fin226 summer 2011 lectures ch 6 slides

8/6/2019 FIN226 Summer 2011 Lectures Ch 6 Slides

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2009, The McGraw-Hill Companies, All Rights Reserved6-1McGraw-Hill/Irwin

Chapter SixBond Markets


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Bond and Bond Markets

Capital markets involve equity and debtinstruments with maturities of more than one year

Bonds are long-term debt obligations issued bycorporations and government units

Bond markets are markets in which bonds areissued and traded

Treasury notes (T-notes) and bonds (T-bonds) Municipal bonds (Munis)

Corporate bonds


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Bond Market Instruments

Outstanding, 1994-2007

$0

$2

$4

$6

$8

$10

$12

Trillions

1994 2007

Corporate Treasuries Munis


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Treasury Notes and Bonds

Treasury notes and bonds (T-notes and T-

bonds) are issued by the U.S. Treasury to finance

the national debt and other governmentexpenditures

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: )(1

t

N

ttt

TGND


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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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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 $1,000 May be either fixed principal or inflation-indexed

inflation-indexed bonds are called Treasury Inflation Protection

Securities (TIPS)

the principal value of TIPS is adjusted by the percentage change in

the Consumer Price Index (CPI) every six months

Trade in very active secondary markets

Prices are quoted as percentages of face value, in 32nds


7/202009, The McGraw-Hill Companies, All Rights Reserved6-7McGraw-Hill/Irwin

Treasury STRIPS

Separate Trading of Registered Interest and Principal

Securities (STRIPS), a.k.a. Treasury zero bonds or

Treasury zero-coupon bonds

Financial institutions and government securities brokers

and dealers create STRIPS from T-notes and T-bonds

STRIPS have the periodic interest payments separated

from each other and from the principal payment

one set of securities reflects interest payments

one set of securities reflects principal payments

STRIPS are used to immunize against interest rate risk




Clean prices are calculated as:

Vb = the present value of the bond

M= the par value of the bond

INT= annual interest payment (in dollars)

N= the number of years until the bond matures

m = the number of times per year interest is paid

id= interest rate used to discount cash flows on the bond

)()(,/,/ NmmidNmmidb

PVIFMPVIFA

m

INTV




Accrued interest on T-notes and T-bonds is

calculated as:

The full (or dirty) price of a T-note or T-bond is

the sum of the clean price (Vb) and the accruedinterest

periodcouponindaysofnumberActual

paymentcouponlastsincedaysofnumberActual

2interestAccrued INT




The primary market of T-notes and T-bonds issimilar to that of T-bills; the U.S. Treasury sells T-notes and T-bonds through competitive and

noncompetitive single-bid auctions 2-year notes are auctioned monthly

3, 5, and 10-year notes are auctioned quarterly (Feb,May, Aug, and Nov)

30-year bonds are auctioned semi-annually (Feb andAug)

Most secondary trading occurs directly throughbrokers and dealers



Municipal Bonds

Municipal bonds (Munis) are securities issued by state

and local governments

to fund imbalances between expenditures and receipts

to finance long-term capital outlays

Attractive to household investors because interest is

exempt from federal and most local income taxes

General obligation (GO) bonds are backed by the full

faith and credit of the issuing municipality

Revenue bonds aresold to finance specific revenue

generating projects



Municipal Bonds

Compare Muni returns with fully taxable

corporate bonds by finding the after tax return for

corporate bonds: ia= ib(1t)ia = after-tax rate of return on a taxable corporate bond

ib = before-tax rate of return on a taxable bond

t = marginal total income tax rate of the bond holder

Alternately, convert Muni interest rates to taxequivalent rates of return: ib= ia/(1t)



Municipal Bonds

Primary markets

firm commitment underwriting: a public offering of Munis made

through an investment bank, where the investment bank guarantees

a price for the newly issued bonds by buying the entire issue andthen reselling it to the public

best efforts offering: a public offering in which the investment

bank does not guarantee a firm price

private placement: bonds are sold on a semi-private basis to

qualified investors (generally FIs)

Secondary markets: Munis trade infrequently due mainly

to a lack of information on bond issuers



Corporate Bonds

Corporate bonds are long-term bonds issued by

corporations

A bond indenture is the legal contract thatspecifies the rights and obligations of the issuer

and the holders

Bearer versus registeredbonds

Term versus serialbonds

Mortgage bonds are secured debt issues



Corporate Bonds

Debentures and subordinated debentures

Convertible bonds versus non-convertible

bonds

icvb = rate of return on a convertible bond

incvb = rate of return on a nonconvertible bond

opcvb = value of the conversion option

Stock warrants give bondholders the opportunity

to purchase common stock at a prespecified price

cvbncvbcvbopii



Corporate Bonds

Callable bonds versus non-callable bonds

incb = rate of return on a noncallable bond

icb = rate of return on a callable bond

opcb = value of the call option

A Sinking fund provision is a requirement thatthe issuer retire a certain amount of the bond issue

early as the bonds approach maturity

cvbcbncbopii



Corporate Bonds

Primary markets are identical to that of Munis

Secondary markets

the exchange market (e.g., NYSE) the over-the-counter (OTC) market

Bond ratings

the two major bond rating agencies are Moodys and

Standard & Poors (S&P) bonds are rated by perceived default risk

bonds may be either investment or speculative (i.e.,junk) grade


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Bond Market Indexes

Managed by major investment banks

Reflect both the monthly capital gain and loss on

bonds plus any interest (coupon) income earned Changes in values of bond indexes can be used by

bond traders to evaluate changes in the investment

attractiveness of bonds of different types and

maturities


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Bond Market Participants

The major issuers of debt market securities are federal,

state and local governments, and corporations

The major purchasers of capital market securities are

households, businesses, government units, and foreign

investors

businesses and financial firms (e.g., banks, insurance companies,

and mutual funds) are the major suppliers of funds for Munis and

corporate bonds foreign investors and governments are the major suppliers of funds

for T-notes and T-bonds


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2009 The McGraw Hill Companies All Rights Reserved6 20McGraw-Hill/Irwin

International Bonds and Markets

International bond markets involve unregistered bonds that areinternationally syndicated, offered simultaneously to investors inseveral countries, and issued outside of the jurisdiction of any singlecountry

Eurobonds are long-term bonds issued outside the country of thecurrency in which they are denominated

Foreign Bonds are long-term bonds issued outside of the issuershome country

Brady Bonds are bonds swapped for an outstanding loan to a less

developed country Sovereign Bonds are Brady Bonds that have had their underlying

collateral removed and the creditworthiness of the country issubstituted instead

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