CHAPTER 7

Bond Markets

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Background on Bonds• Bonds represents long-term debt securities that are issued by

government agencies or corporations• Because these debt securities can be broken into small pieces

owned by thousands of investors, the risk is spread far and wide, usually resulting in a lower rate to the borrower than if there was only one lender

• Most corporations will try to first borrow through the bond market to raise funds before they turn to the stock market because it is cheaper to do so• bond interest payments are tax-deductible but dividends on stock are

not• In general, bond investments are less risky than stocks so investors

demand a higher (more costly) return for stocks

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Background on Bonds• Because bond are traded in large blocks, most individual

investors can only invest through mutual funds• 95% of bond trading is done by institutional investors

• Interest payments occur annually or semiannually• Par value is repaid at maturity• Most bonds have maturities between 10 and 30 years• Bearer bonds require the owner to clip coupons attached to

the bonds (this is rare today)• Registered bonds require the issuer to maintain records of

who owns the bond and automatically send coupon payments to the owners (bonds are recorded in the “street name” of the owner)

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Coupons

Coupon Rates• Named after the coupon or perforated edge of certificate

used to request interest • Also called stated or contract rate

• Coupon rate is contractual interest rate promised in the agreement • Usually approximates current market rates • Fixed throughout term (can’t be changed)• Determines actual cash interest payments

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Yield to Maturity (YTM)• The YTM is the market rate on the date the bonds are

sold/purchased and includes the effect of premiums & discounts

• The YTM is usually different from the coupon rate due to fluctuations of rates over time.

• A difference between the YTM and coupon rate causes the bond to sell for a premium or discount.

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Bonds by Issuer

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Corporate BondsCorporations

Municipal Bonds (Munis)

State and Local Governments

Federal Agency Bnds Federal Agencies

Treasury BondsFederal Government (U.S. Treasury)

Type of BondIssuer

Treasury Notes & Bonds

• The U.S. Treasury issues Treasury notes or bonds to finance federal government expenditures• Note maturities are less than 10 years

• Notes have been primary source of federal borrowing in recent years• Bonds maturities are 10 years or more• An active secondary market exists• The 30-year bond was discontinued in October 2001 but re-

instated in 2006.

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Treasury Notes & Bonds (cont’d)

• Treasury notes/bond auction• Normally held in the middle of each quarter• Financial institutions submit bids for their own accounts

or for clients• Bids can be competitive or noncompetitive

• Competitive bids specify a price the bidder is willing to pay and a dollar amount of securities to be purchased

• Noncompetitive bids specify only a dollar amount of securities to be purchased

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Treasury Bonds (cont’d)

• Trading Treasury bonds• Bond dealers serve as intermediaries in the secondary

market and also take positions in the bonds• About two dozen primary dealers dominate the trading

• Profit from the bid-ask spread• Conduct trading with the Fed during open market operations• Typical daily volume is over $500 billion

• Online trading• Treasury Direct program (http://www.treasurydirect.gov)

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Treasury Bonds (cont’d)• Treasury bond quotations

• Published in financial newspapers• The Wall Street Journal• Barron’s• Investor’s Business Daily

• Bond quotations are organized according to their maturity, with the shortest maturity listed first

• Bid and ask prices are quoted as a percent of par value, with the fractions representing 32nds

• A bid price is what the broker/dealer is willing to pay you when you sell and the ask price is what he will charge you when you buy from him. The difference, or spread, is his profit. For large-volume markets, the spread is smaller.

• Online quotations and average rates at • http://www.investinginbonds.com or http://finance.yahoo.com/bonds • http://www.federalreserve.gov/releases/H15/

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Treasury Bond Quotes

• Treasury Bond Quotations8.38 Aug. 2013-18 103:05 103.11• Coupon rate. 8.38%• Maturity date, Aug. 2018 but callable in 2013• Bid of 103:05 (your sell price) and Ask price of 103:11 (your buy price) are

stated as a percent of face value• Fractions are in 32nds so for you to buy $10000 par of the last bond listed,

you would be charged $10334.44 (103 + 11/32nds x $1000)

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Treasury Bonds (cont’d)

• Stripped Treasury bonds• One security represents the principal payment and a

second security represents the interest payments• Investors who desire a lump sum payment can choose the PO

part• Investors desiring periodic cash flows can select the IO part• Degrees of interest rate sensitivity vary• Backed by U.S. gov’t

• Several securities firms create their own versions of stripped securities• Merrill Lynch’s TIGRs• The Treasury created the STRIPS program in 1985

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Treasury Inflation Protected Securities(TIPS) and US Saving Bonds• Inflation risk to fixed income investors is very high. According to a recent

survey, many investors believed that fixed income debt investments were less susceptible to inflation risk than equity investments. Obviously, the public is woefully ignorant.

• Inflation-indexed Treasury bonds• In 1996, the Treasury started issuing inflation-indexed bonds that provide a return tied to the

inflation rate• The coupon rate is lower than the rate on regular Treasuries, but the principal value increases

by the amount of the inflation rate every six months• Inflation-indexed bonds are popular in high-inflation countries such as Brazil

• US Savings Bonds• Buy at half of face value. Grows to face value at which time may be redeemed. • Popular because of low denomination ($25), safety, and exemption from state income tax• For federal purposes, investor can choose to be taxed incrementally or all at redemption.

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Treasury Inflation Protected Securities(TIPS)

A 10-year bond has a par value of $1,000 and an annual coupon rate of 10 percent. During the first six months after the bond was issued, the inflation rate was 1.3 percent. By how much does the principal of the bond increase? What is the coupon payment after six months?

65.50$$1,0135%Payment Coupon

013,1$1.013$1,000Principal

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Federal Agency Bonds

• Government National Mortgage Association (GNMA) – known as Ginnie Mae• Ginnie Mae does not issue mortgage backed securities like its

cousins Fannie and Freddie, merely guarantees FHA/VA/RHA mortgages , backed by the full faith and credit of the U.S.

• GNMA is not a publically traded company likes its cousins• A U.S. government agency, wholly owned by the Federal

government and operated by the Dept. of HUD• Backed by explicit guarantee of Federal government

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Federal Agency Bonds Federal National Mortgage Association (Fannie Mae or FNMA)

mortgage-backed securities Created in 1938 as part of the New Deal, Fannie Mae is Federally chartered but

privately owned with stock traded on NYSE, ticker FNMA. FNMA was taken over by the Fed Gov’t in Sept/2008 and is now in conservatorship.

No explicit guarantee of bonds by federal government, but gov’t bailed it out in fall/08 – so actions speak louder than words.

Huge corporation – owns a majority of US mortgage market (some 90% of mortgages together with Freddie Mac).

Uses funds from mortgage-backed pass-through securities to purchase conventional mortgages (that are not FHA or VA)

Accounting scandals, CEO Franklin Raines, Barney Frank and politics

Federal Agency Bonds

• Federal Home Loan Mortgage Association (Freddie Mac)• A U.S. government-sponsored agency, but now privately owned

(ticker FMCC).• Created in 1970 by government to compete with FNMA.• Issues bonds and uses proceeds to purchase conventional

mortgages• No explicit guarantee of bonds by federal government, but gov’t

bailed it out in fall/08 – so actions speak louder than words.• Used to provide liquidity for thrifts and support of home ownership• Since Sept/2008, it has been under conservatorship of the Federal

gov’t (as has FNMA)

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Municipal Bonds• Municipal bonds can be classified as either general

obligation bonds or revenue bonds• General obligation bonds are supported by the government’s ability

to tax• Revenue bonds are supported by the revenues of the project for

which the bonds were issued

• Municipal bonds typically pay interest semiannually, with minimum denominations of $5,000

• Municipal bonds have a secondary market• Most municipal bonds contain a call provision

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Municipal Bonds (cont’d)• Credit risk

• Less than .5 percent of all municipal bonds issued since 1940 have defaulted

• Moody’s, Standard and Poor’s, and Fitch Investor Service assign ratings to municipal bonds

• Some municipal bonds are insured against default• Results in a higher cost for the investor

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Municipal Bonds (cont’d)• Variable-rate municipal bonds

• Coupon payments adjust to movements in a benchmark interest rate

• Some variable-rate munis are convertible to a fixed rate under specified conditions

• Investors holding variable rate bonds are hoping that rates increase.

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Municipal Bonds (cont’d)

• Tax advantages• Interest income is normally exempt from federal taxes.

This causes the rates to be lower and is a gift from the federal government to state/local governments

• In this day of large federal budget deficits, there is serious talk in Congress about making muni interest taxable. This would cause an immediate spike in muni rates and make it much more costly for state/local gov’ts to raise money. In addition, rich people would not buy muni bonds anymore, which would dry up funding.

• Interest income earned on bonds that are issued by a municipality within a particular state is exempt from state income taxes

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Municipal Bonds (cont’d)

• Trading and quotations• Investors can buy or sell munis by contacting brokerage

firms• Electronic trading has become popular

• http://www.tradingedge.com

• Online quotations are available at http://www.munidirect.com and http://www.investinginbonds.com

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Municipal Bonds (cont’d)

• Yields offered on municipal bonds• Differs from the yield on a Treasury bond with the same

maturity because:• Of a risk premium to compensate for default risk• Of a liquidity premium to compensate for less liquidity• Of a discount due to the federal tax exemption of municipal

bonds

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Municipal Bonds (cont’d)• Yield curve on municipal bonds

• Typically lower than the Treasury yield curve because of the tax differential

• The municipal yield curve has a similar shape as the Treasury yield curve because:• It is influenced similarly by interest rate expectations• Investors require a premium for longer-term securities with lower

liquidity in both markets

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Annualized Yield Offered on Securities

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Yield Offered on General Obligation Municipal Bonds over Time

Corporate Bonds• Corporations issue corporate bonds to borrow for long-

term periods• Corporate bonds have a minimum denomination of $1,000• Larger bonds offerings are achieved through public

offerings registered with the SEC• Secondary market activity varies• Financial and nonfinancial institutions as well as

individuals are common purchasers• Most corporate bonds have maturities between 10 and 30

years (although some companies have issued bonds with 50 or 100 year maturities)

• Interest paid by corporations is tax-deductible, which reduces the corporate cost of financing with bonds

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Corporate Bonds (cont’d)• Corporate bond yields and risk

• Interest income earned on corporate represents ordinary income

• Yield curve• Affected by interest rate expectations, a liquidity premium, and

maturity preferences of corporations• Similar shape as the municipal bond yield curve

• Default rate• Depends on economic conditions• Less than 1 percent in the late 1990s• Exceeded 3 percent in 2002• Rate increased tremendously in 2008-09

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Corporate Bonds (cont’d)• Corporate bond yields and risk (cont’d)

• Investor assessment of risk• Investors may only consider purchasing corporate bonds after assessing

the issuing firm’s financial condition and ability to cover its debt payments

• Investors may rely heavily on financial statements created by the issuing firm, which may be misleading

• Bond ratings• Bonds with higher ratings have lower yields• Corporations seek investment-grade ratings, since commercial banks

will only invest in bonds with that status• Rating agencies will not necessarily detect any misleading information

contained in financial statements

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Corp. Bond Default (Credit Risk)

  Ratings Assigned by:

Description of Security Moody’s Standard and Poor’s

Highest quality Aaa AAA

High quality Aa AA

High-medium quality A A

Medium quality Baa BBB

Medium-low quality Ba BB

Low quality (speculative) B B

Poor quality Caa CCC

Very poor quality Ca CC

Lowest quality (in default) C DDD, D

Comparison of Baa and Treasury Bond Yields

Source: Federal Reserve

Corporate Bonds (cont’d)

• Private placement of corporate bonds• Often, insurance companies and pension funds

purchase privately-placed bonds• Bonds can be placed with the help of a securities firm• Bonds do not have to be registered with the SEC

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Corporate Bonds (cont’d)• Characteristics of corporate bonds

• The bond indenture specifies the rights and obligations of the issuer and the bondholder

• A trustee represents the bondholders in all matters concerning the bond issue

• Sinking-fund provision• A requirement to retire a certain amount of the bond issue each year or

to stockpile sufficient cash.• Protective covenants:

• Are restrictions placed on the issuing firm designed to protect the bondholders from being exposed to increasing risk during the investment period

• Often limit the amount of dividends and corporate officers’ salaries the firm can pay

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Corporate Bonds (cont’d)• Characteristics of corporate bonds (cont’d)

• Call provisions:• Require the firm to pay a price above par value when it calls its

bonds• The difference between the call price and par value is the call

premium• Are used to:

• Issue bonds with a lower interest rate• Retire bonds as required by a sinking-fund provision

• Are a disadvantage to bondholders

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Corporate Bonds (cont’d)

• Bond collateral• Typically, collateral is a mortgage on real property

• A first mortgage bond has first claim on the specified assets• A chattel mortgage bond is secured by personal property

• Unsecured bonds are debentures. Most bonds are debentures.

• Subordinated debentures have claims against the firm’s assets that are junior to the claims of mortgage bonds and regular debentures

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Corporate Bonds (cont’d)• Low- and zero-coupon bonds:

• Are issued at a deep discount from par value• Require annual tax payments although the interest will not be

received until maturity• Have the advantage to the issuer of requiring low or no cash

outflow• Variable-rate bonds:

• Allow investors to benefit from rising market interest rates over time• Allow issuers of bonds to benefit from declining rates over time

• Convertibility • Convertible bonds allow investors to exchange the bond for a

stated number of shares of common stock• Investors are willing to accept a lower rate of interest on convertible

bonds

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Zero-coupon bonds

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Example of Zero-Coupon Bond, 9%, 8-year, purchased at 50

EffectiveInterest Ending

Year Amortized Value500.00

1 45.25 545.25 2 49.35 594.60 3 53.81 648.41 4 58.68 707.09 5 63.99 771.08 6 69.78 840.86 7 76.10 916.96 8 82.98 999.94

Total 499.94

Rule of 72:

Easy rule of thumb:

Years it takes to double in value x growth rate = 728 x 9 = 72

Investors pay tax on interest accruals each year even though not received in cash until the end.

Corporate Bonds (cont’d)• Trading corporate bonds

• Bonds are traded through brokers, who communicate orders to bond dealers, usually on an electronic trading platform

• A market order transaction occurs at the prevailing market price• A limit order transaction will occur only if the price reaches a

specified limit• Bonds listed on the NYSE are traded through the automated Bond

System (ABS)• Online trading is possible at:

• http://www.schwab.com• http://www.etrade.com

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Corporate Bonds (cont’d)

• Corporate bond quotations• More bonds of more than 1,000 different companies are

traded on the NYSE with a market value of more than $5 trillion

• 95% of trades done by institutional investors• Corporate bond quotations normally include the volume

of trading and the yield to maturity

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Corporate Bonds Quotation

ATT 6.5 29 7.3 214 88.625 +.25

AT&T bond quote 6.5% coupon rate Maturity in 2029 7.3% current yield (annual interest/price) 214 bonds traded on this day Bond priced at close of day 88.625 % of face ($1000) or $886.25

Bond price up .25% of par for the day or $2.50

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Corporate Bonds (cont’d)• Junk bonds

• Junk bonds have a high degree of credit or default risk• About ¼ of total bond market is considered junk.• About 2/3rds of junk bonds have always been rated as junk• About two-thirds of junk bonds are used to finance takeovers• Size of the junk bond market

• About 4,000 junk bond offerings exist with a market value of over $600 billion

• Participation in the junk bond market• Primary investors in junk bonds are mutual funds, life insurance

companies, and pension funds• The junk bond secondary market consists of 20 bond traders

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Default Rate on Corporate Bonds over Time

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Default Rate on Corporate Bonds over Time

Source: Federal Reserve

Corporate Bonds (cont’d)• Junk bonds (cont’d)

• Risk premium of junk bonds• The typical premium is between 3 and 7 percent above Treasury

bonds with the same maturity• Performance of junk bonds

• In the early 1990s, the popularity of junk bonds declined because of• Insider trading allegations• The financial problems of a few major issuers of junk bonds• The financial problems in the thrift industry

• In the late-1990s, junk bonds performed well with few defaults• During the 2008-09 credit crisis, many junk bonds defaulted and

many junk bonds actually lived up to their name.

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Premium (Spread) Offered on Junk Bonds

Source: Federal Reserve

Corporate Bonds (cont’d)

• Junk bonds (cont’d)• Contagion effects in the junk bond market

• Specific adverse information may discourage investors from investment in junk bonds• Ivan Boesky admitting to insider trading violations

• Drexel Burnham Lambert’s bankruptcy filing

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Corporate Bonds (cont’d)• How corporate bonds facilitate restructuring

• Using bonds to finance a leveraged buyout• An LBO is typically financed with senior debt and subordinated

debt• LBO activity increased dramatically in the later 1980s• Many firms with excessive financial leverage resulting from

LBOs reissued stock in the 1990s

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Corporate Bonds (cont’d)• How corporate bonds facilitate restructuring (cont’d)• Using bonds to revise the capital structure

• Debt is perceived to be a cheaper source of capital than equity as long as the corporation can meet its debt payments

• Sometimes, corporations issue bonds and use the proceeds for a debt-for-equity swap

• The takeover can be management –led or it can be a hostile buyout.

• Corporations with an excessive amount of debt can conduct an equity-for-debt swap

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Institutional Use of Bond Markets

• All financial institutions participate in bond markets• On any given day, commercial banks, bond mutual

funds, insurance companies, and pension funds are dominant participants

• A financial institution’s investment decisions will often simultaneously affect bond market and other financial market activity

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Financial Institutions & Bonds

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Financial Institution Participation in Bond Markets

Commercial banks and savings • Purchase bonds for their asset portfolio.and loan associations (S&Ls) • Sometimes place municipal bonds for municipalities.

• Sometimes issue bonds as a source of secondary capital.

Finance companies • Commonly issue bonds as a source of long-term funds.

Mutual funds • Use funds received from the sale of shares to purchase bonds. Some bond mutual fundsspecialize in particular types of bonds, while others invest in all types.

Brokerage rms • Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.

Investment banking rms • Place newly issued bonds for governments and corporations. They may place the bondsand assume the risk of market price uncertainty or place the bonds on a best-effor ts basisin which they do not guarantee a price for the issuer.

Insurance companies • Purchase bonds for their asset portfolio.

Pension funds • Purchase bonds for their asset portfolio.

•

Investors in Corporate Bonds

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Life Insurance Companies

Foreign Investors

Households and Trusts

MutualFunds

Globalization of Bond Markets• Bond markets have become increasingly integrated as a

result of frequent cross-border investments in bonds• Low-quality bonds are issued globally by governments

(e.g. Venezuela, Brazil, Rep. of Chech).• Some countries have defaulted on the bonds (e.g. Russia,

Argentina, Brazil, Yugoslavic countries)• Multi-national corporations also issue global junk bonds• The global development of the bond market is primarily

attributed to bond offerings by country governments (sovereign bonds)

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Globalization of Bond MarketsGreek Debt Crisis

a. In spring of 2010, Greece experienced a credit crisis brought on by weak economic conditions and a large government budget deficit.

b. As Greece’s deficit grew and its economy weakened, investors were concerned that the Greek government would not be able to repay its debt.

c. Recent elections in Greece increase the chance that Greece will reject the EU’s austerity measures and remove itself from the EU, thereby upsetting the whole Euro bed-basket.

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Globalization of Bonds (cont’d)

• Eurobond market• Bonds denominated in various currencies are placed in

the Eurobond market• Dollar-denominated bearer bonds are available in the

Eurobond market• Underwriting syndicates help place Eurobond issues

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Other Long-Term Debt

1. Structured Notes The amount of interest and principal to be paid is based on

specified market conditions. Risk of Structured Notes

In the early 1990s, Orange County, California suffered losses and filed for bankruptcy due to investments in structured notes.

Because of the difficulty in assessing the risk of structured notes, some investors rely on credit ratings. However, credit rates of structured notes have not always served as accurate indicators of risk

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Other Long-Term Debt (cont.)

2. Exchange-traded notesa. Debt instruments in which the issuer promises to pay a return

based on the performance of a specific debt index.b. Typically mature in 10 to 30 years and are not secured by

assets.

3. Auction-rate securitiesa. A way for borrowers (e.g., municipalities and student loan

organizations) to borrow for long-term periods while relying on a series of short-term investments by investors.

b. Every 7 to 35 days, the securities can be auctioned off to other investors, and the issuer pays interest based on the new reset rate to the winning bidders.

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