Chapter 7
Bond Markets
© 2001 South-Western College Publishing Company
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Chapter Objectives
 Provide Informational Background On Treasury,
Municipal, and Corporate Bonds
 Explain The Role Of Bonds To Institutional
Investor
 Discuss The Globalization Of Bond Markets
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Background on Bonds
 Bonds represent long-term debt securities
 The issuer of the bond is obligated to pay
Interest (or coupon) payments periodically
Par value (principal) at maturity
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Background on Bonds
 Bond Yields
The issuer’s cost of financing with bonds
is commonly measured by the yield to
maturity
The yield to maturity is the annualized
discount rate that equates the future
coupon and principal payments to the
bond’s price (or proceeds received from
the bond offering)
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Background on Bonds
 Bond Yields
Consider an investor who can purchase
bonds with 10 years until maturity, a par
value of $1,000, and an 8 percent
annualized coupon rate for $936.
Determine the yield to maturity for this
bond.
N
I
PV
PMT
FV
10
9
-936
80
1000
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Background on Bonds
 Bond Yields
If an investor holds a bond until maturity they
will earn the yield to maturity.
If they sell the bond before maturity, they may
receive more or less than the YTM.
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Background on Bonds
 Bonds are often classified according to the type
of issuer
Issuer
Type of Bond
Federal Government
(Treasury)
Treasury Bonds
Federal Agency
Federal Agency Bonds
State and Local
Governments
Municipal Bonds
Corporations
Corporate Bonds
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Treasury Bonds
 Issued by the U.S. Treasury to finance federal
government expenditures
 Maturity
Notes, < 10 Years
Bonds, > 10 To 30 Years
 Active OTC Secondary Market
 Semiannual Interest Payment
 Benchmark Debt Security For Any Maturity
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Treasury Bonds
 Types of Treasury Bonds
Coupon
Stripped Treasury Bonds
• Cash flows of bonds are stripped by
securities firms
–One security represents the principal
payment only
–Second security represents the interest
payments only
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Treasury Bonds
 Inflation-Indexed Bonds
Began in 1996
Intended for investors who want to ensure
their returns keep up with inflation
Principal value adjusted for the U.S. inflation
rate every 6 months
Still not very popular in U.S. due to low
inflation rate
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Federal Agency Bonds
 Government National Mortgage Association
(GNMA)
Issues bonds and uses proceeds to purchase
FHA and VA mortgages
Backed by mortgages and federal
government
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Federal Agency Bonds
 Federal Home Loan Mortgage Association
(Freddie Mac)
Issues bonds and uses proceeds to
purchase conventional mortgages
Not backed by federal government, but
have low credit risk
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Municipal Bonds
 State and local government obligations
 Revenue Bonds vs. General Obligation Bonds
 Investor interest income exempt from federal
income tax
 Tax Reform Act of 1986 placed limitations on
tax-exempt bond issuance for private purposes
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Corporate Bonds
 When corporations want to borrow for long-term
periods they issue corporate bonds
Usually pay semiannual interest
Most have maturities between 10-30 years
• Recently, Coca-Cola and Walt Disney
issued 100-year bonds
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Corporate Bonds
 Characteristics of Corporate Bonds
Indenture
• Legal document specifying rights and
obligations of issuer and bondholder
–Several hundred pages
Trustee
• Represents bondholders, ensures
compliance
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Corporate Bonds
 Characteristics of Corporate Bonds
Sinking Fund Provision
• Requirement that the firm retire a certain
amount of the bond issue each year
Protective Covenants
• Places restrictions on the firm to protect
bondholders
• Examples: limits dividends and officer
salaries, restricts additional debt
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Corporate Bonds
 Characteristics of Corporate Bonds
Call Provisions
• Call premium
• Advantage to issuers
Bond collateral
• Usually consists of a mortgage on real
property
• Unsecured bonds are called debentures and
are backed only by the general credit of the
issuing firm
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Corporate Bonds
 Characteristics of Corporate Bonds
Low- and Zero-Coupon Bonds
• Early 1980s
• Deep discount
Variable-rate bonds
Convertibility
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Corporate Bonds
 Junk Bonds
Junk bonds are also called high-yield bonds
Original-issue junk bonds became popular in
the 1980s
Size of the market: junk bonds represent
about 25 percent of the market value of all
corporate bonds (around $145 billion in 1998)
The risk premium is between 3 and 7 percent
above Treasury bonds
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Institutional Use of Bond Markets
 Commercial banks and S&Ls
 Finance companies
 Brokerage firms
 Investment banking firms
 Insurance companies
 Pension funds
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Globalization of Bond Markets
 Foreign investment in dollar securities
 Foreign issuance by U.S. firms
 Increased global investment by pension and
mutual funds
 Development of foreign security markets--24
hour trading
 Eurobond market
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Globalization of Bond Markets
 Eurobond market
In 1960s, U.S. corporations were limited to
the amount of funds they could borrow in the
U.S. for overseas operations.
They began to issue bonds in the Eurobond
market where bonds denominated in various
currencies were placed.
• About 75 percent are denominated in U.S.
dollars
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Globalization of Bond Markets
 Eurobond market
An underwriting syndicate on investment
banks participates in placing the bonds
• Issuer can choose the currency in which
the bonds are denominated
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