Chapter 12 The Bond Market
Chapter 12 The Bond Market
Chapter 12 The Bond Market
Capital markets
Capital market is the market for securities with maturity greater than one year (stocks, bonds and
mortgages), typically for long-term financing or investments.
Firms and individuals use the money markets primarily to warehouse funds for short periods of time until a
more important need or a more productive use for the funds arises. By contrast, firms and individuals use
the capital markets for long-term investments.
Purpose:
The primary reason that individuals and firms choose to borrow long-term is to reduce the risk that interest
rates will rise before they pay off their debt. This reduction in risk comes at a cost, however. Most long-term
interest rates are higher than short-term rates due to risk premiums.
- The federal government issues long-term notes and bonds to fund the national debt.
- State and municipal governments also issue long-term notes and bonds to finance capital projects,
such as school and prison construction.
Governments never issue stock because they cannot sell ownership claims.
- Corporations issue both bonds and stock. The distribution of a firm’s capital between debt and
equity is called its capital structure.
Corporations may enter the capital markets because:
1. they do not have sufficient capital to fund their investment opportunities.
2. firms may choose to enter the capital markets because they want to preserve their capital to
protect against unexpected needs.
In either case, the availability of efficiently functioning capital markets is crucial to the continued health
of the business sector. This was dramatically demonstrated during the 2008–2009 financial crisis.
- The largest purchasers of capital market securities are households. Frequently, individuals and
households deposit funds in financial institutions that use the funds to purchase capital market
instruments such as bonds or stock.
Capital Market Trading
Capital market trading occurs in either the primary market or the secondary market.
- The primary market is where new issues of stocks and bonds are introduced. When firms sell
securities for the very first time, the issue is an initial public offering (IPO). Subsequent sales of a
firm’s new stocks or bonds to the public are simply primary market transactions (as opposed to an
initial one).
- The capital markets have well-developed secondary markets. A secondary market is where the sale
of previously issued securities takes place. Secondary markets are critical in capital markets because
most investors plan to sell long-term bonds at some point before they mature.
There are two types of exchanges in the secondary market for capital securities: organized
exchanges and over-the-counter exchanges. Most capital market transactions, measured by
volume, occur in organized exchanges. An organized exchange has a building where securities
(including stocks, bonds, options, and futures) trade.
Types of Bonds
Bonds are securities that represent a debt owed by the issuer to the investor. Bonds obligate the issuer to
pay a specified amount at a given date, generally with periodic interest payments. Long-term bonds traded
in the capital market include long-term government notes and bonds, municipal bonds, and corporate
bonds.
Bond terminology
1. Treasury Notes and Bonds
Treasury Notes and Bonds are issued to finance the national debt. The maturity difference among the
various Treasury securities is the following:
- No default risk (since the Treasury can print money to pay off the debt)
- Very low interest rates (although inflation risk is still present)
The advantage of inflation-indexed securities, also referred to as inflation protected securities, is that they
give both individual and institutional investors a chance to buy a security whose value won’t be eroded by
inflation.
Treasury STRIPS
In addition to bonds, notes, and bills, in 1985 the Treasury began issuing to depository institutions bonds in
book entry form called Separate Trading of Registered Interest and Principal Securities, more commonly
called STRIPS.
A STRIPS separates the periodic interest payments from the final principal repayment. When a Treasury
fixed-principal or inflation indexed note or bond is “stripped,” each interest payment and the principal
payment becomes a separate zero-coupon security.
2. Municipal Bonds
Municipal bonds are securities issued by local, county, and state governments.
- The proceeds from these bonds are used to finance public interest projects, such as schools,
utilities, and transportation systems.
- Interest earned on municipal bonds that are issued to pay for essential public projects are exempt
from federal taxation.
This allows the municipality to borrow at a lower cost because investors will be satisfied with lower
interest rates on tax-exempt bonds. You can use the following equation to determine what tax-free
rate of interest is equivalent to a taxable rate:
Equivalent tax-free rate = taxable interest rate * (1 - marginal tax rate)
Revenue bonds
by contrast, are backed by the cash flow of a particular revenue-generating project. For example,
revenue bonds may be issued to build a toll road, with the tolls being pledged as repayment. If the
revenues are not sufficient to repay the bonds, they may go into default, and investors may suffer
losses.
Revenue bonds tend to be issued more frequently than general obligation bonds.
3. Corporate bonds
When large corporations need to borrow funds for long periods of time, they may issue bonds. Most
corporate bonds have a face value of $1,000 and pay interest semiannually (twice per year).
The bond indenture is a contract that states the lender’s rights and privileges and the borrower’s
obligations. Any collateral offered as security to the bondholders is also described in the indenture.
The degree of risk varies widely among different bond issues because the risk of default depends on the
company’s health, which can be affected by a number of variables.
Characteristics of Corporate Bonds
1. Restrictive Covenants
Rules and restrictions on managers designed to protect the bondholders’ interests are known as restrictive
covenants. They usually limit the amount of dividends the firm can pay (to conserve cash for interest
payments to bondholders) and the ability of the firm to issue additional debt. Typically, the interest rate is
lower the more restrictions are placed on management through these covenants because the bonds will be
considered safer by investors.
2. Call Provisions
Most corporate indentures include a call provision, which states that the issuer has the right to force the
holder to sell the bond back.
If interest rates fall, the price of the bond will rise. If rates fall enough, the price will rise above the call price,
and the firm will call the bond. Because call provisions put a limit on the amount that bondholders can
earn from the appreciation of a bond’s price, investors do not like call provisions.
A second reason that issuers of bonds include call provisions is to make it possible for them to buy back
their bonds according to the terms of the sinking fund. A sinking fund is a requirement in the bond
indenture that the firm pay off a portion of the bond issue each year.
A third reason firms usually issue only callable bonds is that firms may have to retire a bond issue if the
covenants of the issue restrict the firm from some activity that it feels is in the best interest of stockholders.
Finally, a firm may choose to call bonds if it wishes to alter its capital structure. A maturing firm with excess
cash flow may wish to reduce its debt load if few attractive investment opportunities are available.
3. Conversion
Some bonds can be converted into shares of common stock. This feature permits bondholders to share
in the firm’s good fortunes if the stock price rises. Bondholders like a conversion feature. It is very similar
to buying just a bond but receiving both a bond and a stock option.
- Subordinated debentures are similar to debentures except that they have a lower priority claim.
- In the event of a default, subordinated debenture holders are paid only after non subordinated
bondholders have been paid in full.
- As a result, subordinated debenture holders are at greater risk of loss.
Junk Bonds
Bonds at or above Moody’s Baa or Standard and Poor’s BBB rating are considered to be of investment
grade. Those rated below this level are usually considered speculative. Speculative-grade bonds are often
called junk bonds.
In 1995 J.P. Morgan introduced a new way to insure bonds called the credit default swap (CDS). In its
simplest form a CDS provides insurance against default in the principal and interest payments of a credit
instrument.
Investing in Bonds
Bonds represent one of the most popular long-term alternatives to investing in stocks. Bonds are lower risk
than stocks because they have a higher priority of payment. In general, bonds are the most popular
alternative to stocks for long-term investing. They offer relative security and dependable cash payments,
making them ideal for retired investors and those who want to live off their investments.
Many investors think that bonds represent a very low risk investment, since the cash flows are relatively
certain. It is true that high-grade bonds seldom default; however, bond investors face fluctuations in price
due to market interest-rate movements in the economy. As interest rates rise and fall, the value of bonds
changes in the opposite direction. The possibility of suffering a loss because of interest-rate changes is
called interest-rate risk. The longer the time until the bond matures, the greater will be the change in price.