Chapter 6
Bond Markets
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Bond and Bond Markets



Capital markets involve equity and debt
instruments with maturities of more than one year
Bonds are long-term debt obligations issued by
corporations and government units
Bond markets are markets in which bonds are
issued and traded



Treasury notes (T-notes) and bonds (T-bonds)
Municipal bonds (Munis)
Corporate bonds
6-2
Bond Market Instruments
Outstanding, 1994-2010
Bond Market Instruments
6-3
Treasury Notes and Bonds



Treasury notes and bonds (T-notes and Tbonds) are issued by the U.S. Treasury to finance
the national debt and other government
expenditures
The annual federal deficit is equal to annual
expenditures (G) less taxes (T) received
The national debt (ND) is the sum of historical
annual federal deficits:
N
NDt   (Gt  Tt )
t 1
6-4
Current & Projected Federal Debt
Levels
Data Source: CBO
6-5
Treasury Notes and Bonds




Default risk free: backed by the full faith and credit of the
U.S. government
Low returns: low interest rates (yields to maturity) reflect low
default risk
Interest rate risk: because of their long maturity, T-notes and
T-bonds experience wider price fluctuations than money
market securities when interest rates change
Liquidity risk: older issued T-bonds and T-notes trade less
frequently than newly issued T-bonds and T-notes
6-6
Treasury Notes and Bonds




T-notes have original maturities from over 1 to 10 years
T-bonds have original maturities from over 10 years
Issued in minimum denominations (multiples) of $1,000
May be either fixed principal or inflation-indexed




inflation-indexed bonds are called Treasury Inflation Protection
Securities (TIPS)
the principal value of TIPS is adjusted by the percentage change
in the Consumer Price Index (CPI) every six months
Trade in very active secondary markets
Prices are quoted as percentages of face value, in 32nds
6-7
Sample Treasury Bond Quote
Maturity
2017 Nov 15



Coupon
4.250
Bid
112:26
Asked
112:27
Chg
+13
Asked Yld
2.3316
Maturity mo/yr: Month and year, the bond matures November
15, 2017.
Coupon: Coupon rate of 4.250% or $42.50 per year but paid
semiannually ($1,000 face).
Bid: The closing price per $100 of par the dealer will pay to
buy the bond; the seller would receive this price from selling
to the dealer. Prices are quoted in 32nds. In this case,
112:26 = 112 26/32% of $1,000 or $1,128.125.
6-8
Sample Treasury Bond Quote
Maturity
2017 Nov 15


Coupon
4.250
Bid
112:26
Asked
112:27
Chg
+13
Asked Yld
2.3316
Asked: The closing price per $100 of par the dealer requires
to sell the bond; the buyer would pay this price to the dealer.
In this case, 112:27 = 112 27/32% of $1,000 or $1,128.4375.
Chg: The change from the prior closing ASKED price in
32nds. In this case, the ASKED price increased thirteen
32nds from the prior quoted closing ask price.
6-9
Sample Treasury Bond Quote
Maturity
2017 Nov 15

Coupon
4.250
Bid
112:26
Asked
112:27
Chg
+13
Asked Yld
2.3316
Asked Yld = Promised compound yield rate if purchased at
the Asked price. In this case, the yield is 2.3316%.
6-10
Treasury STRIPS



Separate Trading of Registered Interest and Principal
Securities (STRIPS), a.k.a. Treasury zero bonds or Treasury
zero-coupon bonds
Financial institutions and government securities brokers and
dealers create STRIPS from T-notes and T-bonds
STRIPS have the periodic interest payments separated from
each other and from the principal payment



one set of securities reflects interest payments
one set of securities reflects principal payments
STRIPS are used to immunize against interest rate risk
6-11
Sample Treasury STRIP Quote
Maturity
2037 May 15
Bid
24.222
Asked
24.242
Chg
.451
Asked Yld
4.84
• Maturity: May 15, 2037
• Bid and Asked prices are a percentage of face value or a Bid price of
$24.222 and an Ask price of $24.242 per $100 of par or face value.
• Chg: The change from the prior day’s Ask.
• Ask Yld: Promised compound yield rate if purchased at the Asked price,
in this case the yield is 4.84%. Note that the yield is yield to call if the
price is above par and yield to maturity if below par. The yield
calculation uses semiannual compounding to maintain consistency with Tbond and T-note quotes.
McGraw-Hill/Irwin
6-12
6-12
Accrued Interest and Prices

Accrued interest must be paid by the buyer of a
bond to the seller of a bond if the bond is purchased
between interest payment dates.

The price of the bond with accrued interest is called
the full price or the dirty price, the price without
accounting for accrued interest is the clean price.
6-13
Accrued Interest and Prices

“Clean” prices are calculated as:
INT
Vb 
( PVIFAid / m, Nm )  M ( PVIFid / m, Nm )
m
Vb = the present value of the bond
M = the par value of the bond
INT = annual interest payment (in dollars)
N = the number of years until the bond matures
m = the number of times per year interest is paid
id = interest rate used to discount cash flows on the bond
6-14
Accrued Interest on Bonds

Accrued interest on T-notes and T-bonds is
calculated as:
Accrued interest 

INT Actual number of days since last coupon payment

2
Actual number of days in coupon period
The full (or dirty) price of a T-note or T-bond is the
sum of the clean price (Vb) and the accrued interest
6-15
Accrued Interest Example

You buy a 6% coupon $1,000 par T-bond 59 days after the last
coupon payment. Settlement occurs in two days. You become
the owner 61 days after the last coupon payment (59+2), and
there are 121 days remaining until the next coupon payment.
The bond’s clean price quote is 120:19. What is the full or dirty
price (sometimes called the invoice price)?
AccruedInterest 


$60
61

 $10.05
2
(121 61)
The clean price is 120:19 or 120 19/32% of $1,000 or
$1,205.9375.
Thus, the dirty price is $1,205.9375 + $10.05 = $1,215.9875.
6-16
Notes and Bonds Markets

The primary market of T-notes and T-bonds is
similar to that of T-bills; the U.S. Treasury sells Tnotes and T-bonds through competitive and
noncompetitive single-bid auctions




2-year notes are auctioned monthly
3-, 5-, and 10-year notes are auctioned quarterly (Feb,
May, Aug, and Nov)
30-year bonds are auctioned semi-annually (Feb and Aug)
Most secondary trading occurs directly through
brokers and dealers
6-17
Treasury Inflation Protection
Securities (TIPS)




TIPS program in January 1997.
TIPS pay a fixed coupon rate
The principle amount of the bond is indexed
to inflation, adjusted every six months based
on changes in CPI.
Investors are protected from unexpected
increases in inflation.
McGraw-Hill/Irwin
6-18
6-18
TIPS
Example
An investor buys a
$10,000 1 year TIP
security with a 3%
coupon at par.
Suppose that the
CPI increases by
2% in the first six
month the investor
holds the bond and
the CPI increases
by 1.5% in the
second six months.
McGraw-Hill/Irwin
Principal
Coupon
$10,000
3%
time
0
Inflation
Adj. Principal
Coupon Payment
Cash Flow
-10000
Nominal Rate of return
Real Rate of Return
Modified IRR
Terminal Value
FV of Coupon @
1 year
1
2
2%
1.50%
10,200
10,353
153 155.295
153 10,508.3
0.0153 0.015225
0.015
0.015
1.50%
Nom. Rate of return
Total inflation over the year
Real Rate of Return
6-19
Term
10,508.3
155.295
Total 10,663.59
6.6359%
3.5300%
3.00%
6-19
Municipal Bonds

Municipal bonds (Munis) are securities issued by state and
local governments





to fund imbalances between expenditures and receipts
to finance long-term capital outlays
Attractive to household investors because interest is exempt
from federal and most local income taxes
General obligation (GO) bonds are backed by the full faith
and credit of the issuing municipality
Revenue bonds are sold to finance specific revenue
generating projects
6-20
Municipal Bonds

Compare Muni returns with fully taxable
corporate bonds by finding the after tax return
for corporate bonds:
ia = ib(1 – t)
ia = after-tax rate of return on a taxable corporate
bond
ib = before-tax rate of return on a taxable bond
t = marginal total income tax rate of the bond holder

Alternately, convert Muni interest rates to tax
equivalent rates of return: ib = ia/(1 – t)
6-21
Municipal Bond Rates & Taxes

For a 28% tax bracket, what is the equivalent after
tax rate of a 6% corporate yield?


ia = 6%(1- 0.28) = 4.32%
For a 28% tax bracket, what corporate taxable yield
is equivalent to a 4.5% muni bond rate?

ib = 4.5% / (1-0.28) = 6.25%
6-22
Municipal Bonds

Primary markets




firm commitment underwriting: a public offering of Munis made
through an investment bank, where the investment bank
guarantees a price for the newly issued bonds by buying the
entire issue and then reselling it to the public
best efforts offering: a public offering in which the investment
bank does not guarantee a firm price
private placement: bonds are sold on a semi-private basis to
qualified investors (generally FIs)
Secondary markets: Munis trade infrequently due mainly to a
lack of information on bond issuers
6-23
Corporate Bonds





Corporate bonds are long-term bonds issued by
corporations
A bond indenture is the legal contract that specifies
the rights and obligations of the issuer and the
holders
Bearer versus registered bonds
Term versus serial bonds
Mortgage bonds are secured debt issues
6-24
Corporate Bonds


Debentures and subordinated debentures
Convertible bonds versus non-convertible bonds
icvb  incvb  opcvb
icvb = rate of return on a convertible bond
incvb = rate of return on a nonconvertible bond
opcvb = value of the conversion option

Stock warrants give bondholders the opportunity to
purchase common stock at a prespecified price
6-25
Corporate Bonds

Callable bonds versus non-callable bonds
incb  icb  opcvb
incb = rate of return on a noncallable bond
icb = rate of return on a callable bond
opcb = value of the call option

A sinking fund provision is a requirement that the
issuer retire a certain amount of the bond issue early
as the bonds approach maturity
6-26
Corporate Bonds


Primary markets are identical to that of Munis
Secondary markets



the exchange market (e.g., bond division of the NYSE)
the over-the-counter (OTC) market
Bond ratings



the three major bond rating agencies are Moody’s,
Standard & Poor’s (S&P), and Fitch
bonds are rated by perceived default risk
bonds may be either investment or speculative (i.e.,
junk) grade
6-27
Bond Credit Ratings
Bond Credit Ratings (Source: Text Table 6-10)
Explanation
Moody’s
Best quality; smallest degree of risk
Aaa
Aa1
High quality; slightly more long-term risk than top rating
Aa2
Aa3
A1
Upper medium grade; possible impairment in the future
A2
A3
Baa1
Medium grade; lacks outstanding investment characteristics
Baa2
Baa3
Ba1
Speculative issues; protection may be very moderate
Ba2
Ba3
B1
Very speculative; may have small assurance of interest and
B2
principal payments
B3
Issues in poor standing; may be in default
Caa
Speculative in a high degree; with marked shortcomings
Ca
Lowest quality; poor prospects of attaining real investment
C
standing
S&P
AAA
AA+
AA
AAA+
A
ABBB+
BBB
BBBBB+
BB
BBB+
B
BCCC
CC
C
D
6-28
Bond Yield Spreads
6-29
Corporate Bond Quotes




Issuer
Name
Symbol
Coupon
Maturity
Moody’s/S&P/
Fitch
High
Low
Last
Change
Yield
%
Citigroup
C.HVK
6.000%
Dec 2013
A3/--/A+
108.480
106.922
107.606
0.466
3.598
Issuer name, ticker symbol and coupon
Maturity month and year
Bond rating by the three major ratings agencies
High, Low, and Last prices in decimal form as a percent of par



Daily high price was $1,084.80
Change is the change from the prior day’s last price
Yield % is the promised yield to maturity using the last price
6-30
Bond Market Indexes



Managed by major investment banks
Reflect both the monthly capital gain and loss on
bonds plus any interest (coupon) income earned
Changes in values of bond indexes can be used by
bond traders to evaluate changes in the investment
attractiveness of bonds of different types and
maturities
6-31
Bond Market Participants


The major issuers of debt market securities are federal, state
and local governments, and corporations
The major purchasers of capital market securities are
households, businesses, government units, and foreign
investors


Businesses and financial firms (e.g., banks, insurance
companies, and mutual funds) are the major suppliers of funds
for Munis and corporate bonds
Foreign investors and governments are the major suppliers of
funds for T-notes and T-bonds
6-32
International Bonds and Markets

International bond markets involve unregistered bonds that are
internationally syndicated, offered simultaneously to investors in
several countries, and issued outside of the jurisdiction of any single
country

Eurobonds are long-term bonds issued outside the country of the
currency in which they are denominated

Foreign Bonds are long-term bonds issued outside of the issuer’s
home country

Sovereign Bonds are government issued debt
6-33