Chapter 7

Bond Markets

Financial Markets and Institutions, 7e, Jeff Madura

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

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

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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

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Background on Bonds (cont’d)
 Bond yields
 The issuer’s 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

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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 (cont’d)
 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

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Treasury and Federal Agency
Bonds (cont’d)
 Treasury bond auction (cont’d)
 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

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Treasury and Federal Agency
Bonds (cont’d)
 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)

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Treasury and Federal Agency
Bonds (cont’d)
 Treasury bond quotations
 Published in financial newspapers
 The Wall Street Journal
 Barron’s
 Investor’s 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/

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Treasury and Federal Agency
Bonds (cont’d)
 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 Lynch’s TIGRs
 The Treasury created the STRIPS program in 1985

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Treasury and Federal Agency
Bonds (cont’d)
 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 (cont’d)
 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
government’s 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 (cont’d)
 Credit risk
 Less than .5 percent of all municipal bonds
issued since 1940 have defaulted
 Moody’s, Standard and Poor’s, 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 (cont’d)
 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 (cont’d)
 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 (cont’d)
 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 (cont’d)
 Yields offered on municipal bonds
 Differsfrom 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 (cont’d)
 Yield curve on municipal bonds
 Typicallylower 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 (cont’d)
 Corporate bond yields and risk
 Interestincome 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 (cont’d)
 Corporate bond yields and risk (cont’d)
 Investor assessment of risk
 Investors may only consider purchasing corporate bonds after
assessing the issuing firm’s 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 (cont’d)
 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 (cont’d)
 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 (cont’d)
 Characteristics of corporate bonds (cont’d)
 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 (cont’d)
 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
firm’s assets that are junior to the claims of mortgage
bonds and regular debentures

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Corporate Bonds (cont’d)
 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 (cont’d)
 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 (cont’d)
 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 (cont’d)
 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 (cont’d)
 Junk bonds (cont’d)
 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 (cont’d)
 Junk bonds (cont’d)
 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 Lambert’s bankruptcy filing

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Corporate Bonds (cont’d)
 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

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Corporate Bonds (cont’d)
 How corporate bonds facilitate restructuring
(cont’d)
 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 institution’s investment decisions will
often simultaneously affect bond market and
other financial market activity

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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)

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Globalization of Bond Markets
(cont’d)
 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

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