Debt Securities Market Objectives

MODULE 5.
DEBT SECURITIES MARKET
OBJECTIVES
After successful completion of this module, you should be able to:
 Identify different types of bonds

 Select the bond or debt security investments that will yield higher value
COURSE MATERIALS
Debt market or debt securities market is the financial market where the debt instruments or
securities are transacted by suppliers and demanders of funds. This is the:
- Money market for short term debts

- Capital market for long term debts, like equity in the stock market
DEBT INSTRUMENTS
What are debt instruments?
 A paper or electronic obligation that enables the issuer to raise funds by promising to repay
lender in accordance to terms of the contract
 Provide a way to market participants to easily transfer the ownership of debt obligations
from one party to another.
 A legally enforceable evidence of a financial debt, and the promise to timely repay the
principal and interest.
Importance of Debt Instruments

1. It makes the repayment of the debt instrument legally enforceable
2. It increases transferability of the obligation by way of increased liquidity and a means to
trade this in the financial market.
Types of Debt Instruments

a. Short-term debt instruments – obligations both personal and corporate that are paid within
one year.
Examples are: credit card bills, payday loans, car title loans, consumer loans, revolving credit
lines, treasury bills
b. Long term debt instruments – obligations due for payment for over a year through periodic
installment payments.
Examples are: mortgage, car loans
DEBT SECURITY
What is a debt security?

 refers to a debt instrument that has defined basic terms and can be bought or sold between
two parties.
 Also known as fixed-income securities that are traded over the counter
 Interest rate is largely determined by the perceived repayment ability of the borrower.
 The total dollar value of traded debt securities that are conducted daily is much larger than
the traded stocks.
Examples are: collateralized securities, collateralized debt obligations (CDO), collateralized

mortgage obligations (CMO), mortgage backed securities issued by the Government National
Mortgage Association, zero-coupon rate.
Basic terms of a debt security

- Notional (estimated/theoretical) amount or amount borrowed
- Interest rate
- Maturity and renewal date
Types of debt securities

1. Money market debt securities – debt securities with maturities of less than one year like
treasury bills and certificate of deposits
2. Capital debt securities – debt securities with maturities of more than one year like notes,
bonds and mortgage backed securities
Debt Security vs Debt Instrument

What is the difference between debt security and debt instrument?
Debt security
 refers to money borrowed that must be repaid and has a fixed amount, a maturity date and
interest rate.
 Can be bought or sold between two parties
 Some are discounted in the original market price.
 Examples are treasury bills, bonds, preferred stock and commercial paper
Debt instrument
 Can be paper or electronic form; a tool that an entity can utilize to raise capital
 Gives market participants the option to transfer the ownership of the debt obligation from
one party to another
 Primary focuses on debt capital raised by institutional entities.
 Examples are bonds, debentures (unsecured loans), leases, certificates, bills of exchange and
promissory notes, credit cards, loans, credit lines
A bond is a typical example of a debt instrument as it is an instrument of indebtedness of the
bond issuer to the holders. It is also a debt security, under which the issuer owes the holders a debt and
is obliged to pay them interest (the coupon) or to repay the principal at maturity date.
Debt securities have implicit level of safety because they ensure that the principal amount is
returned to the lender at maturity date or upon the sale of the security. They are classified by their level
of default risk, the type of issuer and income payment cycles. The riskier the bond, the higher is its
interest rate or return yield.
Types of bonds
1. Corporate bonds – these are bonds issued by corporations to finance operations or expansions.
2. Government bonds – these are bonds issued by government that provides the face value on the
agreed maturity date with periodic interest payments. This type of bond attracts conservative
investors.
3. Municipal bonds- these are bonds issued by the local government and their agencies purposely
to fund special projects.
4. Mortgage bonds – these are pooled mortgages on real estate properties which are locked in by
the pledge of particular assets. Payments may be monthly, quarterly or semiannually.
5. Asset-backed bonds (Asset-backed Securities ABS) – this is a financial security collateralized by
pool of assets such as loans, leases, credit card debt, royalties or receivables.
6. Collateralized Debt Obligation (CDO) - this is a structured financial product that pools together
cash flow generating assets and repackages this asset pool into discrete tranches (which vary
substantially in their risk profile) that can be sold to investors. Like the senior tranches are
generally safer because they have first priority on payback from the collateral in the event of
default.
Characteristics of Bond
 Coupon rate – this is the fixed interest rate or return of the bond which is paid to the
bondholders semi-annually.
 Maturity date – this is the period when the bond issuer pays the investor at full-faced value of
the bond. This may be short-term or long-term.
 Current or market price – bonds can be purchased at par, below par or above par. The market
price depends on the level of interest rate in the market.
Bond Valuation
This is a technique in determining the theoretical fair value of a bond. Bond valuation includes
calculating the present value of the bond’s future interest payments, also known as its cash flows, and
the bond’s value upon maturity, also known as the face value or par value.
Approach in Bond Valuation
a. Traditional approach – where valuation is to discount every cash flow of a bond by the same
interest rate or discount rate for each period.
b. Arbitrage Free Valuation approach – this value the bond as a package of cash flows, with each
cash flow viewed as a zero-coupon bond and each cash flow discounted at its unique discount
rate.
Valuation of bonds with embedded options

There are two models:
a. The lattice model which is used to value callable bonds and putable bonds
b. The Monte Carlo simulation model which is used to value mortgage-backed securities and
certain types of asset-backed securities.

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MODULE 5.

DEBT SECURITIES MARKET

After successful completion of this module, you should be able to:

 Identify different types of bonds

- Money market for short term debts

What are debt instruments?

Importance of Debt Instruments

Types of Debt Instruments

What is a debt security?

Examples are: collateralized securities, collateralized debt obligations (CDO), collateralized

Basic terms of a debt security

Types of debt securities

Debt Security vs Debt Instrument

Valuation of bonds with embedded options

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