Chapter 7

Bond Markets

Financial Markets and Institutions, 7e, Jeff Madura

Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline
Background on bonds
Treasury and federal agency bonds
Municipal bonds
Corporate bonds
Institutional use of bond markets
Globalization of bond markets

Background on Bonds

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 (contd)

Bond yields

The issuers cost of financing is measured by the yield to

maturity

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

The U.S. Treasury issues Treasury notes

or bonds to finance federal government
expenditures
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
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Treasury and Federal Agency

Bonds (contd)

Treasury bond auction

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

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 (contd)

Treasury bond auction (contd)

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 and Federal Agency

Bonds (contd)

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

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 (contd)

Treasury bond quotations

Published in financial newspapers

The Wall Street Journal

Barrons
Investors 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

http://www.investinginbonds.com
http://www.federalreserve.gov/releases/H15/

Treasury and Federal Agency

Bonds (contd)

Stripped Treasury bonds

One

security represents the principal payment and a

second security represents the interest payments

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

Merrill Lynchs TIGRs

The Treasury created the STRIPS program in 1985
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Treasury and Federal Agency

Bonds (contd)

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

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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
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Treasury and Federal Agency

Bonds (contd)

Savings bonds

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

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

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Municipal Bonds

Municipal bonds can be classified as either general

obligation bonds or revenue bonds

General obligation bonds are supported by he municipal

governments 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

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Municipal Bonds (contd)

Credit risk
Less

than .5 percent of all municipal bonds

issued since 1940 have defaulted
Moodys, Standard and Poors, and Fitch
Investor Service assign ratings to municipal
bonds
Some municipal bonds are insured against
default

Results in a higher cost for the investor

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Municipal Bonds (contd)

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

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Municipal Bonds (contd)

Tax advantages
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

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Municipal Bonds (contd)

Trading and quotations

Investors

can buy or sell munis by contacting

brokerage firms
Electronic trading has become popular

http://www.tradingedge.com

Online

quotations are available at

http://www.munidirect.com and
http://www.investinginbonds.com
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Municipal Bonds (contd)

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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Municipal Bonds (contd)

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

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

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Corporate Bonds (contd)

Corporate bond yields and risk

Interest

income earned on corporate represents

ordinary income
Yield curve

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

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Corporate Bonds (contd)

Corporate bond yields and risk (contd)

Investor assessment of risk

Investors may only consider purchasing corporate bonds after

assessing the issuing firms 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

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

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Corporate Bonds (contd)

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

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Corporate Bonds (contd)

Characteristics of corporate bonds

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

A requirement to retire a certain amount of the bond issue each

year

Protective covenants:

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

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Corporate Bonds (contd)

Characteristics of corporate bonds (contd)

Call

provisions:

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

Are a disadvantage to bondholders

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Corporate Bonds (contd)

Bond collateral
Typically,

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

Unsecured

bonds are debentures

Subordinated debentures have claims against the
firms assets that are junior to the claims of mortgage
bonds and regular debentures

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Corporate Bonds (contd)

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

Variable-rate bonds:

Allow investors to benefit from rising market interest rates over time
Allow issuers of bonds to benefit from declining rates over time

Convertibility

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

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Corporate Bonds (contd)

Trading corporate bonds

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:

http://www.schwab.com
http://www.etrade.com

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Corporate Bonds (contd)

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

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Corporate Bonds (contd)

Junk bonds

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

Currently about 3,700 junk bond offerings exist with a market value
of $80 billion

Participation in the junk bond market

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

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Corporate Bonds (contd)

Junk bonds (contd)

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

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

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Corporate Bonds (contd)

Junk bonds (contd)

Contagion

effects in the junk bond market

Specific adverse information may discourage

investors from investment in junk bonds
Ivan Boesky admitting to insider trading violations
Drexel Burnham Lamberts bankruptcy filing

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Corporate Bonds (contd)

How corporate bonds facilitate

restructuring
Using

bonds to finance a leveraged buyout

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

34

Corporate Bonds (contd)

How corporate bonds facilitate restructuring

(contd)
Using

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

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Institutional Use of Bond Markets

All financial institutions participate in bond

markets
On

any given day, commercial banks, bond mutual

funds, insurance companies, and pension funds are
dominant participants

A financial institutions investment decisions will

often simultaneously affect bond market and
other financial market activity

36

Globalization of Bond Markets

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)
37

Globalization of Bond Markets

(contd)

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

38