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CHAPTER 7
Bond Markets
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Background on Bonds
• Bonds represents long-term debt securities that are issued by
government agencies or corporations
• Because these debt securities can be broken into small pieces
owned by thousands of investors, the risk is spread far and
wide, usually resulting in a lower rate to the borrower than if
there was only one lender
• Most corporations will try to first borrow through the bond
market to raise funds before they turn to the stock market
because it is cheaper to do so
• bond interest payments are tax-deductible but dividends on stock are
not
• In general, bond investments are less risky than stocks so investors
demand a higher (more costly) return for stocks
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Background on Bonds
• Because bond are traded in large blocks, most individual
investors can only invest through mutual funds
• 95% of bond trading is done by institutional investors
•
•
•
•
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 (this is rare today)
• Registered bonds require the issuer to maintain records of
who owns the bond and automatically send coupon payments
to the owners (bonds are recorded in the “street name” of the
owner)
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Coupons
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Coupon Rates
• Named after the coupon or perforated edge of certificate
used to request interest
• Also called stated or contract rate
• Coupon rate is contractual interest rate promised in the agreement
• Usually approximates current market rates
• Fixed throughout term (can’t be changed)
• Determines actual cash interest payments
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Yield to Maturity (YTM)
• The YTM is the market rate on the date the bonds are
sold/purchased and includes the effect of premiums &
discounts
• The YTM is usually different from the coupon rate due to
fluctuations of rates over time.
• A difference between the YTM and coupon rate causes
the bond to sell for a premium or discount.
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Bonds by Issuer
Issuer
Type of Bond
Federal Government
(U.S. Treasury)
Treasury Bonds
Federal Agencies
Federal Agency Bnds
State and Local
Governments
Municipal Bonds
(Munis)
Corporations
Corporate Bonds
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Treasury Notes & Bonds
• The U.S. Treasury issues Treasury notes or bonds to
finance federal government expenditures
• Note maturities are greater than 1 year and up to 0 years
• Notes have been primary source of federal borrowing in recent years
• Bonds maturities are more than 10 years, up to 30 years.
• An active secondary market exists
• The 30-year bond was discontinued in October 2001 but re-instated
in 2006.
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Treasury Notes & Bonds (cont’d)
• Treasury notes/bond auction
• Notes are auctioned every month while bond auctions
normally occur around 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 Bonds (cont’d)
• Trading Treasury bonds
• Bond dealers serve as intermediaries in the secondary
market and also take positions in the bonds
• About two dozen primary dealers dominate the trading
• Profit from the bid-ask spread
• Conduct trading with the Fed during open market operations
• Typical daily volume is over $500 billion
• Online trading
• Treasury Direct program (http://www.treasurydirect.gov)
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Treasury 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
• Traditionally, bid and ask prices were quoted as a percent of par
value, with the fractions representing 32nds (shown using a colon
rather than a decimal). However, today most quotes are in
decimals.
• A bid price is what the broker/dealer is willing to pay you when you
sell and the ask price is what he will charge you when you buy from
him. The difference, or spread, is his profit. For large-volume
markets, the spread is smaller.
• Online quotations and average rates at
• http://www.investinginbonds.com or http://finance.yahoo.com/bonds
• http://www.federalreserve.gov/releases/H15/
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Treasury Bond Quotes
• Treasury Bond Quotations
8.38 Aug. 2013-18
103:05
103.11
• Coupon rate. 8.38%
• Maturity date, Aug. 2018 but callable in 2013
• Bid of 103:05 (your sell price) and Ask price of 103:11 (your buy price) are
stated as a percent of face value
• Fractions are in 32nds so for you to buy $10000 par of the last bond listed,
you would be charged $10334.44 (103 + 11/32nds x $1000)
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Treasury Bonds (cont’d)
• Stripped Treasury bonds
• One security represents the principal only (PO)
payment and a second security represents the interest
only (IO) 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
• Backed by U.S. gov’t
• Several securities firms create their own versions of
stripped securities
• Merrill Lynch’s TIGRs
• The Treasury created the STRIPS program in 1985
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Treasury Inflation Protected Securities(TIPS)
• Inflation risk to fixed income investors is very high.
According to a recent survey, many investors believed that
fixed income debt investments were less susceptible to
inflation risk than equity investments. Obviously, the public
is woefully ignorant.
• 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 Bra
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Treasury Inflation Protected Securities(TIPS)
A 10-year bond has a par value of $1,000 and an annual
coupon rate of 10 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?
Principal  $1,000  1.013  $1,013
Coupon Payment  5%  $1,013  $50.65
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US Savings Bonds
• Buy at half of face value. Grows to face value at which
time may be redeemed.
• Popular because of low denomination ($25), safety, and
exemption from state income tax
• For federal purposes, investor can choose to be taxed
incrementally or all at redemption.
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Federal Agency Bonds
• Government National Mortgage Association (GNMA) –
known as Ginnie Mae
• Ginnie Mae does not issue mortgage backed securities like its
cousins Fannie and Freddie, merely guarantees FHA/VA/RHA
mortgages , backed by the full faith and credit of the U.S.
• GNMA is not a publically traded company likes its cousins
• A U.S. government agency, wholly owned by the Federal
government and operated by the Dept. of HUD
• Backed by explicit guarantee of Federal government
Federal Agency Bonds
 Federal National Mortgage Association (Fannie Mae or FNMA)
mortgage-backed securities
 Created in 1938 as part of the New Deal, Fannie Mae is Federally chartered but
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privately owned with stock traded on NYSE, ticker FNMA. FNMA was taken
over by the Fed Gov’t in Sept/2008 and is now in conservatorship.
No explicit guarantee of bonds by federal government, but gov’t bailed it out in
fall/08 – so actions speak louder than words.
Huge corporation – owns a majority of US mortgage market (some 90% of
mortgages together with Freddie Mac).
Uses funds from mortgage-backed pass-through securities to purchase
conventional mortgages (that are not FHA or VA)
Accounting scandals, CEO Franklin Raines, Barney Frank and politics
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Federal Agency Bonds
• Federal Home Loan Mortgage Association (Freddie Mac)
• A U.S. government-sponsored agency, but now privately owned
(ticker FMCC).
• Created in 1970 by government to compete with FNMA.
• Issues bonds and uses proceeds to purchase conventional
mortgages
• No explicit guarantee of bonds by federal government, but gov’t
bailed it out in fall/08 – so actions speak louder than words.
• Used to provide liquidity for thrifts and support of home ownership
• Since Sept/2008, it has been under conservatorship of the Federal
gov’t (as has FNMA)
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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 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 risk
• Less than .5 percent of all municipal bonds issued since 1940 have
defaulted
• Moody’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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Municipal Bonds (cont’d)
• Variable-rate municipal bonds
• Coupon payments adjust to movements in a benchmark interest
rate
• Some variable-rate munis are convertible to a fixed rate under
specified conditions
• Investors holding variable rate bonds are hoping that rates
increase.
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Municipal Bonds (cont’d)
• Tax advantages
• Interest income is normally exempt from federal taxes.
This causes the rates to be lower and is a gift from the
federal government to state/local governments
• In this day of large federal budget deficits, there is
serious talk in Congress about making muni interest
taxable. This would cause an immediate spike in muni
rates and make it much more costly for state/local
gov’ts to raise money. In addition, rich people would not
buy muni bonds anymore, which would dry up funding.
• Interest income earned on bonds that are issued by a
municipality within a particular state is exempt from
state income taxes
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Municipal Bonds (cont’d)
• Trading and quotations
• Investors can buy or sell munis by contacting brokerage
firms
• Electronic 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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Municipal Bonds (cont’d)
• Yields offered on municipal bonds
• Differs 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
• Of a discount due to the federal tax exemption of municipal
bonds
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Municipal Bonds (cont’d)
• Yield curve on municipal bonds
• Typically lower than the Treasury yield curve because of
the tax differential
• The 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
Annualized Yield Offered on Securities
Yield Offered on General Obligation Municipal
Bonds over Time
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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
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•
•
•
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
(although some companies have issued bonds with 50 or 100 year
maturities, e.g. Boeing & Chevron issued 50 year maturities; and
Disney, AT&T, & Coca-Cola issued 100 year maturities)
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
• Rate increased tremendously in 2008-09
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Corporate Bonds (cont’d)
• 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
Corp. Bond Default (Credit Risk)
Ratings Assigned by:
Description of Security
Moody’s
Standard and Poor’s
Highest quality
Aaa
AAA
High quality
Aa
AA
High-medium quality
A
A
Medium quality
Baa
BBB
Medium-low quality
Ba
BB
Low quality (speculative)
B
B
Poor quality
Caa
CCC
Very poor quality
Ca
CC
Lowest quality (in default)
C
DDD, D
Comparison of Baa and Treasury Bond Yields
Source: Federal Reserve
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Corporate Bonds (cont’d)
• Public Offerings (IPOs)
• Works just like with a stock IPO. An underwriter buys
the bonds and turns around and sells them to the public
• Private placement of corporate bonds
• Often, insurance companies and pension funds
purchase privately-placed bonds
• Bonds can be placed with the help of a securities firm
• Bonds do not have to be registered with the SEC
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Corporate Bonds (cont’d)
• 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 or
to stockpile sufficient cash.
• 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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Corporate Bonds (cont’d)
• 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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Corporate Bonds (cont’d)
• 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. Most 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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Corporate Bonds (cont’d)
• 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 until maturity
• 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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Zero-coupon bonds
Example of Zero-Coupon Bond, 9%, 8-year, purchased at 50
Year
1
2
3
4
5
6
7
8
Total
Effective
Interest
Amortized
45.25
49.35
53.81
58.68
63.99
69.78
76.10
82.98
Ending
Value
500.00
545.25
594.60
648.41
707.09
771.08
840.86
916.96
999.94
499.94
Rule of 72:
Easy rule of thumb:
Years it takes to double in value x growth rate = 72
8 x 9 = 72
Investors pay tax
on interest
accruals each
year even though
not received in
cash until the end.
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Corporate Bonds (cont’d)
• Trading corporate bonds
• Bonds are traded through brokers, who communicate orders to
bond dealers, usually on an electronic trading platform
• 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 Bonds (cont’d)
• Corporate bond quotations
• More bonds of more than 1,000 different companies are
traded on the NYSE with a market value of more than
$5 trillion
• 95% of trades done by institutional investors
• Corporate bond quotations normally include the volume
of trading and the yield to maturity
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Corporate Bonds Quotation
ATT 6.5 29 7.3 214 88.625
+.25
AT&T bond quote
6.5% coupon rate
Maturity in 2029
7.3% current yield (annual interest/price)
214 bonds traded on this day
Bond priced at close of day 88.625 % of face ($1000)
or $886.25
Bond price up .25% of par for the day or $2.50
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Corporate Bonds (cont’d)
• Junk bonds
• Junk bonds have a high degree of credit or default risk
• About ¼ of total bond market is considered junk.
• About 2/3rds of junk bonds have always been rated as junk
• About two-thirds of junk bonds are used to finance takeovers
• Size of the junk bond market
• About 4,000 junk bond offerings exist with a market value of over $600
billion
• Participation in the junk bond market
• 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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Default Rate on Corporate Bonds over Time
Default Rate on Corporate Bonds over Time
Source: Federal Reserve
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Corporate Bonds (cont’d)
• 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
• During the 2008-09 credit crisis, many junk bonds defaulted and
many junk bonds actually lived up to their name.
Premium (Spread) Offered on Junk Bonds
Source: Federal Reserve
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Corporate Bonds (cont’d)
• Junk bonds (cont’d)
• Contagion effects in the junk bond market
• Specific adverse information may discourage investors from
investment in junk bonds
• Ivan Boesky admitting to insider trading violations
• Drexel Burnham Lambert’s bankruptcy filing
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Corporate Bonds (cont’d)
• How corporate bonds facilitate restructuring
• Using bonds to finance a leveraged buyout (LBO)
• An LBO is when management borrows using junk bonds and
uses the money to buy back all the stock, thus taking over the
company.
• 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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Corporate Bonds (cont’d)
• 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
• The takeover can be management –led or it can be a hostile
buyout.
• 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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Financial Institutions & Bonds
Financial Institution
Participation in Bond Markets
Commercial banks and savings
and loan associations (S&Ls)
•
•
•
Finance companies
• Commonly issue bonds as a source of long-term funds.
Mutual funds
• Use funds received from the sale of shares to purchase bonds. Some bond mutual funds
specialize in particular types of bonds, while others invest in all types.
Brokerage rms
• Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.
Investment banking rms
• Place newly issued bonds for governments and corporations. They may place the bonds
and assume the risk of market price uncertainty or place the bonds on a best-efforts basis
in which they do not guarantee a price for the issuer.
Insurance companies
• Purchase bonds for their asset portfolio.
Pension funds
• Purchase bonds for their asset portfolio.
Purchase bonds for their asset portfolio.
•
Sometimes
place municipal bonds for municipalities.
Sometimes issue bonds as a source of secondary capital.
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Investors in Corporate Bonds
Mutual
Funds
Households and
Trusts
Foreign Investors
Life Insurance Companies
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Globalization of Bond Markets
• Bond markets have become increasingly integrated as a
•
•
•
•
•
result of frequent cross-border investments in bonds
Many US financial institutions (e.g. pensions & mutual
funds) invest in foreign bonds to diversity and to get
higher interest rates . . . but exchange rate risk must be
considered!
Low-quality bonds are issued globally by governments
(e.g. Venezuela, Brazil, Rep. of Chech).
Some countries have defaulted on the bonds (e.g.
Argentina, Russia, Brazil, Costa Rica, Yugoslavia)
Multi-national corporations also issue 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
Greek Debt Crisis
a. In spring of 2010,
Greece experienced a
credit crisis brought on
by weak economic
conditions and a large
government budget
deficit.
b. As Greece’s deficit grew
and its economy
weakened, investors
were concerned that the
Greek government would
not be able to repay its
debt.
c. Greece may eventually
reject the EU’s austerity
measures and remove
itself from the EU,
thereby upsetting the
whole Euro breadbasket.
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Globalization of Bonds (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
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Other Long-Term Debt
1. Structured Notes
 The amount of interest and principal to be paid is based on
specified market conditions.
 Risk of Structured Notes
 In the early 1990s, Orange County, California suffered
losses and filed for bankruptcy due to investments in
structured notes.
 Because of the difficulty in assessing the risk of
structured notes, some investors rely on credit ratings.
However, credit rates of structured notes have not
always served as accurate indicators of risk
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Other Long-Term Debt (cont.)
2. Exchange-traded notes
a. Debt instruments in which the issuer promises to pay a return
based on the performance of a specific debt index.
b. Typically mature in 10 to 30 years and are not secured by
assets.
3. Auction-rate securities
a. A way for borrowers (e.g., municipalities and student loan
organizations) to borrow for long-term periods while relying on a
series of short-term investments by investors.
b. Every 7 to 35 days, the securities can be auctioned off to other
investors, and the issuer pays interest based on the new reset
rate to the winning bidders.