Chapter Three

Bond Market
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• The previous discussed short-term securities that trade in a
market we call the money market.
• This chapter talks about the first of several securities that
trade in a market we call the capital market.
• Capital markets are for securities with an original maturity
that is greater than one year.
• These securities include bonds, stocks, and mortgages.
• We will devote an entire chapter to each major type of
capital market security due to their importance to investors,
businesses, and the economy.
• This chapter begins with a brief introduction on how the
capital markets operate before launching into the study of
bonds.
• In the next chapter we will study stocks and the stock market
 Introduction to Debt Market
• A security (also called a financial instrument) is a claim
on the issuer’s future income or assets (any financial
claim or piece of property that is subject to
ownership).
• A bond is a debt security that promises to make
payments periodically for a specified period of time.
• Debt markets, also often referred to generically as the
bond market, are especially important to economic activity
because they enable corporations and governments to
borrow in order to finance their activities;
• The bond market is also where interest rates are
determined.
 Purpose of the Capital Market
• Firms that issue capital market securities and the
investors who buy them have very different
motivations than those who operate in the money
markets.
• Firms and individuals use the money markets primarily
to warehouse funds for short periods of time until a
more important need or a more productive use for the
funds arises.
• By contrast, firms and individuals use the capital
markets for long-term investments.
• The primary reason that individuals and firms choose
to borrow long-term is to reduce the risk that interest
 Capital Market Participants
• The primary issuers of capital market securities
are federal and local governments and
corporations.
• The federal government issues long-term notes
and bonds to fund the national debt. State and
municipal governments also issue long-term notes
and bonds to finance capital projects, such as
school and prison construction.
 Cont’d…

• Corporations issue both bonds and stock.

• One of the most difficult decisions a firm faces can be
whether it should finance its growth with debt or equity.
• The distribution of a firm’s capital between debt and
equity is its capital structure.
• Corporations may enter the capital markets because
they do not have sufficient capital to fund their
investment opportunities.
• Alternatively, firms may choose to enter the capital
markets because they want to preserve their capital to
protect against unexpected needs.
• In either case, the availability of efficiently functioning
capital markets is crucial to the continued health of the
 Cont’d…
• This was dramatically demonstrated during the
2008–2009 financial crisis.
• With the near collapse of the bond and stock
markets, funds for business expansion dried up.
• This led to reduced business activity, high
unemployment, and slow growth.
• Only after market confidence was restored did a
recovery begin.
• The largest purchasers of capital market securities
are households.
• Frequently, individuals and households deposit funds
in financial institutions that use the funds to purchase
capital market instruments such as bonds or stock.
 Capital Market Trading
• Capital market trading occurs in either the primary market or
the secondary market.
• The primary market is where new issues of stocks and bonds
are introduced.
• Investment funds, corporations, and individual investors can
all purchase securities offered in the primary market.
• You can think of a primary market transaction as one
• where the issuer of the security actually receives the
proceeds of the sale.
• When firms sell securities for the very first time, the issue is
an initial public offering (IPO).
• Subsequent sales of a firm’s new stocks or bonds to the
public are simply primary market transactions (as opposed to
an initial one).
 Secondary markets
• The capital markets have well-developed secondary markets.
• A secondary market is where the sale of previously issued securities
takes place, and it is important because most investors plan to sell
long-term bonds before they reach maturity and eventually to sell
their holdings of stock.
• There are two types of exchanges in the secondary market for
capital securities: organized exchanges and over-the-counter
exchanges.
• Whereas most money market transactions originate over the phone,
most capital market transactions, measured by volume, occur in
organized exchanges.
– An organized exchange has a building where securities (including stocks,
bonds, options, and futures) trade.
– Exchange rules govern trading to ensure the efficient and legal operation of
the exchange, and the exchange’s board constantly reviews these rules to
ensure that they result in competitive trading.
 Types of Bonds
• Bonds are securities that represent a debt owed by the issuer to the
investor.
• Bonds obligate the issuer to pay a specified amount at a given date,
generally with periodic interest payments.
• The par, face, or maturity value of the bond is the amount that the
issuer must pay at maturity.
• The coupon rate is the rate of interest that the issuer must pay, and
this periodic interest payment is often called the coupon payment.
• This rate is usually fixed for the duration of the bond and does not
fluctuate with market interest rates.
• If the repayment terms of a bond are not met, the holder of a bond
has a claim on the assets of the issuer.
• Look at the Figure below, the face value of the bond is given in the
upper-right corner.
• The interest rate of 8 %, along with the maturity date, is reported
several times on the face of the bond.
Hamilton/BP Corporate Bond
 Treasury Notes and Bonds
• The U.S. Treasury issues notes and bonds to finance the
national debt.
• The difference between a note and a bond is that notes
have an original maturity of 1 to 10 years while bonds have
an original maturity of 10 to 30 years. (Recall from Chapter
2that Treasury bills mature in less than one year.)
• The Treasury currently issues notes with 2-,3-, 5-, 7-, and 10-
year maturities.
• In addition to the 20-year bond, the Treasury resumed
issuing 30-year bonds in February 2006.
• Table 12.1 summarizes the maturity differences among
Treasury securities.
• The prices of Treasury notes, bonds, and bills are quoted as
a percentage of $100 face value.
• Federal government notes and bonds are free of default risk
because the government can always print money to pay off
 T ABLE Treasury Securities
Type Maturity
Treasury bill Less than 1 year
Treasury note 1 to 10 years
Treasury bond 10 to 30 years

Interest Rate on Treasury Bonds and the Inflation Rate,

Rate (%)
14 1973–2010 (January of each year)
12 10-Year Bonds

10

4 Inflation

0
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
 Treasury Bond Interest Rates
• Treasury bonds have very low interest rates because they have
no default risk.
• Although investors in Treasury bonds have found themselves
earning less than the rate of inflation in some years (see
Figure above), most of the time the interest rate on Treasury
notes and bonds is above that on money market securities
because of interest-rate risk.
• Figure below plots the yield on 20-year Treasury bonds against
the yield on 90-day Treasury bills.
• Two things are noteworthy in this graph.
a) First, in most years, the rate of return on the short-term bill is
below that on the 20-year bond.
b) Second, short-term rates are more volatile than long-term rates.
Short-term rates are more influenced by the current rate of
Rate (%) Interest Rate on Treasury Bills and Treasury
16 Bonds, 1974–2010 (January of each year)
14

20-Year Treasury Bonds

12

10

6 90-Day
Treasury Bills
4

0
1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
 Agency Bonds
• Congress has authorized a number of U.S. agencies to issue
bonds (also known as government-sponsored enterprises (GSEs).
• The government does not explicitly guarantee agency bonds,
though most investors feel that the government would not allow
the agencies to default.
• Issuers of agency bonds include the Student Loan Marketing
Association (Sallie Mae), the Farmers Home Administration, the
Federal Housing Administration, the Veterans Administrations,
and the Federal Land Banks.
• These agencies issue bonds to raise funds that are used for
purposes that Congress has deemed to be in the national
interest.
• For example, Sallie Mae helps provide student loans to increase
access to college.
• The risk on agency bonds is actually very low.
 Municipal Bonds
• Municipal bonds are securities issued by local, county, and
state governments.
• The proceeds from these bonds are used to finance public
interest projects such as schools, utilities, and
transportation systems.
• Municipal bonds that are issued to pay for essential public
projects are exempt from federal taxation.
• This allows the municipality to borrow at a lower cost
because investors will be satisfied with lower interest rates
on tax-exempt bonds. You can use the following equation to
determine what tax-free rate of interest is equivalent to a
taxable rate:
Equivalent tax-free rate = taxable interest rate * (1 - marginal
tax rate)
 Test Your Understanding

• Suppose that the interest rate on a taxable

corporate bond is 9% and that the marginal
tax is 28%.
• Suppose a tax-free municipal bond with a
rate of 6.75% was available.

• Required:
• Which security would you choose?
 Solution
• The tax-free equivalent municipal interest rate
is 6.48%.
• where
– Taxable interest rate = 0.09
– Marginal tax rate = 0.28
• Thus, Since the tax-free municipal bond rate
(6.75%) is higher than the equivalent tax-free
rate (6.48%), choose the municipal bond.
 Types of municipal bonds
• There are two types of municipal bonds: general obligation bonds
and revenue bonds.
1) General obligation bonds:
• do not have specific assets pledged as security or a specific
source of revenue allocated for their repayment.
• Instead, they are backed by the “full faith and credit” of the issuer.
• This phrase means that the issuer promises to use every resource
available to repay the bond as promised. Most general obligation bond
issues must be approved by the taxpayers because the taxing authority
of the government is pledged for their repayment.
2) Revenue bonds, by contrast,:
• are backed by the cash flow of a particular revenue-generating project.
• For example, revenue bonds may be issued to build a toll bridge, with
the tolls being pledged as repayment.
• If the revenues are not sufficient to repay the bonds, they may go into
default, and investors may suffer losses.
 Shifts in the Demand for Bonds
• The conclusion we have reached is that in a business cycle expansion with
growing wealth, the demand for bonds rises and the demand curve for bonds
shifts to the right. Using the same reasoning, in a recession, when income and
wealth are falling, the demand for bonds falls, and the demand curve shifts to
the left.
• Higher expected interest rates in the future lower the expected return for long-
term bonds, decrease the demand, and shift the demand curve to the left.
• Lower expected interest rates in the future increase the demand for long-term
bonds and shift the demand curve to the right
• An increase in the expected rate of inflation lowers the expected return for
bonds, causing their demand to decline and the demand curve to shift to the left.
• An increase in the riskiness of bonds causes the demand for bonds to fall and the
demand curve to shift to the left.
• An increase in the riskiness of alternative assets causes the demand for bonds to
rise and the demand curve to shift to the right
• Increased liquidity of bonds results in an increased demand for bonds, and the
demand curve shifts to the right. Similarly, increased liquidity of alternative
assets lowers the demand for bonds and shifts the demand curve to the left.
 What Do Interest Rates Mean and What Is
Their Role in Valuation?
• Interest rates are among the most closely watched variables
in the economy.
• Their movements are reported almost daily by the news
media because they directly affect our everyday lives and
have important consequences for the health of the
economy.
• They affect personal decisions such as whether to consume
or save
• The yield to maturity is the most accurate measure of
interest rates
• The yield to maturity is what financial economists mean
when they use the term interest rate.
 Yield to Maturity
• Of the several common ways of calculating
interest rates, the most important is the yield to
maturity, the interest rate that equates the
present value of cash flows received from a debt
instrument with its value today.
• Because the concept behind the calculation of the
yield to maturity makes good economic sense,
financial economists consider it the most accurate
measure of interest rates.
 Real and Nominal Interest Rates
• the interest rate that is adjusted by subtracting expected
changes in the price level (inflation) so that it more
accurately reflects the true cost of borrowing.
• This interest rate is more precisely referred to as the ex
ante real interest rate because it is adjusted for expected
changes in the price level.
• The ex ante real interest rate is most important to
economic decisions
• When the real interest rate is low, there are greater
incentives to borrow and fewer incentives to lend.
• The real interest rate is more accurately defined by the
Fisher equation, named for Irving Fisher
 Interest Rates and Returns
• Many people think that the interest rate on a bond
tells them all they need to know about how well off
they are as a result of owning it.
• How well a person does by holding a bond or any
other security over a particular time period is
accurately measured by the return, or, in more
precise terminology, the rate of return.
• For any security, the rate of return is defined as the
payments to the owner plus the change in its value,
expressed as a fraction of its purchase price.
• The return on a bond will not necessarily equal the
interest rate on that bond.
 Why Do Interest Rates Change?
• In the early 1950s, nominal interest rates on three-
month Treasury bills were about 1% at an annual rate;
• by 1981, they had reached over 15%,
• then fell to 3% in 1993,
• rose above 5% by the mid-1990s, dropped to near 1%
in 2003,
• began rising again to over 5% by 2007, and
• then fell to zero in 2008.
What explains these substantial fluctuations
in interest rates?
 Interest
Rate (%)
16

12

8
Nominal Rate

0
Estimated Real Rate

–4
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Real and Nominal Interest Rates (Three-Month Treasury Bill), 1953–2010

 Reasons
1) Interest rates are negatively related to the
price of bonds, so if we can explain why
bond prices change, we can also explain
why interest rates fluctuate.
2) Here we will apply supply-and demand
analysis to examine how bond prices and
interest rates change.
 Determinants of Asset Demand
• An asset is a piece of property that is a store of value. Items such as money,
bonds, stocks, art, land, houses, farm equipment, and manufacturing
machinery are all assets.
• Facing the question of whether to buy and hold an asset or whether to buy
one asset rather than another, an individual must consider the following
factors:
• 1. Wealth, the total resources owned by the individual, including all assets
• Holding everything else constant, an increase in wealth raises the quantity demanded of an
asset.
• 2. Expected return (the return expected over the next period) on one asset
relative to alternative assets
• 3. Risk (the degree of uncertainty associated with the return) on one asset
relative to alternative assets
• holding everything else constant, if an asset’s risk rises relative to that of alternative assets,
its quantity demanded will fall.
• 4. Liquidity (the ease and speed with which an asset can be turned into cash)
relative to alternative assets
• The more liquid an asset is relative to alternative assets, holding everything else unchanged,
the more desirable it is, and the greater will be the quantity demanded.
 Summary
• All the determining factors we have just discussed can be
summarized by stating that, holding all the other factors
constant:
• 1. The quantity demanded of an asset is usually positively
related to wealth, with the response being greater if the asset is
a luxury than if it is a necessity.
• 2. The quantity demanded of an asset is positively related to its
expected return relative to alternative assets.
• 3. The quantity demanded of an asset is negatively related to
the risk of its returns relative to alternative assets.
• 4. The quantity demanded of an asset is positively related to its
liquidity relative to alternative assets.
 L atin.
C----Increase
T----Decrease
TABLE 4.1 Summary Response of the Quantity of an Asset Demanded to
SUMMARY Changes in Wealth, Expected Returns, Risk, and Liquidity

Wealth
T ABLE 4. 2 Summary Factors That Shift the Demand Curve for Bonds

Wealth
P

Bd Bd

Bd Bd

Bd Bd

P
to other assets

Bd Bd

P
to other assets

Bd Bd

in demand would be the opposite of those indicated in the remaining columns.

Rate (%)

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

FI GURE 4. 5 Expected Inflation and Interest Rates (Three-Month Treasury Bills),

1953–2010

mating expected inflation as a function of past interest rates, inflation, and time trends.
 Chapter 5 How Do Risk and Term Structure Affect Interest Rates? 90
Annual
Yield (%)
16

14

12
Corporate Aaa Bonds

10

8
Corporate Baa Bonds
6

4 U.S. Government
Long-Term Bonds
2 State and Local Government
(Municipal)
0
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Interest
Rate (%)
16

14
Three-to-
12 Five-Year
Averages
10

8
20-Year Bond
6 Averages

2 Three-Month Bills
(Short-Term)
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
 Behavior in financial markets
• Expectations of returns, risk, and liquidity are central
elements in the demand for assets;
• Expectations of inflation have a major impact on
bond prices and interest rates;
• expectations about the likelihood of default are the
most important factor that determines the risk
structure of interest rates; and
• expectations of future short-term interest rates play a
central role in determining the term structure of
interest rates.
• Not only are expectations critical in understanding
behavior in financial markets
 Are Financial Markets Efficient?
• To understand how expectations are formed so that we
can understand how securities prices move over time,
we look at the efficient market hypothesis.
• Theoretically, the efficient market hypothesis should be
a powerful tool for analyzing behavior in financial
markets.
• But to establish that it is in reality a useful tool, we must
compare the theory with the data.
• Does the empirical evidence support the theory?
• Though mixed, the available evidence indicates that for
many purposes, this theory is a good starting point for
analyzing expectations.
 The Efficient Market Hypothesis
• To more fully understand how expectations affect
securities prices, we need to look at how information in
the market affects these prices.
• To do this we examine the efficient market hypothesis
(also referred to as the theory of efficient capital markets),
– which states that prices of securities in financial
markets fully reflect all available information.
• Rate of return from holding a security equals the sum of the
capital gain on the security (the change in the price) plus any
cash payments, divided by the initial purchase price of the
security
• The efficient market hypothesis views expectations as equal to
optimal forecasts using all available information
 Rationale Behind the Hypothesis
• To see why the efficient market hypothesis makes
sense, we make use of the concept of arbitrage, in
which market participants (arbitrageurs) eliminate
unexploited profit opportunities, meaning returns
on a security that are larger than what is justified
by the characteristics of that security.
• There are two types of arbitrage,
– pure arbitrage, in which the elimination of unexploited
profit opportunities involves no risk, and
– the type of arbitrage we discuss here, in which the
arbitrageur takes on some risk when eliminating the
unexploited profit opportunities.