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Chapter 7

Bond Markets

© 2001 South-Western College Publishing Company

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Chapter Objectives

Provide Informational Background On Treasury, Municipal, and Corporate Bonds

Explain The Role Of Bonds To Institutional Investor

Discuss The Globalization Of Bond Markets

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Background on Bonds

Bonds represent long-term debt securities The issuer of the bond is obligated to pay

Interest (or coupon) payments periodicallyPar value (principal) at maturity

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Background on Bonds

Bond Yields The issuer’s cost of financing with bonds

is commonly measured by the yield to maturity

The yield to maturity is the annualized discount rate that equates the future coupon and principal payments to the bond’s price (or proceeds received from the bond offering)

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Background on Bonds

Bond YieldsConsider an investor who can purchase

bonds with 10 years until maturity, a par value of $1,000, and 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

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Background on Bonds

Bond Yields If an investor holds a bond until maturity they

will earn the yield to maturity. If they sell the bond before maturity, they may

receive more or less than the YTM.

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Background on Bonds

Bonds are often classified according to the type of issuer

Issuer Type of Bond

Federal Government (Treasury)

Treasury Bonds

Federal Agency Federal Agency Bonds

State and Local Governments

Municipal Bonds

Corporations Corporate Bonds

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Treasury Bonds

Issued by the U.S. Treasury to finance federal government expenditures

MaturityNotes, < 10 YearsBonds, > 10 To 30 Years

Active OTC Secondary Market Semiannual Interest Payment Benchmark Debt Security For Any Maturity

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Treasury Bonds

Types of Treasury BondsCouponStripped Treasury Bonds

• Cash flows of bonds are stripped by securities firms

–One security represents the principal payment only

–Second security represents the interest payments only

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Treasury Bonds

Inflation-Indexed BondsBegan in 1996 Intended for investors who want to ensure

their returns keep up with inflationPrincipal value adjusted for the U.S. inflation

rate every 6 monthsStill not very popular in U.S. due to low

inflation rate

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Federal Agency Bonds

Government National Mortgage Association (GNMA) Issues bonds and uses proceeds to purchase

FHA and VA mortgagesBacked by mortgages and federal

government

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Federal Agency Bonds

Federal Home Loan Mortgage Association (Freddie Mac) Issues bonds and uses proceeds to

purchase conventional mortgagesNot backed by federal government, but

have low credit risk

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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

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Corporate Bonds

When corporations want to borrow for long-term periods they issue corporate bondsUsually pay semiannual interestMost have maturities between 10-30 years

• Recently, Coca-Cola and Walt Disney issued 100-year bonds

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Corporate Bonds

Characteristics of Corporate Bonds Indenture

• Legal document specifying rights and obligations of issuer and bondholder

–Several hundred pagesTrustee

• Represents bondholders, ensures compliance

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Corporate Bonds

Characteristics of Corporate BondsSinking Fund Provision

• Requirement that the firm retire a certain amount of the bond issue each year

Protective Covenants• Places restrictions on the firm to protect

bondholders• Examples: limits dividends and officer

salaries, restricts additional debt

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Corporate Bonds

Characteristics of Corporate BondsCall Provisions

• Call premium• Advantage to issuers

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

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Corporate Bonds

Characteristics of Corporate BondsLow- and Zero-Coupon Bonds

• Early 1980s

• Deep discountVariable-rate bondsConvertibility

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Corporate Bonds

Junk BondsJunk bonds are also called high-yield bondsOriginal-issue junk bonds became popular in

the 1980sSize of the market: junk bonds represent

about 25 percent of the market value of all corporate bonds (around $145 billion in 1998)

The risk premium is between 3 and 7 percent above Treasury bonds

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Institutional Use of Bond Markets

Commercial banks and S&Ls Finance companies Brokerage firms Investment banking firms Insurance companies Pension funds

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Globalization of Bond Markets

Foreign investment in dollar securities Foreign issuance by U.S. firms Increased global investment by pension and

mutual funds Development of foreign security markets--24

hour trading Eurobond market

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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

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Globalization of Bond Markets

Eurobond market An underwriting syndicate on investment

banks participates in placing the bonds

• Issuer can choose the currency in which the bonds are denominated