BOND MARKETS
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Long-term debt securities issued by government agencies or
corporations.
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The issuer is obligated to pay interest (or coupon) payments
periodically (such as annually or semiannually) and the par value
(principal) at maturity.
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Bonds are often classified according to the type of issuer: treasury
bonds, federal agency bonds, municipal bonds, and corporate bonds.
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Most bonds have maturities of between 10 and 30 years.
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Can be issued as bearer bonds or registered bonds.
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Bonds are issued in the primary market through a
telecommunications network.
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Treasury Bonds
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Fed is a large buyer of T-Bonds
Tool for implementing monetary policy
Dealer-dominated secondary market
Semi-annual coupons are typical
Main asset of the FED
Strips (IO or PO) (Separate Trading of Registered Interest
and Principal of Securities): Interest streams repackaged
as separate security (TIGR)
 TIPS (1996) inflation-indexed maturity values
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The U.S. Treasury commonly issues Treasury notes and
Treasury bonds to finance federal government expenditures.
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The minimum denomination for Treasury notes and bonds is
now $100.
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Note maturities are less than 10 years whereas bond
maturities are 10 years or more.
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Receive semiannual interest payments from the Treasury.
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Interest is taxed by the federal government as ordinary
income, but it is exempt from any state and local taxes.
Federal Agency bonds
a. Issued by federal agencies such as the Federal National
Mortgage Association (Fannie Mae) and the Federal Home Loan
Mortgage Association (Freddie Mac) who use the proceeds to
purchase mortgages in the secondary market.
b. During the credit crisis in 2008, Fannie Mae and Freddie Mac
experienced financial problems because they had purchased
risky subprime mortgages that had a high frequency of defaults.
c. The federal government rescued Fannie Mae and Freddie Mac so
that they could resume issuing bonds and continue to channel
funds into the mortgage market.
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Municipal Bonds
 Issued by states, counties, cities and state agencies
 Interest is exempt from Federal taxation
 General obligation bonds are supported by the municipal government’s
ability to tax.
 Revenue bonds are supported by revenues of the project (tollway, toll
bridge, state college dormitory, etc.) for which the bonds were issued.
 Some types, i.e. industrial development bonds, may be completely taxexempt
 Tax-preference results in lower offered yields (rationale for computing
before-tax equivalent yields)
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Credit Risk of Municipal Bonds
 Ratings of Municipal Bonds
Moody’s, Standard & Poor’s, and Fitch Investors Service assign
ratings to municipal bonds based on the ability of the issuer to repay
the debt.
 Impact of the Credit Crisis on Municipal Bond Risk
During weak economic conditions, some state and local
governments with large budget deficits may not be able to sell
additional bonds, even when offering a higher yield, if investors are
concerned that the governments may default on their debt.
 Insurance against Credit Risk of Municipal Bonds
Some municipal bonds are insured to protect against default.
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Corporate Bonds
 Terms spelled out in the Indenture Agreement; face value,
maturity, coupon, form of collateral if any
 Insurance Cos are principal buyers of corporate bonds w/
households second Sold through public offerings; About
half are privately-placed
 Proceeds may be used to fund expansion, finance
acquisitions or LBO or to refund maturing bond issues or
to refund higher interest rate debt
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1. Corporate Bond Offerings
a. Public offering: Underwriters try to place newly issued bonds
with institutional investors.
b. Private placement
 Small firms that borrow small amounts of funds (such as $30
million) may consider private placements rather than public
offerings.
 The institutional investors that purchase a private placement
include insurance companies, pension funds, and bond mutual
funds.
2. Characteristics of Corporate Bonds
a. Sinking fund provision - a requirement that the firm retire a
certain amount of the bond issue each year.
b. Protective covenants – restrictions placed on the issuing firm
that are designed to protect bondholders from being exposed
to increasing risk during the investment period.
2. Characteristics of Corporate Bonds (Cont.)
c. Call provisions
 Normally requires a price above par value when bonds are
called. The difference between the bond’s call price and par
value is the call premium.
 Call when rates drop or rise??????
d. Bond collateral - Bonds can be classified according to whether
they are secured by collateral and by the nature of that
collateral.
e. Low and zero-coupon bonds
i. Issued at a deep discount from par value.
ii. Are purchased mainly for tax-exempt investment accounts.
2. Characteristics of Corporate Bonds (Cont.)
f. Variable rate bonds – Long term debt securities with a coupon
rate that is periodically adjusted.
g. Convertibility - Allows investors to exchange the bond for a
stated number of shares of the firm’s common stock.
h. Default Rate - The general level of defaults on corporate bonds
is a function of economic conditions.
i. Bond Ratings
 Corporate bonds that receive higher ratings can be placed at
higher prices (lower yields).
 As a result of the Financial Reform Act of 2010, rating agencies
are subject to oversight by a newly established Office of Credit
Ratings.
 Zero-Coupon bonds pay no coupons; sold at PV of maturity
value; result is very much like a T-bill except the maturity
can be up to 30 years
 A favorite vehicle for in substance defeasance of debt for corps
seeking to restructure their balance sheets,
 High risk uncollateralized bonds are frequently called "junk
bonds"
 The US Tax Code favors debt financing; interest paid with
pre-tax dollars
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Interest Rate Risk
 Change in price of seasoned bonds as rates change over time
 Sensitivity a function of coupon and term to maturity
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Reinvestment Rate Risk
 Valuation formulas assume future cash flows reinvested at the
expected rate of return
 If rates drop, future cash flows are invested at lower rates, reducing
the future value of reinvested cash flows
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C.
Default (or business) Risk
 Risk that payments may not be made
 Importance of indenture agreement
D.
Maturity Risk
 The longer the maturity, the greater the risk
E.
Liquidity Risk
 The inability or difficulty in selling for cash
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F.
Companies' debt issues are rated for riskiness
 Standard & Poor's, Moody's, Fitch's
 Ratings: AAA to D (S&P scheme)
 Ratings are important for many reasons; cost to borrow,
legal list requirements High Quality (AAA - AA), Investment
Grade (AAA - BBB), Speculative (BB and B), Highly
speculative (C's), Default (D's)
 Public Utilities are the single largest issuer of bonds
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Impact of Exchange Rates on Foreign Bond
Returns
 Dealing with the double problems of Interest-Rate and
Currency Parity
 Use of interest rate swaps in international bond markets
 Use of currency swaps in international bond markets
 Economic growth rate differentials as well as government
policy
 Always a good idea to diversify international bond
portfolios
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How is buying and selling accomplished in the T-Bond market?
How does the Fed use its inventory of treasury securities?
Who issues municipals? What is their principal attraction to an
investor?
What type of investor should be most interested in municipals?
What are zero-coupon bonds? Why might borrowers prefer them?
What are the main sources of risk in a bond investment? What
happens to yeild/price as risk increases?
What are the two sources of risk when investing in foreign bonds?
How might the risk be minimized??
Q&A: 2, 4, 8, 9, 14, 15 Interp: a, b, c
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