Chapter Six

Bond Markets

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consent of McGraw-Hill Education.
 Bond Markets
Capital markets are markets for equity and debt
instruments with original issue maturities of more than one
year.
Bonds are long-term debt obligations issued by
corporations and government units.
Bond markets are markets in which bonds are issued and
traded.
• Treasury notes (T-notes) and bonds (T-bonds).
• Municipal bonds.
• Corporate bonds.

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 Bond Market Instruments
Outstanding, 1994 - 2016
Figure 6–1 Bond Market Instruments Outstanding, 1994–2016

Sources: Federal Reserve Board website, “Flow of Funds Accounts,” various

issues. www.federalreserve.gov
Access the long description slide. 6-3
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 Treasury Notes and Bonds 1

• Treasury notes and bonds (T-notes and T-bonds) are

issued by the U.S. Treasury to finance the national debt
and other government expenditures.
• The annual federal deficit is equal to annual expenditures
(G) less taxes (T) received.
• The national debt (ND) is the sum of historical annual
federal deficits:
𝑁

𝑁𝐷𝑡 = ෍(𝐺𝑡 − 𝑇𝑡 )
𝑡=1

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 Composition of the U.S. National
Debt
Figure 6–2 Composition of the U.S. National Debt

*Includes securities held by government trust funds, revolving funds, and special funds such as Social Security and government
pension funds.
†Includes U.S. savings securities, dollar-denominated foreign government securities issued by the U.S. Treasury directly to foreign
governments, and other.
Sources: U.S. Treasury Department, Treasury Bulletin, various issues. www.ustreas.gov
Access the long description slide. 6-5
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 Treasury Notes and Bonds 2

• Default risk free: backed by the full faith and credit of the U.S.
government.
• Low returns: low interest rates (yields to maturity) reflect low
default risk.
• Interest rate risk: because of their long maturity, T-notes and
T-bonds experience wider price fluctuations than money
market securities when interest rates change.
• Liquidity risk: older issued T-bonds and T-notes trade less
frequently than newly issued T-bonds and T-notes.

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 Treasury Notes and Bonds 3

T-notes have original maturities from over 1 to 10 years.

T-bonds have original maturities from over 10 years.
Issued in minimum denominations (multiples) of $100.
May be either fixed principal or inflation-indexed.
• Principal value used to determine the coupon on inflation-
indexed bonds is adjusted to reflect inflation (measured by
the CPI).
• In other words, the semiannual coupon payments and the
final principal payment of inflation-indexed bonds are
based on the inflation-adjusted principal value of the
security.
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 Treasury Notes and Bonds 3

• Trade in very active secondary markets.

• Prices are quoted as percentages of face value.

• Coupon rates are set at intervals of 0.125.

1
or of 1 percent.
8

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 Sample Treasury Bond Quote 1

$1,000 par Treasury Bond

Maturity Coupon Bid Asked Chg Asked Yld

11/15/2045 3.000 107.6563 107.6865 0.0938 2.624

• Maturity mo/yr: Month and year, the bond matures November

15, 2045, but it may be callable before that time.
• Coupon: Coupon rate of 3% or $30.00 per year but paid
semiannually ($1,000 face).
• Bid: The closing price per $100 of par the dealer will pay to buy
the bond; the seller would receive this price from selling to the
dealer. In this case, 107.6563% of $1,000 or $1,076.56.
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 Sample Treasury Bond Quote 2

Maturity Coupon Bid Asked Chg Asked Yld

11/15/2045 3.000 107.6563 107.6865 0.0938 2.624

• Asked: The closing price per $100 of par the dealer requires to sell
the bond; the buyer would pay this price to the dealer. In this case,
107.6865% of $1,000 or $1,076.87.
• Chg: The change from the prior closing Asked price. In this case, the
Asked price increased 0.0938 from the prior quoted closing ask
price.
• Asked Yld = Promised compound yield rate if purchased at the
Asked price. In this case, the yield is 2.624% .

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 Bond Valuation

• The market price of an asset equals:

CF1 CF2 CF3 CFN + M
P= + + + ... +
(1 + r ) (1 + r ) (1 + r )
1 2 3
(1 + r ) N

where: P = the price of the financial asset

CFt = cash flow at end of year t (t=1,2,…,N)
N = maturity of the financial asset
r = appropriate discount rate

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McGraw-Hill/Irwin
 Bond Valuation
The market price of an asset equals:

INT1 INT2 INT3 INTN + M

P= + + + ... +
(1 + r ) (1 + r ) (1 + r )
1 2 3
(1 + r ) N

where: P = the price of the financial asset

CFt = cash flow at end of year t (t=1,2,…,N)
N = maturity of the financial asset
r = appropriate discount rate

© 2019 McGraw-Hill Education.

McGraw-Hill/Irwin
 Bond Valuation
The market price of an asset equals:

where: PVn = the price of the financial asset

CFt = cash flow at end of year t (t=1,2,…,N)
N = maturity of the financial asset
r = appropriate discount rate

© 2019 McGraw-Hill Education.

McGraw-Hill/Irwin
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 Treasury STRIPS
Separate Trading of Registered Interest and Principal Securities
(STRIPS), a.k.a. “Treasury zero bonds” or “Treasury zero-coupon
bonds”.
• Treasury security in which the periodic interest payment is separated from
the final principal payment, effectively creating two sets of securities –
one set for each semiannual interest payment and one for the final
principal payment.
Created by the U.S. Treasury in response to the separate trading of
Treasury security principal and interest that had been developed by
securities firms.
STRIPS may be used to immunize against interest rate risk.

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 Treasury Note and Bond Yields
t
• Prices quoted in the financial æ ö
÷
mN ç
INT ç
ç 1 ÷÷
÷ M
press (i.e., “clean prices”) are vb = å ç
ç
ç r
÷
÷
m t= 1 ç1 + b ÷
+
æ rb ÷ ömN
÷ ç1 + ÷
calculated as: è m÷
ç ø ç
ç m÷
è ø
æ 1 ö
÷
ç
ç1 - mN ÷
ç æ r ö ÷
÷ æ ö
÷
ç
ç ç b ÷ ÷ ç
ç ÷
ç1 + ÷
÷ ÷ ç ÷
INT ç
ç ç
è m ø ÷
÷ ç 1 ÷
÷
= ç
ç ÷
÷ + M ç
ç mN ÷
m çç
rb ÷
÷ ç
çæ rb ÷ ö ÷ ÷
÷
ç ÷
÷ çç
ç1 + ÷ ÷
ç
ç m ÷
÷ ç
èç
è m ÷
÷
ø ø
ç
ç ÷
÷
Vb = the present value of the bond è ø

M = the par (i.e., face) value of the bond

INT = annual interest payment = par value * coupon rate
N = the number of years until the bond matures
m = the number of times per year interest is paid
rb = interest rate used to discount cash flows on the bond 6-16
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 Treasury Note and Bond Yields
t
• Prices quoted in the financial æ ö
÷
mN ç
INT ç
ç 1 ÷÷
÷ M
press (i.e., “clean prices”) are vb = å ç
ç
ç r
÷
÷
m t= 1 ç1 + b ÷
+
æ rb ÷ ömN
÷ ç1 + ÷
calculated as: è m÷
ç ø ç
ç m÷
è ø
æ 1 ö
÷
ç
ç1 - mN ÷
ç æ r ö ÷
÷ æ ö
÷
ç
ç ç b ÷ ÷ ç
ç ÷
ç1 + ÷
÷ ÷ ç ÷
INT ç
ç ç
è m ø ÷
÷ ç 1 ÷
÷
= ç
ç ÷
÷ + M ç
ç mN ÷
m çç
rb ÷
÷ ç
çæ rb ÷ ö ÷ ÷
÷
ç ÷
÷ çç
ç1 + ÷ ÷
ç
ç m ÷ ç
èç
è m ÷
ø ÷
ø
ç ÷
÷
ç
è ÷
ø
Vb = the present value of the bond
M = the par (i.e., face) value of the bond
INT = annual interest payment = par value * coupon rate
N = the number of years until the bond matures
m = the number of times per year interest is paid
rb = interest rate used to discount cash flows on the bond 6-17
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 Accrued Interest 1

Accrued interest must be paid by the buyer of a bond to

the seller of a bond if the bond is purchased between
interest payment dates.
• It is the portion of the coupon payment accrued between the last
coupon payment and the settlement day .

The price of the T-bond or T-note with accrued interest is

called the full price or the dirty price, while the price
without accounting for accrued interest is the clean price.

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 Accrued Interest 2

• Accrued interest on T-notes and T-bonds is calculated as:

𝐼𝑁𝑇 Actual number of days since last coupon payment

Accrued interest = ×
2 Actual number of days in coupon period

• The full (or dirty) price of a T-note or T-bond is the sum of the
clean price (Vb) and the accrued interest.

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 Accrued Interest Example
• You buy a 6% coupon $1,000 par T-bond 59 days after the last
coupon payment. Settlement occurs in two days. You become the
owner 61 days after the last coupon payment (59+2), and there are
121 days remaining until the next coupon payment. The bond’s
clean price quote is 120.59375. What is the full or dirty price
(sometimes called the invoice price)?

$60 61
Accrued Interest =  =$10.05
2 (121+ 61)
• The clean price is 120.59375% of $1,000 or $1,205.9375.
• Thus, the dirty price is $1,205.9375 + $10.05 = $1,215.9875.

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 Accrued Interest Exercise
On October 5, 2022, you purchase a $10,000 T-note that
matures on August 15, 2031 (settlement occurs one day
after purchase, so you receive actual ownership of the bond
on October 6, 2022). The coupon rate on the T-note is
4.375 percent and the current price quoted on the bond is
105.250 percent. The last coupon payment occurred on
May 15, 2022 (144 days before settlement), and the next
coupon payment will be paid on November 15, 2022
(40 days from settlement).

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 Accrued Interest Exercise

a. Calculate the accrued interest due to the seller from the

buyer at settlement.
b. Calculate the dirty price of this transaction.

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 Accrued Interest Exercise
On July 10, 2022, you purchase a $10,000 T-note that matures
on December 31, 2028 (settlement occurs one day after
purchase, so you receive actual ownership of the bond on July
11, 2022). The coupon rate on the T-note is 2.125 percent and
the current price quoted on the bond is 98.250 percent. The last
coupon payment occurred on June 30, 2022 (11 days before
settlement), and the next coupon payment will be paid on
December 31, 2022 (173 days from settlement).
a. Calculate the accrued interest due to the seller from the
buyer at settlement.
b. Calculate the dirty price of this transaction.

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 Sessional 1 till here!!

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