Bonds
Dr. Manzoor A. Khalidi
Introduction
Difference between Intermediation and
Disintermediation
Developed Capital Markets: Anglo Saxon Countries (USA
and UK)
Pakistan: Bond Markets, especially Corporate Bond are
relatively underdeveloped
Classification of Financial
Instruments
Equity: Unsure streams
Bonds: Sure Streams
Fixed at the time of the issue
Floating - Linked to a reference rate (LIBOR, KIBOR), fixed at
periodic intervals
Hybrid
Forward, Futures
Swaps
Options
Classification of Bonds
Money Market Instruments: less than one year maturity
Issued at Discount (Par value includes interest at maturity)
Government: Treasury Bills (3m, 6m, 9m, 12m)
Corporate: commercial Paper (270 day)
Capital Market Instruments
Government: USA: Notes (Less than 10 years), Bonds (10 or more); UK: Consuls (perpetual bonds)
Corporate: Bonds
Structured Finance Instruments (e.g. Mortgage Bonds)
Eurobonds
Foreign Bonds
Pakistan:
Government Bonds: PIBs
Corporate Bonds and CP: TFCs
Islamic Bond: Ijara Sukuks (Rent on tangible assets, case of Etisalat purchase of band width)
Repayment Terms
Bullet
Balloon
Amortization
Annuity
Zero Coupon
Default Risk
Government Bonds: Almost Zero default Risk
Corporate Bonds: Yield Curve plus Default Risk measured by
Credit Rating (also liquidity risk)
Credit Rating Agencies
Global Players: S&P, Moody, Finch (40,40,15)
Pakistan: JCR-VIS (Fahim), PACRA (Javed Masud, IBCA, LSE)
Credit Rating
S&P: AAA, AA, A, BBB, BB, B, CCC, CC, C, D (each further divided into 3
with plus and minus)
Moody: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, D (with each further divided
into three: 1, 2, 3)
Pricing (Yield / Interest Rate) of
Bonds
Primary Markets
Government Bonds: Single Price Auction
Government (SBP) Announces the term to maturity, stated interest rate, and an indicated
of the size of issue.
Primary dealers (NIB, HBL, NBP, JS Bank, SCBP, UBL, MCB, ABL, Faisal, Alfalfa, Pak Oman,
and Citibank) offer their own bids, and those on behalf of their clients stating the bid price
per RS 100/- and the bid amount.
Government decides the total value of bids to accept. The lowest bid price per RS 100/- at
which the government accepts the bids sets the yield of the bond.
Corporate Bonds:
Internationally: Purchased at discount by the underwriter then printers placed with a
network of clients at a price depending on the demand conditions in the market at the time
of issue.
Pakistan: Generally privately placed by the underwriter at par. Sometimes a small portion
of the issue also sold through IPO.
Secondary Market
Liquidity provided by the market makers
Government Bonds: Primary dealers act as the market makers.
Corporate Bonds: The underwriters act as market makers
Bonds sold through IPO also traded at the stock exchange.
Players in the bond market:
Banks Treasury Departments (SLR Requirement, investments, and liquidity
management via repo and rev repo)
Mutual Funds (income fund, cash fund, balanced funds)
Corporates (Investment for liquidity management, and Provident Fund)
Insurance companies (life insurance companies have long term liabilities)
Pension Funds (same as life insurance companies)
Pricing in the Secondary Market
Government Bonds
SBP discount rate
Recent auction in the primary market
Open market operations
For corporate bonds:
Yield curve
Changes in credit rating
Liquidity
Environment in the market (e.g, default by other players, credit crunch)
Price equals present value of cash flows discounted at the prevailing
discount rate.
When SBP decrease its discount rate, the price of bonds in the secondary
market increases, and vice versa.
