Investments:
Theory and Applications
Mark Hirschey
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Chapter 6
Part 2
Bond Market
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How to Read Bond
Tables
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Bond Listings
 Due to the number of debt securities, it’s not possible
for newspapers to list “every” bond outstanding in the
debt markets.
 Bonds are not as actively traded as stocks
 Only a small fraction of outstanding bonds trade on
any given day
 Most retail bond investors purchase debt securities to:


receive regular interest income and
hold until maturity: time when bond principal and all
interest will be paid in full.
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Bond Listings
 To find precise bid-ask information for any
given fixed-income security:

Bond investors supply their broker with the bond’s
CUSIP number: Unique code to identify
financial securities.

Developed by: the Committee on Uniform
Security Identification Procedures as a method or
identifying corporate, U.S. government, and
municipal securities.
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Corporate Bonds
 Corporate Bond tables provide basic information:



Bond coupon rate: Bond interest rate expressed as a % of
par value
Term-to-maturity

Call information
Recent price
Current yield

Volume traded – on corporate bond listings


Figure 6.6 and Table 6.1, Panel A. (pages 213-14)
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Treasury Bonds
 Bid and ask prices are stated in terms of percentages of
the bond’s $1,000 Face Amount: Stated bond
principal obligation

Sometimes referred to as the Principal Amount or par
value
 Table 6.1, Panel B, Page 214


Bid: 97:09 = $972.8125
Ask: 97:10 = $973.125
–
–
–
–
The numbers after the colons represent 32nds
09 = 9/32% = .28125
.9728125 x 1000 = $972.8125
This bond is selling at a discount to par
» (less
than the©$1,000
amount)
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Treasury Bonds
 Discount to Par: Mark down from par value
 Bond sells for less than $1,000 par value
 Occurs when: current interest rate > bond coupon rate
 For instance: Ask of 97:10 means the bond is selling for
approximately 97% of face value
 Example:
 Original $1000 Bond Issued with a 10% coupon rate =
$100 coupon payment
 If the current interest rate is 12%
 Bond will sell for less than $1,000 par value
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Treasury Bonds
 Premium to Par: Excess of market price over face
amount.



Bond sells for more than $1,000 par value
Occurs when: current interest rate < bond coupon rate
For instance: Ask of 101:21 means the bond is selling for
approximately 101% of face value
 Example:
 Original $1000 Bond Issued with a 10% coupon rate =
$100 coupon payment
 If the current interest rate is 8%
 Bond will sell for more than $1,000 par value
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Municipal Bond Market
 Tax-exempt bond market
 Not federally taxed
 Most popular bond market sector for individual
investors

30% - held by individual investors
 Table 6.1, Panel C, Page 214
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Corporate Bonds
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Uses of Corporate Debt
 Corporations raise capital to finance
investments in:

Inventory

Plant and equipment

Research and development

General business expansion
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Uses of Corporate Debt
 In deciding how to raise capital for investment,
corporations can issue:

Debt (Bonds)

Equity (Stock)

A mixture of both
 The driving force that determines the method of raising
capital is the desire to “minimize cost of capital”

Match their financing requirements with investor needs
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Uses of Corporate Debt
 Most corporate debt securities offer bond
investors:

Predictable cash flows and rates of return

Generally secure investments

Bondholders have a significant claim on corporate cash
flow and assets, as creditors of the issuing corporation.
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Uses of Corporate Debt
 Most corporate bonds are purchased by
underwriters:

who then make them available to investors
 Following issuance:

Many corporate bonds trade in an efficient OTC
market

Maintained by national and regional bond dealers
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Uses of Corporate Debt
 “Unlike” common stock:
 Which features a certificate that signifies
ownership
 Corporate bonds are commonly issued in book-
entry form only.
 Book-Entry Form: Computer record of
ownership for bonds with no certificate.

A brokerage statement is the bond investor’s only
“proof of ownership”
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Uses of Corporate Debt
 Corporations typically issue long-term debt
 But also, issue debt for short term needs:

Finance imports

Meet seasonal cash-flow needs

Create bridge financing until conditions are right
for longer-term debt issues.

Bridge Financing: Short-term loans to satisfy
temporary borrowing needs.
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Corporate Bond
Characteristics
 The precise terms of the legal agreement between the
corporation and the bondholder are called the
Indenture: Legal terms of bond agreement

Specifies the duties and obligations of the trustee



How and when the principal will be repaid
The rate of interest




Usually a bank or trust company hired by the corporation
Interest on corporate bonds is usually paid twice a year
A description of any property to be pledged as collateral
Callable features
Steps the bondholder can take in the event of default
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Corporate Bond
Characteristics
 In the past, many corporate bonds were sold as:
 Bearer Bonds: Bonds with ownership defined by
possession
 Coupon Bonds: Bonds with physical interest vouchers.
 Both Bearer and Coupon Bonds:
 Featured coupons that were submitted twice a year to an
authorized bank for the payment of interest
 Highly negotiable (could be used like cash)
 Made tracking interest difficult for the IRS
 The Tax Reform Act of 1982 ended the practice of issuing
bearer bonds
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 items
Still
in copyright
circulation
Corporate Bond
Characteristics
 Today, all fixed-income securities are sold as
Registered Bonds: bonds sold in book-entry
form.

They come with the name of the bondholder

Interest income comes twice a year in the form of a
check

At maturity, the registered owner receives a check
for the principal.
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Corporate Bond
Characteristics
 Since 1986, all U.S. government bonds have
been sold in book-entry form.

The owner of book-entry bonds has no certificate
 The Federal Reserve Board computer keeps track
of:


bond ownership and
required interest payments
 A growing number of corporate bonds are also
being sold in book-entry form.
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Corporate Bond
Characteristics
 An Unsecured Corporate Bond: is debt
backed only by the corporation’s:

Reputation
 Credit record
 Financial stability
 Sometimes referred to as debentures – unsecured
corporate bonds
 Generally issued by the largest and most
creditworthy corporations.
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Corporate Bond
Characteristics
 A Senior Bond: has prior claim to other junior
securities in the event of default of bankruptcy.
 Every debt security has priority or senior claim
to preferred stock, which has priority to
common stock.

Debt

Preferred Stock

Common Stock
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Corporate Bond
Characteristics
 Mortgage Bond: Debt backed by a property lien
 Pledged assets typically have a market value greater than
the bond issue
 If the company defaults, real assets are sold off to satisfy
the mortgage bondholders
 Closed-End Mortgage Bond: Debt secured by assets
pledged to that specific bond issue.

Pledged assets can only be sold to pay off a specific
bond issue
 Open-End Mortgage Bond: Debt with pledged assets
that can be sold to pay off multiple bond issues.
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Corporate Bond
Characteristics
 Equipment Trust Certificates: Debt backed by an
equipment lien

The corporate equivalent of a personal auto loan
 Usually 20-50% of the purchase price is paid as a form of
down payment
 The balance is paid off over a term of three to 10 years
 When the loan is fully paid, the company receives clear title
from the trustee

If the company defaults on its loan, equipment is sold and
the bondholders are paid off.
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Corporate Bond
Characteristics
 Many equipment trust certificates are Serial Bonds: a
series of bonds to be retired in sequence.

Each payment represents both interest and a repayment of
principal.
 A debenture (unsecured debt) that is subordinated
(less important) comes behind every other creditor, but
still ahead of preferred and common stock

Creditors, Subordinated Debentures, Preferred Stock
Holders, Common Stock Holders.
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Corporate Bond
Characteristics
 Income Bond: Bonds with interest that must
be paid “only” in the event of positive earnings.

Only pay interest to the extent that the issuing
corporation has earned income
 Usually issued by the least creditworthy corporate
borrowers or by companies already in bankruptcy.
 The only bond type in which failure to pay interest
in a timely fashion does not lead to immediate
default
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U.S. Treasury Securities
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Treasury Securities
Market
 The federal government has three potential
sources of funds to support various projects:

Tax revenues

Printing money



Inflation
Undermine economic confidence
Issue public debt
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Treasury Securities
Market
 When the federal government spends more
than:

it receives in tax revenues

or can be financed through an increase in the
money supply

it must borrow in the bond market.
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Treasury Securities
Market
 The Federal Reserve tries to:

Manage growth in the economy and

Tame the rate of inflation.
 The Federal Reserve System, through its New
York branch, uses the Treasury securities
market to implement monetary policy.
 An efficient means for financing federal deficits
at the lowest possible cost.
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Treasury Securities
Market
 If the Fed wishes to increase the money supply,
it buys Treasury securities

Injects funds into the financial system

Reduces interest rates
 If the Fed wishes to decrease the money supply,
it sells Treasury securities

Withdraws funds from the financial system

Increase interest rates
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Treasury Securities
Market
 Treasury securities carry the “full faith and
credit” backing of the U.S. government

Considered among the safest fixed-income
investments in the world
 The Wall Street Journal and other leading
financial publications provide Treasury
securities interest rate quotes
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Treasury Securities
Market
 The Treasury issues securities through regularly
scheduled public auctions.
 Primary Dealers: Investment bankers that buy
new Treasury securities
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Treasury Securities
Market
 Primary Dealers:
 Key participants in the auctions
 Obligated to bid at every auction for their own account and
on behalf of customers
 Obligated to make a continuous secondary market in
Treasury securities
 Provide bids and offers in the secondary market
 Maintain a working inventory of bonds once Treasury
securities are issued
 Act in conjunction with bond-brokers, who act as
intermediaries between dealers and institutional and
individual customers.
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Treasury Securities
Market
 The largest portion of the U.S. debt market is
accounted for by Treasury securities.
 Trading volume in the Treasury securities market is
enormous:


Averages roughly $190.7 billion a day
The world’s most liquid securities market
 The liquidity and efficiency of this market:
 help maintain the value of the U.S. dollar in world trade
 allow the dollar to remain the world’s preeminent exchange
currency
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Treasury Securities
Market
 The U.S. Treasury is the largest issuer of debt
securities in the world:

An estimated $3.2 trillion in marketable Treasury securities
are outstanding
 Principle buyers include:
 Institutional investors



Pension funds
Mutual funds
Insurance companies

International investors
 Many large institutional investors such as mutual funds
hold Treasury securities on behalf of individuals
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T-Bills, T-Notes, T-Bonds
 Treasury securities are the safest of all bonds in
circulation:

Full-faith-and-credit backing of the U.S.
government

Rely on the interest and principal paying might of
the U.S. taxpayer
 Seasoned Treasury securities trade in the
secondary or capital market
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T-Bills, T-Notes, T-Bonds
 T-bills:

Very actively traded, highly liquid direct short-term
obligations of the U.S. Government
 Sold by government auction on a once-a-week basis
 Mature in less than one year, usually 3 and 6 months
 Face amount can vary from $10,000 to $1 million
 Do not pay interest; purchased at a discount from par
 The “implied” interest rate is determined at auction through
the forces of supply and demand


If government borrowing needs rise, the supply of T-bills will
increase, T-bill prices will fall, investor yields will rise.
Only offered in book-entry form
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T-Bills, T-Notes, T-Bonds
 T-notes:
 Direct obligations of the U.S. Government
 Maturities range from 1 to 10 yrs
 Pay semiannual interest
 Always expire at par value which may vary from:
$5,000 to $10,000 to $1 million
 Different length T-notes are auctioned at various
periods throughout the year
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T-Bills, T-Notes, T-Bonds
 T-bonds:
 Direct obligations of the U.S. Government
 Maturities of 10 to 30 yrs.
 Pay semiannual interest
 Callable beginning 5 years prior to maturity
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Agency and AssetBacked Securities
Markets
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Agency Securities
 Certain U.S. Government agencies and
government-sponsored enterprises issue debt
securities to help finance desirable privatesector activities such as:

Home ownership

Farming

Education
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Agency Securities
 Government Sponsored Enterprises:
“Private” corporations with a “Public” purpose.
 These bond issuers are able to:

Borrow at favorable rates

Funnel proceeds into sectors of the economy that
would not otherwise enjoy such affordable
financing
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Agency Securities
 The Federal Agency Market includes debt
securities issued by:

Fannie Mae

Freddie Mac

The Federal Farm Credit System

Federal Home Loan Banks

Student Loan Marketing Association (Sallie Mae)

The Small Business Administration
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Agency Securities
 Most Agency Securities:

Do not carry the government’s full-faith-and-credit
guarantee

But their credit quality is enhanced by their
government sponsored status
 The Agency Securities market is:

Much smaller than the Treasury securities market

But highly efficient and liquid
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Agency Securities
 Most Agency Securities are purchased by
Institutional investors:

Pension funds

Insurance companies
 Many individual investors hold indirectly
through mutual funds.
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Mortgage-Backed
Securities
 Both Fannie Mae and Freddie Mac supply “lenders”
with money:

Purchase home mortgages in the secondary market






Initial Lenders sell the mortgage loans they generate
Use the proceeds to make new mortgage loans
Results in a constant replenishment of the supply of mortgage
funds
Makes mortgages more affordable
Assemble these mortgages into diversified packages or
Pools (diversified loan portfolios) of such loans
Then issue securities that represent a proportionate share
in the interest and principal payments derived on that pool
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Mortgage-Backed
Securities
 Mortgage Securitization Process: process of
creating diversified loan portfolios and selling
proportionate share to investors.
 Mortgage-backed securities:

Are bought by dealers and sold to investors around
the world
 As the underlying mortgage loans are paid off by
homeowners, investors receive monthly payments
of interest and principal
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Mortgage-Backed
Securities
 Fannie Mae and Freddie Mac trade on the NYSE and
get their resources from:


Equity investors
Borrowing from both private investors and the Treasury
Department
 Both earn a profit: the interest paid on the mortgage-
backed securities tends to be about 1% per year less
than the amount earned on the underlying pool of
mortgages.
 Fannie Mae and Freddie Mac purchase more than 50%
of all residential loans originated during a given year.
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Mortgage-Backed
Securities
 Ginnie Mae is a government agency within HUD
created by Congress to ensure adequate funds for
government loans

insured by the Federal Housing Administration (FHA) and
guaranteed by the Department of Veterans Affairs (VA) and
Veterans Administration.
 Ginnie Mae issues modified pass-through certificates
that represent an interest in a given pool of FHA and
VA mortgages
 Ginnie Mae bonds are backed by the full faith and
credit of the U.S. Government.
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Mortgage-Backed
Securities
 Most mortgage securities are issued and/or
guaranteed by:

Ginnie Mae

Fannie Mae

Freddie Mac

Regarded as safe

Pay relatively low semiannual interest
Exempt from state and local income taxes

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Mortgage-Backed
Securities
 Other private institutions have also built a
profitable business packaging mortgage pools:

Subsidiaries of investment banks

Financial institutions

Home builders
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Other Asset-Backed
Securities
 Transforming individual loans into diversified
pools of related securities has been extended
from home mortgages to a broad range of
consumer and commercial debt:

Credit card debt

Auto loans

Home equity loans

Equipment leases
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Other Asset-Backed
Securities
 Provides a ready source of funds for lending to
consumers and other borrowers.
 Like mortgage-backed securities, asset-backed
securities are:

Underwritten by dealers

Sold to investors around the world
 One of the fastest-growing areas in the financial
services sector.
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The Repurchase
(or Repo) Market
 Repo Market: Securities lending market

A means through which securities dealers can finance their
bond “inventories”.
 A securities dealer sells bonds to a cash investor
(Large institutional investor) and simultaneously
agrees to repurchase them at a later date for an agreedon price to finance a bond position.

Large institutional investors can often earn better shortterm yields by investing idle cash in the repo market than
from bank deposits or money market instruments.
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The Repurchase
(or Repo) Market
 The repo market is used as a relatively safe haven for
cash investments by:




Securities firms
Pension funds
State and local governments
Mutual funds
 Repo agreements are relatively safe because they’re
typically executed in conjunction with:



U.S. Treasury Bonds
Mortgage Securities
Other forms of highly liquid debt securities
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Money Market
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Market Characteristics
 The Money Market: is the market used for
buying and selling short-term debt securities
that can be quickly converted into cash.
 The buyer of a money market instrument is the
lender.
 The seller of a money market instrument is the
borrower.
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Market Characteristics
 Money market instruments

Have a term-to-maturity of one year or less

Typically issued at a discount from par or face
value

Typically, $100,000 is the minimum face amount
traded in the money market

Dominated by Institutional Investors
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Market Characteristics

Smaller investors participate via money-market
mutual funds that have minimum investment
requirements as low as $1,000
 Generally regarded as safe
 Free from interest-rate risk, due to very short
maturities
 Only blue-chip private sector and government
issuers

Only government-issued money market instruments are
default risk free
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Money Market
Instruments
 Huge trading volume ensures low dealer bid-ask
spreads and low customer trading costs.
 Dealer spreads spreads in the T-bill market, for
example, often range as low as six to eight basis
points, or .06 to .08%
 Basis Point: 1/100th of 1%

1% is 100 basis points

½% is 50 basis points
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Money Market
Instruments
 Commercial Paper: Money Market
instruments issued by private entities.

Finance dealer paper

Industrial dealer paper
 Bankers’ Acceptances: Time drafts drawn on
an accepted banking institutions

The bank substitutes their credit for that of an
importer or other holder of merchandise.
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Money Market
Instruments
 Negotiable Certificates of Deposit: Time
deposits at commercial banks.
 Project Notes: Local public housing agency
issues secured by the full faith and credit of the
U.S. government
 Tax Anticipation Notes: Municipal bonds
issued on the expectation of the near-term
receipt of additional tax revenues.
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Money Market
Instruments
 Bond Anticipation Notes: Municipal bonds
issued on the expectation of the near-term
receipt of funds from a bond issue.
 Revenue Anticipation Notes: Municipal bonds
issued on the expectation of the near-term
receipt of revenue from the state or federal
government.
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Money Market
Instruments
 Due to the short maturities of money market
instruments:
“Borrowers” receive great flexibility in funding short-term
cash needs.
 “Investors” obtain a liquid,low-risk investment that
generally offers a higher yield than bank deposits.

 The rising popularity of money market mutual funds
has been a major factor in the growth of demand for
money market instruments.
 Extremely cost-effective source of corporate finance.
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Municipal Bonds
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Tax Advantages
 State and local governments and their agencies
borrow money by issuing Municipal Bonds:
Debt issued by state or local governments.
 Funds are used to build, repair, and improve:





Schools
Streets
Highways
Hospitals
Sewer Systems, etc.
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Tax Advantages
 Projects that benefit the entire community
(schools, courthouses, municipal office
buildings) are typically funded by general
obligation bonds:

Repaid with tax revenues
 Projects that benefit only certain users or user
groups (utilities, toll roads) are typically funded
by revenue bonds:

Repaid for with user fees
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Tax Advantages
 “Interest” (not capital gains) on municipal bonds is
excluded from “federal” taxation on the basis:
improper for the federal government to tax state and
local operations
 In most states, “interest income” received from
securities issued by governmental units within the state
is also exempt from state and local taxes.

If a resident of New York City buys a municipal bond
issued by the City of New York, “interest income” is not
subject to income taxes imposed by the: federal
government, New York State, or New York City.
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Tax Advantages
 Municipal bond investors are willing to accept
lower yields due to federal tax relief
 Therefore, state and local governments are able
to borrow at interest rates that are lower than
would otherwise be possible.

Capital gains realized from the sale of municipal
bonds are not exempt from tax.
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Tax Advantages
 The favorable tax treatment of municipal bond interest
income creates a Clientele Effect: Ownership
influence resulting when specific securities have
special appeal to certain investors.
 Municipal Securities are of primary appeal to those
investors with the highest taxable income.

High-Income Individuals, investing directly or through
mutual funds, etc., hold about three-quarters of the roughly
$1.5 trillion of municipal debt outstanding.
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Tax Advantages
 The municipal securities market:

Is generally regarded as having relatively high
quality, given the taxing authority of state and local
governments

Has a safety record that is second only to the U.S.
Treasury bond market

Appeals to a wide variety of bond investors
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Municipal Bond Types
 A wide variety of municipal bonds are issued by state
and local governments to support general and specific
financing needs:
 General Obligation Bonds: Municipal bonds backed
by the full faith and credit of the issuer.


Issued by cities, counties, and school districts
Among the most creditworthy of all municipal bond
instruments



Backed by the full faith and credit of the issuer
Issuing authorities can raise property taxes to ensure payment
Property and other assets can be sold to satisfy legal claims
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Municipal Bond Types
 Limited Tax Bonds: Bonds payable from the
proceeds of a specific tax.
 Special Tax Bonds: Limited tax bonds

Gasoline tax

Special assessment levy

Ad valorem tax


Based on values
In proportion to the value
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Municipal Bond Types
 Revenue Bonds: Bonds payable from the
earnings of revenue-producing government
agencies or public enterprises.

Water and Sewer Utilities
 School Districts
 Airport authorities
 Many such agencies or enterprises have the
ability to levy service charges or fees

i.e. landing fees at the local airport
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Municipal Bond Types
 Industrial Revenue Bonds: Bonds used to
develop industrial and/or commercial property
for the benefit of private users.

Money raised is used to pay for the construction of
new facilities which are then leased to a corporate
guarantor
 The safety of industrial revenue bonds depends on
the creditworthiness of the issuing municipality
and the corporate guarantor.
 The yield is generally somewhat higher
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Municipal Bond Types
 Moral Obligation Bonds: Bonds backed by
the good name of the issuer.
 Double-Barreled Bonds: Tax-exempt
municipal bonds backed by a pledge of two or
more sources.

Backed by a second source of revenue to increase
their safety.
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Sources of Bond Market
Information
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Print and Broadcast
Media
 Print Media:
 The Wall Street Journal
 Investor’s Business Daily
 Barron’s
 All have:
 Extensive tables
 Commentary about factors influencing the fixedincome securities market
 Historical snapshots
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Print and Broadcast
Media
 Broadcast Media:

CNBC

CNNfn


Treasury bond prices during the day
Economic releases that effect bond yields
 The Internet:

www.bondmarket.com

Maintained by the Bond Market Association
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Bond Market Association
 The Bond Market Association:

A nonprofit organization

Headquartered in New York City

Represents securities firms and banks that
underwrite, trade, and sell debt securities

Membership is open to bona fide dealers in bonds
and other debt securities
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Answers to Selected
End of Chapter 6 Questions
and Suggested Study
 Study the following end-of








chapter questions:
1. (c)
3. (a)
4. (d)
5. (a)
6. (c)
7. (d)
8. (b)
9. (c)
13. (a)
 14. (d)
 17. (d)
 18. (a)
 19. (d)
 20. (d)
 Read the Chapter
 Read the Chapter
“Summary”
 Review the Power Point
Presentation
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