1

CHAPTER 7

Bond Markets

Financial Markets and Institutions, 10e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
 2

Chapter Outline
• Background on bonds
• Types of bonds and their characteristic
• Globalization of bond markets
• Other types of long-term debt securities
 3

Background on Bonds
• 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 and automatically send coupon
payments to the owners
 4

How Bond Markets Facilitate the Flow of Funds

Spending on
$ to buy Treasury U.S. $
bonds Government
Treasury
Programs

Purchases of
$ to buy Federal $ Mortgages Originated
Agency bonds Corporations by Financial
Households, Institutions
and
Institutional Spending on State
Investors $ to buy Municipal $ and Local
bonds Municipalities
Government
Programs

$ to buy Corporate Spending to

bonds $
Corporations Expand
Operations
 5

Institutional Use of Bond Markets

• All financial institutions participate in bond
markets
• On any given day, commercial banks, bond mutual
funds, insurance companies, and pension funds are
dominant participants
• A financial institution’s investment decisions will
often simultaneously affect bond market and
other financial market activity
 6

Participation of Financial Institution in Bond Markets

FINANCIAL INSTITUTION PARTICIPATION IN BOND MARKETS

Commercial banks and savings and - Purchase bonds for their asset portfolio
loan associations(S&Ls) - Sometimes place municipal bonds for municipalities
- Sometimes issue bonds as a source of secondary capital
Finance companies - Commonly issue bonds as a source of long-term funds

Mutual funds - Use funds received from the sale of shares to purchase
bonds. Some bond mutual funds specialize in particular types
of bonds, while others invest in all types
Brokerage firms - Facilitate bond trading by matching up buyers and sellers of
bonds in the secondary market
Investment banking firms - Place newly issued bonds for governments and
corporations. They may place the bonds and assume the
risk of market price uncertainty or place the bonds on a
best-efforts basis in which they do not guarantee a price for
the issuer.
Insurance companies - Purchase bonds for their asset portfolio

Pension funds - Purchase bonds for their asset portfolio

 7

Background on Bonds (cont’d)

• Bond yields
• Issuer’s perspective
The issuer’s cost of financing is measured by the yield to maturity
• 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
• Investor’s perspective
The holding period return is used by investors who do not hold a
bond to maturity
 8

Treasury and Federal Agency Bonds

• 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
 9

Treasury and Federal Agency Bonds

(cont’d)
• 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
• 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
 10

Treasury and Federal Agency Bonds

(cont’d)
• 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
• Profit from the bid-ask spread
• Conduct trading with the Fed during open market operations
• Typical daily volume is about $200 billion
• Online trading
• TreasuryDirect program (http://www.treasurydirect.gov)
• Treasury bond quotations
• Online quotations at
• http://www.investinginbonds.com
• http://www.federalreserve.gov/releases/H15/
 11

Treasury and Federal Agency Bonds

(cont’d)
• Stripped Treasury bonds
• One security represents the principal payment and a
second security represents the interest payments
• 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
 12

Treasury and Federal Agency Bonds

(cont’d)
• 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
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?
Principal  $1,000  1.013  $1,013
Coupon Payment  5%  $1,013  $50.65
13
 14

Treasury and Federal Agency Bonds

(cont’d)
• Savings bonds
• Issued by the Treasury
• Denomination is as small as $25
• 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
 15

Municipal Bonds
• Municipal bonds can be classified as either general
obligation bonds or revenue bonds
• General obligation bonds are supported by the municipal
government’s ability to tax
• Revenue bonds are supported by the revenues of the project for
which the bonds were issued
• 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
 16

Municipal Bonds (cont’d)

• 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
• Results in a higher cost for the investor
 17

Municipal Bonds (cont’d)

• 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
 18

Municipal Bonds (cont’d)

• 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
 19

Municipal Bonds (cont’d)

• Trading and quotations
• Investors can buy or sell munis by contacting brokerage firms
• Electronic trading has become popular
• http://www.tradingedge.com
• Online quotations are available at http://www.munidirect.com and
http://www.investinginbonds.com
 20

Municipal Bonds (cont’d)

• 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
• Of a liquidity premium to compensate for less liquidity
• The federal tax exemption of municipal bonds
 21

Municipal Bonds (cont’d)

• 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
• Investors require a premium for longer-term securities with lower
liquidity in both markets
 22

Corporate Bonds
• 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
 23

Corporate Bonds (cont’d)

• Corporate bond yields and risk
• Interest income earned on corporate represents
ordinary income
• Yield curve
• Affected by interest rate expectations, a liquidity premium, and
maturity preferences of corporations
• Similar shape as the municipal bond yield curve
• Default rate
• Depends on economic conditions
• Less than 1 percent in the late 1990s
• Exceeded 3 percent in 2002
 24

Corporate Bonds (cont’d)

• Corporate bond yields and risk (cont’d)
• Investor assessment of risk
• 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
• 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
 25

Corporate Bonds (cont’d)

• 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
 26

Corporate Bonds (cont’d)

• 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:
• 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
 27

Corporate Bonds (cont’d)

• Characteristics of corporate bonds (cont’d)
• Call provisions:
• Require the firm to pay a price above par value when it calls its bonds
• 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
• Are a disadvantage to bondholders
 28

Corporate Bonds (cont’d)

• Bond collateral
• Typically, 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
 29

Corporate Bonds (cont’d)

• 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
• Variable-rate bonds:
• 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
 30

Corporate Bonds (cont’d)

• 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:
• http://www.schwab.com
• http://www.etrade.com
 31

Corporate Bonds (cont’d)

• 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
 32

Corporate Bonds (cont’d)

• Junk bonds
• 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
• Currently about 3,700 junk bond offerings exist with a market value of
$80 billion
• Participation in the junk bond market
• 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
 33

Corporate Bonds (cont’d)

• Junk bonds (cont’d)
• Risk premium of junk bonds
• The typical premium is between 3 and 7 percent above Treasury
bonds with the same maturity
• Performance of junk bonds
• In the early 1990s, the popularity of junk bonds declined because
of
• Insider trading allegations
• The financial problems of a few major issuers of junk bonds
• The financial problems in the thrift industry
• In the late-1990s, junk bonds performed well with few defaults
 34

Corporate Bonds (cont’d)

• Junk bonds (cont’d)
• Contagion effects in the junk bond market
• Specific adverse information may discourage investors from investment
in junk bonds
 35

Corporate Bonds (cont’d)

• How corporate bonds facilitate restructuring
• Using bonds to finance a leveraged buyout
• An LBO is typically financed with senior debt and subordinated debt
• LBO activity increased dramatically in the later 1980s
• Many firms with excessive financial leverage resulting from LBOs
reissued stock in the 1990s
 36

Corporate Bonds (cont’d)

• How corporate bonds facilitate restructuring
(cont’d)
• Using 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
 37

Globalization of Bond Markets

• 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)
 38

Globalization of Bond Markets (cont’d)

• 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