Chapter 6 – Bond Market
1
Learning Outcomes
• Definition of Bonds
• Definition of Bond Market
• Bond Market Securities
– Overview
– Characteristics
– Trading Process
• International Aspects of Bond Markets
2
Definition of Bonds
Bonds are long term debt obligations
issued by corporations and government
units.
Proceeds from a bond issue are used to
raise funds to support long-term
operations of the issuer
bond issuers promise to pay the face
value plus coupon interest on the
borrowed funds
If the terms of the repayment are not met
by the bond issuer, the bond holder
(investor) has a claim on the assets of the
bond issuer.
3
Definition of Bond Market
•
Bond Markets are markets in which bonds are issued and
traded.
•
Bond Markets are traditionally classified into 3 types:
Treasury
Notes
and
Bonds
1
2
Municipal
Bonds
3
Corporate
Bonds
4
Treasury Notes and Bonds
•
Treasury notes & bonds (T-notes and T-bonds) are issued by
the U.S. Treasury to finance the federal government
expenditures.
•
They are similar to T-bills in some ways and different in other
ways.
Similarities
Differences
1. T-notes and bonds are backed by the full
faith and credit of the U.S. government.
2. T-notes and bonds trade in very active
secondary markets.
1. T-notes and bonds experience wider price
fluctuations.
2. T-notes and bonds T-notes and T-bonds
pay coupon interest (semiannually).
3. T-note maturity 1-10 years and T-bond
maturity more than 10 years
5
Treasury Notes and Bonds
(Cont.)
STRIPS
In 1985, the Treasury began issuing 10-year notes and 30-year
bonds to financial institutions using a book-entry system under a
program titled “Separate Trading of Registered Interest and
Principal Securities” (STRIPS).
CP1
CP2
STRIPS
Funds
US
Treasury
Financial
Institution
CP3
T-note or
bond
Funds
CP4
FV
6
Treasury Notes and Bonds
(Cont.)
Accrued Interest:
When an investor buys a T-note or T-bond between coupon
payments, the buyer must compensate the seller for that portion of
the coupon payment accrued between the last coupon payment
and the settlement day (normally, settlement takes place 1 to 2
days after a trade) while the seller was still the owner of the
security. This amount is called accrued interest.
Dirty or Full
Price
At settlement, the buyer must pay the
seller the purchase price of the T-note or
T-bond plus accrued interest
Clean Price
The price without the accrued interest
added on
7
Treasury Notes and Bonds
(Cont.)
Accrued Interest (Cont.):
𝑨𝒄𝒄𝒓𝒖𝒆𝒅 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝑰𝑵𝑻
𝑨𝒄𝒕𝒖𝒂𝒍 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒅𝒂𝒚𝒔 𝒔𝒊𝒏𝒄𝒆 𝒍𝒂𝒔𝒕 𝒄𝒐𝒖𝒑𝒐𝒏 𝒑𝒂𝒚𝒎𝒆𝒏𝒕
=
×
𝟐
𝑨𝒄𝒕𝒖𝒂𝒍 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒅𝒂𝒚𝒔 𝒊𝒏 𝒄𝒐𝒖𝒑𝒐𝒏 𝒑𝒆𝒓𝒊𝒐𝒅
Example (1)
On August 5, 2016, you purchase a $10,000 T-note that matures on
May 15, 2022 (settlement occur 2 days after purchase). The coupon
rate on the T-note is 5.875% and the current price of the bond is
101.3437% of the face value. The last coupon payment occurred 83
days before settlement, and the next coupon payment will be paid 101
days from settlement. Calculate the accrued interest and the full
price?
Accrued interest =
5.875%
2
×
83
184
= 1.3251%
Full price = clean price + accrued interest
Full price = 101.3437% + 1.3251% = 102.6688% or $10,266.88
8
Treasury Notes and Bonds
(Cont.)
Treasury Inflation Protection Securities (TIPS)
In January 1997, the U.S. Treasury began
issuing inflation-indexed bonds called
Treasury Inflation Protection Securities (TIPS),
which provide returns tied to the inflation rate.
The principal value on a TIPS bond can
increase (or decrease) by the amount of U.S.
inflation as measured by the percentage
change in the Consumer Price Index (CPI)
every six months. The principal is called the
inflation-adjusted principal.
TIPS bonds are used by investors who wish to
earn a rate of return on their investments that
keeps up with the inflation rate over time.
9
Treasury Notes and Bonds
(Cont.)
Example (2)
Consider an investor who, on January 1, 2016, purchases a TIPS bond
with an original principal of $100,000, a 4% annual (or 2% semiannual)
coupon rate, and 10 years to maturity. If the semiannual inflation rate
during the first six months is 0.5%, determine the first coupon
payment paid on June 30, 2016?
Inflation adjusted principle = $100,000 * 1.005 = $100,500
The first coupon payment = $100,500 * 2% = $2,010
If the semiannual inflation rate during the second six months is 1%,
determine the second coupon payment paid on December 31, 2016?
Inflation adjusted principle = 100,500 * 1.01 = $101,505
The second coupon payment = $101,505 * 2% = $2,030.10
10
Treasury Notes and Bonds
(Cont.)
The New Issue (Primary Market)Trading Process for T-Notes and TBonds:
the U.S. Treasury sells Tnotes and T-bonds
through Treasury
auctions.
Awards are announced
the following day.
The Treasury issues a press release
about a week before each auction
announcing the details of the auction,
including the auction date, the amount
to be sold, and other details about the
securities to be issued.
Bids may be submitted by government
securities dealers, businesses, and
individuals through a Federal Reserve
Bank.
The Secondary Market Trading Process for T-Notes and T-Bonds:
The secondary market trading of Treasury notes and bonds occurs directly
through broker and dealer trades.
11
Municipal Bonds
•
Municipal bonds are securities issued by state (e.g. counties &
cities) and local governments.
•
Proceeds are used to fund temporary imbalances between
operating expenditures and receipts or to finance long term
projects such as school construction, or transportation systems.
Tax
Receipts
Sources of
Repayments
Revenues
generated
from a
project
12
Municipal Bonds (Cont.)
•
Municipal bonds have some advantages over other types and
some disadvantages such as:
Advantages
Disadvantages
Interest
payments on
municipal
bonds are
exempt
(excused)
from federal
income taxes
and most
state and
local income
taxes
Municipal
bonds are
not default
risk free as
local
governments
are limited to
their local
tax revenue
base as
sources of
repayment.
13
Municipal Bonds (Cont.)
•
Two types of municipal bonds exist:
General
Obligation
(GO) bonds
These bonds are backed
by the full faith and
credit of the issuer– that
is, the state or local
government promises to
use all of its financial
resources (e.g. taxation
powers) to repay the
bond.
Revenue
Bonds
These bonds are sold
to finance a specific
revenue-generating
project and are backed
by cash flows from the
project and assets may
be pledged as
collateral. *
14
Municipal Bonds (Cont.)
The New Issue (Primary Market)Trading Process for Municipal
Bonds:
Primary
Market
Private
Placement*
IPO
Firm
Commitment
Underwriting**
Best Effort
Offering***
15
Municipal Bonds (Cont.)
The Secondary Market Trading Process for Municipal Bonds:
the secondary
market for
municipal bonds
is thin (i.e. trades
are relatively
infrequent).
This is a result of
lack of
information on
bond issuers as
information is
generally more
costly to obtain
and evaluate.
Privately placed
bonds have
traditionally been
among the most
illiquid securities
as issuers tend to
be less well
known. *
16
Corporate Bonds
•
Corporate bonds are all long term bonds issued by
corporations.
•
The bond indenture is the legal contract that specifies the
rights and obligations of the bond issuer and the bond holders.
•
The bond indenture contains a number of covenants
(restrictions) which include the following:
1
2
Limiting the ability of
Rights for the bond
the issuer to increase
issuer as the ability to
dividends paid to equity
call the bond issue
holders
the bond indenture helps lower the
risk (and therefore the interest cost) of
the bond issue.
17
Corporate Bonds (Cont.)
Term versus
Serial Bonds
Sinking
Fund
Provision
Mortgage
Bonds
Corporate Bonds
Characteristics
Debentures
and
subordinated
debentures
Callable
Bonds
Stock
Warrants
Convertible
Bonds
18
Term Bonds:
The entire issue
matures on a
single date.
Term versus Serial
Bonds
Corporate Bonds (Cont.)
Serial Bonds:
The issue
contains many
maturity dates,
with a portion
of the issue
being paid off
on each date.
19
Corporate Bonds (Cont.)
Mortgage
Bonds*
Corporations issue mortgage bonds to
finance specific projects that are pledged
as collateral for the bond issue.
Debentures**
Bonds that are backed only by the general
credit worthiness of the issuing firm
unsecured by collateral are called
debentures.
Subordinated
Debentures***
Subordinated
debentures
are
also
unsecured and they are junior in their
rights to mortgage bonds and regular
debentures. They have low credit rating
20
Corporate Bonds (Cont.)
Convertible Bonds: convertible bonds are
bonds that may be exchanged for another
security of the issuing firm (e.g. common
stock) at the discretion of the bond holder.
Thus, convertible bonds are hybrid
securities involving elements of both debt
and equity.
Conversion is an attractive option or feature
to bond holders if the market value of the
securities the bond holder receives with
conversion exceeds the market value of the
bond
21
Corporate Bonds (Cont.)
Conversion Value = current market price of common
stock received on conversion X conversion rate
Example (3)
In July 2013, Microsoft Corporation had a convertible bond
issue outstanding. Each bond, with a face value of $1000,
could be converted into common shares at a rate of 29.9434
shares of stock per $1000 face value bond (the conversion
rate). Microsoft’s common stock was trading at $31.78 per
share. Microsoft’s convertible bonds were trading at 95.125
percent of the face value of the bond, or $951.25.
Determine whether or not it is profitable to convert the bonds
into common stock in Microsoft Corporation?
Conversion value = $31.78 * 29.9434 = $951.601
22
Corporate Bonds (Cont.)
Bonds issued with stock warrants attached
give the bond holder an opportunity to
detach the warrants to purchase common
stock at a prespecified price up to a
prespecified date.
Bondholders will exercise their warrants if
the market value of the stock is greater than
the price at which the stock can be
purchased through the warrants.
Risky firms commonly attach stock
warrants to their bonds to increase the
bonds’ marketability
23
Corporate Bonds (Cont.)
Callable bonds: many corporate bond issues
include a call provision, which allows the
issuer to require the bond holder to sell the
bond back to the issuer at a given (call) price
usually set above par value of the bond.
The difference between the call price and
the face value on the bond is called the call
premium.
Bonds are usually called in when interest
rates drop (and bond prices rise) so that the
issuer can gain by calling in the old bonds
(with higher coupon rates) and issuing new
bonds (with lower coupon rates).
24
Corporate Bonds (Cont.)
Sinking Fund Provision: Many bonds have a
sinking fund provision, which is a
requirement that the issuer retire a certain
amount of the bond issue early over a number
of years, especially as it approaches maturity.
The bond issuer provides the funds to the
trustee by making frequent payments to a
sinking fund.
This sinking fund accumulates in value and
is eventually used to retire the entire bond
issue at maturity.
25
Corporate Bonds (Cont.)
The New Issue (Primary Market)Trading Process for Corporate
Bonds:
Primary sales of corporate bond issues occur in a manner identical
to municipal bonds.
The Secondary Market Trading Process for Corporate Bonds:
The
Exchange
Market
(NYSE)*
The overthecounter
Market**
26
International Aspects of Bond
Markets
•
International bond markets are those markets which offer
bonds to investors in different countries and issue bonds
outside the control of a single country.*
Foreign
Bonds
Sovereign
Bonds
Eurobonds
International
Bonds
27
International Aspects of Bond
Markets (Cont.)
Eurobonds*
Eurobonds are long term bonds issued and
sold outside the country of the currency in
which they are denominated (e.g. dollar –
denominated bonds issued in Asia).
Foreign
Bonds
Foreign bonds are long term bonds issued
outside of the issuer’s home country and
are usually denominated in the currency of
the country in which they are issued (e.g.
Japanese firm issuing dollar-denominated
bond in US).
Sovereign
Bonds**
Sovereign bonds are government-issued,
foreign currency-denominated debt.
http://online.wsj.com/mdc/public/page/2_30
22-govtbonds.html?mod=mdc_bnd_gvtbnd
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Learning Outcomes
• Definition of Bonds
• Definition of Bond Market
• Bond Market Securities
– Overview
– Characteristics
– Trading Process
• International Aspects of Bond Markets
29