Bond Markets

Background on Bonds

 Bonds represent long-term debt securities

 Contractual
 Promise to pay future cash flows to investors

 The issuer of the bond is obligated to pay:

 Interest (or coupon) payments periodically usually
semiannually
 Par or face value (principal) at maturity

 Primary vs. Secondary market for bonds

Background on Bonds

Bond Interest Rates

The issuer’s cost of financing with bonds

is the coupon rate
 Determined by current market rates and risk
 Usually fixed throughout term
 Determines periodic interest payments
Background on Bonds

Bond Yield to Maturity

The yield to maturity (YTM) is the yield that

equates the future coupon and principal payments
with the bond price
 The YTM is the investor’s expected rate of return if the
bond is held to maturity
 The actual YTM may vary from the expected because of
risks assumed by the investors
Background on Bonds

Bond Yield to Maturity

An investor can purchase a ten-year, $1000 par

value bond with an 8 percent annualized coupon
rate for $936. Determine the yield to maturity for
this bond.
N I PV PMT FV
10 –936 80 1000
Background on Bonds

Bond Yield to Maturity

An investor can purchase a ten-year, $1000 par

value bond with an 8 percent annualized coupon
rate for $936. Determine the yield to maturity for
this bond.
N I PV PMT FV
10 9 –936 80 1000
Background on Bonds

Bonds by Issuers

Issuer Type of Bond

Federal Government Treasury Bonds
(U.S. Treasury)
Federal Agencies Federal Agency Bonds
State and Local Municipal Bonds
Governments
Corporations Corporate Bonds
U. S. Treasury Bonds

 Issued by the U.S. Treasury to finance federal

government expenditures
 Maturity
 Notes, < 10 Years
 Bonds, > 10 to 30 Years

 Active OTC Secondary Market

 Semiannual Interest Payments
 Benchmark Debt Security for Any Maturity
U. S. Treasury Bond Yield To Maturity

2013 – $1000
$83.80 Ask $1033.44 Calc
Today
Pmt Price = PV* YTM
=N
FV

*
Ask Price = 103 and 11/32 % of
Face Value or $1033.4375
Treasury Bonds

Cash Flow Variation in T-Bonds

 Coupon bonds
 Interest paid semiannually
 To registered bondholders
 Stripped Treasury bonds
 Zero-coupon securities are sold with claims on U. S.
Treasury bonds held in a trust
 One security represents the principal payment (np) at maturity
 Other securities represents the interest payments (ci) at
interest paying dates
Federal Agency Bonds

 Government National Mortgage Association

(GNMA)
 Issues bonds and uses proceeds to purchase
insured FHA and VA mortgages
 A U.S. Government Agency
 Backed by explicit guarantee of Federal
Government
 Example of social allocation of capital
Municipal Bonds

 State and local government obligations

 Revenue bonds vs. general obligation Bonds
 Investor interest income exempt from federal
income tax
 Tax Reform Act of 1986 placed limitations on
tax-exempt bond issuance for private purposes
Corporate Bonds

 When corporations want to borrow for long-

term periods, they issue corporate bonds
 Usually pay semiannual interest
 Most have maturities between 10-30 years
 Public offering vs. private placement
 Limited exchange, larger OTC secondary market
 Investors seek safety of principal and steady
income
Corporate Bonds

Corporate Bond Terminology

 Indenture
 Legal document specifying rights and obligations of
issuer and bondholder
 Trustee
 Represents bondholders to assure compliance with
indenture
Corporate Bonds

Corporate Bond Terminology

 Sinking Fund Provision

 Requirement that the firm retire a certain amount or
number of bonds each year
 Protects investors with principal reduction
 Protective Covenants
 Places restrictions on the firm to protect bondholders
 Examples: limits dividends and officer salaries, restricts
additional debt
Corporate Bonds

Corporate Bond Terminology

 Call provisions: Ability to pay bonds off early

 Call premium
 Advantage to issuers; disadvantage to investor
 Bond collateral
 Usually consists of a mortgage on real property
 Unsecured bonds are called debentures and are backed only
by the general credit of the issuing firm
Corporate Bonds

Corporate Bond Terminology

 Low-coupon and zero-coupon bonds

 Provide investors known rate of return
 Imputed interest income taxed if not in tax-sheltered
investment plan
 Attractive to pension funds with expected payouts
 Variable-rate bonds
 Convertible bonds
Corporate Bonds

 Junk Bonds
 Junk bonds are also called high-yield bonds or
noninvestment rated bonds
 Popularized in the direct finance boom of the
1980s
 The risk premium is between three and seven
percent above Treasury bonds and susceptible to
contagion effects
 Secondary market supported by dealer market
Corporate Bonds Market Quotation

ATT 6 ½ 29 7.3 214 88 5/8th +1/4

 AT&T bond quote for 1/13/02 (U.S. Exchange Bond)

 6.5% coupon rate
 Maturity in 2029
 7.3% current yield (annual interest/price)
 214 bonds traded on this day
 Bond priced at close of day 88 5/8th % of face
($1000) or $886.25
 Bond price up ¼ point for the day or $2.50
Participants in Bond Market

Financial Institution Participation in Bond Markets

Commercial banks and savings • Purchase bonds for their asset portfolio.

and loan associations (S&Ls) •

• Sometimes place municipal bonds for municipalities.

• Sometimes issue bonds as a source of secondary capital.

Finance companies • Commonly issue bonds as a source of long-term funds.

Mutual funds • Use funds received from the sale of shares to purchase bonds. Some bond mutual funds

specialize in particular types of bonds, while others invest in all types.

Brokerage rms • Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.

Investment banking rms • Place newly issued bonds for governments and corporations. They may place the bonds

and assume the risk of market price uncertainty or place the bonds on a best-efforts basis

in which they do not guarantee a price for the issuer.

Insurance companies • Purchase bonds for their asset portfolio.

Pension funds • Purchase bonds for their asset portfolio.

Globalization of Bond Markets

Eurobond Market

 In 1960s, U.S. corporations were limited to the

amount of funds they could borrow in the U.S. for
overseas operations.
 They began to issue bonds in the Eurobond market
where bonds denominated in various currencies
were placed.
 About 75 percent are denominated in U.S. dollars
Globalization of Bond Markets

Eurobond Market

 An underwriting syndicate of investment banks

participates in placing the bonds
 Issuer can choose the currency in which the bond
interest and principal are denominated
 Dollar denominated most common
 Bearer bonds vs. registered bonds