Adopted from “Financial Markets and Institutions” – Mishkin & Eakins (9E)

For TCHE401/TCH401E Classes in FTU only, no further distribution/reproduction allowed.

In this chapter, we focus on longer-term securities: bonds. Bonds
are like money market instruments, but they have maturities that
exceed one year. These include Treasury bonds, corporate bonds,
mortgages, and the like.
•Purpose of the Capital Market
•Financial Guarantees for Bonds
•Capital Market Participants
•Oversight of the Bond Markets
•Capital Market Trading
•Current Yield Calculation
•Types of Bonds
•Finding the Value of Coupon
•Treasury Notes and Bonds Bonds
•Municipal Bonds •Investing in Bonds
•Corporate Bonds
Original maturity is greater than one year, typically for long-term
financing or investments
Best known capital market securities:
Stocks and bonds
Primary issuers of securities:
Federal and local governments: debt issuers
Corporations: equity and debt issuers
Largest purchasers of securities:
You and me
Really?
1. Primary market for initial sale (IPO)
2. Secondary market
Over-the-counter
Organized exchanges (i.e., NYSE)
1-7
Bonds are securities that represent debt owed by the issuer to the
investor, and typically have specified payments on specific dates.
Types of bonds we will examine include long-term government
bonds (T-bonds), municipal bonds, and corporate bonds.
The U.S. Treasury issues notes and bonds to finance its operations.
The following table summarizes the maturity differences among
the various Treasury securities.

Type Maturity
Treasury bill Less than 1 year
Treasury note 1 to 10 years
Treasury bond 10 to 30 years
No default risk since the Treasury can print money to payoff the
debt
Is it true that the Treasury, not the FED, prints money?
Very low interest rates, often considered the risk-free rate
(although inflation risk is still present)
Treasury Inflation-Indexed Securities: the principal amount is tied
to the current rate of inflation to protect investor purchasing
power
Treasury STRIPS: the coupon and principal payments are
“stripped” from a T-Bond and sold as individual zero-coupon
bonds.
Although not technically Treasury securities, agency bonds are
issued by government-sponsored entities, such as GNMA, FNMA,
and FHLMC.
The debt has an “implicit” guarantee that the U.S. government will
not let the debt default. This “guarantee” was clear during the
2008 bailout…
Both Fannie and Freddie managed their political situation
effectively, allowing them to engage in risky activities, despite
concerns raised.
By 2008, the two had purchased or guaranteed over $5 trillion in
mortgages or mortgage-backed securities.
Part of this growth was driven by their Congressional mission to
support affordable housing. They did this by purchasing subprime
and Alt-A mortgages.
As these mortgages defaults, large losses mounted for both
agencies.
By October of 2016, the two agencies had paid $250 billion in
dividends to the treasury.
Issued by local, county, and state governments
Used to finance public interest projects
Tax-free municipal interest rate = taxable interest rate  (1 −
marginal tax rate)
Two types
General obligation bonds
Revenue bonds
NOT default-free (e.g., Orange County California)
Defaults in 1990 amounted to $1.4 billion in this market
Suppose the rate on a corporate bond is 5% and the rate on a
municipal bond is 3.5%. Which should you choose? Your marginal
tax rate is 28%.
Suppose the rate on a corporate bond is 5% and the rate on a
municipal bond is 3.5%. Which should you choose? Your marginal
tax rate is 28%.
Find the equivalent tax-free rate (ETFR):
ETFR = 5%  (1 − MTR) = 5%  (1 − 0.28)
The ETFR = 3.36%. If the actual muni-rate is above this (it is),
choose the muni.
Typically have a face value of $1,000, although some have a face
value of $5,000 or $10,000
Pay interest semi-annually
Cannot be redeemed anytime the issuer wishes, unless a specific clause states
this (call option).
Degree of risk varies with each bond, even from the same issuer.
Following suite, the required interest rate varies with level of risk.
The degree of risk ranges from low-risk (AAA) to higher risk
(BBB). Any bonds rated below BBB are considered sub-investment
grade debt.
Registered Bonds
Replaced “bearer” bonds
IRS can track interest income this way
Restrictive Covenants
Mitigates conflicts with shareholder interests
May limit dividends, new debt, ratios, etc.
Usually includes a cross-default clause
Call Provisions
Higher required yield
Mechanism to adhere to a sinking fund provision
Interest of the stockholders
Alternative opportunities
Conversion
Some debt may be converted to equity
Similar to a stock option, but usually more limited
Secured Bonds
Mortgage bonds
Equipment trust certificates
Unsecured Bonds
Debentures
Subordinated debentures
Variable-rate bonds
Junk Bonds
Debt that is rated below BBB
Often, trusts and insurance companies are not permitted to invest in junk
debt
Michael Milken developed this market in the mid-1980s, although he was
subsequently convicted of insider trading
Standard & Poor’s Moody’s Definition
AAA Aaa Best quality and highest rating. Capacity to
pay interest and repay principal is
extremely strong. Smallest degree of
investment risk.
AA Aa High quality. Very strong capacity to pay
interest and repay principal and differs
from AAA/Aaa in a small degree.
A A Strong capacity to pay interest and repay
principal. Possess many favorable
investment attributes and are considered
upper-medium-grade obligations.
Somewhat more susceptible to the adverse
effects of changes in circumstances and
economic conditions.
Standard & Poor’s Moody’s Definition
BBB Baa Medium-grade obligations. Neither highly protected nor
poorly secured. Adequate capacity to pay interest and
repay principal. May lack long-term reliability and
protective elements to secure interest and principal
payments.
BB Ba Moderate ability to pay interest and repay principal. Have
speculative elements and future cannot be considered
well assured. Adverse business, economic, and financial
conditions could lead to inability to meet financial
obligations.
B B Lack characteristics of desirable investment. Assurance of
interest and principal payments over long period of time
may be small. Adverse conditions likely to impair ability
to meet financial obligations.
Standard & Poor’s Moody’s Definition
CCC Caa Poor standing. Identifiable vulnerability to
default and dependent on favorable
business, economic, and financial
conditions to meet timely payment of
interest and repayment of principal.
CC Ca Represent obligations that are speculative
to a high degree. Issues often default and
have other marked shortcomings.
C C Lowest-rated class of bonds. Have
extremely poor prospects of attaining any
real investment standard. May be used to
cover a situation where bankruptcy
petition has been filed, but debt service
payments are continued.
Standard & Poor’s Moody’s Definition
CI Caa Reserved for income bonds on which no
interest is being paid.
D Ca Payment default.
NR No public rating has been requested.
(+) or (−) C Ratings from AA to CCC may be modified by
the addition of a plus or minus sign to show
relative standing within the major rating
categories.
Some debt issuers purchase financial guarantees to lower the risk
of their debt.
The guarantee provides for timely payment of interest and
principal, and are usually backed by large insurance companies.
As it turns out, not all guarantees actually make sense!
In 1995, JPMorgan created the credit default swap (CDS), a type of insurance
on bonds.
In 2000, Congress removed CDSs from any oversight.
By 2008, the CDS market was over $62 trillion!
2008 losses on mortgages lead to huge payouts on this insurance.
Bond trades are not available to the public, making trading less
transparent.
TRACE, under FINRA, was developed to:
Make some bond transactions reported to the public
Develop a trading platform to make transaction data available to the public
Violation Fine
Excessive trading $5,000 to $110,000
Excessive markups $5,000 to $146,000
Failure to supervise $5,000 to $73,000
Fraud/Misrepresentation $2,500 to $146,000
Late reporting $5,000 to $146,000
Net capital deficiencies $1,000 to $73,000
Outside business activities $2,500 to $73,000
Recordkeeping violations $1,000 to $146,000
Sale of unregistered securities $2,500 to $73,000
Unsuitable recommendations $2,500 to $110,000
Bond yields are quoted using a variety of conventions, depending
on both the type of issue and the market.
We will examine the current yield calculation that is commonly
used for long-term debt.
What is the current yield for a bond with a face value of $1,000, a
current price of $921.01, and a coupon rate of 10.95%?
Answer:
ic = C / P = $109.50 / $921.01 = 11.89%
Note: C (coupon) = 10.95%  $1,000
= $109.50
Bond pricing is, in theory, no different than pricing any set of
known cash flows.
Once the cash flows have been identified, they should be
discounted to time zero at an appropriate discount rate.
Term Definition

Coupon interest rate The stated annual interest rate on the

bond. It is usually fixed for the life of the
bond.
Current yield The coupon interest payment divided by
the current market price of the bond.

Face amount The maturity value of the bond. The holder

of the bond will receive the face amount
from the issuer when the bond matures.
Face amount is synonymous with par
value.
Term Definition

Indenture The contract that accompanies a bond and

specifies the terms of the loan agreement.
It includes management restrictions, called
covenants.
Market rate The interest rate currently in effect in the
market for securities of similar risk and
maturity. The market rate is used to value
bonds.
Term Definition

Maturity The number of years or periods until the

bond matures and the holder is paid the
face amount.
Par value The same as face amount, the maturity
value of the bond.

Yield to maturity The yield an investor will earn if the bond

is purchased at the current market price
and held until maturity.
Let’s use a simple example to illustrate the bond pricing idea.
What is the price of two-year, 10% coupon bond (semi-annual
coupon payments) with a face value of $1,000 and a required rate
of 12%?
Solution:
1. Identify the cash flows:
$50 is received every six months in interest
$1000 is received in two years as principal repayment
2. Find the present value of the cash flows (calculator solution):
N = 4, FV = 1000, PMT = 50, I = 6
Computer the PV. PV = 965.35
Bonds are the most popular alternative to stocks for long-term
investing.
Even though the bonds of a corporation are less risky than its
equity, investors still have risk: price risk and interest rate risk,
which were covered in chapter 3
Purpose of the Capital Market: provide financing for long-term
capital assets
Capital Market Participants: governments and corporations issue
bond, and we buy them
Capital Market Trading: primary and secondary markets exist for
most securities of governments and corporations
Types of Bonds: includes Treasury, municipal, and corporate bonds
Treasury Notes and Bonds: issued and backed by the full faith and
credit of the U.S. Federal government
Municipal Bonds: issued by state and local governments, tax-
exempt, defaultable.
Corporate Bonds: issued by corporations and have a wide range of
features and risk
Financial Guarantees for Bonds: bond “insurance” should the
issuer default
Oversight of the Bond Markets: TRACE developed to add
transparency to bond markets
Bond Current Yield Calculation: how to calculation the current
yield for a bond
Finding the Value of Coupon Bonds: determining the cash flows
and discounting back to the present at an appropriate discount
rate
Investing in Bonds: most popular alternative to investing in the
stock market for long-term investments