Transcript Kidwell, Peterson, Blackwell & Whidbee

CHAPTER 8
BOND MARKETS
Capital Markets
Capital market instruments are long term
securities issued to finance capital goods
and/ or long term projects.
They are not highly marketable.
Using them reduce the refinancing
problems.
Their interest rates are higher than those of
short term securities.
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Capital markets bring together the borrowers and
suppliers of long-term funds and also allow people
with previously issued securities to trade them for
cash in secondary capital markets.
Major Issuers (borrowers)
Households - mortgages.
Business - bonds and stock
Governments - federal, state, and local bonds.
Major Investors
Households (directly or indirectly through
financial intermediaries).
Foreign investors.
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U.S. Government Issues and Agency
Securities
1. U.S. Treasury Notes and Bonds
Coupon bearing issues (has coupon payment
and is usually paid semiannually).
Notes - one to ten-year maturity.
Bonds - over ten-year maturity.
Sold in auction by the Treasury Department.
Trend is now toward more short-term market
financing and less long-term financing.
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2. Inflation-Indexed Notes and Bonds :
Treasury also issue notes and bonds adjusted for inflation
called Treasury Inflation Protection Securities (TIPS).
Principal adjusts for inflation
Minimum denomination is $1,000.
Example : An investor bought a TIP with original
principal of $100,000, 3% annual coupon rate
compounded semiannual (1.5% semiannual) and 10
years maturity.
If the semiannual inflation rate during the first 6 months
is 1%, the principal amount will be adjusted upward by
1 % to $101,000 and hence the first coupon payment
will be $ 1,515(101,000*1.5%).
The principal will be adjusted before every coupon
payment and the investor receives at maturity the
greater of either the final principal or the initial par
amount.
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TIPS are used for
1. Provide investors with a way to protect
their investments against inflation.
2. The yield on TIPS provides a direct
measure for real interest rate. Therefore
expected inflation can be calculate through
subtracting the yield on TIPS from the
yield of comparable security.
Example : yield on 5 –year TIPS= 1.10%.yield on 5year Treasury note =3.49%
Expected inflation = 3.49-1.10= 2.39%
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3. Separate Trading of Registered Interest
and Principal (STRIP).
A strip is just a Treasury security that has been
separated into its component parts : coupon payment
and principal payment.
Each coupon and principal of a U.S. Treasury note or
bond is sold separately by a dealer.
Each separated security is a zero-coupon bond.
The price of the original T-note/bond is lower than the
price of the strips securities because the zero-coupon
bonds are highly desired by investors as they are used
in managing the interest rate risk. Dealers engage in
creating STRIPs created because investors value zerocoupon default risk-free securities and are willing to
pay more for STRIPs than original bonds.
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Example:10 year Treasury note if coupon is
paid semi-annually can be divided into 21
strips.(20 coupon payments and 1 principal)
Strips can be used to manage interest rate
risk as they are zero coupon bond, if you
hold it to maturity you get rid of price risk
and it already does not have reinvestment
risk as it is zero coupon bond.
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State and Local Government Bonds
Known as municipal bonds
Types of Municipal Bonds
1. General Obligation (GO) Bonds- backed by
taxing power of political entity. In case of default,
the city or local government will raise tax to pay
the principal and coupon payments. They are
issued to provide basic services to communities
such as education, health services etc.
2. Revenue Bonds - financed and paid back with
cash flows from a specific project. In case of
default, only the revenue generated from the
project backs these bonds. Projects like bridges,
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water treatment.
3. Industrial Development Bonds (IDB) - public
financing of private business.
4. Mortgage-backed bonds: Issued by city
housing authorities to finance homes for low and
moderate income people. Because these bonds are
tax exempt the issuer use them to borrow funds at
low interest and then make low interest mortgage
loans.
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Municipal Bonds (continued)
The Relation between Municipals and
Taxable Yields
Interest on municipal bonds is exempt from
federal income tax.
The yield on municipals equals the yield on
taxables times one minus the marginal tax rate.
im = it (1-T)
If investor’s marginal tax rate is high then
municipal will generate higher after tax yield
than taxable securities and vice versa.
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Corporate vs. Municipal Bond
An investor has the choice of an AA-rated
corporate bond with a yield of 6% or an
AA-rated municipal yielding 4%. If the
investor has a marginal tax rate of 30%,
which bond should he/she select?
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Corporate vs. Municipal-Bond
The after-tax rate on the corporate is
6%(1 - 0.3) = 4.2% > 4% on the municipal
bond or
The pretax equivalent rate on the municipal
bond would be 4%/(1 - 0.3) = 5.7% < 6%
on the corporate

Select the corporate bond!
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Municipal Bonds (continued)
Three groups of investors in municipal bonds
whose demands are affected by their high federal
tax exposure are:
High income Households - affected by income
level and marginal tax rates.
Casualty insurance companies - determined by
industry profitability.
Commercial banks.
Commercial banks and casualty insurance companies
tend to buy tax-exempt securities with maturities that
meets their preferences, such as high credit quality
shorter term securities for commercial banks and
higher yield, lower credit rating, longer maturities for
casualty insurance companies.Copyright© 2008 John Wiley & Sons, Inc.
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Municipal Bonds (continued)
The Market for Municipal Bonds
Primary market.
• Large number of relatively small bond issues.
• Underwritten by investment bankers from local to
national markets.
• Most general obligation (GO) bonds are sold by
competitive bid.
Secondary market not well-developed - OTC
market made by dealers.
• thin secondary markets lead to larger bid-ask
spreads because it is difficult to match the buyer and
seller.
• limited marketability may leads to higher yields
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Corporate Bonds
Debt contracts require borrowers to make
periodic payments of interest (usually
semiannually) and repay principal, usually
$1,000, at maturity date.
Types of ownership record
Bearer bonds - coupon bond owned by bearer.
Registered bonds - owner noted by records.
Maturity
Term bonds - all bonds in the issue mature on
one date. Most corporate bonds are term bonds.
Serial bonds - bonds in the issue mature on
different dates.
• Most municipal bonds are serial issues.
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The Bond Indenture
Corporate bonds have an indenture( bond
legal contract) which states the rights,
privileges and obligations of the bond issuer
and the bondholder. Some bonds have
collateral assets or securities to which the
bondholders have prior claim in the event of
default of the issuer. Mortgage bond - real
assets pledged.
Equipment trust certificates – cars, trucks or
identifiable equipment.
Collateral bonds - secured by financial assets
(e.g. stocks).
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If no assets are pledged, the bonds are secured
only by the firm’s potential to generate cash flows
are called Debentures – (unsecured bonds) and such
bonds will have higher yields than similar secured
bonds.
Debentures can be
Senior debt –In the event of default, giving
the bondholders first priority to firm’s assets
after the secured claims.
Subordinated (junior) debt– Bondholder’s
claims to the company’s assets rank behind
the senior debt.
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Corporate Bonds Provisions
Many corporate bonds have provisions such as :
Sinking fund Provisions– Rather than the issuer
repaying the entire principal of a bond issue on the
maturity date, the issuer provide funds to
another company(trustee) retire a portion of the issue
annually. The retirements of the bonds (which is must as
promised in indenture) could be through purchasing
them in open market or calling them if a call provision is
present.
Call provision - borrower right to buy back bond
before maturity.
Convertible bonds are bonds that can be converted to
another security at the discretion(choice) of the
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Investors in Corporate Bonds
Major investors include:
Life insurance companies.
Pension funds.
Corporate bonds are attractive to life insurance and pension
funds because such bonds are long term, high yields and
since they in low marginal tax brackets and thus these bonds
provide them with higher yields than the tax exempt bonds.
Households.
Foreign Investors.
Investor requirements:
Long-term investment horizon.
Liquidity not always needed - hold to maturity.
Safety - investment grade.
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Tax considerations.
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Primary Market for Corporate Bonds
1. Public sale - open to all interested buyers,
which is done through investment banks that
acts as underwriters.
Competitive sale - public auction among
underwriters and the issue is sold to the
underwriter with the bid that results with
lowest borrowing cost to the issuer.
Negotiated sale - underwriting contract
signed with specific underwriters.
The main difference between the two methods
of sale is that in negotiated sale the
investment banker provides the origination
and advising services as part of the negotiated
package, while in the competitive sale the
investment banker does
not
provide
these
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2008 John
Wiley & Sons,
Inc.
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services.
Primary Market for Corporate Bonds
2. Private placement - sold to limited number
(< 35) of sophisticated buyers, avoiding
registration and disclosure requirements.
private placements have increased relative to
public sale.
when interest rates are high and/or when capital
market conditions are unstable, private
placements increase.
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Secondary Market for Corporate Bonds
Most secondary trading of corporate bonds
occurs through dealers.
the volume of trading is low – a thin
market, thus there is a wide bid/ask
differential in the market.
corporate bonds are less marketable than money
market instruments because they are long term,
in general longer-term securities are riskier and
less marketable.
Corporate bonds have special features such as
call provision that make them difficult to value.
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Junk bond issuance in the late 1990’s
Junk bonds are low rated (high default risk)
corporate bonds.
Development of the junk bond primary market
was enhanced by the secondary market maintained
by Drexel, Burnham and Lambert in the early
1980s.
Higher risk firms found they could issue longer
term, more flexible securities in the high-yield
market rather than borrow from commercial banks
and demand for junk bonds came from financial
institutions such as life insurance, pension funds,
mutual funds.
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