copyright © 2007 by the mcgraw-hill companies, inc. all rights reserved. mcgraw-hill /irwin 6-1...

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill /Irwin 6-1

Chapter SixBond Markets


Chapter Outline

1. Overview

2. Treasury Notes & Bonds

3. Munis

4. Corporate Bonds

5. Bond Rating

6. International Bond Markets

1. Overview

2. Treasury Notes & Bonds

3. Munis

4. Corporate Bonds

5. Bond Rating

6. International Bond Markets


1. Overview of the Bond Markets

• A bond is a promise to make periodic coupon payments and to repay principal at maturity; breech of this promise is an event of default

• Bonds carry original maturities greater than one year so bonds are instruments of the capital markets

• Issuers are corporations and government units

• A bond is a promise to make periodic coupon payments and to repay principal at maturity; breech of this promise is an event of default

• Bonds carry original maturities greater than one year so bonds are instruments of the capital markets

• Issuers are corporations and government units


Bond Market Participants

• The major issuers of debt market securities are federal, state and local governments and corporations

• The major purchasers of capital market securities are households, businesses, government units and foreign investors

• Businesses and financial firms (e.g., banks, insurance companies, mutual funds) are the major suppliers of funds for all three types of bonds

• The major issuers of debt market securities are federal, state and local governments and corporations

• The major purchasers of capital market securities are households, businesses, government units and foreign investors

• Businesses and financial firms (e.g., banks, insurance companies, mutual funds) are the major suppliers of funds for all three types of bonds


Bond Market Instruments Outstanding, 1994-2004 ($Bn)

0

2000

4000

6000

8000

10000

1994 1997 2000 2004

Treas. bonds Muni. securities Corp. bonds Total

0

2000

4000

6000

8000

10000

1994 1997 2000 2004

Treas. bonds Muni. securities Corp. bonds Total


2. Treasury Notes and Bonds

• T-notes and T-bonds issued by the U.S. Treasury to finance the national debt and other federal government expenditures

• Backed by the full faith and credit of the U.S. government and are default risk free

• Pay relatively low rates of interest (yields to maturity)• Given their longer maturity, not entirely risk free due

to interest rate fluctuations• Pay coupon interest (semiannually): notes have

maturities from 1-10 years; bonds 10-30 years

• T-notes and T-bonds issued by the U.S. Treasury to finance the national debt and other federal government expenditures

• Backed by the full faith and credit of the U.S. government and are default risk free

• Pay relatively low rates of interest (yields to maturity)• Given their longer maturity, not entirely risk free due

to interest rate fluctuations• Pay coupon interest (semiannually): notes have

maturities from 1-10 years; bonds 10-30 years


Composition of the U.S. National Debt ($Bn)

0

500

1000

1500

2000

2500

3000

3500

1994 1997 2000 2004

T-bills T-notes and bonds Govt. acc. sec. Other

0

500

1000

1500

2000

2500

3000

3500

1994 1997 2000 2004

T-bills T-notes and bonds Govt. acc. sec. Other


Primary Market in Treasury Notes & Bonds

Similar to the primary market T-bill sales, the Treasury sells T-notes and bonds through competitive and noncompetitive auctions Auction Pattern for Treasury Notes and bonds

Security Purchase Minimum General Auction Schedule

2-year note $1,000 Monthly 5-year note $1,000 Feb, May-Aug, Nov10-year note $1,000 Feb, May-Aug, Nov

Similar to the primary market T-bill sales, the Treasury sells T-notes and bonds through competitive and noncompetitive auctions Auction Pattern for Treasury Notes and bonds

Security Purchase Minimum General Auction Schedule

2-year note $1,000 Monthly 5-year note $1,000 Feb, May-Aug, Nov10-year note $1,000 Feb, May-Aug, Nov


Secondary Market in Treasury Notes & Bonds

• Most secondary market trading occurs directly through brokers and dealers

• Wall Street Journal shows full list of Treasury securities that trade daily

• Most secondary market trading occurs directly through brokers and dealers

• Wall Street Journal shows full list of Treasury securities that trade daily


• Coupon rate set at time of auction and fixed for life

• Par value adjusted for inflation based on the Consumer Price Index

• Semi-annual coupon payments are based on the inflation adjusted par value

• At maturity investor receives the inflation adjusted par value

• Coupon rate set at time of auction and fixed for life

• Par value adjusted for inflation based on the Consumer Price Index

• Semi-annual coupon payments are based on the inflation adjusted par value

• At maturity investor receives the inflation adjusted par value

(TIPS) Treasury Inflation Protected Securities


Treasury STRIPS

Separate Trading of Registered Interest and Principal Securities

• A treasury security in which the individual interest payments are separated from the principal payment

• Effectively creates sets of securities--one for each semiannual interest payment one one for the final principal payment

• Often referred to as “Treasury zero-coupon bonds”• Created by U.S. Treasury in response to separate trading

of treasury security principal and interest developed by securities firms; only available through FIs and government securities brokers

Separate Trading of Registered Interest and Principal Securities

• A treasury security in which the individual interest payments are separated from the principal payment

• Effectively creates sets of securities--one for each semiannual interest payment one one for the final principal payment

• Often referred to as “Treasury zero-coupon bonds”• Created by U.S. Treasury in response to separate trading

of treasury security principal and interest developed by securities firms; only available through FIs and government securities brokers


3. Municipal Bonds (Munis)

• Securities issued by state and local governments to fund either temporary imbalances between operating expenditures and receipts or to finance long-term capital outlays for activities such as school construction, public utility construction or transportation systems

• Tax receipts or revenues generated are the source of repayment

• Attractive to household investors because interest (but not capital gains) are tax exempt

• Securities issued by state and local governments to fund either temporary imbalances between operating expenditures and receipts or to finance long-term capital outlays for activities such as school construction, public utility construction or transportation systems

• Tax receipts or revenues generated are the source of repayment

• Attractive to household investors because interest (but not capital gains) are tax exempt


Types of Municipal Bonds

• General Obligation Bonds– bonds backed by the full faith and credit of the

issuer

• Revenue Bonds– bonds sold to finance a specific revenue

generating project and are backed by cash flows from that project

• General Obligation Bonds– bonds backed by the full faith and credit of the

issuer

• Revenue Bonds– bonds sold to finance a specific revenue

generating project and are backed by cash flows from that project


Tax Exemption and Muni Yields

ia = ib(1 - t)

Where: ia = After-tax (equivalent tax exempt) rate of return on a taxable bond ib = Before-tax rate of return on a taxable bond t = Income tax rate of the marginal bond holder

Example: You can invest in taxable corporate bonds that are paying 10% annually. Your marginal tax rate is 28%. The after- tax rate of return on the taxable bond is:

10%(1-.28) = 7.2%

ia = ib(1 - t)

Where: ia = After-tax (equivalent tax exempt) rate of return on a taxable bond ib = Before-tax rate of return on a taxable bond t = Income tax rate of the marginal bond holder

Example: You can invest in taxable corporate bonds that are paying 10% annually. Your marginal tax rate is 28%. The after- tax rate of return on the taxable bond is:

10%(1-.28) = 7.2%


Primary Market Placement Choices for Munis

• General Public Offering– underwriter is selected either by negotiation or

by competitive bidding– the underwriter offers the bonds to the general

public

• Rule 144A Placement– bonds are sold on a semi-private basis to

qualified investors (generally FIs)

• General Public Offering– underwriter is selected either by negotiation or

by competitive bidding– the underwriter offers the bonds to the general

public

• Rule 144A Placement– bonds are sold on a semi-private basis to

qualified investors (generally FIs)


Top Municipal Bond Underwriters

Principal Amount Market No. ofUnderwriter (in millions $$) Share Issues

UBS Financial Services $35,811.6 13.5% 631Citigroup 30,092.8 11.3% 476Lehman Brothers 22,021.1 8.3% 170Merrill Lynch 18,708.8 7.1% 208Goldman Sachs 18,081.6 6.8% 132J.P. Morgan Securities 17,685.0 6.7% 324Bear, Stearns 15,464.1 5.8% 133Morgan Stanley 14,695.8 5.5% 179RBC Dain Rauscher 11,157.6 4.2% 533Banc of America Securities 10,403.2 3.9% 327

Industry totals $265.5 billion

Principal Amount Market No. ofUnderwriter (in millions $$) Share Issues

UBS Financial Services $35,811.6 13.5% 631Citigroup 30,092.8 11.3% 476Lehman Brothers 22,021.1 8.3% 170Merrill Lynch 18,708.8 7.1% 208Goldman Sachs 18,081.6 6.8% 132J.P. Morgan Securities 17,685.0 6.7% 324Bear, Stearns 15,464.1 5.8% 133Morgan Stanley 14,695.8 5.5% 179RBC Dain Rauscher 11,157.6 4.2% 533Banc of America Securities 10,403.2 3.9% 327

Industry totals $265.5 billion


Contracting Choices with the Underwriter

• Firm commitment underwriting– the issue of securities in which the investment bank

guarantees the corp. a price for newly issued securities by buying the whole issue at a fixed price from the corporate issuer then seeks to resell to suppliers of funds (investors) at a higher price

• Best efforts underwriting– the issue of securities in which the underwriter does not

guarantee a price to the issuer and acts more as a placing or distribution agent, bank acts as agent on a fee basis related to its success in placing the issue

• Firm commitment underwriting– the issue of securities in which the investment bank

guarantees the corp. a price for newly issued securities by buying the whole issue at a fixed price from the corporate issuer then seeks to resell to suppliers of funds (investors) at a higher price

• Best efforts underwriting– the issue of securities in which the underwriter does not

guarantee a price to the issuer and acts more as a placing or distribution agent, bank acts as agent on a fee basis related to its success in placing the issue


Secondary Market for Munis

• Secondary market is thin (i.e. trades are relatively infrequent) due to a lack of information on bond issuers, who are generally much smaller than corporate bond issuers

• Secondary market is thin (i.e. trades are relatively infrequent) due to a lack of information on bond issuers, who are generally much smaller than corporate bond issuers


4. Corporate Bonds

• All long-term bonds issued by corporations

• Minimum denominations publicly traded corporate bonds is $1,000

• Generally pay interest semiannually

• Bond indenture– legal contract that specifies the rights and

obligations of the bond issuer and the bond holder

• All long-term bonds issued by corporations

• Minimum denominations publicly traded corporate bonds is $1,000

• Generally pay interest semiannually

• Bond indenture– legal contract that specifies the rights and

obligations of the bond issuer and the bond holder


Types of Corporate Bonds

• Bearer bonds– coupons attached that are presented by the holder to

the issuer for interest payments when due• Registered bonds

– the owner of the bond is recorded by the issuer and coupon payments are mailed to the registered owner

• Term bonds– entire issue matures on a single date

• Serial bonds– mature on a series of dates (continued)

• Bearer bonds– coupons attached that are presented by the holder to

the issuer for interest payments when due• Registered bonds

– the owner of the bond is recorded by the issuer and coupon payments are mailed to the registered owner

• Term bonds– entire issue matures on a single date

• Serial bonds– mature on a series of dates (continued)



• Mortgage bonds– issued to finance specific projects which are pledged as

collateral

• Equipment Trust Certificates– bonds collateralized with tangible non-real estate property

• Debentures– backed solely by the general credit of the issuing firm and

unsecured by specific assets or collateral

• Subordinated debentures– unsecured debentures that are junior in their rights to

mortgage bonds and regular debentures (continued)

• Mortgage bonds– issued to finance specific projects which are pledged as

collateral

• Equipment Trust Certificates– bonds collateralized with tangible non-real estate property

• Debentures– backed solely by the general credit of the issuing firm and

unsecured by specific assets or collateral

• Subordinated debentures– unsecured debentures that are junior in their rights to

mortgage bonds and regular debentures (continued)



• Convertible bonds– may be exchanged for another security of the issuing firm at the

discretion of the bond holder

• Stock Warrant– give the bond holder an opportunity to purchase common stock

at a specified price up to a specified date

• Callable bonds– allow the issuer to force the bond holder to sell the bond back

to the issuer at a price above the par value (call price)

• Sinking Fund bonds– bonds that include a requirement that the issuer retire a certain

amount of the bond issue each year

• Convertible bonds– may be exchanged for another security of the issuing firm at the

discretion of the bond holder

• Stock Warrant– give the bond holder an opportunity to purchase common stock

at a specified price up to a specified date

• Callable bonds– allow the issuer to force the bond holder to sell the bond back

to the issuer at a price above the par value (call price)

• Sinking Fund bonds– bonds that include a requirement that the issuer retire a certain

amount of the bond issue each year


Primary and Secondary Markets for Corp Bonds

• Primary sales of corp bonds occur through either a public sale (issue) or a private placement similar to municipal bonds

• Two secondary markets– the exchange market (e.g., the NYSE) – the over-the-counter (OTC) market

• OTC electronic market dominates trading in corp bonds

• Primary sales of corp bonds occur through either a public sale (issue) or a private placement similar to municipal bonds

• Two secondary markets– the exchange market (e.g., the NYSE) – the over-the-counter (OTC) market

• OTC electronic market dominates trading in corp bonds


5. Bond Ratings

• Bonds are rated by the issuer’s default risk

• Large bond investors, traders and managers evaluate default risk by analyzing the issuer’s financial ratios and security prices

• Two major bond rating agencies are Moody’s and Standard & Poor’s (S&P)

• Bonds assigned a letter grade based on perceived probability of issuer default

• Bonds are rated by the issuer’s default risk

• Large bond investors, traders and managers evaluate default risk by analyzing the issuer’s financial ratios and security prices

• Two major bond rating agencies are Moody’s and Standard & Poor’s (S&P)

• Bonds assigned a letter grade based on perceived probability of issuer default


Bond Credit Ratings

Explanation Moody’s S&P

Investment grade categories: Best quality; smallest degree of risk Aaa AAAHigh quality; slightly more long-term Aa1 AA+ risk than top rating Aa2 AA Aa3 AAUpper medium grade; possible A1 AA- impairment in the future A2 A+ A3 A-Medium grade; lack outstanding Baa1 BBB+ investment characteristics Baa2 BBB Baa3 BBB-


Investment grade categories: Best quality; smallest degree of risk Aaa AAAHigh quality; slightly more long-term Aa1 AA+ risk than top rating Aa2 AA Aa3 AAUpper medium grade; possible A1 AA- impairment in the future A2 A+ A3 A-Medium grade; lack outstanding Baa1 BBB+ investment characteristics Baa2 BBB Baa3 BBB-

(continued)


Bond Credit Ratings


Speculative investment grades:Speculative issues; protection may Ba1 BB+ be very moderate Ba2 BB

Ba3 BB-Very speculative; may have small B1 B+

assurance of interest and principle B2 B payment B3 B-

Issues in poor standing; may be in default Caa CCCSpeculative in a high degree Ca CC Lowest quality; poor prospects of attaining C C real investment standing D


Speculative investment grades:Speculative issues; protection may Ba1 BB+ be very moderate Ba2 BB

Ba3 BB-Very speculative; may have small B1 B+

assurance of interest and principle B2 B payment B3 B-

Issues in poor standing; may be in default Caa CCCSpeculative in a high degree Ca CC Lowest quality; poor prospects of attaining C C real investment standing D


6. International Aspects of Bond Markets

• International bond market– trades bonds that are underwritten by an

international syndicate– offer bonds simultaneously to investors in

several countries– issue bonds outside the jurisdiction of any

single country– offer bonds in unregistered form

• International bond market– trades bonds that are underwritten by an

international syndicate– offer bonds simultaneously to investors in

several countries– issue bonds outside the jurisdiction of any

single country– offer bonds in unregistered form


Eurobonds, Foreign Bonds, Brady Bonds and Sovereign Bonds

• Eurobonds– long-term bonds issued and sold outside the country of the

currency in which they are denominated (e.g., dollar-denominated bonds issued in Europe or Asia)

• Foreign Bonds– long-term bonds issued by firms and governments outside of

the issuer’s country, usually denominated in the currency of the country in which they are issued

• Brady Bonds and Sovereign Bonds– a bond that is swapped for an outstanding loan to a lesser

developed country, sovereign bonds carry the creditworthiness of the lesser developed country

• Eurobonds– long-term bonds issued and sold outside the country of the

currency in which they are denominated (e.g., dollar-denominated bonds issued in Europe or Asia)

• Foreign Bonds– long-term bonds issued by firms and governments outside of

the issuer’s country, usually denominated in the currency of the country in which they are issued

• Brady Bonds and Sovereign Bonds– a bond that is swapped for an outstanding loan to a lesser

developed country, sovereign bonds carry the creditworthiness of the lesser developed country

copyright © 2007 by the mcgraw-hill companies, inc. all rights reserved. mcgraw-hill /irwin 6-1...

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