Bond Markets

Chapter SixBond Markets1McGraw-Hill/IrwinBond and Bond MarketsCapital markets involve equity and debt instruments with maturities of more than one yearBonds are long-term debt obligations issued by corporations and government unitsBond markets are markets in which bonds are issued and tradedTreasury notes (T-notes) and bonds (T-bonds)Municipal bonds (Munis)Corporate bonds2McGraw-Hill/IrwinBond Market Instruments Outstanding, 1994-20073McGraw-Hill/IrwinTreasury Notes and Bonds Treasury notes and bonds (T-notes and T-bonds) are issued by the U.S. Treasury to finance the national debt and other government expendituresThe annual federal deficit is equal to annual expenditures (G) less taxes (T) receivedThe national debt (ND) is the sum of historical annual federal deficits: 4McGraw-Hill/IrwinTreasury Notes and Bonds Default risk free: backed by the full faith and credit of the U.S. governmentLow returns: low interest rates (yields to maturity) reflect low default riskInterest rate risk: because of their long maturity, T-notes and T-bonds experience wider price fluctuations than money market securities when interest rates changeLiquidity risk: older issued T-bonds and T-notes trade less frequently than newly issued T-bonds and T-notes5McGraw-Hill/IrwinTreasury Notes and Bonds T-notes have original maturities from over 1 to 10 yearsT-bonds have original maturities from over 10 yearsIssued in minimum denominations (multiples) of $1,000May be either fixed principal or inflation-indexedinflation-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 monthsTrade in very active secondary marketsPrices are quoted as percentages of face value, in 32nds6McGraw-Hill/IrwinTreasury STRIPS Separate Trading of Registered Interest and Principal Securities (STRIPS), a.k.a. Treasury zero bonds or Treasury zero-coupon bondsFinancial institutions and government securities brokers and dealers create STRIPS from T-notes and T-bondsSTRIPS have the periodic interest payments separated from each other and from the principal paymentone set of securities reflects interest paymentsone set of securities reflects principal paymentsSTRIPS are used to immunize against interest rate risk7McGraw-Hill/IrwinTreasury Notes and Bonds“Clean” prices are calculated as:Vb = the present value of the bondM = the par value of the bondINT = annual interest payment (in dollars)N = the number of years until the bond maturesm = the number of times per year interest is paidid = interest rate used to discount cash flows on the bond8McGraw-Hill/IrwinTreasury Notes and BondsAccrued interest on T-notes and T-bonds is calculated as:The full (or dirty) price of a T-note or T-bond is the sum of the clean price (Vb) and the accrued interest9McGraw-Hill/IrwinTreasury Notes and BondsThe primary market of T-notes and T-bonds is similar to that of T-bills; the U.S. Treasury sells T-notes and T-bonds through competitive and noncompetitive single-bid auctions2-year notes are auctioned monthly3, 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 dealers10McGraw-Hill/IrwinMunicipal BondsMunicipal bonds (Munis) are securities issued by state and local governmentsto fund imbalances between expenditures and receiptsto finance long-term capital outlaysAttractive to household investors because interest is exempt from federal and most local income taxesGeneral obligation (GO) bonds are backed by the full faith and credit of the issuing municipalityRevenue bonds are sold to finance specific revenue generating projects 11McGraw-Hill/IrwinMunicipal BondsCompare 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 bondib = before-tax rate of return on a taxable bondt = marginal total income tax rate of the bond holderAlternately, convert Muni interest rates to tax equivalent rates of return: ib = ia/(1 – t)12McGraw-Hill/IrwinMunicipal BondsPrimary marketsfirm 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 publicbest efforts offering: a public offering in which the investment bank does not guarantee a firm priceprivate 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 issuers13McGraw-Hill/IrwinCorporate BondsCorporate bonds are long-term bonds issued by corporationsA bond indenture is the legal contract that specifies the rights and obligations of the issuer and the holdersBearer versus registered bondsTerm versus serial bondsMortgage bonds are secured debt issues14McGraw-Hill/IrwinCorporate BondsDebentures and subordinated debenturesConvertible bonds versus non-convertible bondsicvb = rate of return on a convertible bondincvb = rate of return on a nonconvertible bondopcvb = value of the conversion optionStock warrants give bondholders the opportunity to purchase common stock at a prespecified price15McGraw-Hill/IrwinCorporate BondsCallable bonds versus non-callable bondsincb = rate of return on a noncallable bondicb = rate of return on a callable bondopcb = value of the call optionA Sinking fund provision is a requirement that the issuer retire a certain amount of the bond issue early as the bonds approach maturity16McGraw-Hill/IrwinCorporate BondsPrimary markets are identical to that of MunisSecondary marketsthe exchange market (e.g., NYSE)the over-the-counter (OTC) marketBond ratingsthe two major bond rating agencies are Moody’s and Standard & Poor’s (S&P)bonds are rated by perceived default riskbonds may be either investment or speculative (i.e., junk) grade17McGraw-Hill/IrwinBond Market IndexesManaged by major investment banksReflect both the monthly capital gain and loss on bonds plus any interest (coupon) income earnedChanges in values of bond indexes can be used by bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities18McGraw-Hill/IrwinBond Market ParticipantsThe major issuers of debt market securities are federal, state and local governments, and corporationsThe major purchasers of capital market securities are households, businesses, government units, and foreign investorsbusinesses and financial firms (e.g., banks, insurance companies, and mutual funds) are the major suppliers of funds for Munis and corporate bondsforeign investors and governments are the major suppliers of funds for T-notes and T-bonds19McGraw-Hill/IrwinInternational Bonds and MarketsInternational 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 countryEurobonds are long-term bonds issued outside the country of the currency in which they are denominatedForeign Bonds are long-term bonds issued outside of the issuer’s home countryBrady Bonds are bonds swapped for an outstanding loan to a less developed countrySovereign Bonds are Brady Bonds that have had their underlying collateral removed and the creditworthiness of the country is substituted instead20McGraw-Hill/Irwin