THE BOND MARKET
Shujaat Ali Sherzaman Kakar Haji Shabbir Ahmed
WHAT IS A BOND?
A bond is a debt security, When you purchase a
bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer.
Bonds issued by corporations or the US government are
usually taxable Bonds issued by state governments or municipalities are usually exempt from tax
Components
The issuer, similar to a holder of an option Principal amount Specified interest rate; paid to the issuer
yearly (also known as the coupon) Date of maturity
Variables that Effect Value
Maturity Redemption Features Credit Quality Interest Rate Price Yield Tax Status
MATURITY
[Link]-term notes: maturities of up to 4 years; [Link]-term notes/bonds: maturities of five to 12 years; [Link]-term bonds: maturities of 12 or more years.
REDEMPTION FEATURES
Bond with a redemption provision usually have
higher return to compensate for the risk that the bonds might be called early. CALL Option: provisions that allow or require the issuer to repay the investors principal at a specified date before maturity. PUT Option: option of requiring the issuer to repurchase the bonds, at a specified time, prior to maturity.
CREDIT RATINGS
Each of the agencies assigns its ratings based on an in-depth analysis of the issuer's financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond.
Credit Ratings
Credit Risk
Prime Excellent Upper Medium Lower Medium Speculative Very Speculative Default
Standard and Poor's Moody's
Aaa Aa A Baa Ba B, Caa Ca, C AAA AA A BBB BB B, CCC, CC D
Fitch
AAA AA A BBB BB B, CCC, CC, C DDD, DD, D
INTEREST RATES
FIXED:
Stays same until maturity; ie: buy a $1000 bond with 8% fixed interest rate and you will receive $80 every year until maturity and at maturity you will receive the $1000 back.
FLOATING: adjustable to prevailing market rates. PAYABLE AT MATURITY: receive no
payments until maturity and at that time you receive principal plus the total interest earned compounded semiannually at the initial interest rate.
PRICE
The amount you pay for the bond
Newly issued bonds will pay close to their facevalue Traded bonds fluctuate in response to changing interest rates
Bonds traded higher than their face-value are said to
be sold at a premium Bonds traded lower than their face-value are said to be be sold at discount
YIELD
Yield is the return you actually earn on the
bond--based on the price you paid and the interest payment you receive Two Types of Yields: Current Yield: annual return on the amount paid for the bond and is derived by dividing the bond's interest payment by its purchase price Yield To Maturity: total return you will receive by holding the bond until it matures or is called.
YIELD contd
From the time a bond is originally issued until the
day it matures, its price in the marketplace will fluctuate according to changes in market conditions or credit quality. The constant fluctuation in price is true of individual bonds-and true of the entire bond market-with every change in the level of interest rates typically having an immediate, and predictable, effect on the prices of bonds.
YIELD (Linking price and yield)
Most important thing to remember!!!!
**When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues **When prevailing prices fall, prices of outstanding bonds rise, until the yield of older bonds is low enough to match the lower interest rate on new issues.
YIELD (Linking interest rate and maturity)
The longer it takes for a bond to mature, the
greater the risk that prices will fluctuate along the way By watching a yield curve you can gain a sense of where the market perceives interest rates to be headed
TAXABLE STATUS
Some bonds offer special tax advantages.
There is no state or local income tax on the interest from U.S. Treasury bonds, and no federal income tax on the interest from most municipal bonds, and in many cases no state or local income tax, as well.
INTEREST RATE-INFLATION
As a general rule: the bond market, and the
overall economy, benefit from steady, sustainable growth rates. But steep rises in economic growth can lead to inflation, which raises the costs of goods and services for everyone, leads to higher interest rates and erodes a bond's value.
INTEREST RATE-INFLATION
Interest rates rise due to:
The Federal Reserve trying to slow economic
growth through market forces acting in anticipation of interest rate moves **Since rising interest rates push bond prices down, the bond market tends to react negatively to reports about strong economic growth.
TYPES OF BONDS
Municipal: issued to raise money for schools, hospitals, highways, etc. Corporate: debt obligations issued by private and public corporations Zero-Coupon: Bonds with no periodic interest payments (introduced to the marketplace in 1982)
MARKETABLILITY
How quickly and easily a bond can be
bought or sold For a bond to have high marketability, there must be a large trading volume as well as a large number of dealers in the security
BOND BENEFITS
Some portion of portfolio should be in
bonds High degree of safety with regular, scheduled,
predictable payments
Global Financial Stability Report-2005, IMF
Country Bond Market as % of GDP
India 0.4 Malaysia 38.2 China 0.7 USA 22 Brazil 0.6 Korea 21.1 Russia 1.5 Japan 16.3 Global Financial Stability Report-2005, IMF
Bond market of Pakistan
[Link] Background Pakistan inherited an undersized and undeveloped financial structure after the independence. The financial structure that we have today in Pakistan is the result of many experiments, policy shifts and developments. We can segregate the eras of policy shifts & developments into following periods; 1947-1960 Private sector development 1960-1971 On the developing of public sector institutions Eg: KPR, SSGCL etc 1971-1990 The private sector development almost clogged. The banking sector came into governments control during this period
Continued
Prior to 1990, the biggest issue of bonds by some company
Issuing Corporation WAPDA Issuance Year 1988 Funds Generated RS 22.5 billion Experience Failure Reason WAPDA was unable to payback on maturity due to insufficient funds
Post 1990 Era
This is the era in which Pakistan came into
the fixed income Securities Market. We can segregate the post 1990 bond market into 1) Government Debt Securities, 2) Corporate Debt Securities.
The government of Pakistan has run over large fiscal deficits over the two decades. The fiscal deficit stands at $373 billion in fiscal year 2006-07 . T
. Government Debt Securities
The government of Pakistan has run over
large fiscal deficits over the two decades. The fiscal deficit stands at $373 billion in fiscal year 2006-07 . This has resulted into the accumulation of large domestic debt of Rs. 2511 billion in fiscal year 2006-07
PIBs- Pakistan Investment Bonds
Government of Pakistan issued long term
paper (FIBs) in 1992 The auction of FIBs was stopped in 1998 due to less response by the public on the declining earnings on these instruments PIBs were launched in December 2000 for creating a benchmark yield curve and to enhance the corporate debt market.
Charecterstics of PIBs
Issued in five tenors of 3, 5, 10, 15 and 20-years maturity.
Primary Dealer maintains a Subsidiary General Ledger Account (SGLA) with SBP for the settlement purpose Purchased by individuals, institutions and corporate bodies including banks irrespective of their residential status. SBP & Ministry of Finance announce the coupon rates and the target amounts after consulting each other Profit is Paid Semiannually The PIBs represent 63% of total permanent debt while 13.23% of the total domestic debt by March 2007.
Market Treasury Bills (MTBs)
Market Treasury Bills are the short term securities for
government borrowing. They have the following Characteristics; Issued in three tenors of 3-month, 6-month and 12months maturity Zero Coupon bonds sold at a discount to their face values Purchased by individuals, institutions and corporate bodies including banks irrespective of their residential status. Primary Dealer maintains a Subsidiary General Ledger Account (SGLA) with SBP for the settlement purpose The outstanding amount of MTBs as of March 2007 is Rs. 1086.25 billion (43.25% of total Domestic Debt)
Auction Process for Government Securities
State bank of Pakistan acts as an agent for the government to raise the
short term & long term funds from the market. State Bank sells the MTBs and PIBs to the 10 primary Dealers through price sealed bids auction. The 10 primary dealers are: ABN Amro Bank NV Citibank Habib Bank Limited JS Bank Limited MCB Bank Limited National Bank of Pakistan Pak Oman Investment Co. Prime Commercial Bank Standard Chartered Bank (Pakistan) Limited United Bank Limited
Corporate Debt Market(TFC)
The bond market in Pakistan saw its first
corporate issuance in 1995 by Packages Limited. Issuing Corporation Packages Limited Funds Raised RS 232 million Issuance Year 1995 Rating (PACRA) A+ Coupon Rate 18.50%
Cont`d
The largest TFC (term finance
certificates)was issued by PIA in 2003 Issuing Corporation PIA Funds Raised RS 15.4 billion Issuance Year 2003 Reason Purchase of Boeing 777s
TFC Issues in Pakistan, January 1995 to July 1999
Issuer Packag es
Feb. 1995
SSGC
Nishat TEK
Jan. 1996
ICI
Gatron
Inter Bank
Dec. 1998
Saudi Pak
Feb. 1999
Dewan Salman
May. 1999
Date of subscripti on Rating Coupon rate(%) Tenors (Yrs) 5
Oct. 1995
Sep. 1996
Jun. 1998
A+ 18.5
AA 18.25
A+ 18
AA 18.7
A+ 18
A 17.5
A+ 18.5
A+ 19
Engro Rupiya
Fixed Profit rate of 14.5% per year payable every 6 months
. Maturity duration 3years Minimum investment of Rs. 25,000 with increments of Rs. 5,000 Rated AA which denotes very high credit quality No minimum holding period so investments can be encashed anytime subject to service charges of 2% on the investment balance for en-cashments before completion of 3 years
Credit Rating Agencies
There are two credit rating agencies in
Pakistan. 1 Pakistan credit rating agency (PACRA) 2 Duff & Phelps Rating Agency & Vital Information Services (DCR-VIS)
Impediments to Bond Market Development in Pakistan
Crowding Out by the Government
Securities Lack of Benchmark Yield Curve Administrative Hurdles Liquidity/ Secondary Market Non-diverse Investor Base Disclosure Requirements/Transparency
Recommendations
Increased Size of the Bond Market Building a yield curve for the bond market Stopping Institutional Investors from NSS Diversifying Investor Base Investor Awareness Availability of Professionals Risk Management/ Hedging Instruments Administrative Reforms Stopping the Municipal Bonds
