FMPRR_Interest Rate & Currency Derivatives Cand SO_Debt_Bond Market.docx

The Debt (Bond) Market ====================== The Debt/Bond Market -------------------- ### What is a bond? A **bond **is a type of **debt instrument** issued (sold) by a government, company, corporation, or local authority to **raise money** for projects and operations. Subsequently, when invest...

The Debt (Bond) Market ====================== The Debt/Bond Market -------------------- ### What is a bond? A **bond **is a type of **debt instrument** issued (sold) by a government, company, corporation, or local authority to **raise money** for projects and operations. Subsequently, when investors buy bonds from bond issuers, they provide** small loans **to the issuers.**  ** A diagram of a bond Description automatically generated Source: [nds%2F&docid=mVkAMVyr\_E04jM&w=602&h=337&q=types%20of%20bonds%20debt%20securities](https://www.google.com/imgres?imgurl=https%3A%2F%2Fwww.wallstreetmojo.com%2Fwp-content%2Fuploads%2F2018%2F02%2FBonds.jpg.webp&tbnid=uXFpFfk9mbKx6M&vet=12ahUKEwjv7-2cv7mCAxU5sCcCHd2zAV8QMygDegQIARBR..i&imgrefurl=https%3A%2F%2Fwww.wallstreetmojo.com%2Fbonds%2F&docid=mVkAMVyr_E04jM&w=602&h=337&q=types%20of%20bonds%20debt%20securities&ved=2ahUKEwjv7-2cv7mCAxU5sCcCHd2zAV8QMygDegQIARBR)  ### The Bond Market The bond market is the mechanism / conventions that exist for the issue of, investing in, and the trading of, instruments that represent the long-term undertakings (usually of a fixed capital nature) of the issuers. The key elements in the bond market are: 1. **Bonds** may be defined as long-term debt obligations issued by various entities including corporations and government etc. Investors, often referred to as bondholders or creditors, lend money to the issuer by purchasing bonds. Each issuer undertakes to repay the face value at the end of the stated redemption (maturity) period of the bond, plus interest at specified intervals or at the end of the period, and the interest rate may be fixed or floating. 2. **Market Mechanism** is the structure, systems and conventions that exist to facilitate the issue and trading of bonds. There are two types of market, - the **over-the counter (OTC**) market and - the exchange-regulated market. Most bond markets around the world are OTC markets; the South African bond market is one of the few markets that are primarily exchange regulated. 3. **Issuer -** There are five broad classes of *issuers* in the bond market: 4. **Investing -** Each type of investor has unique investment goals and considerations. Some seek steady income, while others focus on capital appreciation or risk management. The bond market\'s diversity allows investors to tailor their portfolios to meet specific financial objectives and risk tolerances. 5. **Trading -** Trading in bonds (broking and dealing) is a large business in most financial markets - and particularly so in South Africa where it is claimed by some that the bond market is one of the most liquid in the world. - **Broker-dealers** are smaller JSE Debt Market member firms that trade for own account or for clients. - **Interdealer brokers** offer a brokerage service exclusively between the market making members of the JSE Debt Market. 6. **Long-term undertakings of a fixed capital nature** of issuers are what give rise to the issue of bonds. Many companies and governments and public enterprises have a requirement for long-term funds to finance projects such as infrastructure (roads, telecommunications systems, deep mining, etc. ### Key terms regarding the trading of bonds Understanding these terms is crucial for investors, traders, and other market participants involved in the JSE bond/debt market, as they provide the foundation for effective communication and decision-making in the bond/debt trading environment. **JSE (Johannesburg Stock Exchange):** The primary stock exchange in South Africa, where bonds are listed and traded. **Bond:** A debt instrument that represents a loan made by an investor to a borrower (usually a government or corporation). Bonds typically pay periodic interest and return the principal at maturity. **Issuer:** The entity (government, municipality, or corporation) that borrows money by issuing bonds. **Listing:** The process of a bond being officially admitted to trade on the JSE. **Coupon Rate:** The fixed annual interest rate paid on the face value of the bond. It determines the periodic interest payments to bondholders. **Maturity Date:** The date on which the principal amount of a bond becomes due and is repaid to the bondholder. **Yield:** The return on investment for a bond, expressed as a percentage, taking into account the bond\'s current market price, coupon interest rate, and time to maturity. **Credit Rating:** An assessment of the creditworthiness of a bond issuer, assigned by credit rating agencies. Higher credit ratings indicate lower credit risk. **Yield to Maturity (YTM):** The total return anticipated on a bond if it is held until it matures, considering the current market price, par value, coupon interest rate, and time to maturity. **Bid Price:** The highest price a buyer is willing to pay for a bond. **Ask Price:** The lowest price a seller is willing to accept for a bond. **Spread:** The difference between the bid and ask prices, representing the transaction cost and liquidity of the bond. **Market Maker:** A financial institution or individual that facilitates trading by quoting bid and ask prices for bonds, providing liquidity to the market. **Trading Floor:** The physical or virtual location where bond trading takes place, facilitated by brokers, market makers, and electronic trading platforms. **Settlement Date:** The date on which the buyer must pay for the purchased bonds, and the seller must deliver the bonds. **Clearing House:** An intermediary entity that facilitates the settlement of trades by ensuring the delivery of securities and the transfer of funds between buyers and sellers. **Nominal Value:** The face value of the bond, representing the amount borrowed and the amount to be repaid at maturity. ### Bonds versus Stocks Generally, investors are advised to **diversify** their investment portfolios **between stocks and bonds**. Bonds and stocks are **two different methods** a company can use to **raise money** to fund current operations or to expand its operations. Therefore, before investing in stocks or bonds, or in both, it is beneficial to take note of the **fundamental differences** between the two types of securities. **Stocks** - **stocks represent shares** of a particular company. When an investor buys shares of a company, he or she buys a **portion of the company** and becomes a **partial owner**, even a small owner. That is why stocks are also referred to as **equity**. - As partial owners, investors **share in the profits and losses** of a company. If a **company performs well** and its worth increases over time, investors will benefit from that. However, an **underperforming company's share price** could fall, causing losses for shareholders. The worst-case scenario is that a company could go bankrupt, effecting an investor to lose his or her entire investment in the company. - Because of the nature of stock trading, stocks are often a **riskier short-term investment **than bonds, given the amount of money an investor could lose in a short period of time. - After a company's shares have been sold via an initial public offering (IPO), they are traded globally on different **stock exchanges**. **Bonds** - Bonds **represent debt**. When issuing a bond, the issuer is issuing debt with the undertaking to pay interest on the **amount (face value) borrowed** and to pay the amount borrowed back at its maturity date. - Bonds guarantee a **fixed income** over a period of time, and they are in general **less risky than stocks**. However, they lack the long-term potential of stocks. - Bonds are generally not sold on localised exchanges but are mainly **sold over the counter (OTC)**. ### Introduction to bond/debt markets videos For practical purposes and to augment your comprehension, we\'ve incorporated informative YouTube videos for your reference. It\'s essential to emphasise that this content is provided as supplementary material and is not subject to examination. These videos serve as an additional resource to enhance your understanding of the topic at hand. [**www.investopedia.com/terms/b/bondmarket.asp**](http://www.investopedia.com/terms/b/bondmarket.asp)  A person holding a computer and a tablet Description automatically generated ### Who are Bond Issuers? **Government bonds** - These are bonds **issued by governments **and are also called **sovereign debt**. Typically, in developed countries these bonds are considered '**risk-free**' because they are backed by the credit of a stable and financially strong government, meaning that it is always anticipated that these **governments will not default in payment of debts**. - **Interest** on government bonds is generally lower in relation to other fixed-income financial instruments. **Municipal bonds** Bonds that are **issued by local authorities**, such as municipalities and cities. **Corporate bonds** - **Corporate bonds** are issued by **companies**. They carry **more risk** than government bonds but provide a higher yield. - **Convertible bonds** and **callable bonds** are two specific types of corporate bonds. ### Parastatal entities (also called public enterprises). The bonds of public enterprises are generally referred to as parastatal bonds or public enterprise bonds or state-owned enterprise (SOE) bonds. public enterprises in South Africa may be split into financial and non-financial public enterprises. Of these enterprises, only a few are borrowers in the bond market. ### Special purpose vehicles (SPVs) A special purpose vehicle (SPV) is a corporate body (usually a limited liability company) created by a sponsor (e.g., a bank) to fulfil a specific or a temporary objective (for example for a bank to take certain assets off its balance sheet to release capital for other lending purposes). The SPV issues debt obligations (bonds in this case -- usually in credit risk-related tiers) to finance its assets and the assets provide the return (cash flow) to the bondholders. ### Foreign sector entities. Foreign entities and governments have been permitted to issue and list bonds in South Africa. The bonds are denominated in ZAR and are referred to as foreign bonds. Examples of foreign bonds that were / are listed on the JSE-Debt Market: - Swaziland Posts and Telecommunications Corporation. - Mauritius Commercial Bank Limited. - Namibia Power. ### Types of bonds found in international bond markets are the following: **Plain Vanilla** The two main characteristics of this bond are the *fixed term* and the *fixed rate*. Plain vanilla is fixed-term, fixed-rate, and registered bond. It is a traditional debt instrument that serves as a benchmark or reference point in the bond market. The essence of a plain vanilla bond lies in its simplicity, making it easy to understand for investors. **Bearer bonds versus registered bonds** Bearer bonds contrast to registered bonds. The plain vanilla bond is a registered bond meaning that a register of owners is maintained. The register has two purposes: proof of ownership (together with the certificate) and the payment of interest to the registered owner. **Bearer Bonds:** - Pros: Anonymity in ownership, easy transferability, and simplicity in trading. - Cons: Higher risk of loss or theft since possession of the physical certificate is crucial, and potentially increased difficulty in tracking ownership. **Registered Bonds:** - *Pros:* Reduced risk of loss or theft since ownership is recorded electronically, and the issuer can communicate directly with bondholders. Increased protection for bondholders in case of lost or stolen bonds. - *Cons:* Less anonymity, and the transfer process may be more cumbersome compared to bearer bonds **Note:** *they are no longer issued in the developed markets.* Floating Rate Bonds Vs Fixed Rate Bonds A floating rate bond (also called "floating rate note" - FRN) contrasts with a fixed rate bond. This bond usually has the **same features as a plain vanilla bond except that it does not have a fixed coupon**, i.e., the rate payable on the bond is not fixed. Instead, the rate payable is linked to some benchmark rate. The benchmark rate can be any rate that floats, i.e., changes frequently with market conditions, but it is a rate that is quoted regularly and is reliable in terms of reflecting market conditions accurately. Zero Coupon Bond versus Coupon Bond The *zero-coupon bond* from the *coupon bond*, and it is the most straightforward of all bonds. The face of the certificate has the name of the investor, the nominal (face) value and the maturity date. It is *issued at a discount rate*, which reflects the interest rate that the issuer is prepared to pay, i.e., the market rate for 3-year money. The return to the investor is the difference between that nominal value and the price paid, i.e., the discount amount. ### Types of bonds and debt instruments that may be traded on the JSE: The Johannesburg Stock Exchange (JSE) in South Africa lists various types of bonds and debt instruments. These are general categories, and within each, there can be a variety of structures and terms. Therefore, Investors should consider their risk tolerance, investment goals, and market conditions when investing in bonds or debt instruments. The following are types of bonds and debt instruments that may be traded on the JSE:  **Risks involved in bond trading (*but not limited to*)** image Although bonds are generally observed as safe investments, they do carry their own risks. - ***Credit risk*** Credit risk, also called default risk, refers to a situation when a bond issuer is unable to pay the interest or principal on a bond in time or at all. Credit risk can be managed by confirming an issuer's bond rating before buying a bond. Credit rating agencies such as Moody's, Standard & Poor's, and Fitch provide credit ratings for bond issuers. The riskier the investment, the lower the rating. When an issuer's credit rating dips below a certain level, its bonds are considered 'junk bonds'. - ***Inflation risk*** Inflation risk occurs when the inflation rate in a country rises to such an extent that the returns associated with a bond are reduced. It has the greatest effect on fixed-rate bonds. - ***Liquidity risk*** Investors in bonds also face liquidity risk, especially with regard to corporate bonds. This is the risk that a bondholder might not be able to sell his or her bond without delay due to a thin bond market, characterised by a low number of sellers and buyers, reflecting lower liquidity in the particular market. Low buying interest can cause considerable price volatility, forcing an investor to sell his or her bond at a lower price than the expected selling price. - ***Interest rate risk*** Interest rate risk is one of the two main risks regarding bonds, the other one being credit risk. The longer a bond's duration, the greater its interest rate risk.   There is an inverse relationship between market interest rates and bond prices. When interest rates increase, bond prices tend to fall and vice versa. For example, high interest rates tend to make bonds less attractive for investors because they have other investment opportunities with higher returns at their disposal. A bond with a falling price will trade at a discount, reflecting the lower return the investor will make on the bond. Source: [www.thebalancemoney.com%2Fwhat-are-bonds-and-how-do-they-work](https://www.google.com/url?sa=i&url=https%3A%2F%2Fwww.thebalancemoney.com%2Fwhat-are-bonds-and-how-do-they-work-3306235&psig=AOvVaw0vPKyt_BTnBcIcvJ4pfIZw&ust=1699707830327000&source=images&cd=vfe&opi=89978449&ved=0CBIQjRxqFwoTCNDLkp6_uYIDFQAAAAAdAAAAABAW) ### Classification of Bonds ***Recap: Bonds Issuers*** **Holders of bonds are:** - Household sector. - Corporate sector. - Foreign sector. - Reserve Bank. - Private sector banks. - Short-term insurers. - Long-term insurers. - Pension and provident funds. - Public Investments Corporation (PIC) - Securities unit trusts. - Investment trusts / companies. - Hedge funds. Risks subsequent to Holding Bonds Because the South Africa bond market is an exchange-traded market, and because the certificates of the issuers are dematerialised in the CSD, the risk of tainted scrip entering the market and settlement risk (which may be grouped under the term "counterparty risk") are virtually non-existent. This leaves bondholders facing risks such as Market risk, Credit risk, Call risk, Reinvestment risk, Liquidity risk, Volatility risk, Exchange rate risk, Incident risk, Inflation risk ### Bond Derivatives Bond derivatives are financial instruments whose value is derived from the price of an underlying bond. These derivatives provide investors with a way to speculate on or hedge against changes in interest rates, credit spreads, or other factors affecting bond prices. The two primary types of bond derivatives are bond futures and bond options. In the many bond markets of the world there exist vibrant markets for the derivative instruments that have been created for the purpose of transferring interest rate risk, namely: - Forwards. - Futures. - Options on "physicals". - Options on futures. - Bond warrants. - Interest rate swaps. - Bond-equity swaps. - Swaps ### JSE-Debt Market (JSE -DM) Over the years, JSE stockbrokers increased their business in the bond market, the JSE started developing rules for its members conducting business in this market. Over time these rules became more elaborate and more JSE brokers entered the bond market. However, the non-JSE market remained an OTC market. The JSE-Debt Market exists to **facilitate the issue and trading of bonds**. While issuers are not required by law to list the debt securities, they issue on the JSE-Debt Market, it is likely that issuers will, and the reason for this is that demand is positively affected by a listing. **The advantages of an exchange-driven market such as the JSE-Debt Market are:** - Elimination or lessening of the risk of trading. - Efficiency of trading. - The risks referred to above are eliminated or lessened: - **Counterparty risk**: the investor deals with a JSE-Debt Market member who is under constant surveillance. - **Settlement risk:** deals are settled efficiently by the exchange / CSD (STRATE) in a dematerialised environment. - **Member fraud risk:** is reduced because of surveillance; in the unlikely event of this occurring the guarantee fund of the exchange covers investor losses. - **Tainted scrip risk:** is eliminated in a dematerialised market. Over the counter (OTC) means informal or non-exchange-driven and it contrasts with an exchange-traded market such as the JSE-Debt Market. In OTC markets various risks exist, such as: - **Settlement risk** - the risk of the deal not being settled promptly. - **Counterparty risk** - the risk of one of the (principal) counterparties to a deal backing out on a deal. - **Member fraud risk** - the risk of the intermediary (the member) accepting the funds from the buyer and not paying the seller. - **Tainted scrip risk** - the risk of non-valid securities certificates being introduced into the market. How to start trading with bonds ------------------------------- - When deciding on which bonds to invest in, firstly assess your **personal needs **and **investment goals**, such as generating profits, obtaining a steady source of income, or protecting your investment portfolio. - Bonds are traded on the **bond market**, also referred to as the **debt market** or **credit market**. The bond market is not a centralised location but an **over the counter (OTC) market**. - New bond issues are put up for trade on the **primary market**, and any subsequent trading takes place on the **secondary market**, enabling investors to buy and sell bonds already owned. Trading of bonds in South Africa, investors have, inter alia, the following possibilities: - They can access the following bonds through the **Debt Market of the Johannesburg Stock Exchange (JSE)**: - **Government bonds**. - **Corporate bonds**. - **Green bonds** -- According to the JSE: 'With JSE Green Bonds, issuers can raise the capital they need to bring their green investments to life. - **Repo bonds** -- An opportunity for traders (speculators) to 'go short' on the bond market. - Trade through a **certified, experienced, and reliable broker**. - Buy government bonds through **reputable financial institutions**, such as banks. Bonds can also be traded through **bond exchange-traded funds (ETFs)**. There are bond ETFs for all the main types of bonds, such as government, corporate, and municipal, to name but a few.