Chapter Outline
Background on bonds
◼ Treasury and federal agency bonds
◼ Municipal bonds
◼ Corporate bonds
◼ Institutional use of bond markets
◼ Globalization of bond markets
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Chapter 7
Bond Markets
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
Background on Bonds
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Bonds represents long-term debt securities that are
issued by government agencies or corporations
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
Registered bonds require the issuer to maintain records
of who owns the bond and automatically send coupon
payments to the owners
Background on Bonds (cont’d)
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Bond yields
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The issuer’s cost of financing is measured by the yield to
maturity
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The annualized yield that is paid by the issuer over the life of the
bond
Equates the future coupon and principal payments to the initial
proceeds received
Does not include transaction costs associated with issuing the bond
Earned by an investor who invests in a bond when it is issued and
holds it until maturity
The holding period return is used by investors who do not hold a
bond to maturity
Treasury and Federal Agency
Bonds
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The U.S. Treasury issues Treasury notes
or bonds to finance federal government
expenditures
Treasury and Federal Agency
Bonds (cont’d)
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 Normally
held in the middle of each quarter
 Financial institutions submit bids for their own
accounts or for clients
 Bids can be competitive or noncompetitive
 Note
maturities are usually less than 10 years
 Bonds maturities are 10 years or more
 An active secondary market exists
 The 30-year bond was discontinued in
October 2001
Treasury and Federal Agency
Bonds (cont’d)
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Treasury bond auction (cont’d)
 The Salomon Brothers scandal
◼ In a 1990 bond auction, Salomon Brothers purchased 65
percent of the bonds issued (exceeding the 35 percent
maximum)
◼ Salomon resold the bonds at higher prices to other
institutions
◼ In August of 1991, the Treasury Department temporarily
barred Salomon Brothers from bidding on Treasury securities
◼ In May 1992 Salomon paid fines of $190 million to the SEC
and Justice Department
◼ Salomon created a reserve fund of $100 million to cover
claims from civil lawsuits
Treasury bond auction
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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
Treasury and Federal Agency
Bonds (cont’d)
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Trading Treasury bonds
 Bond
dealers serve as intermediaries in the
secondary market and also take positions in the
bonds
 30 primary dealers dominate the trading
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Profit from the bid-ask spread
Conduct trading with the Fed during open market operations
Typical daily volume is about $200 billion
 Online trading
◼ TreasuryDirect program (http://www.treasurydirect.gov)
Treasury and Federal Agency
Bonds (cont’d)
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Treasury bond quotations
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Published in financial newspapers
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The Wall Street Journal
Barron’s
Investor’s Business Daily
Bond quotations are organized according to their maturity, with
the shortest maturity listed first
Bid and ask prices are quoted per hundreds of dollars of par
value
Online quotations at
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http://www.investinginbonds.com
http://www.federalreserve.gov/releases/H15/
Treasury and Federal Agency
Bonds (cont’d)
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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 Brazil
Treasury and Federal Agency
Bonds (cont’d)
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Stripped Treasury bonds
 One
security represents the principal payment and a
second security represents the interest payments
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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
 Several
securities firms create their own versions of
stripped securities
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Merrill Lynch’s TIGRs
The Treasury created the STRIPS program in 1985
Computing the Interest Payment
of an Inflation-Indexed Bond
A 10-year bond has a par value of $1,000 and a
coupon rate of 5 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
Treasury and Federal Agency
Bonds (cont’d)
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Savings bonds
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Ginnie Mae issues bonds and purchases mortgages that are
insured by the FHA and the VA
Freddie Mac issues bonds and purchases conventional
mortgages
Fannie Mae issues bonds and purchases residential mortgages
Municipal Bonds (cont’d)
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Issued by the Treasury
Have a 30-year maturity and no secondary market
Series EE bonds provide a market-based interest rate
Series I bonds provide a rate of interest tied to inflation
Interest on savings bonds is not subject to state and local taxes
Federal agency bonds
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Municipal Bonds
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
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Results in a higher cost for the investor
Municipal bonds can be classified as either general
obligation bonds or revenue bonds
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General obligation bonds are supported by he municipal
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
Municipal Bonds (cont’d)
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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
Municipal Bonds (cont’d)
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Tax advantages
Municipal Bonds (cont’d)
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 Interest
income is normally exempt from federal taxes
 Interest income earned on bonds that are issued by a
municipality within a particular state is exempt from
state income taxes
 Interest income earned on bonds issued by a
municipality within a city in which the local
government imposes taxes is normally exempt from
the local taxes
Municipal Bonds (cont’d)
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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
◼ The federal tax exemption of municipal bonds
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Trading and quotations
 Investors
can buy or sell munis by contacting
brokerage firms
 Electronic trading has become popular
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http://www.tradingedge.com
 Online
quotations are available at
http://www.munidirect.com and
http://www.investinginbonds.com
Municipal Bonds (cont’d)
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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
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Corporate Bonds
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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
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
Interest paid by corporations is tax-deductible, which reduces the
corporate cost of financing with bonds
Corporate Bonds (cont’d)
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Corporate bond yields and risk (cont’d)
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Investor assessment of risk
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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
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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
Corporate Bonds (cont’d)
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Corporate bond yields and risk
 Interest
income earned on corporate represents
ordinary income
 Yield curve
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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
Corporate Bonds (cont’d)
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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
Corporate Bonds (cont’d)
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Characteristics of corporate bonds
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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
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Characteristics of corporate bonds (cont’d)
 Call
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A requirement to retire a certain amount of the bond issue each
year
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Bond collateral
 Typically,
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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
Corporate Bonds (cont’d)
 Unsecured
bonds are debentures
 Subordinated debentures have claims against the
firm’s assets that are junior to the claims of mortgage
bonds and regular debentures
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
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Are a disadvantage to bondholders
Corporate Bonds (cont’d)
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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, ,
don’t pay yearly interest, reduce tax => increase CF, don’t need high
issue cost. Co that not pay tax intrested in this kind.
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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
provisions:
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Protective covenants:
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Corporate Bonds (cont’d)
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Variable-rate bonds:
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Allow investors to benefit from rising market interest rates over time
Allow issuers of bonds to benefit from declining rates over time
Convertibility
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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
Corporate Bonds (cont’d)
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Trading corporate bonds
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Bonds are traded through brokers, who communicate orders to
bond dealers
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:
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Junk bonds
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Junk bonds have a high degree of credit risk
About two-thirds of junk bonds are used to finance takeovers
Size of the junk bond market
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Currently about 3,700 junk bond offerings exist with a market value
of $80 billion
Participation in the junk bond market
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70 large issuers of junk bonds each have more than $1 billion in
debt outstanding
Primary investors in junk bonds are mutual funds, life insurance
companies, and pension funds
The junk bond secondary market consists of 20 bond traders
Corporate bond quotations
 More
than 2,000 bonds are traded on the
NYSE with a market value of more than $2
trillion
 Corporate bond prices are reported in eighths
 Corporate bond quotations normally include
the volume of trading and the yield to maturity
http://www.schwab.com
http://www.etrade.com
Corporate Bonds (cont’d)
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Corporate Bonds (cont’d)
Corporate Bonds (cont’d)
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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
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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
Corporate Bonds (cont’d)
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Junk bonds (cont’d)
 Contagion
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Corporate Bonds (cont’d)
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effects in the junk bond market
 Using
Specific adverse information may discourage
investors from investment in junk bonds
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
Ivan Boesky admitting to insider trading violations
 Drexel Burnham Lambert’s bankruptcy filing
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How corporate bonds facilitate restructuring
(cont’d)
 Using
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Institutional Use of Bond Markets
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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
Corporations with an excessive amount of debt can conduct
an equity-for-debt swap
bonds to finance a leveraged buyout
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Corporate Bonds (cont’d)
How corporate bonds facilitate
restructuring
All financial institutions participate in bond
markets
 On
any given day, commercial banks, bond mutual
funds, insurance companies, and pension funds are
dominant participants
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A financial institution’s investment decisions will
often simultaneously affect bond market and
other financial market activity
Globalization of Bond Markets
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Bond markets have become increasingly
integrated as a result of frequent cross-border
investments in bonds
Low-quality bonds issued globally by
governments and large corporations are global
junk bonds
The global development of the bond market is
primarily attributed to bond offerings by country
governments (sovereign bonds)
Globalization of Bond Markets
(cont’d)
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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