Chapter 19 Government Bonds. 19-2 Government Bond Basics In 2007, the gross public debt of the U.S....
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Transcript of Chapter 19 Government Bonds. 19-2 Government Bond Basics In 2007, the gross public debt of the U.S....
Chapter 19
Government Bonds
19-2
Government Bond Basics• In 2007, the gross public debt of the U.S.
government was more than $5 trillion, making it the largest single borrower in the world.
• The U.S. Treasury finances government debt by issuing marketable as well as non-marketable securities.
• Municipal government debt is also a large debt market. • > 85,000 U.S. state and local governments.• Together, they contribute about $2 trillion of outstanding
debt.
19-3
Government Bond Basics
• Marketable • Can be traded among investors• U.S. T-bills, T-notes, and T-bonds
• Non-marketable • Must be redeemed by the issuer• U.S. Savings Bonds • Government Account Series• State and Local Government Series
19-4
U.S. Treasury Bills
• T-Bills = Short-term obligations
• Maturing in 6 months or less• Originally issued with maturities of 4, 13, or
26 weeks
• Sold at a discount from par• Discount represents the imputed interest
• Smallest denomination = $1,000
19-5
U.S. Treasury Notes• Treasury Notes = Medium-term obligations
• Original maturities of 10 years or less, but > 1 year• Normally issued with maturities of 2, 5, or 10
years
• Pay semiannual coupons• Face values as low as $1,000
19-6
U.S. Treasury Bonds
• Long-term obligations• Coupon rate set at issue based on
prevailing market interest rates.
• Coupon rate constant over life of security
• Semiannual coupon payments
19-7
Treasury STRIPS• Separate Trading of Registered Interest and
Principal of Securities• Derived from:
• Treasury notes w/original maturity = 10 years• Treasury bonds w/original maturity = 30 years
• Divided into:• Coupon strips• Principal strips
• STRIPS = Zero-coupon bonds; “zeroes”• STRIPS price = PV(a single cash flow)
19-8
Calculating a STRIPS Price• What is the price of a STRIPS maturing in 15
years with a face value of $100,000 and a yield to maturity of 6.5%?
773083820651
000100 Price STRIPS
30.,$
).(
,$
=PRICE(“07/01/2008”,”07/01/2023”,0,0.065,100,2,3)
N=30; I/Y=3.25; PMT=0; FV=100,000
CPT PV = $38,308.7684
19-9
Calculating YTM on a STRIPS• What is the yield to maturity of a STRIPS
maturing in 12 years with a face value of $20,000 and a price of $11,000?
%.,$
,$0451
00011
000202 YieldSTRIPS
241
N=24; PV=-11,000; PMT=0; FV=20,000
CPT I/Y = 0.0252 x 2 = 5.04%
=YIELD(“07/01/2008”,”07/01/2020”,0,55,100,2,3)
19-10
Zero Coupon Bond Prices by Yield to Maturity and Maturity
19-11
Zero Coupon Bond Prices
19-12
WSJ Prices for Treasury Bonds, Notes and Bills
19-13
Treasury Bond and Note Prices• When a callable T-bond has a price above par,
the reported yield is a yield to call (YTC). Since 1985 however, the Treasury has issued only non-callable bonds.
• Because T-bonds and notes pay semiannual coupons, bond yields are stated on a semiannual basis.
• The relationship between the price of a note or bond and its YTM was discussed in a previous Chapter (Bond Prices and Yields).
19-14
T-Bond and T-Note Prices• Quoted on a % of par basis
• Fractions of a percent stated in 32nds• “104:20” = 104 + 20/32 % = 104.625%
• Bonds callable within last 5 years of life (“C”)• Since 1985 – no callable bonds issued
• Semiannual coupons
MM YTM
FV
YTMYTM
C22
2121
11 Price Bond (10.3)
19-15
Treasury Note QuotesAsked
Maturity Coupon Bid Asked yield2008 Jul 31 5.000 100:07 100:08 0.65232008 Aug 15 3.250 100:05 100:06 1.35772008 Aug 15 4.125 100:07 100:09 1.33292008 Aug 31 4.875 100:14 100:15 1.57152008 Sep 15 3.125 100:08 100:09 1.58262008 Sep 30 4.625 100:20 100:21 1.62922008 Oct 15 3.125 100:12 100:13 1.52892008 Oct 31 4.875 100:30 100:31 1.65922008 Nov 15 3.375 100:15 100:16 1.90672008 Nov 15 4.375 100:26 100:27 1.87752008 Nov 15 4.750 100:31 100:31 1.93262008 Nov 30 4.625 101:03 101:04 1.71792008 Dec 15 3.375 100:20 100:21 1.82932008 Dec 31 4.750 101:09 101:10 1.9290
19-16
Treasury Bond Prices and YTMfor Different Maturities
19-17
Inflation-Indexed Treasury Securities• In recent years, the U.S. Treasury has issued
securities that guarantee a fixed rate of return in excess of realized inflation rates.
• These inflation-indexed U.S. Treasury securities:• Pay a fixed coupon rate on their current principal,
and • Adjust their principal semiannually according to
the most recent inflation rate
19-18
Inflation-Indexed Treasury Securities
19-19
Treasury Inflation-Protected Securities (TIPS)
Beginning Interest EndingDate Rate Principal Paid Inflation Principal
1/1/2008 3% $1,000 n/a n/a $1,0007/1/2008 3% $1,000 $15.00 1.50% $1,0151/1/2009 3% $1,015 $15.23 1.75% $1,0337/1/2009 3% $1,033 $15.49 2.00% $1,0531/1/2010 3% $1,053 $15.80 1.80% $1,0727/1/2010 3% $1,072 $16.09 2.50% $1,099
Inflation-Indexed Treasury Securities Fixed coupon paid on current principal Principal adjusted for inflation semiannually
19-20
TIPS Price QuotesAccrued
Maturity Coupon Bid Asked Yield* Principal2009 Jan 15 3.875 103.00 103.01 -1.966 13132010 Jan 15 4.250 107.10 107.11 -0.583 12802010 Apr 15 0.875 101.30 101.31 -0.232 11372011 Jan 15 3.500 109.04 109.05 -0.134 12372011 Apr 15 2.375 106.08 106.09 0.101 10852012 Jan 15 3.375 110.26 110.27 0.273 12132012 Apr 15 2.000 106.02 106.03 0.366 10612012 Jul 15 3.000 110.13 110.14 0.375 11982013 Apr 15 0.625 100.10 100.11 0.554 10192013 Jul 15 1.875 106.14 106.15 0.563 1172
19-21
U.S. Treasury General Auction Pattern• The Federal Reserve Bank conducts regularly
scheduled auctions for T-bills, notes, and bonds.• 4-week, 13-week, and 26-week T-bills are auctioned
weekly• 2-year T-notes are auctioned monthly• 5-year and 10-year T-bonds auctions occur about
four times per year for each maturity• Since 1998, all U.S. Treasury auctions = single-price
auctions in which all accepted bids pay the stop-out bid.
19-22
U.S. Treasury Auctions• Conducted by Federal Reserve Bank
• Non-competitive bids• Quantity only• Open to individual investors• Bids accepted automatically• Bidders pay the stop-out bid
• Competitive bids• Price and quantity• Open only to Treasury securities dealers• Accept those ≥ Stop-out bid
19-23
U.S. Treasury Auctions• All noncompetitive bids are accepted
automatically and are subtracted from the total issue amount.
• Then, a stop-out bid is determined. This is the price at which all competitive bids are sufficient to finance the remaining amount.
• Since 1998, all U.S. Treasury auctions have been single-price auctions in which all accepted bids pay the stop-out bid.
19-24
Treasury Bill Auction ExampleBidder Price Bid Quantity Bid
A $9,650 $5 billionB $9,600 $4 billionC $9,550 $3 billionD $9,500 $6 billionE $9,450 $2 billion
The Fed has announced an offering of Treasury bills with a face value of $20 billion.
The response is $2 billion of noncompetitive bids and the competitive bids shown above.
Which bids are accepted and at what price?
How much money is raised by the offering?
19-25
Treasury Bill Auction ExampleBidder Price Bid Quantity Bid
A $9,650 $5 billionB $9,600 $4 billionC $9,550 $3 billion $18bD $9,500 $6 billionE $9,450 $2 billion
Offering = $20b - $2b noncompetitive bids = $18b
Bidders A-D quantities sum to $18 billion
A, B, C, D and the noncompetitive bids are accepted
The Price paid by all accepted bidders is $9,500
The offering will raise $9,500/$10,000 x $40b = $38 billion.
“stop-out bid”
19-26
Series EE U.S. Savings Bonds• Face values $25 - $10,000• Original price = ½ face value• 20 year maturity• Monthly interest accruals to redemption value• Fixed interest rates set May 1 & November 1• Must hold 1 year
• Penalty if held < 5 years
19-27
Series I U.S. Savings Bonds• Designed to provide a guaranteed real rate of return• Face values $50 - $10,000• Original price = face value• Interest
• Fixed-rate constant over life of bond• Variable semiannual inflation rate• Earn interest for up to 30 years • Monthly interest accruals to redemption value• Fixed interest rate and inflation adjustment set May 1
and November 1• Must hold 1 year; Penalty if held < 5 years
19-28
Federal Government Agency Securities
• Most U.S. government agencies consolidate their borrowing through the Federal Financing Bank, which obtains funds directly from the U.S. Treasury
• Some agencies authorized to issue securities directly to the public:• The World Bank• Tennessee Valley Authority
• Credit quality ≈ U.S. Treasury issues• Higher yields than Treasuries• Less liquid market
19-29
Federal Government Agency Securities
19-30
Municipal Bond (“Munis”)
• Intermediate- to long-term interest-bearing obligations
• Issues by state and local governments, or agencies of those governments
• “Tax-exempt market”
• Coupon interest usually exempt from federal income tax
• Insured
19-31
Municipal Bond Insurance
• Insured municipal bonds• Secured by the issuer’s resources• Also backed by an insurance policy written
by a commercial insurance company
• With bond insurance:
• Credit quality of the bond issue additionally determined by the financial strength of the insurance company
19-32
Municipal Bond Features
• Typically callable• Semiannual coupons• Par value denomination of $5,000• Prices stated as a percentage of par value • Commonly issued with serial maturity structure• May be putable, have variable interest rates, or both
• Variable-rate demand obligation, VRDO• May be strippable
• Muni-strips
19-33
Municipal Bond Quotes
19-34
Municipal Bonds
19-35
Types of Municipal Bonds• Revenue Bonds
• Secured by proceeds from projects financed• Credit quality =f (ability of project to generate income)
• General Obligation Bonds• Secured by general taxing power of municipality• “Full faith and credit bonds”
• Hybrid Bonds• Revenue bond secured by specific project cash flows• “Moral obligation bond”
19-36
Municipal Bond Credit Ratings
19-37
Municipal Bond Credit RatingsRating Agency
S$P Moody's Fitch Credit Rating Description
AAA Aaa AAA Highest credit qualityAA Aa AA High credit qualityA A A Good credit quality
BBB Baa BBB Satisfactory credit quality
BB Ba BB Speculative credit qualtyB B B Highly speculative quality
CCC Caa CCC Poor credit qualityCC Ca CC Probably default
C C C Imminent defaultD DDD In default
DD, D
Investment-Grade Bond Ratings
Speculative-grade Bond Ratings
Extremely Speculative-Grade Bond Ratings
19-38
Municipal Bond Insurance
• Insured municipal bonds, besides being secured by the issuer’s resources, are also backed by an insurance policy written by a commercial insurance company.
• With bond insurance, the credit quality of the bond issue is additionally determined by the financial strength of the insurance company.
19-39
Equivalent Tax YieldWhat is the tax equivalent yield for an investor in a 28% marginal tax bracket considering a municipal bond with a tax-exempt yield of 7.5%?
%.416710.28-1
7.50 yieldtaxable Equivalent
ratetax marginal1
yieldexempt-Tax yieldtaxable Equivalent
19-40
Equivalent Taxable Yield• Suppose you are trying to decide
whether to buy:
• A corporate bond paying an annual coupon interest of 8%, or
• A municipal bond paying an annual coupon interest of 5%
19-41
Equivalent Taxable Yield• How do you decide?
• If a tax-exempt retirement account, the corporate bond is preferred
• If not tax-exempt, decide on an after-tax basis• Calculate an equivalent taxable yield or an after-
tax yield
Rate)Tax Marginal - (1 YieldTaxable ieldAftertax y
RateTax Marginal - 1
YieldExemptTax YieldTaxable Equivalent
19-42
Example: Equivalent Taxable Yield
• Suppose you are in the 35% marginal tax bracket:
Choose the corporate bond (8% > 7.69%)• Suppose you are in the 40% marginal tax bracket:
Choose the municipal bond (5% > 4.8%)
7.69%0.35 - 1
5%
Rate Tax Marginal - 1
YieldExempt Tax Yield Taxable Equivalent
4.8% .40) - (1 8% ieldAftertax Y
19-43
Critical Marginal Tax Rate
• What marginal tax rate would make you indifferent between purchasing the two bonds?
• Calculate the critical marginal tax rate:
Yield Taxable
YieldExempt Tax - 1 Rate Tax Marginal Critical
37.5%8%
5%1
Yield Taxable
YieldExempt Tax - 1 Rate Tax Marginal Critical
19-44
Taxable Municipal Bonds
• Tax Reform Act of 1986 • Imposed restrictions on the types of municipal
bonds that qualify for federal tax exemption of interest payments
• Act expanded the definition of private activity bonds, which are taxable municipal bonds used to finance facilities used by private businesses.
• Yields often similar to the yields on corporate bonds
19-45
Useful Websites• www.treasurydirect.gov (lots of information on Treasuries)• www.investinginbonds.com (information on bonds, bonds,
bonds)• www.ustreas.gov (visit the U.S. Treasury)• www.savingsbonds.com (for the latest on Savings Bonds)• www.sifma.org (Securities Industry and Financial Markets
Association)• www.municipalbonds.com (check out munis)• www.firstmiami.com (First Miami - muni bonds purchasable
on-line)• www.muniauction.com (Muni Bond Auction on-line)