Bond Markets

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Chapter 7

Bond Markets

Financial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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Chapter Outline

Background on bonds Treasury and federal agency bonds Municipal bonds Corporate bonds Institutional use of bond markets Globalization of bond markets

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Background on Bonds

Bonds represents long-term debt securities that are issued by government agencies or corporations

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 Registered bonds require the issuer to maintain records

of who owns the bond and automatically send coupon payments to the owners

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Background on Bonds (cont’d)

Bond yields The issuer’s cost of financing is measured by the yield to

maturity The annualized yield that is paid by the issuer over the life of the

bond Equates the future coupon and principal payments to the initial

proceeds received Does not include transaction costs associated with issuing the bond Earned by an investor who invests in a bond when it is issued and

holds it until maturity The holding period return is used by investors who do not hold a

bond to maturity

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Treasury and Federal Agency Bonds The U.S. Treasury issues Treasury notes

or bonds to finance federal government expendituresNote maturities are usually less than 10 yearsBonds maturities are 10 years or moreAn active secondary market existsThe 30-year bond was discontinued in

October 2001

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Treasury and Federal Agency Bonds (cont’d) Treasury 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 and Federal Agency Bonds (cont’d) Treasury bond auction (cont’d)

The Salomon Brothers scandal In a 1990 bond auction, Salomon Brothers purchased 65

percent of the bonds issued (exceeding the 35 percent maximum)

Salomon resold the bonds at higher prices to other institutions

In August of 1991, the Treasury Department temporarily barred Salomon Brothers from bidding on Treasury securities

In May 1992 Salomon paid fines of $190 million to the SEC and Justice Department

Salomon created a reserve fund of $100 million to cover claims from civil lawsuits

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Treasury and Federal Agency Bonds (cont’d) Trading Treasury bonds

Bond dealers serve as intermediaries in the secondary market and also take positions in the bonds

30 primary dealers dominate the trading Profit from the bid-ask spread Conduct trading with the Fed during open market operations Typical daily volume is about $200 billion

Online trading TreasuryDirect program (http://www.treasurydirect.gov)

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Treasury and Federal Agency 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 per hundreds of dollars of par value

Online quotations at http://www.investinginbonds.com http://www.federalreserve.gov/releases/H15/

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Treasury and Federal Agency 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

Several securities firms create their own versions of stripped securities

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Treasury and Federal Agency Bonds (cont’d) 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

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Computing the Interest Payment of an Inflation-Indexed BondA 10-year bond has a par value of $1,000 and a coupon rate of 5 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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Treasury and Federal Agency Bonds (cont’d) Savings bonds

Issued by the Treasury Denomination is as small as $25 Have a 30-year maturity and no secondary market Series EE bonds provide a market-based interest rate Series I bonds provide a rate of interest tied to inflation Interest on savings bonds is not subject to state and local taxes

Federal agency bonds Ginnie Mae issues bonds and purchases mortgages that are

insured by the FHA and the VA Freddie Mac issues bonds and purchases conventional

mortgages Fannie Mae issues bonds and purchases residential mortgages

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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 municipal

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 riskLess than .5 percent of all municipal bonds

issued since 1940 have defaultedMoody’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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Variable-rate municipal bondsCoupon payments adjust to movements in a

benchmark interest rateSome variable-rate munis are convertible to a

fixed rate under specified conditions

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Tax advantages Interest income is normally exempt from federal taxes Interest income earned on bonds that are issued by a

municipality within a particular state is exempt from state income taxes

Interest income earned on bonds issued by a municipality within a city in which the local government imposes taxes is normally exempt from the local taxes

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Trading and quotations Investors can buy or sell munis by contacting

brokerage firmsElectronic 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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Yields offered on municipal bondsDiffers 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 The federal tax exemption of municipal bonds

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Yield curve on municipal bondsTypically lower than the Treasury yield curve

because of the tax differentialThe 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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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 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

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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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Private placement of corporate bondsOften, insurance companies and pension

funds purchase privately-placed bondsBonds can be placed with the help of a

securities firmBonds do not have to be registered with the

SEC

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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 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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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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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 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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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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Trading corporate bonds Bonds are traded through brokers, who communicate orders to

bond dealers 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 bond quotationsMore than 2,000 bonds are traded on the

NYSE with a market value of more than $2 trillion

Corporate bond prices are reported in eighthsCorporate bond quotations normally include

the volume of trading and the yield to maturity

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Junk bonds Junk bonds have a high degree of credit risk About two-thirds of junk bonds are used to finance takeovers Size of the junk bond market

Currently about 3,700 junk bond offerings exist with a market value of $80 billion

Participation in the junk bond market 70 large issuers of junk bonds each have more than $1 billion in

debt outstanding 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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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

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

Specific adverse information may discourage investors from investment in junk bonds

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How corporate bonds facilitate restructuringUsing 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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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

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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Globalization of Bond Markets

Bond markets have become increasingly integrated as a result of frequent cross-border investments in bonds

Low-quality bonds issued globally by governments and large corporations are 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 Markets (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

Bond Markets

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