Summary

Comparing Money Market Securities: Money Market

Securities and Their Depth

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 Chapter Preview

In this chapter, we focus on longer-term

securities: bonds. Bonds are like money
market instruments, but they have maturities
that exceed one year. These include
Treasury bonds, corporate bonds,
mortgages, and the like.

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 Chapter Preview
We examine how capital markets operate, and then
focus our attention on the bonds and the bond
market. We will conclude this topic with Chapter 14
on mortgages. Topics include:
Purpose of the Capital Market
Capital Market Participants
Capital Market Trading
Types of Bonds
Treasury Notes and Bonds

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 Chapter Preview (cont.)
Municipal Bonds
Corporate Bonds
Financial Guarantees for Bonds
Current Yield Calculation
Finding the Value of Coupon Bonds
Investing in Bonds

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 Capital Market
Capital markets are financial markets for the buying and selling of long-
term debt- or equity-backed securities. These markets channel the wealth
of savers to those who can put it to long-term productive use, such as
companies or governments making long-term investments. Financial
regulators, such as the UK's Bank of England (BoE) or the U.S securities
and Exchange Commission (SEC), oversee the capital markets in their
jurisdictions to protect investors against fraud, among other duties.
Modern capital markets are almost invariably hosted on computer-based
electronic trading systems; most can be accessed only by entities within
the financial sector or the treasury departments of governments and
corporations, but some can be accessed directly by the public.[2] There
are many thousands of such systems, most serving only small parts of
the overall capital markets. Entities hosting the systems include stock
exchanges, investment banks, and government departments.

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 Capital Market
A key division within the capital markets is between the primary
markets and secondary markets. In primary markets, new stock
or bond issues are sold to investors, often via a mechanism
known as underwriting. The main entities seeking to raise long-
term funds on the primary capital markets are governments
(which may be municipal, local or national) and business
enterprises (companies). Governments tend to issue only
bonds, whereas companies often issue either equity or bonds.
The main entities purchasing the bonds or stock include
pension funds, hedge funds, sovereign wealth fund, and less
commonly wealthy individuals and investment banks trading on
their own behalf. In the secondary markets, existing securities
are sold and bought among investors or traders, usually on an
exchange, over the counter, or elsewhere.
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 Capital Market
In the secondary markets, existing securities are sold and
bought among investors or traders, usually on an
exchange, over the counter, or elsewhere. The existence
of secondary markets increases the willingness of
investors in primary markets, as they know they are likely
to be able to swiftly cash out their investments if the need
arises.
A second important division falls between the stock
markets (for equity securities, also known as shares,
where investors acquire ownership of companies) and the
bond markets (where investors become creditors).

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 Purpose of the Capital Market
Capital market plays an important role in mobilizing
resources, and diverting them in productive channels. In this
way, it facilitates and promotes the process of economic
growth in the country.
1. Link between Savers and Investors: The capital market
functions as a link between savers and investors. It plays an
important role in mobilizing the savings and diverting them in
productive investment. In this way, capital market plays a
vital role in transferring the financial resources from surplus
and wasteful areas to deficit and productive areas, thus
increasing the productivity and prosperity of the country.

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 Purpose of the Capital Market
2. Encouragement to Saving: With the development of
capital, market, the banking and non-banking institutions
provide facilities, which encourage people to save more.
In the less- developed countries, in the absence of a
capital market, there are very little savings and those who
save often invest their savings in unproductive and
wasteful directions, i.e., in real estate (like land, gold, and
jewellery) and conspicuous consumption.

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 Purpose of the Capital Market
3. Encouragement to Investment: The capital market
facilitates lending to the businessmen and the government
and thus encourages investment. It provides facilities
through banks and nonbank financial institutions. Various
financial assets, e.g., shares, securities, bonds, etc.,
induce savers to lend to the government or invest in
industry. With the development of financial institutions,
capital becomes more mobile, interest rate falls and
investment increases.

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 Purpose of the Capital Market
4.Promotes Economic Growth: The capital market not
only reflects the general condition of the economy, but
also smoothens and accelerates the process of economic
growth. Various institutions of the capital market, like
nonbank financial intermediaries, allocate the resources
rationally in accordance with the development needs of
the country. The proper allocation of resources results in
the expansion of trade and industry in both public and
private sectors, thus promoting balanced economic growth
in the country.

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 Purpose of the Capital Market
5. Stability in Security Prices: The capital market tends
to stabilize the values of stocks and securities and reduce
the fluctuations in the prices to the minimum. The process
of stabilization is facilitated by providing capital to the
borrowers at a lower interest rate and reducing the
speculative and unproductive activities.

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 Purpose of the Capital Market
6. Benefits to Investors: The credit market helps the investors,
i.e., those who have funds to invest in long-term financial
assets, in many ways:
It brings together the buyers and sellers of securities and thus
ensure the marketability of investments,
By advertising security prices, the Stock Exchange enables the
investors to keep track of their investments and channelize
them into most profitable lines,
It safeguards the interests of the investors by compensating
them from the Stock Exchange Compensating Fund in the
event of fraud and default.

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 Capital Market Participants
Commercial Banks: Commercial banks are those companies
which are engage in accepting deposits from savers and lending it
back to deficit groups who are demanding loans and advances in
order to invest business. Commercial banks are a major source of
deposits collectors among the all other kinds of financial
institutions. They mobilize their depository funds in many forms for
example, lending to individuals and corporations, invest in stock
market and participate other forms of investment.
Saving Banks: Like commercial banks, savings banks also
accumulate the scattered savings of the country and then create
investment friendly funds and lastly channelize these funds into
productive investments. Most savings banks are mutual in nature.

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 Capital Market Participants
Investment Banks: Investment banks are those, which under
write shares and debentures of corporate firms and deal in
capital market through trading various transactions. They also
create securities & provide institutional financing.
Credit Unions: Credit union differs from commercial savings
banks in that they are not profit oriented company and restrict
their business to the main members only. They use most of
their funds to provide loans to their internal members.
Finance Companies: Most finance companies obtain funds by
issuing securities and then lend the funds to individuals and
small businesses.

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 Capital Market Participants
Developmental Financial Institutions: DFIs play the
significant role as the source of long-term funds mainly for the
corporate firms. They supply fixed capital to the investors for
investment in fixed capital expenditures. They also perform the
underwriting functions relating to shares and debentures of the
corporate firms.
Stock Exchange: Stock exchange means any body comprising
of individuals organizations whether incorporated or not,
constituted for the purpose of assisting and controlling of
buying, selling or dealing in securities. In its primary market,
funds are obtained by issuing shares, stocks and securities of
the firms, individuals and government.

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 Capital Market Participants
Leasing Companies: Leasing companies are the easiest
sources of financing fixed assets requirements of the corporate
firms, individuals and other organizations.
Mutual Funds: Some of the mutual funds concentrate their
investments in capital market securities such as stocks or
bonds. In this way, they provide funds for long-term
investments by the investors.
Insurance Companies: Insurance companies receive premium
in exchange for insurance policies and use these funds to
purchase a variety of securities. Thus, they invest the proceeds
received from insurance in stocks and bonds.

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 Capital Market Trading

1. Primary market for initial sale (IPO):

Companies can avoid paying fees to investment banks by
using a direct public offering, though this is not a common
practice as it incurs other legal costs and can take up
considerable management time

1. Secondary market
Over-the-counter
Organized exchanges (i.e., NYSE)

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 Examples of capital market transactions

A government raising money on the

primary markets: When a government wants to raise
long term finance it will often sell bonds to the capital markets.
In the 20th and early 21st century, many governments would
use investment banks to organize the sale of their bonds.
However, since 1997 it has been increasingly common for
governments of the larger nations to bypass investment banks
by making their bonds directly available for purchase over the
Internet. Many governments now sell most of their bonds by
computerized auction.

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 Examples of capital market transactions

A company raising money on the

primary markets: When a company wants to raise
money for long term investment, one of its first decisions is
whether to do so by issuing bonds or shares. If it chooses
shares, it avoids increasing its debt, and in some cases the new
shareholders may also provide non monetary help, such as
expertise or useful contacts. On the other hand, a new issue of
shares can dilute the ownership rights of the existing
shareholders, and if they gain a controlling interest, the new
shareholders may even replace senior managers. From an
investor's point of view, shares offer the potential for higher
returns and capital gains if the company does well.

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 Examples of capital market transactions

Conversely, bonds are safer if the company does poorly, as

they are less prone to severe falls in price, and in the event of
bankruptcy, bond owners are usually paid before shareholders.
When a company raises finance from the primary market, the
process is more likely to involve face-to-face meetings than
other capital market transactions. Whether they choose to issue
bonds or shares, companies will typically enlist the services of
an investment bank to mediate between themselves and the
market.

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 Examples of capital market transactions

Trading on the secondary markets: Most capital market

transactions take place on the secondary market. On the primary
market, each security can be sold only once, and the process to
create batches of new shares or bonds is often lengthy due to
regulatory requirements. On the secondary markets, there is no
limit on the number of times a security can be traded, and the
process is usually very quick. With the rise of strategies such as
high frequency trading, a single security could in theory be traded
thousands of times within a single hour. Transactions on the
secondary market don't directly help raise finance, but they do
make it easier for companies and governments to raise finance on
the primary market, as investors know if they want to get their
money back in a hurry, they will usually be easily able to re-sell
their securities.
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 Types of Bonds
Bonds are securities that represent debt owed by the issuer to
the investor, and typically have specified payments on specific
dates generally with periodic interest payments.
Thus a bond is a form of loan the holder of the bond is the
lender (creditor), the issuer of the bond is the borrower (debtor),
and the coupon is the interest. Bonds provide the borrower with
external funds to finance long-term investment, or, in the case
of government bonds, to finance current expenditure.
Bonds and stocks are both securities, but the major difference
between the two is that (capital) stockholders have an equity
stake in the company (i.e. they are investors), whereas
bondholders have a creditor stake in the company (i.e. they are
lenders)
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 Issuance of Bonds

Issuance: Bonds are issued by public authorities, credit

institutions, companies and supranational institutions in the
primary markets. The most common process for issuing bonds
is through underwriting.
In contrast, government bonds are usually issued in an auction.
In some cases both members of the public and banks may bid
for bonds. In other cases only market makers may bid for
bonds. The overall rate of return on the bond depends on both
the terms of the bond and the price paid. The terms of the
bond, such as the coupon, are fixed in advance and the price is
determined by the market.

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 Features of Bonds
Features
Principal: Nominal, principal, par or face amount is the
amount on which the issuer pays interest, and which, most
commonly, has to be repaid at the end of the term. Some
structured bonds can have a redemption amount which is
different from the face amount and can be linked to
performance of particular assets such as a stock or
commodity index, foreign exchange rate or a fund. This
can result in an investor receiving less or more than his
original investment at maturity.

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 Features of Bonds
Maturity: The issuer has to repay the nominal amount on
the maturity date. As long as all due payments have been
made, the issuer has no further obligations to the bond
holders after the maturity date. The length of time until the
maturity date is often referred to as the term or tenor or
maturity of a bond. The maturity can be any length of time,
although debt securities with a term of less than one year are
generally designated money market instruments rather than
bonds. Most bonds have a term of up to 30 years. Some
bonds have been issued with terms of 50 years or more, and
historically there have been some issues with no maturity
date (irredeemable).

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 Types of Bonds
Some bonds have been issued with terms of 50 years or
more, and historically there have been some issues with
no maturity date (irredeemable). In the market for United
States Treasury securities, there are three categories of
bond maturities:
short term (bills): maturities between one to five year;
(instruments with maturities less than one year are called
Money Market Instruments)
medium term (notes): maturities between six to twelve
years;
long term (bonds): maturities greater than twelve years.
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 Features of Bonds
Coupon: The coupon is the interest rate that the issuer
pays to the holder. Usually this rate is fixed throughout the
life of the bond. It can also vary with a money market
index, such as LIBOR, or it can be even more exotic. The
name "coupon" arose because in the past, paper bond
certificates were issued which had coupons attached to
them, one for each interest payment. On the due dates the
bondholder would hand in the coupon to a bank in
exchange for the interest payment. Interest can be paid at
different frequencies: generally semi-annual, i.e. every 6
months, or annual.

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 Types of Bonds:
Sample Corporate Bond

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 Treasury Notes and Bonds
A Treasury Note is a type of short term debt instrument
issued by the United States prior to the creation of the
Federal Reserve System in 1913. Without the alternatives
offered by a federal paper money or a central bank, the
U.S. government relied on these instruments for funding
during periods of financial stress such as the War of 1812,
the panic of 1837, and the American Civil War.
The U.S. Treasury issues notes and bonds to finance its
operations.

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 Treasury Notes and Bonds
The difference between a note and a bond is that notes
have an original maturity of 1 to 10 years while bonds
have an original maturity of 10 to 30 years. The Treasury
currently issues notes with 2-3, 5-7, and 10 years
maturities.
Federal government notes and bonds are free of default
risk because the government can always print money to
pay off the debts if necessary, but this doesnt mean that
these securities are risk free.
The following table summarizes the maturity differences
among the various Treasury securities.

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Treasury Notes and Bonds

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 Treasury Bond Interest Rates

No default risk since the Treasury can print

money to payoff the debt
Very low interest rates, often considered
the risk-free rate (although inflation risk is
still present)

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 Treasury Bond Interest Rates

No default risk since the Treasury can print

money to payoff the debt
Very low interest rates, often considered
the risk-free rate (although inflation risk is
still present)

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 Treasury Bond Interest Rates
The next two figures show historical
rates on Treasury bills, bonds, and the inflation rate.Two
things in said graph are note worthy:
First in most years the rate of return on the short term bill
is below that on the 20-year bond.
Second short term Rates are more volatile than long term
rates. Short term rates are more influenced by the current
rate of inflation. Investors in long term securities expect
extremely high or low inflation rates to return to more
normal levels, so long term rates do not change as much
as short term rates.
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Treasury Bond Interest Rates

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Treasury Bond Interest Rates:
Bills vs. Bonds

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 Treasury Bonds:
Recent Innovation
Treasury Inflation Protected Securities (TIPS): In 1997 the
Treasury Department began offering an innovative bond
designed to remove inflation risk from holding treasury
securities. The inflation indexed bonds have an interest
rate that does not change throughout the term of security.
An advantage of inflation indexed securities also referred
to as inflation protected securities is that they give both
individual and institutional investors a chance to buy a
security whose value wont be eroded by inflation. These
securities can be used by retirees who want to hold a very
low risk portfolio.

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 Treasury Bonds:
Recent Innovation
Treasury STRIPS (Separate Trading of Registered
Interest and Principal Securities): the coupon and
principal payments are stripped from a T-Bond and
sold as individual zero-coupon bonds.
STRIPS are also called zero coupon securities
because the only time an investor receives a payment
during the life a STRIPS is when it matures.

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 Chapter Summary

Purpose of the Capital Market: provide

financing for long-term capital assets
Capital Market Participants: governments
and corporations issue bond, and we
buy them
Capital Market Trading: primary and
secondary markets exist for most securities
of governments and corporations
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 Chapter Summary (cont.)

Types of Bonds: includes Treasury,

municipal, and corporate bonds
Treasury Notes and Bonds: issued and
backed by the full faith and credit of the
U.S. Federal government
.

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