Treasury, Agency, Corporate and
Municipal Bonds
1. Treasury Bonds
2. Agency Bonds
3. Corporate Bonds
4. Municipal Bonds
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Facts
The second largest sector of bond market is the
treasury securities market
The smallest sector is agency bond market
Most municipal bonds are tax-exempt
Junk bonds have lower return than stocks
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Different Treasury Securities
Fixed-principal treasury securities (page 128)
Treasury inflation protection securities (TIPS)
• Treasury securities that adjust for inflation
• First time issue is Jan. 29, 1997
• Coupon rate is fixed
• See “inflation-indexed treasury securities” under
“Treasury Bonds, Notes and Bills” in WSJ
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Example
Coupon rate for a TIPS is 3.5%, annual inflation is
3%. Suppose an investor purchases a bond on
1/1/2005, par value $100,000.
(1) What are the par and coupon payment on
6/30/2005?
(2) Suppose semi-annual inflation rate for the
second 6 month period is 1%, what are the par
and coupon payment on 12/31/2005?
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Features of TIPS
• Still a fixed rate product
• The adjustment in coupon payments subject
to federal tax
• Possibility of disinflation
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Auction Process
Treasury securities on a regular cycle:
T-bills: 4 weeks, 13 weeks, 26 weeks
T-notes: 2-, 5-, and 10-year
It offers additional shares of outstanding securities,
referred to as a “reopening” of an issue, mainly for
5- and 10-year issues
Debt buyback plan: redeem un-matured securities
through reverse auctions
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Auction Process
Alternative Bids
(1) Noncompetitive bid: like a market order. Has limit.
(2) Competitive bid: specify both the quantity and the yield at
which the bidder is willing to purchase the auctioned
security.
Process (pages 129):
(1) Deducting the total noncompetitive tenders and nonpublic
(2) Stop-out yield
(3) bid-to-cover ratio
(4) What about yield is 3.039%?
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Types of Auctions
Dutch auction: the auctioneer sets an
extraordinarily high price and lowers it until
someone bids on the item.
Traditional auction: the price rises until one
bidder is left.
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Secondary market
Traded in the OTC market
On-the-run issues
Off-the-run issues
When-issued market
Dealer versus Interdealer
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Quotes for T-bills and T-bonds
(1) Quotes for Treasury Bills (see WSJ)
(2) On a bank discount basis, not on a price basis
D 360
Yd 

F
t
Example: what is the quote on a bank discount basis for a
Treasury bill with 100 days to maturity, a face value
of $100,000, selling for $99,100?
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Quotes on Treasury Coupon Securities
(1) Price per $100 par; 32nd (See WSJ)
(2) Accrued interest (AI)
annual _ dollar _ coupon
Days _ in _ AI _ period
AI 

2
Days _ in _ coupon _ period
To estimate the two “days” in the above formula, we need:
a. Trade day
b. Settlement day
c. Actual day count convention
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Stripped Treasury Securities
Trademark securities
Treasury receipts
Strips
Tax treatment: accrued interest is taxed each
year, though interest is not paid.
Reconstituting a bond
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Agency Securities
Federally Agency Institutions
see page 139
Government-sponsored enterprises (GSEs)
privately owned, publicly chartered entities. They were
created by Congress to reduce the cost of capital for certain
borrowing sectors of the economy deemed to be important
enough to warrant assistance, including farmers,
homeowners, and students
See “Government Agency and Similar Issues” in
WSJ.
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GSEs
Fannie Mae (see page 139)
Freddi Mac
Federal Home Loan Bank System
Federal agriculture Mortgage Corporation
Federal Farm Credit Bank System
Student Loan Marketing Association
Financing Corporation
Resolution Trust
Corporation
Farm Credit Financial Assistance Corporation
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Features of Corporate Bonds
Bond indenture
Security for bonds
Debenture bonds
Provisions
Covenants
For quotes: see “corporate bonds” in WSJ.
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Provisions for Paying Off Bonds Prior
to Maturity
Traditional call and refund provision
Make whole call provision
•
The payment when the issuer calls a bond is determined
by the present value of the remaining payments
discounted at a small spread over a maturity-matched
Treasury yield
Sinking fund provision
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Covenants
Affirmative covenants
Restrictive covenants
Maintenance test
Debt incurrence test
Cash flow test
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Factors Affecting Corporate Bond Ratings
Quality of management
Capacity to pay
Collateral
Covenant
Quality rating schedule: see page 154.
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TRACE
Page 152
The reporting system, the Trade Reporting
and Compliance Engine (TRACE), requires
that all broker/dealers who are member
firms of the Financial Integrity Regulatory
Authority (FINRA) report transactions to
corporate bonds to TRACE.
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High-yield Corporate Bond Sector
AKA junk bonds, non-investment-grade bonds. They
are issues with quality ratings below triple B
(1) Original-issue high-yield bonds
(2) Fallen angels
Default rates: see Exhibit 7-4 on page 155.
For quotes, see “High-Yield Bonds” in WSJ
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High-Yield Bonds
Do junk bonds provide extremely high
returns?
Exhibit 7-6, page 169.
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Medium-Term Notes (MTN)
A corporate debt instrument, with the unique characteristic
that notes are offered continuously to investors by an agent
of the issuer.
Maturity ranges
• 9m – 1y
• 1y – 18m
• 18m – 2y
• So on up to 30 years
• Register with SEC under Rule 415
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Commercial Papers
Short term unsecured promissory note that is
issued in the open market and that
represents the obligation of the issuing
corporation.
Ranges in maturity from 1 day to 270 days
Bridge financing
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Bankruptcy and Credit Rights
Liquidation – chapter 7 of the bankruptcy act
Reorganization -- chapter 11 of the
bankruptcy act
Absolute priority
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Municipal Securities
Issued by Municipality, including state or local government
The exemption of interest income from federal taxation
Short-term notes: to cover seasonal and temporary
imbalance between outlays for expenditure and inflow
from taxes.
Long-term bonds: to finance long-term capital projects such
as schools, bridges, and airports; long term budget deficit
from current operation.
For Quotes: see “Tax-exempt Bonds” under “Bond Market
Data Bank” in WSJ
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Types of Municipal Bonds
Tax-backed debt (page 182)
• General obligation debt
• Appropriation-back obligation
• Debt obligations supported by public credit
enhancement program
Revenue Bonds (page 183-187)
• Airport revenue bonds
• College and university revenue bonds
• Water revenue bonds
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Redemption Features of
Municipal Bonds (page 191)
• Serial maturity structure: a portion of debt
obligation to be retired each year
• Term maturity structure: provides for the debt
obligation to be repaid on a final date, typically
through a sinking fund provision that begin 5 to 10
years before the final term maturity.
• Catastrophe call provision: requires the issuer to
call the entire issue if the facility is destroyed.
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Floater/Inverse Floater
• A municipal dealer can buy a fixed-rate municipal
bond and place it in a trust, then the trust issues a
floater and an inverse floater
• The investors in the inverse floater can purchase
the corresponding floater at auction and combine
two positions to effectively own the underlying
fixed-rate bonds.
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Risk Exposures of municipal bonds
Credit risk
Interest rate
Reinvestment risk
Tax risk
• Decrease in tax
• A tax-exempt issue may eventually be
declared to be taxable by the IRS
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Yield of Municipal Bonds
tax  exempt _ yield
equivalent _ taxable _ yield 
1  m arg inal _ tax _ rate
yield _ ratio 
yield _ on _ municipal _ bond
yield _ on _ same _ maturity _ Treasury _ bond
See “Bond yield” under “Bond Market Data Bank” in WSJ.
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Taxable Municipal Bonds
Purposes: (1) local sports facilities, (2) investor-led housing
projects, (3) advanced refunding of issues that are not
permitted to be refunded, and (4) underfunded pension
With taxable municipal bonds, a municipality needs to pay a
higher yield than if it issued a tax-exempt municipal bond.
Why does it want to do this?
• Tax Reform Act 1986 imposes restrictions on what type of
projects and the upper limit could be financed with taxexempt municipal bonds.
• U.S. tax code restrict arbitrage opportunities that a
municipality can realize
• Different investor base
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Non-US Bonds
Internal Market versus External Market
• Internal market includes domestic and foreign bonds
– Yankee bonds, bulldog bonds
• External market: offshore bond market or Eurobonds
(page 208)
By trading bloc
• Dollar bloc
• European bloc
• Japan
• Emerging markets
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Non-US Government Bond Markets
The two largest non-U.S. government bond markets
are those in Japan and Germany: Japan (JGB),
Germany (Bunds)
Inflation-indexed bonds – page 215
Sovereign Bond – page 216
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Sovereign Bond Ratings
Sovereign debt is the obligation of a country’s central
government.
U.S. government debt is not rated by any nationally
recognized statistical rating organization, the debt of other
national governments is rated.
S&P, Moody’s and Fitch all assign ratings to sovereign
bonds.
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Distribution of New Government
Issues (page 215)
Regular calendar auction/Dutch style
Regular calendar auction/minimum price
Ad hoc auction system
Tap system
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Major other bonds
Pfandbriefe market bonds: issued by mortgage
banks in Germany; the largest asset in the
European bond market and the sixth largest
in the world. Page 220
Emerging Market Bonds: also known Brady
bonds, issued in Latin America, Asia and
Eastern Europe. Page 221
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