The Bond Markets: Chapter

Preview
 We examine how capital markets operate, and then
focus our attention on the bonds and the bond
market. Topics include:
 Purpose of the Capital Market
 Capital Market Participants
 Capital Market Trading
 Types of Bonds
 Treasury Bonds
 Municipal Bonds

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Chapter Preview (cont.)
 Corporate Bonds
 Financial Guarantees for Bonds
 Bond Yield Calculations
 Finding the Value of Coupon Bonds
 Investing in Bonds

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 Purpose of the Capital Market

 Best known capital market securities:

 Stocks
 Bonds
 The purpose of money market is for warehousing
funds for short term; while the purpose of capital
market is for long term investment;
 Original maturity is greater than
one year, typically for long-term financing or
investments

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 Capital Market Participants

 Primary issuers of securities:

 Federal and local governments: debt issuers
 Corporations: equity and debt issuers
 Largest purchasers of securities:
 Households-You and me

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Capital Market Trading

1. Primary market for initial public offerings

(IPO)
2. Secondary market
 Over-the-counter
 Organized exchanges (i.e., NYSE)

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Types of Bonds

 Bonds are securities that represent debt

owed by the issuer to the investor, and
typically have specified payments on
specifies dates.
 Types of bonds we will examine include long-
term government bonds (T-bonds), municipal
bonds, and corporate bonds.

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Types of Bonds: Sample Corporate
Bond
The par value, coupon rate are given on the
bond.

Figure 10.1 Sohio/BP Corporate Bond 7

Treasury 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.

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Treasury Bonds

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Treasury Bond Interest Rates

 No default risk since the Treasury can print

money to payoff the debt
 Very low interest rates, often considered the
risk-free rate (although inflation risk is still
present)

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Treasury Bond Interest Rates

 The next two figures show historical

rates on Treasury bills, bonds, and the
inflation rate.

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Treasury Bond Interest Rates

Figure 10.2 Interest Rate on Treasury Bonds and the Inflation Rate, 1973–2004

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Treasury Bond Interest Rates:
Bills vs. Bonds

Figure 10.3 Interest Rates on Treasury Bills

and Treasury Bonds, 1973–2002 (January of each year)
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 Treasury Bonds: Recent
 Innovation
Treasury Inflation-Indexed Securities:
The interest rate does not change throughout the term of
the security, but the principal amount is tied to the current
rate of inflation to protect investor purchasing power.
 Treasury STRIPS (Separate Trading of Registered
Interest and Principal of Securities, 注册本息分离交易债
券 ): the coupon and principal payments are “stripped”
from a T-Bond and sold as individual zero-coupon bonds.
Eg. A STRIPS Treasury note with five years remaining to maturity
becomes 11 separate securities that can be traded individually.

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Treasury Bonds: Agency Debt

 Congress has authorized a number of US

agencies such as GNMA, FNMA, and
FHLMC, to issue bonds.(p166)
 The debt has an “implicit” guarantee that the
U.S. government will not let the debt default.

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Municipal Bonds
 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)

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Municipal Bonds: Example

Suppose the rate on a corporate bond is 9% and

the rate on a municipal bond is 6.75%. Which
should you choose?

Answer: Find the marginal tax rate:

6.75% = 9% x (1 – MTR), or MTR = 25%

If you are in a marginal tax rate above 25%,

the municipal bond offers a higher after-tax
cash flow.

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Municipal Bonds
 Two types (p167)
 General obligation bonds ( 一般责任债券 ) –do not have
specific assets pledged as security or a specific source of
revenue allocated for their repayment. They are backed
by “the full faith and credit” of the issuers;
 Revenue bonds （收益债券） -backed by the cash flow of
a particular revenue-generating project.

 NOT default-free (e.g., Orange County California)

 Defaults in 1990 amounted to $1.4 billion in this market

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Corporate Bonds

 Typically have a face value of $1,000,

although some have a face value of $5,000
or $10,000.
 Pay interest semi-annually.

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Corporate Bonds
 Most are callable （可赎回） , meaning that the
issuer may redeem ( 赎回 ) the bonds after a specific
date.
 The bond indenture ( 债务契约 ) states the lender’s
rights and privileges and the borrower’s obligations.
 Degree of risk varies with each bond, even from the
same issue. The required interest rate varies with
level of risk.

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Corporate Bonds

 The next slide shows the interest rate on

various bonds from 1973-2004.
 The degree of risk ranges from low-risk
(AAA) to higher risk (BBB). Any bonds rated
below BBB are considered sub-investment
grade debt.

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Corporate Bonds: Interest Rates

Figure 10.5 Corporate Bond Interest Rates, 1973–2004 (End of year)

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 Corporate Bonds:
Characteristics of Corporate
 Bonds
Registered Bonds
 Replaced “bearer” bonds
 IRS (Inland Revenue Service 国税局 ) can track
interest income this way

 Restrictive Covenants 限制性契约

 Mitigates( 使缓和 ) conflicts with shareholder interests
 May limit dividends, new debt ratios, restriction on
merger, etc.

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Corporate Bonds: Characteristics of
Corporate Bonds
 Call Provisions 可赎回条款 (p170)
 The right for the issuers to force the holders to sell back.
(usually at the bond’s par price or slightly higher (usu. One year’s interest
cost)
 Sinking fund( 偿债基金 ) Issuer pays off a portion of the bond
issue each year.
 Interest of the stockholders
 Higher yield for the call provision
 Conversion
 Some debt may be converted to equity
 Similar to a stock option, but usually more limited

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Conversion/Equity-related
bonds
Convertible bond: allows the investor to exchange the
bond for a predetermined number of equity shares of
the issuer. Convertibles usually sell at a premium
above the larger of their straight debt value and their
conversion value. See the example in the next slide.
 Bonds with equity warrants: can be reviewed as
straight fixed-rate bonds with the addition of a call
option feature. The warrant entitles the bondholder to
purchase a certain number of equity shares in the
issuer at a prestated price over a predetermined
period of time.

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Example
 A convertible bond pays interest annually at a coupon
rate of 5% on a par value of $1,000. The bond has 10
years maturity remaining and the discount rate on other-
wise identical non-convertible debt is 5%. The bond is
convertible into shares of common stock at a conversion
price of $25 per share (i.e. the bond is exchangeable for
40 shares). Today’s closing stock price was $31.25.
What is the least that this bond will sell for?
 The straight bond value is $1,000 since the coupon rate
equals the yield to maturity. At today’s stock price the
bond is worth $1,250 converted into 40 shares of stock.

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Example
 A convertible bond pays interest annually at a coupon rate
of 5% on a par value of $1,000. The bond has 10 years
maturity remaining and the discount rate on other-wise
identical non-convertible debt is 6.5%. The bond is
convertible into shares of common stock at a conversion
price of $25 per share (i.e. the bond is exchangeable for
40 shares). Today’s closing stock price was $20. What is
the least that this bond will sell for?
 At today’s stock price the bond is worth $800 converted
into 40 shares of stock.
 The straight bond value = $892.17: N=10; I/YR =6.5; PV=
892.17; PMT= $50; FV = 1,000.
 $892.17
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Corporate Bonds:
Types of Corporate Bonds
 Secured Bonds
 Mortgage bonds
 Equipment trust certificates

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Corporate Bonds:
Types of Corporate Bonds
 Unsecured Bonds
 Debentures （信用债券） : are long-term
unsecured bonds that are backed only be the
general creditworthiness of the issuer. Debentures
usually have attached to them indenture.
 Subordinated debentures 附属债券 – lower

priority claim
 Variable-rate bonds 利率可变债券

The interest rate on them is tied to another market

interest rate, such as the rate on treasury bond,
and is adjusted periodically.

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Corporate Bonds:
Characteristics of Corporate
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 convicted of insider
trading

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Corporate Bonds: Debt Ratings

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Corporate Bonds:
Debt Ratings (cont.)

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Financial Guarantees for Bonds
 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.
 Financial guarantees were developed in 1970s to
insure municipal bonds and expanded to cover
many corporate bonds as well later on.

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Bond Yield Calculations

 Bond yields are quoted using a variety of

conventions （惯例） , depending on both
the type of issue and the market.
 We will examine two bond yield calculations
commonly used for short and long-term debt.

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Bond Yield Calculations:
Current Yield(p. 174)
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% x $1,000 = $109.50

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Bond Yield Calculations: Yield on a
Discount Basis (p175)
贴现基础上的收益率
For simplicity, use Yield on a Discount Basis instead
of yield to maturity.
(F-P)/F, one year:360, see p175 formula (2).
What is the discount yield for a one-year bond with a
face value of $1,000, and a current price of $875?

Answer:
idb = [ (F-P) / F ] x [ 360 / days to maturity]
= [ (1000 – 875) / 1000 ] x [360 / 365] = 12.33%

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Yield on a discount rate vs yield to
maturity
 Yield on a discount rate understates the more
accurate “yield to maturity”, and longer the
maturity of the discount bond, the greater this
understatement becomes.
 However, a change in the discount yield
always indicates a change in the same
direction for the yield to maturity, i.e., both
negatively related to the price of the bond.

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Finding the price of semiannual
bonds
Bond pricing is, in theory, no different than
pricing any set of known cash flows – the
current price is the present value of all future
cash flows.
The table on the next slide outlines some of
the terminology unique to debt, which may be
necessary to understand to determine the
cash flows.

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Finding the Value of Coupon Bonds

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Finding the Price of Coupon
Bonds
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%?

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10.5.6 Finding the Price of
Coupon Bonds
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

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Investing in Bonds

 Bond 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.

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Investing in Bonds

The next slide shows the amount of bonds

and stock issued from 1983 to 2003.
Note how much larger the market for new
debt is. Even in the late 1990s, which were
boom years for new equity issuances, new
debt issuances still outpaced equity by
over 5:1.

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10.6.2 Investing in Bonds

Figure 10.6 Bonds and Stocks Issued, 1983–2003

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Chapter Summary

 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.

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Chapter Summary (cont.)

 Types of Bonds: includes Treasury,

municipal, and corporate bonds
 Treasury 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.

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Chapter Summary (cont.)

 Corporate Bonds: issued by corporations and

have a wide range of features and risk
 Financial Guarantees for Bonds: bond
“insurance” should the issuer default
 Bond Yield Calculations: calculations for
current yield and discount yield

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Chapter Summary (cont.)

 Finding the Price 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

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Group work
 Chinese bond market
 Please include the following points:
1) Participants
2) Size
3) Instruments
4) Market function
5) Regulation institutions and main regulation aspects
6) Room for development

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