School of Economics and Business Sarajevo

The Bond Market

PhD Prof. Muharem Karamujic

PhD Prof. Sead Kreso
Sarajevo, Fall 2013/2014

Contents
General Introduction ............................................................................................................................... 2
Introduction to Capital Markets .............................................................................................................. 3
Importance of Bonds ............................................................................................................................... 4
Bond terminology and characteristics................................................................................................. 4
Types of bonds .................................................................................................................................... 4
Government Bonds (U.S. Treasury Notes and Bonds) .................................................................... 5
Municipal Bonds (Munis)................................................................................................................. 5
Corporate Bonds.............................................................................................................................. 5
Foreign Bonds .................................................................................................................................. 5
Bond valuation .................................................................................................................................... 6
Why Are Bond Markets Important? ........................................................................................................ 7
Junk bonds ....................................................................................................................................... 7
U.S. Bond Market ................................................................................................................................ 7
Bond markets in Bosnia and Herzegovina ........................................................................................... 9
Conclusion ............................................................................................................................................. 10
Bibliography........................................................................................................................................... 11

General Introduction
If we go back to the history, we can see that financial instruments have developed as human needs
and ideas were developing. Bonds also been developed as way of financing in order to invent the
different way how to obtain funds.
We should all be able to know the fundamental things about ways of financing, no matter are we
economics students or just average citizens, it is important to know how we could find funds for our
business. Also, as average citizens it is important to know how could we earn some money. And if we,
as citizens have an opportunity to earn money, but also to contribute our society with investment in
some government or municipal bonds then it is really important to be able to find information we
need, but also to know at least fundamental things. But, as economics students, logically, we need to
know more, and to be able to interpret and analyse information available.
Through my work, I will try to explain the importance of the bond market and its stability. Paper is
divided to 3 parts. I will start with capital markets and their importance since the bonds are
instruments on the capital market. Step by step, through the paper I will try to define and explain
fundamental theoretical part about bonds, but also to use examples and to provide the updated data
about the topic. The latest part of the work is related to the bond market specifically, and in this part
I will also try to explain the bond market of U.S. and our country.

Introduction to Capital Markets

Capital markets are the markets where the securities with original maturity longer than one year are
traded. Securities which are traded on capital markets are stocks, bonds and mortgages. Companies,
regarding the situation in which they are can choose between the previously mentioned instruments,
in order to finance growth of their business. Decision which instrument should be used still stands for
one of the hardest for companies. Capital structure represents the way that a corporation uses to
finance its assets. It is a combination of equity, debt and hybrid securities
Interest rates on long-term securities are higher than the interests on short-term securities because
holding an asset for longer period represent more time and chance for risky changes to affect the
value of the asset.
Primary market represents the place where the securities are created, that is, the place where newly
issued securities are introduced. When firm sells its securities for the first time publicly, that issue is
called initial public offering (IPO). Secondary market represents the place where already issued
stocks are traded. All stock exchanges and bond exchanges that we are familiar with represent the
secondary market. Exchanges where capital securities can be sold we divide on organized exchanges
and over-the-counter exchanges.
Governments and corporations represent the primary issuers on capital market. Governments do not
issue stock. Stock stands for share of ownership, and government is not able to sell part of the
country ownership.
Economic benefits for a country are increasing with development of capital markets in the country.
William C. Dudley and R. Glenn Hubbard (2004) published the paper How Capital Markets Enhance
Economic Performance and Facilitate Job Creation where they have explained the effects of
development of capital markets on the development of the country. Some of their overall
conclusions are:

The development of the capital markets has provided significant benefits to the average
citizen. Most importantly, it has led to more jobs and higher wages.
By raising the productivity growth rate, the development of the capital markets has enabled
the economy to operate at a lower unemployment rate. In addition, higher productivity
growth has led to faster gains in real wages.
The capital markets have also acted to reduce the volatility of the economy. Recessions are
less frequent and milder when they occur. As a result, upward spikes in the unemployment
rate have occurred less frequently and have become less severe.
Effective capital markets require a firm foundation. This includes the enforcement of laws
and property rights, transparency and accuracy in accounting and financial reporting, and
laws and regulations that provide the proper incentives for good corporate governance. A
well developed financial system is a spur to growth, macroeconomic performance, and more
rapid growth in living standards.

So, the general conclusion is that, even on the first reading of the reasoning above, the one should be
able to notice importance of capital markets and positive effects on the economy with their
development.

Importance of Bonds
A bond is a long-term contract under which a borrower agrees to make payments of interest and
principal, on specific dates, to the holders of the bond. (Brigham & Daves, 2007)
The first bond issued was first ever government bond. It was issued by the Bank of England (1963) in
order to be able to raise money to finance a war against France. Later, other governments also
started with issuing bonds to fund governments spending and wars. Bonds are also used by different
entities in order to obtain funds to finance their projects.

Bond terminology and characteristics

Par
value/face Amount of money the government or corporation borrows and promises
amount
to repay on the maturity day.
Coupon
rate

interest The stated annual interest rate on the bond. It is usually fixed for the life of
the bond. 1

Market rate

The interest rate currently in effect in the market for securities of like risk
and maturity. It is used to value bonds.

Maturity date

The interest rate currently in effect in the market for securities of like risk
and maturity. It is used to value bonds.

Indenture

The contract that accompanies a bond and specifies the terms of loan
agreement. It includes management restrictions.

Provision to call or
redeem bonds
The right to call the bonds for redemption.
Yield to maturity

The yield an investor will earn if the bond is purchased at the current
market price and held until maturity.

Yield to call

Expected rate of return when the bond is called.

Current yield

The coupon interest payment divided by the current market price of the
bond.

11 Brigham & Daves (2007)

Types of bonds
Typically, when we divide bonds, first division is on government and corporate bonds. The difference
is in issuer, which automatically rises difference in risk and possibility of default on question. Another
difference, interconnected to the first one is the difference in liquidity of secondary markets. In order
to be able to notice more differences, main groups of bonds, not just government and corporate are
discussed.

There are also zero-coupon bonds, which pay no coupon, just the par value on maturity date. This kind of
bonds is usually sold at discount.

Government Bonds (U.S. Treasury Notes and Bonds)

As it can be concluded from the name, these bonds are issued by government. U.S. Treasury Bonds
are most famous and recognized bonds in the world. We need to make a difference between notes
and bonds. Notes have an original maturity of 1 to 10 years. Bonds original maturity is from 10 to 30
years. Treasury notes and bonds are default risk free (government can always print money to pay off
the debt if it is necessary. But, even if they are default risk free, they are not free from other risks.
Agency bonds (U.S. Agencies)
Bonds issued by government-sponsored enterprises are called agency bonds. Most investors
consider these bonds as very secure, almost without possibility of default. They know that
government does not issue these bonds, but they are also conscious that government would not
allow agencies to fail.
Municipal Bonds (Munis)
Municipal bonds represent the securities which are issued by local, county and state governments. In
most cases, these bonds are issued in order to fund public projects. Municipal bonds are exempt
from federal taxation.
Corporate Bonds
When companies need money to finance their projects and investments they always reconsider
financing by extra equity issuing a new stocks or financing by debt issuing bonds. On the market,
bonds issuing represents positive signal, while new stocks issuing represents negative signal. Today,
bearer bonds are replaced by registered bonds. Corporate bonds are usually issued with restrictive
covenants and call provision.
Junk bonds
Junk bonds (high-yield or non-investment grade bonds) are fixed-income instruments that are rated
by Standard & Poor's rating of BB or lower, or Ba or lower by Moody's. These bonds are called
junk bonds because of higher default risk that they bring in comparison to investment-grade bonds.
Junk bonds are risky, but also speculative. They offer higher yields that investment-grade bonds
which are safer. The higher yields for junk bonds exist because companies who issue this type of
bond do not have excellent credit ratings. In order to attract investors and make them accept the
risk, companies have to provide higher yield.
Foreign Bonds
These bonds represent the bonds issued by foreign governments or corporations. When it is said
foreign, it is meant foreign for investor. They are exposed to default risk. Also, all foreign bonds are
exposed to the currency risk, except those whose currency is pegged to the home currency of an
investor.

Bond valuation
Bonds are valued same as any financial asset. Its value represents the present value of all expected
future cash flows. So, in order to evaluate the bond, that is to calculate its value we need to:

Identify the cash flows that are expected as a result of owning of the bond
Determine the discount rate which is required by investor for holding of bond
Calculate the present value of all cash flows expected from that bond. That is, to
discount the cash flows by the discount rate required by investor.

Formula for bonds valuation:

(

Where:
P

price of the bond

yearly coupon payment

face value of the bond

years to maturity date

annual market interest rate

In the cases when coupon payments are more frequent, the formula should be adjusted. Coupon
value (C) and interest rate (i) should be divided by number of coupon payments in one year and last
discount. Years to maturity (n) date should be corrected to periods to maturity date which represent
the value of years to maturity date multiplied with the number of coupons in one year.
After defining the fundamental things, there is still need to explain Why are bonds so important?
Bonds definitely represent an invention of human kind which made improvements in business life,
but also in everyday too. Bonds provide the funds for different levels of government and private
enterprises. With these funds development and long-term projects are realised. But without funds, it
is not even possible to start any kind of project. So, bonds raise the funds from which many projects
that affect our well-being, life quality and other variables are started and finished.

Why Are Bond Markets Important?

Bond markets represent the place where bonds are traded. There are primary markets where newly
issued bonds are traded. Secondary markets are market for transactions with already issued bonds.
Usually, the bond market refers to the government bond market, but there are also bond markets for
corporate bonds and financial instruments like mortgage bonds. The reason is that government
bonds are most liquid kind of bonds, other are more or less illiquid.
Corporate bonds are traded primarily in the over-the-counter market rather than in organized
exchanges. Most bonds are owned by and traded among the large financial institutions (for example,
life insurance companies, mutual funds, and pension funds, all of which deal in very large blocks of
securities), and it is relatively easy for the over-the-counter bond dealers to arrange the transfer of
large blocks of bonds among the relatively few holders of the bonds. ( Brigham & Daves, 2007)
Bond markets are not hot. One will hear much more information about stocks and stock market,
fluctations, changes and news there than about the same in bond market. A lot of people
understands just partially how bond markets work. But still, they are important for financial markets.
When the level of importance is defined, it is enugh to say that bond markets are often called
backbone to financial markets. With this market, companies have opportunity to raise liquid cash and
grow, government can invest in publicly needed projects and economy can develop. Beside the direct
effects on the economy, bonds help keep the low tax rates. It is because government has different
way to raise money for different needs and to help it finance public debt.
Bond markets are so powerful, that they have the power to change government policy.
Junk bonds
The modern high-yield-bond market dates back to the 1980s. Until then, high-yield bonds were
usually fallen angelscompanies which previously had an investment-grade credit rating but had
seen their finances suffer. But Michael Milken and his team at Drexel Burnham Lambert, an
investment bank, discovered there was a market for high-yield debt from new issuers, often in
connection with companies making takeover bids. The market is now huge. A study by Russell, a
consultancy, estimated its total size at $1.7 trillion. Almost half of all the corporate bonds rated by
Standard & Poors are classed as speculative, a polite term for junk.
Until the hiatus related to the budget crisis in America, companies were rushing to take advantage of
this financing opportunity. In the first nine months of the year global high-yield-bond issuance
reached $378.2 billion, up by 27% on the same period in 2012, according to Dealogic, a financial-data
firm. Sprint, an American telecoms company, raised $6.5 billion in two simultaneous bond issues, the
largest-ever junk financing. (The Economist, 2013)

U.S. Bond Market

For a long time in our history, capital markets of U.S. have represented a role model for other
countries. U.K. markets are the closest for comparison. We all learned about U.S Tresuries, different
kinds and when they are used. U.S. represents the only country which has used bond financing in
that huge scale to finance expenditures, in contrast to other major developed economies such as
France, Germany, and Japan. In those countries the banking system dominates credit allocation. U.S.
securities market represents the worlds largest securities market in the world.

The New York Stock Exchange (NYSE) is the largest centralized bond market and mainly there are
represented corporate bonds. But, most governments have bond markets with lack of centralization.
Most outstanding bonds are in the hands of institutions. It is because individual bond issues are so
specific and because of lack of liquidity for large number of smaller issues. The trade is conducted in
a way as bond trade is conducted everywhere in the world, basic principles, except the scale of trade
is the greatest in the U.S. Their bonds are recognized internationally, and demad was really high. The
greatest owner of U.S. Tresuries is China.
Today, situation in U.S. is not as it was before. Financial problems are hitting each day, more and
more. The dollar value has dropped and is still dropping. About the possible effects of dollar
dropping, highly respected financial expert, Dr. Martin Weiss realised shocking news:
...the U.S. bond market is about to collapse. He says global bond investors are about to rise
in rebellion and dump their U.S. bond holdings. If that happens the dollar value would drop
even further, bond prices would drop, interest rates would increase sharply, and the economy
would be in big trouble.(James Bailey, 2013)
But this is one side opinion. Definitely, there are opposite opinions. There are others that believe that
the U.S. bond, but also the whole capital market will recover. We can all have our opinions. Mine is
that it will be hard, but that they wont allow the crash of the markets. Eventually, the time will show
what is going to happen.

Bond markets in Bosnia and Herzegovina

B&H is more developed as banking country, than as capital market country. Banks are main financial
institution and mainly most of financial transactions is done by them. Beside this, Sarajevo Stock
Exchange and Banja Luka Stock Exchange are stock exchanges where securities are traded. On these
markets bonds are traded. With a click on the Bonds tab, the one can see all transactions. Trade with
securities is regulated by two securities commissions on the entity levels.
Bonds with origin from Bosnia and Herzegovina have B rating on the international market according
to the S&P rating agency. The issues can be open and closed. Open offer is conducted in a way that
public invitation is sent to the public via public media. Closed offer is a call for bond trade to
previously known buyers: institutional investors, shareholders or employees of issuer, or up to 20
persons who have status of investors. There is no tax on interest from bonds, but income tax is
charged.
Bond trade is not in large scales. State does not issue government bonds according to the rules of
Currency Board regime. Bonds are issued and traded on the following levels:
-

Bonds of Federation of B&H

Bonds of Republic of Srpska (frozen currency savings bonds, war claim bonds,
Bonds of Brko Distrikt
Municipal bonds
Corporate bonds which are rare

The latest information about bond trading on Sarajevo Stock Exchange: In the first half of the year
2013, debt market segment on the Sarajevo Stock Exchange (SASE) experienced noteworthy
improvement in the secondary trade segment, while primary issuances were surprisingly downsized.
Clearly, bonds listed on the Official Quotation were in the highlight of the first half of the year with
almost 70% better performance than in the same period of 2012, with recorded trading amount of
BAM 9 million. (Raiffeisen Research, August 2013)
The bond market is not so active. But, if we consider all these facts, there is an opportunity for
development. Firstly, there is a need to build a trust and stimulate demand for the bonds. In this way,
funds for lower state levels can be obtained and invested in infrastructure. Also, with development of
bond market, companies would be able to obtain fund and improve their businesses. With
development of bond market the base for further society development would be made.

Conclusion
Researching the topic Bond markets has created more interest in investigating the topic. I have been
able to notice even more than before importance of the bond market and the effects that it creates
to the countrys economy. So, it is notable that development of bond market represents a variable in
development of the country. Economy is affected positively if it is developed, and negatively if it is
not, or if it crashes. As always for barely everything in finance, the trust plays an important role. If
people trust and invest, the movements toward success are visible.
On the example of the U.S. we could conclude how developed capital market, where bond market
takes a great share it is obvious that development of market and economy were correlated. But also,
nowadays, we can see how the negative information available and lack of the trust affect the market.
Effects of not adopting of budget for the following fiscal year has decreased investors trust. But still,
U.S. can conduct these problems if they do not continue in increasing manner. Some smaller
economies would probably be in greater problems with such issues.
In the example of our country, we could notice capital bond market is not developed enough. There
are some constraints, like currency board regime which does not allows open market operations for
the country and issuing of the government bonds. But, there are opportunities for us which should
be used.

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Bibliography
Books:
Brigham E.F., & Daves P.R. (2007). Intermediate Financial Management (p. 113). Thomson/SouthWestern.
Mishkin, F. S., & Eakins, S. G. (2012). Financial Markets And Institutions, /E. Pearson.
Papers:
Dudley W.C., & Hubbard R.G. (2004). How Capital Markets Enhance Economic Performance and
Facilitate Job Creation (p. 3). Global Markets Institute, Goldman Sachs.
Raiffeisen Research (2013). Bosnia and Herzegovina Economic Report issue no. 7. Raiffeisen Bank d.d.
Bosna i Hercegovina
Official Gazette of Federation of Bosnia and Herzegovina (-) Law on Securities
Articles:
Bailey J. (2013). Dr. Martin Weiss: Shocking Forecast of U.S. Bond Market Collapse. Retrieved from:
http://z3news.com
Unkown (2013). High-yield bonds - An appetite for junk. The Economist Magazine. Retrieved from:
http://economist.com/

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