Chapter 10

The Bond Markets

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Chapter Preview

We examine how capital markets operate, and then focus our attention on the bonds and the bond market. Topics include: Purpose of the Capital Market Capital Market Participants Capital Market Trading Types of Bonds Treasury Bonds Municipal Bonds

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Chapter Preview (cont.)

Corporate Bonds

Financial Guarantees for Bonds

Bond Yield Calculations

Finding the Value of Coupon Bonds

Investing in Bonds

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10.1.1 Purpose of the Capital Market Best known capital market securities:

Stocks Bonds

The purpose of money market is for warehousing funds for short term; while the purpose of capital market is for long term investment;

Original maturity is greater than one year, typically for long-term financing or investments

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10.1.2 Capital Market Participants Primary issuers of securities:

Federal and local governments: debt issuers Corporations: equity and debt issuers

Largest purchasers of securities: Households-You and me

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10.1.3 Capital Market Trading

1. Primary market for initial public offerings (IPO)

2. Secondary market Over-the-counter Organized exchanges (i.e., NYSE)

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10.1.4 Types of Bonds

Bonds are securities that represent debt owed by the issuer to the investor, and typically have specified payments on specifies dates.

Types of bonds we will examine include long-term government bonds (T-bonds), municipal bonds, and corporate bonds.

8Figure 10.1 Sohio/BP Corporate Bond

10.2 Types of Bonds: Sample Corporate Bond

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10.2.1 Treasury Bonds

The U.S. Treasury issues notes and bonds to finance its operations.

The following table summarizes the maturity differences among the various Treasury securities.

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10.2.2 Treasury Bonds

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10.2.3 Treasury Bond Interest Rates No default risk since the Treasury can print

money to payoff the debt

Very low interest rates, often considered the risk-free rate (although inflation risk is still present)

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10.2.4 Treasury Bond Interest Rates The next two figures show historical

rates on Treasury bills, bonds, and the inflation rate.

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Figure 10.2 Interest Rate on Treasury Bonds and the Inflation Rate, 1973–2004

10.2.5 Treasury Bond Interest Rates

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Figure 10.3 Interest Rates on Treasury Bills and Treasury Bonds, 1973–2002 (January of each year)

10.2.6 Treasury Bond Interest Rates: Bills vs. Bonds

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10.2.7 Treasury Bonds: Recent Innovation Treasury Inflation-Indexed Securities:

the principal amount is tied to the current rate of inflation to protect investor purchasing power

Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities, 离拆单售债券本息票 ): the coupon and principal payments are “stripped” from a T-Bond and sold as individual zero-coupon bonds.

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10.2.8 Treasury Bonds: Agency Debt Congress has authorized a number of US

agencies such as GNMA, FNMA, and FHLMC, to issue bonds.(p250)

The debt has an “implicit” guarantee that the U.S. government will not let the debt default.

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10.3 Municipal Bonds

Issued by local, county, and state governments

Used to finance public interest projects

Tax-free municipal interest rate = taxable interest rate (1 marginal tax rate)

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10.3.1 Municipal Bonds: Example

Suppose the rate on a corporate bond is 9% and the rate on a municipal bond is 6.75%. Which should you choose?

Answer: Find the marginal tax rate:

6.75% = 9% x (1 – MTR), or MTR = 25%

If you are in a marginal tax rate above 25%, the municipal bond offers a higher after-tax cash flow.

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10.3.2 Municipal Bonds

Two types (p251) General obligation bonds ( 一般信用担保债券 ) -

backed by “the full faith and credit”of the issurers; Revenue bonds （收益债券） -backed by the cash

flow of a particular revenue-generating project.

NOT default-free (e.g., Orange County California) Defaults in 1990 amounted to $1.4 billion in this

market

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10.3.3 Municipal Bonds

The next slide shows the volume of general obligation bonds and revenue bonds issued from 1984 through 2003.

Note that general obligation bonds represent a higher percentage in the latter part of the sample.

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Figure 10.4 Issuance of Revenue and General Obligation Bonds, 1984–2003 (End of year)

10.3.4 Municipal Bonds: Comparing Revenue and General Obligation Bonds

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10.4 Corporate Bonds

Typically have a face value of $1,000, although some have a face value of $5,000 or $10,000

Pay interest semi-annually

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10.4.1 Corporate Bonds

Cannot be redeemed ( 赎回 ) anytime the issuer wishes, unless a specific clause states this (call option 购买选择权 ).

Degree of risk varies with each bond, even from the same issue. The required interest rate varies with level of risk.

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10.4.2 Corporate Bonds

The next slide shows the interest rate on various bonds from 1973-2004.

The degree of risk ranges from low-risk (AAA) to higher risk (BBB). Any bonds rated below BBB are considered sub-investment grade debt.

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10.4.3 Corporate Bonds: Interest Rates

Figure 10.5 Corporate Bond Interest Rates, 1973–2004 (End of year)

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10.4.4 Corporate Bonds: Characteristics of Corporate Bonds Registered Bonds

Replaced “bearer” bonds IRS (Inland Revenue Service 国税局 ) can track

interest income this way

Restrictive Covenants 限制性契约 Mitigates conflicts with shareholder interests

May limit dividends, new debt, ratios, etc.

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10.4.5 Corporate Bonds: Characteristics of Corporate Bonds Call Provisions 回购条款

The right for the issuers to force the holders to sell back. Sinking fund Interest of the stockholders Higher yield for the call provision

Conversion Some debt may be converted to equity

Similar to a stock option, but usually more limited

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10.4.6 Corporate Bonds: Characteristics of Corporate Bonds Secured Bonds

Mortgage bonds Equipment trust certificates

Unsecured Bonds Debentures Subordinated debentures 附属债券 – lower

priority claim Variable-rate bonds 利率可变债券 ///

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Junk Bonds Debt that is rated below BBB Often, trusts and insurance companies are not

permitted to invest in junk debt Michael Milken developed this market in the mid-

1980s, although he was convicted of insider trading

10.4.7 Corporate Bonds: Characteristics of Corporate Bonds

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10.4.8 Corporate Bonds: Debt Ratings

The next slide explains in further details the rating scale for corporate debt. The rating scale is for Moody’s. Both Standard and Poor’s and Fitch have similar debt rating scales.

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10.4.9 Corporate Bonds: Debt Ratings

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10.4.10 Corporate Bonds: Debt Ratings (cont.)

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10.4.11 Financial Guarantees for Bonds Some debt issuers purchase financial guarantees to

lower the risk of their debt.

The guarantee provides for timely payment of interest and principal, and are usually backed by large insurance companies.

Financial guarantees were developed in 1970s to insure municipal bonds and expanded to cover many corporate bonds as well later on.

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10.5.1 Bond Yield Calculations

Bond yields are quoted using a variety of conventions, depending on both the type of issue and the market.

We will examine two bond yield calculations commonly used for short and long-term debt.

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10.5.2 Bond Yield Calculations: Current Yield

What is the current yield for a bond with a face value of $1,000, a current price of $921.01, and a coupon rate of 10.95%?

Answer:

ic = C / P = $109.50 / $921.01 = 11.89%

Note: C ( coupon) = 10.95% x $1,000 = $109.50

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10.5.3 Bond Yield Calculations: Yield on a Discount Basis

What is the discount yield for a one-year bond with a face value of $1,000, and a current price of $875?

Answer:idb = [ (F-P) / F ] x [ 360 / days to maturity]

= [ (1000 – 875) / 1000 ] x [360 / 365] = 12.33%

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10.5.4 Finding the Value of Coupon Bonds

Bond pricing is, in theory, no different than pricing any set of known cash flows – the current price is the present value of all future cash flows.

The table on the next slide outlines some of the terminology unique to debt, which may be necessary to understand to determine the cash flows.

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10.5.5 Finding the Value of Coupon Bonds

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10.5.5 Finding the Value of Coupon Bonds

Let’s use a simple example to illustrate the bond pricing idea.

What is the price of two-year, 10% coupon bond (semi-annual coupon payments) with a face value of $1,000 and a required rate of 12%?

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10.5.6 Finding the Value of Coupon BondsSolution:

1. Identify the cash flows:• $50 is received every six months in interest• $1000 is received in two years as principal repayment

2. Find the present value of the cash flows (calculator solution):

N = 4, FV = 1000, PMT = 50, I = 6

Computer the PV. PV = 965.35

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10.6 Investing in Bonds

Bond are the most popular alternative to stocks for long-term investing.

Even though the bonds of a corporation are less risky than its equity, investors still have risk: price risk and interest rate risk, which were covered in chapter 3

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10.6.1 Investing in Bonds

The next slide shows the amount of bonds and stock issued from 1983 to 2003.

Note how much larger the market for new debt is. Even in the late 1990s, which were boom years for new equity issuances, new debt issuances still outpaced equity by over 5:1.

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Figure 10.6 Bonds and Stocks Issued, 1983–2003

10.6.2 Investing in Bonds

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Chapter Summary

Purpose of the Capital Market: provide financing for long-term capital assets

Capital Market Participants: governments and corporations issue bond, and we buy them

Capital Market Trading: primary and secondary markets exist for most securities of governments and corporations

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Chapter Summary (cont.)

Types of Bonds: includes Treasury, municipal, and corporate bonds

Treasury Bonds: issued and backed by the full faith and credit of the U.S. Federal government

Municipal Bonds: issued by state and local governments, tax-exempt, defaultable.

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Chapter Summary (cont.)

Corporate Bonds: issued by corporations and have a wide range of features and risk

Financial Guarantees for Bonds: bond “insurance” should the issuer default

Bond Yield Calculations: calculations for current yield and discount yield

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Chapter Summary (cont.)

Finding the Value of Coupon Bonds: determining the cash flows and discounting back to the present at an appropriate discount rate

Investing in Bonds: most popular alternative to investing in the stock market for long-term investments