discount.
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Now consider a floater characterized by
default risk
The risk premium required by the market need
not be constant over time.
Assume that at the time of issue YTM = 5-
year T-note rate + 75bp
The coupon would have been set equal to this
rate and the bond would have been issued at par
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Six months hence the issue may be perceived
as more risky
YTM = 5-year T-note rate + 95 bp
The coupon will however be set equal to the
prevailing 5-year rate + 75 b.p.
If so the issue will not reset to par at the next
coupon date.
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Floaters may come with a CAP or a FLOOR or
BOTH
The CAP is a maximum coupon rate
Protects issuers against rising rates
The FLOOR is a minimum coupon rate
Protects investors against falling rates
When there is a spread over LIBOR
There is a natural floor
LIBOR cannot be less than zero
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In the case of such floaters the coupon
varies inversely with the benchmark.
For instance the rate may be specified as
10% - LIBOR.
As LIBOR rises, the coupon will decrease,
As LIBOR falls, the coupon will increase.
In this case a floor has to be specified
Coupons cannot become negative
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