Chapter 7 Bond Markets Financial Markets and Institutions

Chapter Outline Background on bonds n Treasury and federal agency bonds n Municipal bonds n Corporate bonds n Institutional use of bond markets n Globalization of bond markets n 2

Background on Bonds n n n 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 automatically send coupon payments to the owners 3

Background on Bonds (cont’d) n Bond yields ¨ The issuer’s cost of financing is measured by the yield to maturity n n ¨ 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 4

Treasury and Federal Agency Bonds n 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 5

Treasury and Federal Agency Bonds (cont’d) n 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 n n 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 6

Treasury and Federal Agency Bonds (cont’d) n Treasury bond auction (cont’d) ¨ The Salomon Brothers scandal n In a 1990 bond auction, Salomon Brothers purchased 65 percent of the bonds issued (exceeding the 35 percent maximum) n Salomon resold the bonds at higher prices to other institutions n In August of 1991, the Treasury Department temporarily barred Salomon Brothers from bidding on Treasury securities n In May 1992 Salomon paid fines of $190 million to the SEC and Justice Department n Salomon created a reserve fund of $100 million to cover claims from civil lawsuits 7

Treasury and Federal Agency Bonds (cont’d) n 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 n n n Profit from the bid-ask spread Conduct trading with the Fed during open market operations Typical daily volume is about $200 billion ¨ Online trading n Treasury. Direct program (http: //www. treasurydirect. gov) 8

Treasury and Federal Agency Bonds (cont’d) n Treasury bond quotations ¨ Published in financial newspapers n n n 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 ¨ n n http: //www. investinginbonds. com http: //www. federalreserve. gov/releases/H 15/ 9

Treasury and Federal Agency Bonds (cont’d) n Stripped Treasury bonds ¨ One security represents the principal payment and a second security represents the interest payments n n n 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 n n Merrill Lynch’s TIGRs The Treasury created the STRIPS program in 1985 10

Treasury and Federal Agency Bonds (cont’d) n 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 11

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? 12

Treasury and Federal Agency Bonds (cont’d) n Savings bonds ¨ ¨ ¨ n 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 ¨ 13

Municipal Bonds n 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 ¨ n n n 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 14

Municipal Bonds (cont’d) n 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 n Results in a higher cost for the investor 15

Municipal Bonds (cont’d) n 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 16

Municipal Bonds (cont’d) n 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 17

Municipal Bonds (cont’d) n Trading and quotations ¨ Investors can buy or sell munis by contacting brokerage firms ¨ Electronic trading has become popular n http: //www. tradingedge. com ¨ Online quotations are available at http: //www. munidirect. com and http: //www. investinginbonds. com 18

Municipal Bonds (cont’d) n Yields offered on municipal bonds ¨ Differs from the yield on a Treasury bond with the same maturity because: Of a risk premium to compensate for default risk n Of a liquidity premium to compensate for less liquidity n The federal tax exemption of municipal bonds n 19

Municipal Bonds (cont’d) n Yield curve on municipal bonds ¨ Typically lower 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 n Investors require a premium for longer-term securities with lower liquidity in both markets n 20

Corporate Bonds n n n n 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 21

Corporate Bonds (cont’d) n Corporate bond yields and risk ¨ Interest income earned on corporate represents ordinary income ¨ Yield curve n n Affected by interest rate expectations, a liquidity premium, and maturity preferences of corporations Similar shape as the municipal bond yield curve ¨ Default rate n Depends on economic conditions n Less than 1 percent in the late 1990 s n Exceeded 3 percent in 2002 22

Corporate Bonds (cont’d) n Corporate bond yields and risk (cont’d) ¨ Investor assessment of risk n n ¨ 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 n n n 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 23

Corporate Bonds (cont’d) n 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 24

Corporate Bonds (cont’d) n 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: n n 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 25

Corporate Bonds (cont’d) n Characteristics of corporate bonds (cont’d) ¨ Call provisions: n Require the firm to pay a price above par value when it calls its bonds ¨ n 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 ¨ n Are a disadvantage to bondholders 26

Corporate Bonds (cont’d) n Bond collateral ¨ Typically, n n 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 27

Corporate Bonds (cont’d) n 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, , don’t pay yearly interest, reduce tax => increase CF, don’t need high issue cost. Co that not pay tax intrested in this kind. ¨ ¨ n Variable-rate bonds: ¨ ¨ n 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 ¨ 28

Corporate Bonds (cont’d) n 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: n n http: //www. schwab. com http: //www. etrade. com 29

Corporate Bonds (cont’d) n 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 30

Corporate Bonds (cont’d) n 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 ¨ n ¨ Currently about 3, 700 junk bond offerings exist with a market value of $80 billion Participation in the junk bond market n n n 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 31

Corporate Bonds (cont’d) n Junk bonds (cont’d) ¨ Risk premium of junk bonds n The typical premium is between 3 and 7 percent above Treasury bonds with the same maturity ¨ Performance of junk bonds n In the early 1990 s, the popularity of junk bonds declined because of ¨ ¨ ¨ n Insider trading allegations The financial problems of a few major issuers of junk bonds The financial problems in the thrift industry In the late-1990 s, junk bonds performed well with few defaults 32

Corporate Bonds (cont’d) n Junk bonds (cont’d) ¨ Contagion n 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 ¨ 33

Corporate Bonds (cont’d) n How corporate bonds facilitate restructuring ¨ Using bonds to finance a leveraged buyout n An LBO is typically financed with senior debt and subordinated debt n LBO activity increased dramatically in the later 1980 s n Many firms with excessive financial leverage resulting from LBOs reissued stock in the 1990 s 34

Corporate Bonds (cont’d) n How corporate bonds facilitate restructuring (cont’d) ¨ Using n n n 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 35

Institutional Use of Bond Markets n All financial institutions participate in bond markets ¨ On any given day, commercial banks, bond mutual funds, insurance companies, and pension funds are dominant participants n A financial institution’s investment decisions will often simultaneously affect bond market and other financial market activity 36

Globalization of Bond Markets n n n 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) 37

Globalization of Bond Markets (cont’d) n 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 38