Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
and
Lanny R. Martindale, Texas A&M University
Copyright© 2006 John Wiley & Sons, Inc.
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CHAPTER 8
BOND MARKETS
Capital Markets
Economic purpose - brings together longterm (over 1 year) borrowers and long-term
investors.
Major Issuers (borrowers)
Households - mortgages.
Business - bonds and stock
Governments - federal, state, and local bonds.
Major Investors
Households (directly or indirectly through
financial intermediaries).
Foreign investors.
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Economic Sectors
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Capital Market Instruments Outstanding
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Types of Capital Market Claims
Corporate stock - studied in Chapter 9
Bonds - studied here in Chapter 8
Mortgages - studied in Chapter 10
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U.S. Treasury and Agency Securities
U.S. Government Issues - Notes and Bonds
Coupon issues.
Notes - one to ten-year maturity.
Bonds - over ten-year maturity.
Sold by auction by the Federal Reserve banks.
Trend is toward more money market financing
and less capital market financing – 30-year Tbond issues discontinued.
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How to Read Treasury Quotes
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U.S. Treasury and Agency Securities (continued)
Inflation-Indexed Notes and Bonds (TIPS) – see
example on p. 206.
Principal adjusts for inflation
Fixed coupon rate determined by auction process
Minimum denomination is $1,000.
Separate Trading of Registered Interest and
Principal (STRIPS).
Securitized U.S. Treasury note or bond
Interest and principal zero coupon securities sold based
on interest and principal cash flows of underlying bond.
Market values total value of STRIPS created more than
underlying bonds.
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State and Local Government Bonds
Known as municipal bonds or munis
Types of Municipal Bonds
General Obligation (GO) - backed by taxing
power of political entity.
Revenue - financed and paid back with cash
flows from a specific project.
Industrial Development Bonds (IDB) - public
financing of private business.
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Municipal Bonds (continued)
The Relation between Municipals and
Taxable Yields
Interest on municipal bonds is exempt from
federal tax on coupon interest payments.
Muni bonds and taxable corporates are similar
except for the taxation of interest.
The yield on municipals equals the yield on
taxables times one minus the marginal tax rate.
im = it (1-T)
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Corporate vs. Muni Bond
An investor has the choice of a Aa rated
corporate bond with a yield of 6% or a Aa
rated muni-bond yielding 4%. If the
investor has a marginal tax rate of 30%,
which bond should he/she select?
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Corporate vs. Muni-Bond
The after-tax rate on the corporate is
6%(1 - 0.3) = 4.2% > 4% on the muni bond or
The pretax equivalent rate on the muni bond
would be 4%/(1 - 0.3) = 5.7% < 6% on the
corporate

Select the corporate bond!
Copyright© 2006 John Wiley & Sons, Inc.
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Municipal Bonds (continued)
Three groups of investors in municipal
bonds whose demands are affected by their
high federal tax exposure are:
Households - affected by income level and
marginal tax rates.
Casualty insurance companies - investment
determined by industry profitability.
Commercial banks - the Tax Reform Act of
1986 ended the tax deductibility of interest
expense incurred on borrowing for the purchase
of tax exempt securities.
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Who Invests in Municipal Bonds?
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Municipal Bonds (continued)
The Market for Municipal Bonds
Primary market.
• Many individual smaller issuers.
• Underwritten by investment bankers-from local to
national markets.
• Most general obligation (GO) bonds are sold by
competitive bid.
Secondary market not well-developed - OTC
market made by dealers.
• thin secondary markets lead to larger bid-ask
spreads.
• limited marketability leads to higher yields
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Corporate Bonds
Debt contracts (indenture) requiring
borrower to make periodic payments of
interest and repay principal, usually $1,000,
at maturity date.
Types of ownership record
Bearer bonds - coupon bond owned by bearer.
Registered bonds - owner noted by records.
Maturity
Term bonds - all bonds mature at future date.
Serial bonds - bonds mature at varying future
dates.
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The Bond Indenture
Collateral
Mortgage bond - real assets pledged.
Equipment trust certificates - specific, titled, or
identifiable equipment.
Collateral bonds - secured by financial assets.
Debentures - unsecured bonds.
Claim on assets
Senior debt - first priority to general assets.
Subordinated - asset claim ranking of
unsecured debentures below senior or specific
general creditors.
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The Bond Indenture (concluded)
Means of principal payment
Sinking fund –
• building a sum for retirement
• the periodic retirement of a number of bonds
selected randomly.
Call provision - borrower right to retire bond
before maturity.
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Investors in Corporate Bonds
Major investors include:
Life insurance companies.
Pension funds.
Households.
Foreign Investors.
Investor requirements:
Long-term investment horizon.
Liquidity not always needed - hold to maturity.
Safety - investment grade.
Tax considerations.
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Market for Corporate Bonds
Public sale - open to all interested buyers.
Competitive sale - public auction among
underwriters.
Negotiated sale - underwriting contract
signed with specific underwriters.
Most secondary trading of corporate bonds
occurs through dealers vs. exchanges.
the volume of trading is low-a thin market,
thus there is a wide bid/ask differential in the
market.
corporate bonds are less marketable than
money market instruments.
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Market for Corporate Bonds
Private placement - sold to limited number
(< 35) of sophisticated buyers, avoiding
SEC registration.
private placements have increased relative to
public sale.
when interest rates are high and/or when capital
market conditions are unstable, private
placements increase.
SEC Rule 144a (1990) liberalized the
regulation of private placements. It allows
secondary market trading of private placements.
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Junk bond issuance in the late 1990’s
Junk bonds are low rated (high default risk)
corporate bonds.
Development of the junk bond primary market
was enhanced by the secondary market maintained
by Drexel, Burnham and Lambert in the early
1980s.
Higher risk firms found they could issue longer
term, more flexible securities in the high-yield
market rather than borrowing from commercial
banks.
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The Role of Financial Guarantees
Cover the payment of principal and interest in the event of
default.
Substitutes the credit standing of the guarantor for that of
the security issuer.
The quality of a financial guarantee depends on the
reputation and financial strength of the guarantor.
Provided for a fee by
Commercial banks - letters of credit to back commercial paper or
swaps.
Insurance companies - insurance policies to back bond issues.
Guarantee lowers the default risk of the issue and increases
marketability leading to a lower yield to investors.
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Securitized Credit Instruments
Securitization is the packaging loans and selling the claims
to the future cash flows of the loans is called securitization.
The originator designs securities (claims) desired by
investors. The returns are derived from the cash flows of the
loans packaged in a trust arrangement.
The sum of the value of the new securities exceeds the value
of the loan cash flows, providing incentives to unbundle the
loan cash flows.
A variety of asset-backed securities have been created,
beginning in the mortgage market and now extending to
other types of loans. mortgage-backed securities (MBS) are
issued by both federal agencies as well as by private investor
groups (see Chapter 9).
Very often, privately originated asset-backed securities have
been made more attractive to investors by a variety of
“credit enhancements”, which lower costs to issuers and
default risk to investors.
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Securitized Credit Instruments (continued)
Tranches - The variety of claims, called in
some cases tranches vary from low to very
high risk.
Financial guarantees enhance the value of the
low risk end tranches.
The residual or non-guaranteed tranches have a
higher risk/return profile.
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Financial Markets Regulators
The Securities and Exchange Commission
(SEC) is the principle regulator of financial
markets.
SEC established in Federal Securities Act of
1933.
Scope ranges from disclosure requirements to
proper operation of capital markets.
Public firms file regular reports with the SEC.
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Financial Markets Regulators continued)
Information filing is costly and time consuming; some
firms prefer private placements or borrowing from a few
sophisticated investors.
Registration and prospectus are not required, as in a
"general public" security offering.
All states have security laws related to issuing and trading
securities.
The securities industry has had a good record of selfregulation, with the SEC watching to step in when the
public's interest is not served.
The National Association of Security Dealers
(NASD) is one of the foremost private regulatory
bodies.
They assist in maintaining the trust of the general
public, which is the major source of funds for the
capital markets.
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Global Bond Markets
Foreign Bonds –issued in a financial market of a
nation by a foreign company in that country.
When a foreign company like Nestle (Swiss) issues a
bond in the U. S. corporate bond market, it is
considered to be a foreign bond and is referred to as
“Yankee bonds”.
Similarly, foreign firms issuing corporate bonds in the
Japanese market will have their bonds referred to as
“Samurai bonds”.
Foreign bonds must confirm to the regulations imposed
in the country of issue, denominated in the currency of
that country, are brought to the market by investment
bankers of that country, and sold only to investors of
that country.
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Global Bond Markets (continued)
Eurobonds – issued by an entity in one or more countries
denominated in a currency other than the currency of the
country where the bonds are issued.
IBM issues a dollar denominated bond outside of the
U.S. - Eurobond.
Eurobonds are brought to the market by a multinational
syndicate of investment banks.
Eurobond are often bearer bonds and do not have to be
registered.
Interest or coupon payments are annual.
Some Eurobonds are convertible, while call provisions
are common even in short-maturity Eurobonds.
Floating rate Eurobonds are referred to as Floating
Rate Notes (FRNs), and is based on LIBOR.
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Global Bond Markets (continued)
International credit ratings have become a
more significant influence than domestic
ratings on the interest rates of debt.
International credit ratings also take country
or political risk into consideration.
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