The Bond Market

8/3/2019 The Bond Market

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THE BOND MARKET

Shujaat Ali

Sherzaman KakarHaji Shabbir Ahmed


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WHAT IS A BOND?

A bond is a debt security, When you purchase abond, you are lending money to a government,

municipality, corporation, federal agency or otherentity known as the issuer.

Bonds issued by corporations or the US government are

usually taxable

Bonds issued by state governments or municipalities areusually exempt from tax


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Components

The issuer, similar to a holder of an option

Principal amount

Specified interest rate; paid to the issueryearly (also known as the coupon)

Date of maturity


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Variables that Effect Value

Maturity

Redemption Features

Credit Quality

Interest Rate

Price Yield

Tax Status


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MATURITY

1.Short-term notes: maturities of up to 4

years;

2.Medium-term notes/bonds: maturities offive to 12 years;

3.Long-term bonds: maturities of 12 or

more years.


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REDEMPTION FEATURES

Bond with a redemption provision usually havehigher 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 aspecified date before maturity.

PUT Option: option of requiring the issuer torepurchase the bonds, at a specified time, priorto maturity.


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CREDIT RATINGS

Each of the agencies assigns its ratings based on an in-depth analysis of theissuer's financial condition and management, economic and debt

characteristics, and the specific revenue sources securing the bond.

Credit Risk Moody's

Standard and

Poor's Fitch

Prime Aaa AAA AAA

Excellent Aa AA AA

Upper Medium A A A

Lower Medium Baa BBB BBB

Speculative Ba BB BB

Very Speculative B, Caa B, CCC, CC B, CCC, CC, C

Default Ca, C D DDD, DD, D

Credit Ratings


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INTEREST RATES

FIXED: Stays same until maturity; ie: buy a $1000bond with 8% fixed interest rate and you will receive $80

every year until maturity and at maturity you will receivethe $1000 back.

FLOATING: adjustable to prevailing market rates.

PAYABLE AT MATURITY: receive nopayments until maturity and at that time you receive

principal plus the total interest earned compounded semi-

annually at the initial interest rate.


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PRICE

The amount you pay for the bond

Newly issued bonds will pay close to their face-

value 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 tobe be sold at discount


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YIELD

Yield is the return you actually earn on thebond--based on the price you paid and theinterest payment you receive

Two Types of Yields:

Current Yield: annual return on the amountpaid for the bond and is derived by dividing the

bond's interest payment by its purchase priceYield To Maturity: total return you will

receive by holding the bond until it matures or iscalled.


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YIELD contd

From the time a bond is originally issued until theday it matures, its price in the marketplace will

fluctuate according to changes in marketconditions 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 typicallyhaving an immediate, and predictable, effect on

the prices of bonds.


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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 olderbonds 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.


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YIELD (Linking interest rate and maturity)

The longer it takes for a bond to mature, thegreater 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


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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 nofederal income tax on the interest from

most municipal bonds, and in many cases

no state or local income tax, as well.


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INTEREST RATE-INFLATION

As a general rule: the bond market, and theoverall 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 tohigher interest rates and erodes a bond's

value.


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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 pricesdown, the bond market tends to react negativelyto reports about strong economic growth.


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TYPES OF BONDS

Municipal: issued to raise money for schools,

hospitals, highways, etc.

Corporate: debt obligations issued by privateand public corporations

Zero-Coupon: Bonds with no periodic

interest payments (introduced to themarketplace in 1982)


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MARKETABLILITY

How quickly and easily a bond can bebought or sold

For a bond to have high marketability, theremust be a large trading volume as well as a

large number of dealers in the security


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BOND BENEFITS

Some portion of portfolio should be inbonds

High degree of safety with regular, scheduled,predictable payments


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Global Financial Stability

Report-2005, IMF Country Bond Market as % of GDP

India 0.4 Malaysia 38.2

China 0.7 USA 22Brazil 0.6 Korea 21.1

Russia 1.5 Japan 16.3

Global Financial Stability Report-2005,IMF


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Bond market of Pakistan

1.Country BackgroundPakistan inherited an undersized and undevelopedfinancial structure after the independence. Thefinancial structure that we have today in Pakistan isthe result of many experiments, policy shifts anddevelopments. We can segregate the eras of policyshifts & developments into following periods;

1947-1960 Private sector development1960-1971 On the developing of public sector

institutions Eg: KPR, SSGCL etc1971-1990 The private sector development almost clogged.

The banking sector came into governments control duringthis period


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Continued

Prior to 1990, the biggest issue of bonds by some company

Issuing Corporation WAPDA

Issuance Year 1988Funds Generated RS 22.5 billion

Experience Failure

Reason WAPDA was unable to payback on maturity due

to insufficient funds


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Post 1990 Era

This is the era in which Pakistan came intothe fixed income Securities Market. We can

segregate the post 1990 bond market into 1) Government Debt Securities,

2) Corporate Debt Securities.

Th f P ki h l fi l d fi i h d d Th fi l d fi i d $373 billi i fi l 2006 07


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. Government Debt Securities

The government of Pakistan has run overlarge fiscal deficits over the two decades.

The fiscal deficit stands at $373 billion infiscal year 2006-07 . This has resulted into

the accumulation of large domestic debt of

Rs. 2511 billion in fiscal year 2006-07

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 .


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PIBs- Pakistan Investment Bonds

Government of Pakistan issued long termpaper (FIBs) in 1992

The auction of FIBs was stopped in 1998due to less response by the public on the

declining earnings on these instruments

PIBs were launched in December 2000 forcreating a benchmark yield curve and to

enhance the corporate debt market.


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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 corporatebodies 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 while13.23% of the total domestic debt by March 2007.


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Market Treasury Bills (MTBs)

Market Treasury Bills are the short term securities forgovernment borrowing. They have the following

Characteristics;

Issued in three tenors of 3-month, 6-month and 12-months maturity

Zero Coupon bonds sold at a discount to their face values

Purchased by individuals, institutions and corporate

bodies including banks irrespective of their residentialstatus.

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)


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Auction Process for Government

Securities State bank of Pakistan acts as an agent for the government to raise theshort 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


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Corporate Debt Market(TFC)

The bond market in Pakistan saw its firstcorporate issuance in 1995 by Packages

Limited.Issuing Corporation Packages Limited

Funds Raised RS 232 million

Issuance Year 1995Rating (PACRA) A+

Coupon Rate 18.50%


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Cont`d

The largest TFC (term financecertificates)was issued by PIA in 2003

Issuing Corporation PIA

Funds Raised RS 15.4 billion

Issuance Year 2003Reason Purchase of Boeing 777s


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TFC Issues in Pakistan,

January 1995 to July 1999

Issuer Packag

es

SSGC Nishat

TEK

ICI Gatron Inter

Bank

Saudi

Pak

Dewan

Salman

Date of

subscription

Feb.

1995

Oct.

1995

Jan.

1996

Sep.

1996

Jun.

1998

Dec.

1998

Feb.

1999

May.

1999

Rating A+ AA A+ AA A+ A A+ A+

Coupon

rate(%)

18.5 18.25 18 18.7 18 17.5 18.5 19

Tenors

(Yrs)

5 5 3 5 5 5 3 5


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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 en-

cashed anytime subject to service charges of 2% on the

investment balance for en-cashments before completion of

3 years


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Credit Rating Agencies

There are two credit rating agencies inPakistan.

1 Pakistan credit rating agency (PACRA)

2 Duff & Phelps Rating Agency & Vital

Information Services (DCR-VIS)


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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


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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

The Bond Market

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