Bond Markets
Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.
Chapter Outline
Background on bonds Treasury and federal agency bonds Municipal bonds Corporate bonds Institutional use of bond markets Globalization of bond markets
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
Bond yields
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
The holding period return is used by investors who do not hold a bond to maturity
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
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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
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
Bond quotations are organized according to their maturity, with the shortest maturity listed first Bid and ask prices are quoted per hundreds of dollars of par value Online quotations at
http://www.investinginbonds.com http://www.federalreserve.gov/releases/H15/
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
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
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Savings bonds
Issued by the Treasury 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 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
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Municipal Bonds
Municipal bonds can be classified as either general obligation bonds or revenue bonds
General obligation bonds are supported by he municipal governments 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
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Credit risk
Less
than .5 percent of all municipal bonds issued since 1940 have defaulted Moodys, Standard and Poors, and Fitch Investor Service assign ratings to municipal bonds Some municipal bonds are insured against default
payments adjust to movements in a benchmark interest rate Some variable-rate munis are convertible to a fixed rate under specified conditions
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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
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can buy or sell munis by contacting brokerage firms Electronic trading has become popular
http://www.tradingedge.com
Online
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
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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
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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
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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
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Investors may only consider purchasing corporate bonds after assessing the issuing firms 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 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
Bond ratings
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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
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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 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
Protective covenants:
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provisions:
The difference between the call price and par value is the call premium
Require the firm to pay a price above par value when it calls its bonds
Bond collateral
Typically,
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 firms assets that are junior to the claims of mortgage bonds and regular debentures
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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
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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
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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
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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 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
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Insider trading allegations The financial problems of a few major issuers of junk bonds The financial problems in the thrift industry
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Specific adverse information may discourage investors from investment in junk bonds
Ivan Boesky admitting to insider trading violations Drexel Burnham Lamberts bankruptcy filing
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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
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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
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any given day, commercial banks, bond mutual funds, insurance companies, and pension funds are dominant participants
A financial institutions investment decisions will often simultaneously affect bond market and other financial market activity
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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)
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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
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