An Introductory Overview of the Bond Market Alistair Borg* Kane Cortis Therese Lethridge Kimberley Charlie Mifsud Alan Psaila *Alistair Borg is an Executive at the Central Bank of Malta's Investments Department. Therese Lethridge, Kane Cortis, Kimberley Charlie Mifsud and Alan Psaila are Research Analysts at the Central Bank of Malta's Investments Department. The authors would like to thank Mr. André Psaila for his constant guidance and reference in writing this report as well as reviewing the report throughout. Furthermore, the authors would like to thank Mr. Alexander Demarco and Mr. Markus Alefelder for their guidance and support throughout the research preparation of this paper. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Central Bank of Malta or the Eurosystem. Corresponding author’s email address: [email protected] Abstract This study is intended to offer the reader a basic understanding of fixed-income securities, focusing on bonds and the security’s many variants that make up the debt instrument category. The report introduces multiple forms of these debt securities, with an overview of the main characteristics and a general notion of the different types of issuers and bonds. References to the local fixed-income market are also made throughout this paper, whereby one can see the number of secured and unsecured debt at the time the report was compiled, while also specifying certain local approaches in terms of accrued interest, amongst others. The report follows with a brief description of the risks faced by bondholders, concluding with a brief summary of the report. Keywords: fixed-income, debt, bonds, yield, spread, interest rate, risk. I Contents Executive Summary ................................................................................................................................................ 1 1.0 Introduction ............................................................................................................................................... 2 2.0 Bond Characteristics .................................................................................................................................. 3 2.1 Principal ............................................................................................................................................... 3 2.2 Coupon .................................................................................................................................................. 3 2.3 Maturity ................................................................................................................................................ 3 2.4 Yield-to-Maturity .................................................................................................................................. 4 2.5 Spreads over Risk-free Rate ................................................................................................................. 5 2.6 Accrued Interest ................................................................................................................................... 6 2.7 Credit Ratings ...................................................................................................................................... 6 2.8 Bond Indentures ................................................................................................................................... 8 2.9 Sinking Fund ........................................................................................................................................ 9 2.10 Secured/Unsecured ................................................................................................................................ 9 2.10.1 Debentures ................................................................................................................................. 10 2.11 Embedded Options .............................................................................................................................. 10 2.11.1 Convertible Bonds ...................................................................................................................... 12 2.11.2 Callable Bonds ........................................................................................................................... 12 2.11.3 Putable Bonds ............................................................................................................................. 13 3.0 Types of Bonds ........................................................................................................................................ 14 3.1 By Issuers ........................................................................................................................................... 14 3.1.1 Sovereign Bonds......................................................................................................................... 14 3.1.2 Corporate Issuers ........................................................................................................................ 15 3.2 By Structure ....................................................................................................................................... 16 3.2.1 Fixed Rate Bonds ............................................................................................................................ 16 3.2.2 Floating Rate Bonds ........................................................................................................................ 16 3.2.3 Inflation Linked Bonds ................................................................................................................... 17 3.2.4 Discount Bonds ............................................................................................................................... 17 3.2.5 Green Bonds.................................................................................................................................... 18 3.2.6 Sukuk Bonds ................................................................................................................................... 18 4.0 Risks Associated with Investing in Bonds ............................................................................................... 19 4.1 Interest Rate Risk ................................................................................................................................... 19 4.2 Reinvestment Risk .................................................................................................................................. 19 4.3 Credit Risk ............................................................................................................................................. 19 i. Default Risk ......................................................................................................................................... 19 ii. Credit Spread Risk .............................................................................................................................. 19 iii. Downgrade Risk .............................................................................................................................. 19 II 4.4 Liquidity Risk ......................................................................................................................................... 20 4.5 Inflation Risk .......................................................................................................................................... 20 4.6 Market Risk ............................................................................................................................................ 20 5.0 Conclusion .................................................................................................................................................. 21 6.0 References and Bibliography ...................................................................................................................... 22 Appendix .............................................................................................................................................................. 23 III Executive Summary Benjamin Franklin once suggested that “an investment in knowledge pays the best interest”, proposing that the greatest investment one can make is an investment in educating oneself through research, study and analysis, prior to making any investment decisions. The explanation of certain bond characteristics such as the coupon, principal, maturity and yield-to-maturity are described, and serve as a foundation for the remainder of the report. The report presents the Maltese yield curve shifting throughout 2014 till 2019, with the most recent yield curve also depicting negative yielding bonds up until the 5-year maturity. This is mainly the result of the accommodative market conditions throughout the period. Different issuers have different risk profiles and hence different spreads, which is then reflected in an assigned credit rating. Credit ratings are meant to suggest the creditworthiness associated to either an issuer or issue. As at 12 November 2019, Malta was assigned investment grade ratings by four of the most reputable rating agencies. Provisions relating to collateral, embedded options, sinking funds and the bond’s dividend policy can be found in the bond’s indenture. The amount of secured listed corporate debt in the Maltese corporate debt market adds up to 26%. The Maltese