Chapter Six
Bond Markets
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Chapter Outline
1.
2.
3.
4.
5.
6.
Overview
Treasury Notes & Bonds
Munis
Corporate Bonds
Bond Rating
International Bond Markets
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1. Overview of the Bond Markets
• A bond is a promise to make periodic coupon
payments and to repay principal at maturity;
breech of this promise is an event of default
• Bonds carry original maturities greater than
one year so bonds are instruments of the
capital markets
• Issuers are corporations and government units
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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, mutual funds) are the
major suppliers of funds for all three types of
bonds
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Bond Market Instruments Outstanding,
1994-2004 ($Bn)
10000
8000
6000
4000
2000
0
1994
Treas. bonds
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1997
2000
Muni. securities
6-5
2004
Corp. bonds
Total
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2. Treasury Notes and Bonds
• T-notes and T-bonds issued by the U.S. Treasury to
finance the national debt and other federal government
expenditures
• Backed by the full faith and credit of the U.S.
government and are default risk free
• Pay relatively low rates of interest (yields to maturity)
• Given their longer maturity, not entirely risk free due to
interest rate fluctuations
• Pay coupon interest (semiannually): notes have
maturities from 1-10 years; bonds 10-30 years
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Composition of the U.S. National Debt ($Bn)
3500
3000
2500
2000
1500
1000
500
0
1994
T-bills
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1997
T-notes and bonds
6-7
2000
Govt. acc. sec.
2004
Other
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Primary Market in Treasury Notes & Bonds
Similar to the primary market T-bill sales, the Treasury
sells T-notes and bonds through competitive and
noncompetitive auctions
Auction Pattern for Treasury Notes and bonds
Security
2-year note
5-year note
10-year note
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Purchase Minimum
$1,000
$1,000
$1,000
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General Auction Schedule
Monthly
Feb, May-Aug, Nov
Feb, May-Aug, Nov
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Secondary Market in Treasury Notes & Bonds
• Most secondary market trading occurs
directly through brokers and dealers
• Wall Street Journal shows full list of
Treasury securities that trade daily
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(TIPS) Treasury Inflation Protected Securities
• Coupon rate set at time of auction and fixed
for life
• Par value adjusted for inflation based on the
Consumer Price Index
• Semi-annual coupon payments are based on
the inflation adjusted par value
• At maturity investor receives the inflation
adjusted par value
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Treasury STRIPS
Separate Trading of Registered Interest and Principal Securities
• A treasury security in which the individual interest
payments are separated from the principal payment
• Effectively creates sets of securities--one for each
semiannual interest payment one one for the final
principal payment
• Often referred to as “Treasury zero-coupon bonds”
• Created by U.S. Treasury in response to separate trading
of treasury security principal and interest developed by
securities firms; only available through FIs and
government securities brokers
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3. Municipal Bonds (Munis)
• Securities issued by state and local governments to
fund either temporary imbalances between operating
expenditures and receipts or to finance long-term
capital outlays for activities such as school
construction, public utility construction or
transportation systems
• Tax receipts or revenues generated are the source of
repayment
• Attractive to household investors because interest (but
not capital gains) are tax exempt
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Types of Municipal Bonds
• General Obligation Bonds
– bonds backed by the full faith and credit of the
issuer
• Revenue Bonds
– bonds sold to finance a specific revenue
generating project and are backed by cash flows
from that project
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Tax Exemption and Muni Yields
ia = ib(1 - t)
Where:
ia = After-tax (equivalent tax exempt) rate of return on a taxable
bond
ib = Before-tax rate of return on a taxable bond
t = Income tax rate of the marginal bond holder
Example: You can invest in taxable corporate bonds that are paying
10% annually. Your marginal tax rate is 28%. The aftertax rate of return on the taxable bond is:
10%(1-.28) = 7.2%
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Primary Market Placement Choices for
Munis
• General Public Offering
– underwriter is selected either by negotiation or
by competitive bidding
– the underwriter offers the bonds to the general
public
• Rule 144A Placement
– bonds are sold on a semi-private basis to
qualified investors (generally FIs)
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Top Municipal Bond Underwriters
Underwriter
Principal Amount
(in millions $$)
UBS Financial Services
Citigroup
Lehman Brothers
Merrill Lynch
Goldman Sachs
J.P. Morgan Securities
Bear, Stearns
Morgan Stanley
RBC Dain Rauscher
Banc of America Securities
Industry totals
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$35,811.6
30,092.8
22,021.1
18,708.8
18,081.6
17,685.0
15,464.1
14,695.8
11,157.6
10,403.2
Market
Share
13.5%
11.3%
8.3%
7.1%
6.8%
6.7%
5.8%
5.5%
4.2%
3.9%
No. of
Issues
631
476
170
208
132
324
133
179
533
327
$265.5 billion
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Contracting Choices with the Underwriter
• Firm commitment underwriting
– the issue of securities in which the investment bank
guarantees the corp. a price for newly issued securities by
buying the whole issue at a fixed price from the corporate
issuer then seeks to resell to suppliers of funds (investors) at a
higher price
• Best efforts underwriting
– the issue of securities in which the underwriter does not
guarantee a price to the issuer and acts more as a placing or
distribution agent, bank acts as agent on a fee basis related to
its success in placing the issue
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Secondary Market for Munis
• Secondary market is thin (i.e. trades
are relatively infrequent) due to a lack
of information on bond issuers, who
are generally much smaller than
corporate bond issuers
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4. Corporate Bonds
• All long-term bonds issued by corporations
• Minimum denominations publicly traded
corporate bonds is $1,000
• Generally pay interest semiannually
• Bond indenture
– legal contract that specifies the rights and
obligations of the bond issuer and the bond holder
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Types of Corporate Bonds
• Bearer bonds
– coupons attached that are presented by the holder to
the issuer for interest payments when due
• Registered bonds
– the owner of the bond is recorded by the issuer and
coupon payments are mailed to the registered owner
• Term bonds
– entire issue matures on a single date
• Serial bonds
– mature on a series of dates
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Types of Corporate Bonds
• Mortgage bonds
– issued to finance specific projects which are pledged as
collateral
• Equipment Trust Certificates
– bonds collateralized with tangible non-real estate property
• Debentures
– backed solely by the general credit of the issuing firm and
unsecured by specific assets or collateral
• Subordinated debentures
– unsecured debentures that are junior in their rights to mortgage
bonds and regular debentures
(continued)
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Types of Corporate Bonds
• Convertible bonds
– may be exchanged for another security of the issuing firm at the
discretion of the bond holder
• Stock Warrant
– give the bond holder an opportunity to purchase common stock
at a specified price up to a specified date
• Callable bonds
– allow the issuer to force the bond holder to sell the bond back to
the issuer at a price above the par value (call price)
• Sinking Fund bonds
– bonds that include a requirement that the issuer retire a certain
amount of the bond issue each year
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Primary and Secondary Markets for Corp
Bonds
• Primary sales of corp bonds occur through
either a public sale (issue) or a private
placement similar to municipal bonds
• Two secondary markets
– the exchange market (e.g., the NYSE)
– the over-the-counter (OTC) market
• OTC electronic market dominates trading in
corp bonds
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5. Bond Ratings
• Bonds are rated by the issuer’s default risk
• Large bond investors, traders and managers
evaluate default risk by analyzing the issuer’s
financial ratios and security prices
• Two major bond rating agencies are Moody’s and
Standard & Poor’s (S&P)
• Bonds assigned a letter grade based on perceived
probability of issuer default
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Bond Credit Ratings
Explanation
Moody’s
Investment grade categories:
Best quality; smallest degree of risk
Aaa
High quality; slightly more long-term
Aa1
risk than top rating
Aa2
Aa3
Upper medium grade; possible
A1
impairment in the future
A2
A3
Medium grade; lack outstanding
Baa1
investment characteristics
Baa2
Baa3
S&P
AAA
AA+
AA
AA
AAA+
ABBB+
BBB
BBB(continued)
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Bond Credit Ratings
Explanation
Moody’s
Speculative investment grades:
Speculative issues; protection may
Ba1
be very moderate
Ba2
Ba3
Very speculative; may have small
B1
assurance of interest and principle
B2
payment
B3
Issues in poor standing; may be in default
Caa
Speculative in a high degree
Ca
Lowest quality; poor prospects of attaining
C
real investment standing
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S&P
BB+
BB
BBB+
B
BCCC
CC
C
D
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6. International Aspects of Bond Markets
• International bond market
– trades bonds that are underwritten by an
international syndicate
– offer bonds simultaneously to investors in
several countries
– issue bonds outside the jurisdiction of any
single country
– offer bonds in unregistered form
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Eurobonds, Foreign Bonds, Brady Bonds
and Sovereign Bonds
• Eurobonds
– long-term bonds issued and sold outside the country of the
currency in which they are denominated (e.g., dollardenominated bonds issued in Europe or Asia)
• Foreign Bonds
– long-term bonds issued by firms and governments outside of
the issuer’s country, usually denominated in the currency of
the country in which they are issued
• Brady Bonds and Sovereign Bonds
– a bond that is swapped for an outstanding loan to a lesser
developed country, sovereign bonds carry the creditworthiness
of the lesser developed country
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