Bond Markets

Background on BondsBonds represent long-term debt securitiesContractualPromise to pay future cash flows to investorsThe issuer of the bond is obligated to pay:Interest (or coupon) payments periodically usually semiannuallyPar or face value (principal) at maturityPrimary vs. secondary market for bonds

Background on Bonds

The issuers cost of financing with bonds is the coupon rateDetermined by current market rates and riskUsually fixed throughout termDetermines periodic interest paymentsBond Interest Rates

Background on Bonds

The yield to maturity (TYM) is the yield that equates the future coupon and principal payments with the bond priceThe YTM is the investors expected rate of return if the bond is held to maturityThe actual YTM may vary from the expected because of risks assumed by the investors

Bond Yield to Maturity

Background on Bonds

An investor can purchase a ten-year, $1000 par value bond with an 8 percent annualized coupon rate for $936. Determine the yield to maturity for this bond.Bond Yield to Maturity

NIPVPMTFV10936801000

Background on Bonds

An investor can purchase a ten-year, $1000 par value bond with an 8 percent annualized coupon rate for $936. Determine the yield to maturity for this bond.Bond Yield to Maturity

NIPVPMTFV109936801000

Background on Bonds

Bonds by Issuers

U. S. Treasury BondsIssued by the U.S. Treasury to finance federal government expendituresMaturityNotes, < 10 YearsBonds, > 10 to 30 YearsActive OTC Secondary MarketSemiannual Interest PaymentsBenchmark Debt Security for Any Maturity

U. S. Treasury Bond Yield To Maturity $83.80 Pmt 2013 Today= N$1000Ask Price =FV Calc YTM

Treasury Bonds

Coupon bondsInterest paid semiannuallyTo registered bondholdersStripped Treasury bondsZero-coupon securities are sold with claims on U. S. Treasury bonds held in a trustOne security represents the principal payment (np) at maturityOther securities represents the interest payments (ci) at interest paying dates

Cash Flow Variation in T-Bonds

Federal Agency Bonds

Government National Mortgage Association (GNMA)Issues bonds and uses proceeds to purchase insured FHA and VA mortgagesA U.S. Government AgencyBacked by explicit guarantee of Federal GovernmentExample of social allocation of capital

Municipal BondsState and local government obligationsRevenue bonds vs. general obligation BondsInvestor interest income exempt from federal income taxTax Reform Act of 1986 placed limitations on tax-exempt bond issuance for private purposes

Corporate BondsWhen corporations want to borrow for long-term periods they issue corporate bondsUsually pay semiannual interestMost have maturities between 10-30 yearsPublic offering vs. private placementLimited exchange, larger OTC secondary marketInvestors seek safety of principal and steady income

Corporate Bonds

IndentureLegal document specifying rights and obligations of issuer and bondholderTrusteeRepresents bondholders to assure compliance with indenture

Corporate Bond Terminology

Corporate Bonds

Sinking Fund ProvisionRequirement that the firm retire a certain amount or number of bonds each yearProtects investors with principal reductionProtective CovenantsPlaces restrictions on the firm to protect bondholdersExamples: limits dividends and officer salaries, restricts additional debt

Corporate Bond Terminology

Corporate Bonds

Call provisions: Ability to pay bonds off earlyCall premiumAdvantage to issuers; disadvantage to investorBond collateralUsually consists of a mortgage on real propertyUnsecured bonds are called debentures and are backed only by the general credit of the issuing firm

Corporate Bond Terminology

Corporate Bonds

Low-coupon and zero-coupon bondsProvide investors known rate of returnImputed interest income taxed if not in tax-sheltered investment planAttractive to pension funds with expected payoutsVariable-rate bondsConvertible bonds

Corporate Bond Terminology

Corporate BondsJunk BondsJunk bonds are also called high-yield bonds or noninvestment rated bondsPopularized in the direct finance boom of the 1980sThe risk premium is between three and seven percent above Treasury bonds and susceptible to contagion effectsSecondary market supported by dealer market

Corporate Bonds Market QuotationATT 6 29 7.3 214 88 5/8th +1/4 AT&T bond quote for 1/13/02 (U.S. Exchange Bond)6.5% coupon rate Maturity in 20297.3% current yield (annual interest/price)214 bonds traded on this dayBond priced at close of day 88 5/8th % of face ($1000) or $886.25Bond price up point for the day or $2.50

Exhibit 7.5

Globalization of Bond Markets

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

Eurobond Market

Globalization of Bond Markets

An underwriting syndicate of investment banks participates in placing the bondsIssuer can choose the currency in which the bond interest and principal are denominatedDollar denominated most commonBearer bonds vs. registered bondsEurobond Market