Finance 300 Financial Markets Lecture 16 Professor J. Petry, Fall, 2002©

Finance 300Financial Markets

Lecture 16

Professor J. Petry, Fall, 2002©

http://www.cba.uiuc.edu/jpetry/Fin_300_fa02/http://webboard.cites.uiuc.edu/

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HousekeepingAgenda

– Please note that your first Stewardship Report is due the class period after the next exam.

• The next exam is Tuesday, November 5th. – Will cover chapters VI, VII and VIII.

• Stewardship report are due Thursday, November 7th. – Bond Analysis Project Begins a week from today.

• Be sure your groups are set by this Thursday, October 24th. • Sign-up form will be posted at 12:50, Tuesday, October 29th.

It will be the same place as before.

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Chapter VI – Government BondsThe US Fixed Income Market

Sector Size ($bln) % of MarketTreasury 2,967$ 18.8%Federal Agency 1,907$ 12.1%Tax-exempt 1,555$ 9.8%Corporate 3,372$ 21.3%Mortgage-backed 2,491$ 15.8%Asset Backed 854$ 5.4%Money Market 2,656$ 16.8%

15,802$ 100.0%*Statistical Abstract of the United States, 2001.

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Chapter VI – Government Bonds

Government Bond Market Components– US Treasury is single largest debt issuer in the world. Treasury

Notes and Bonds account for nearly $3 trillion in debt, this does not count short term money market issuance of the US government, nor government sponsored agency debt.

– Until recently, debt issuance had been fueled by large government deficits.

– Federal Agencies (Freddie Mac, Fannie Mae) and Municipalities (state and local governments) make up the remainder of government related debt.

– Corporate, asset backed and mortgage backed fixed income securities are the next two chapters.

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Treasury Notes & Treasury Bonds: Primary Market– There are ~40 primary market dealers. To become a dealer you

must meet Federal Reserve Standards and capital requirements. You must also agree to bid in all Treasury market auctions and to make a market in Treasury Securities.

– Auctions are held on a regular basis. They are similar to T-bill auctions, but Notes and Bonds are awarded on at the same market clearing yields for all participants—all purchases are at the same price.

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Chapter VI – Government BondsTreasury Notes & Treasury Bonds: Secondary Market

– The secondary market is principally OTC (Over the Counter).• OTC is an informal network of brokers and dealers who negotiate sales of securities, as

opposed to them trading on a formal exchange (e.g. NYSE). – Inside Market: the market where treasury dealers trade with one another

through brokers.– Government brokers: trade not for their own accounts, but for dealers. This

provides the dealers anonymity. – Outside Market: the market where dealers trade with investors in the retail

market.– When-Issued Market: An investor buys a security after the announcement of

a bond issue, but before the bond is actually issued by the Treasury. The seller obtains and delivers the bond to the purchaser as soon as it is issued.

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– Dealer’s Profit• Come from three sources: bid-ask spread, inventory profits &

carry.– Pricing of T-Notes & T-Bonds

• Specified in dollars per $100 face value, in 32nds.• Occasionally you will see + after quote, which means to add

1/64. 98:12+ would therefore mean, 98 and 12/32 plus 1/64 = 98 and 25/64s.

• Maturity is always on the 15th of the month.

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Government Bonds & NotesRate Maturity Bid Ask Chg Ask Yld9 1/4 Aug 05 103:23 103:25 +3 5.86

6 Aug 05n 98:22 98:24 +3 5.868 Aug 06n 103:25 103:27 +7 6.08

7 1/2 Feb 08 103:31 104:01 +10 6.259 1/2 Feb 08n 110:14 110:16 +11 6.25

12 3/8 May 11 132:18 132:24 +20 6.4312 1/2 Aug 09-14 147:17 147:23 +23 6.70

12-Jun-04

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– Accrued Accounting• When government bonds/notes change hands between coupon payments, the

spoils need to be divided between the seller and purchaser of the bond. • Accrued accounting on government issues are based on the actual number of

days in the month and in the year--including leap years.– Example: You buy 6 of ‘05 on June 13, 2004

• Note that the quote on previous page was for June 12 th, there is a one day delay for transaction to settle. You receive the bond June 13 th. Since buyer will receive the full coupon, must compensate the seller in purchase price.

• It pays coupons on August 15th and February 15th of $60,000/2=30,000. (The prices quoted in the WSJ are for round lots of $1,000,000.)

• The coupon period from Feb 15th to Aug 15th is 182 (2004 is a leap year = 182; would be 181 in non-leap years) and from Aug 15 th to Feb 15th is 184 days for total of 366 (365 in non-leap years). – Feb to Aug: 28-15, 31, 30, 31, 30, 31, 15 = 182; – Aug to Feb: 31-15, 30, 31, 30, 31, 31, 15 = 184

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– Accrued Accounting Example (cont’d)• The last coupon payment was Feb 15; the seller held for 119 days: (29-

15) + 31 + 30 + 31 + 13; You will hold for 63 days: (30-13) + 31 + 15• The coupon proceeds are divided accordingly.

$30,000 x 63/182 = $10,384.62$30,000 x 119/182 = $19,615.38

• The Invoice Price is the base price of the bond plus accrued interest$987,500.00 base price $19,615.38 accrued interest$1,007,115.38 invoice price

Number of Days By MonthJan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec31 28+ 31 30 31 30 31 31 30 31 30 31

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Chapter VI – Government BondsGovernment Bond Yield & Accrued Interest

Using BA II Plus

Calculator Date enter CalculateTechnique Enter Calculate DT1= 6-13-04

SDT= 6-13-04 DT2= 8-15-04CPN= 6 DBD= 63.00000RDT= 8-15-05 ACT

RV= 100 DT1= Sun=ACT DT2= Sun=2/Y * Use 2nd [Date] to open spreadsheet

YLD= 7.118779PRI= 98.75

AI= 1.961538* AI calculated once you enter dates.

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– Example: Things to Do: VI-1 On June 12, 2004 (the day of the price quote above) you put in an order for a

$1,000,000 12 3/8% May 2011 bond.1. What is the price of this bond before accrued interest?2. Accrued interest for how many days adds how much to the price of the

bond?3. What is the total invoice price of the bond?4. When will you receive your first coupon?5. How much will you receive on this first coupon date?6. On the first coupon payment date you will have earned how much interest

over how many days?7. Calculate the yield to maturity.

Number of Days By MonthJan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec31 28+ 31 30 31 30 31 31 30 31 30 31

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– Call Features• Some T-bonds had been issued with a call feature 5 years prior to maturity. These

bonds are no longer issued, though some remain outstanding. There have never been callable notes.– For callable bonds trading at a premium to face value, yields are calculated to the nearest

call date. For callable bonds trading at a discount, yields are calculated to maturity.– Flower Bonds

• Certain government issues which had tax advantages to investors because they could be redeemed @ par to pay Federal Estate Taxes. These bonds are no longer being issued, and all issues have matured as of 1998.

– Stripped Treasuries• As we saw in Chapter VI, coupon bonds can be taken apart and sold separately. This

becomes a stripped treasury bond. You then have individual prices and yields for each coupon payment and the principal.

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Chapter VI – Government BondsFederal Agencies

– Some Federal Agencies issue their own securities to finance their own activities. There is about 1.9 trillion in outstanding debt of this type.

– Agencies generally formed for public policy reasons to channel credit to a particular sector of the economy that congress believes is not receiving adequate credit through normal private sources.

– Most debt is issued to support home mortgages and farm credit.– Agency debt is not regulated by the SEC.

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Chapter VI – Government BondsMuni’s

– Tax exempt bonds issued by state and local governments. There are about 88,000 such government entities in the US with about 1.6 trillion in debt outstanding.

– Muni’s are similar to treasury and corporate bonds, but interest income is exempt from federal income taxation, as well as taxation from state and local taxes of the home state. The exception to this tax exemption regards federal capital gains taxes—which still applies.

– The wide variety of muni bonds (callable, differing maturities, etc) is a function of the large number of issues. No SEC regulation of this market.

– There are a number of different types of Muni’s• General Obligation Bonds: backed by “the full faith and credit” (I.e. taxing

power) of the issuer. These bonds are generally viewed as nearly free of default risk.

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Chapter VI – Government BondsMuni’s (cont’d)

• Revenue Bonds: issued to finance particular projects and are backed by either revenues from that project or by the municipal agency operating the project.– Typical issues of revenue bonds include airports, hospitals, turnpikes and port

authorities.• Revenue bonds are have a higher default risk than do GO bonds.• Industrial Development Bonds are a particular type of Revenue bond.

IDBs are issued to finance commercial enterprises, such as the construction of a factory that can then be operated by a private firm. In effect, this allows the firm access to the municipalities ability to borrow at tax free rates.

– The tax treatment of muni’s allows them to be issued at a much lower yield than would be acceptable to purchasers if they were not tax advantaged.

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Chapter VI – Government BondsMuni’s (cont’d)

– y ( 1 – t ) = ym or y = ym / ( 1 - t )y = traditional taxable yieldt = marginal tax rate of the borrowerym= the equivalent yield on a tax-free municipal bond

• What yield should the City of Champaign place on its next 20 year GO bond if the equivalent Treasury bond yields 4.5%, and marginal tax rates in Champaign average 25%?

• 4.5% (1-.25) = 3.38%• If an investor is considering a federal Treasury bond which yields 5.0% or a

municipal bond which yields 3.8%, and the investors marginal tax rate is .20%, which bond is preferable? What if the investor’s marginal tax rate goes to 30%?

– Tax Risk: The additional risk of investing in muni’s which arises by the possibility that the tax exemption might change. Changes might involve the marginal tax rate of the investor, or the tax status of a particular municipal bond issue.

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Chapter VI – Government BondsMuni’s

– Muni’s are traded over-the-counter, and are generally qouted on a yield basis.

– Bond Buyer: A daily publication of fixed income statistics and indeces including new issue information

– Munifacts: on line access to BondBuyer data. – Blue List: Short for “The Blue List of Current Municipal Offerings

put out daily by S&P. Contains prices, yields and other market information.

Documents

Finance 300 Financial Markets Lecture 16 Professor J. Petry, Fall, 2002©