CHAPTER 8

BOND MARKETS
CHAPTER OBJECTIVES
1.
This chapter continues our review of the fixed-income financial markets, and analyzes
the debt securities of the capital market. In the last chapter we studied the money market, a collection of
markets where short-term, marketable obligations with little chance of default are bought and sold. This
chapter focuses on the debt capital market, its securities, its issuers, and investors.
2.
The primary objective of this chapter is to describe the function of major participants in,
and financial instruments traded in, our nation's capital markets.
3.
Students should note that the secondary market for capital markets instruments allows
households, businesses, and other participants to diversify risk and obtain portfolio flexibility. As a result,
more funds flow into the capital markets, flow to the most productive uses (allocational efficiency), and
as competition increases among financial market dealer/brokers and financial institutions, the savers'
returns are higher and the borrowers' costs are lower (operational efficiency) than would otherwise be the
case.
4.
Students should be familiar with the broad spectrum of financial instruments that
comprise the capital markets. The major instruments include corporate, municipal, government and
convertible bonds, and preferred and common stocks, covered in the next chapter. The use of financial
guarantees has become very important, as has securitization.
5.
Each year money and capital markets move closer to a fully integrated 24-hour
international market. Trading of U.S. Treasuries approaches that today.
CHANGES FROM THE LAST EDITION
1.

All tables and figures have been updated.

2.

The Fixed Income Markets chapter has been split into two chapters: Money Markets (last
chapter) and Bond Markets for this edition.

CHAPTER KEY POINTS

1.
Capital markets exist to facilitate the transfer of funds from surplus spending units to
deficit spending units. In contrast with short-term money markets, the capital markets are concerned with
the transfer of funds that can be used to finance long-term capital investments.
2.
Financial markets operate with varying degrees of efficiency. Allocational efficiency is
the extent funds flow from saving to the highest productive uses. Operational efficiency is present when
there is sufficient competition between market makers (broker/dealer) and financial institutions. Most
students have had some background discussion related to informational efficiency, the extent to which all

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participants are receiving timely, accurate, complete information. The extent of informational and
operational efficiency affects the extent of allocational efficiency.
3.
The secondary market for capital markets securities is important because it allows
investors to alter the risk exposure of their portfolios before maturity. During the 1980s Drexel, Burnham
and Lambert developed and maintained a secondary market for high yield, junk bonds. Thus a working
secondary market enhances the primary market. Investors are encouraged to buy new securities if a
secondary market is present to provide liquidity.
4.
Corporations and government units are the major issuers of capital market claims (deficit
spending units), and households are the major holders of capital market claims. Financial intermediaries
acquire capital market claims with funds obtained by issuing their own liabilities. The type of capital
market claims that each intermediary acquires depends on its business objectives, its tax status, and the
type liabilities it has issued to obtain its funds.
5.
A number of service institutions facilitate capital market transactions. These include:
investment banks, brokers and dealers, security exchanges, credit rating services, financial institutions
who extend financial guarantees, and regulatory authorities--particularly the Securities and Exchange
Commission (SEC).
6.

The major capital market instruments covered in this and following chapters are as

follows:
Debt
Securities

Equity
Securities

corporate bonds
state and municipal bonds
government bonds
federal agency bonds
mortgages

common stock
preferred stock
convertible stock

ANSWERS TO END-OF-CHAPTER QUESTIONS

1.
Calculate the gross profit that an underwriter would make if it sold $10 million worth of
bonds at par (face value) and paid the firm that sold the bonds 99.25% of par.
The gross profit would be .75% of the $10 million raised in the market or
.0075 (10,000,000) = $75,000.
2.
If a bond dealer bought a $100,000 municipal bond at 90% of par and sold it at 93% of
par, how much money did the dealer make on the bid-ask spread?
The spread of 3% of $100,000 is $3000.
3.
If a corporate bond paid 9% interest, and you are in the 28% income tax bracket, what
rate would you have to earn on a general obligation municipal bond of equivalent risk and maturity in

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order to be equally well off? Given that municipal bonds are often not easily marketable, would you want
to earn a higher or lower rate than the rate you just calculated?
The after tax yield on the taxable corporate bond is 9%(1-.28) =6.48% is the comparable rate of a
tax-free municipal bond. For any added risk on the muni-bond, the investor would pay less or require a
higher rate of return above 6.48%.
4.
If a trust is established to securitize $100 million in auto loans that paid 13% interest
and the average rate paid on the tranches issued was 10%, while financial guarantees to protect against
default on the loans cost 1.5%, how much money would the creator of the trust have available to pay for
loan servicing and profits if the financial guarantee was purchased?
With a revenue rate of 13% and expenses of 11.5% (10% rate plus 1.5% guarantee cost), the
annual cash flows available for loan servicing and profits is .015 x $100 million = $1.5 million.
5.
Why are private placements of securities often popular with both the buyer and seller of
the securities?
Private placements are direct sales between borrowers and the ultimate investor. The costly and
time-consuming SEC registration is not required for private placements. In general, both issuers and
investors believe they can negotiate a better deal than if they transacted in the public market.
6.
Give a concise definition for the following types of municipal bonds: (a) general
obligation, (b) revenue, (c) industrial development, and (d) mortgage-backed.
The important characteristics of the above bonds are: (a) general obligation bonds are backed by
the full taxing ability of the states or municipalities; (b) revenue bonds default risk characteristics are
determined by the expected revenue flow from the revenue project; (c) industrial development bonds are
essentially loans at the tax-exempt interest rate to business; and (d) mortgage-backed bonds are
collateralized by mortgages and provide mortgage loans to individuals at the tax-exempt rate.
7.
What features make municipal bonds attractive to certain groups of investors? Why do
other investors not want to hold municipal securities?
All other factors being equal, investors select the security that provides the highest after-tax yield.
In general, investors in high tax brackets find municipal bonds attractive investments --they have higher
after-tax yields compared to similar taxable securities.
8.
Define the following terms: (a) private placement, (b) asset-backed security, (c) callable
securities, (d) sinking fund provisions, and (e) convertible features of securities.
The above terms are explained as follows: (a) private placement is the sale of bonds to a single
investor or small group of sophisticated investors, that meet the guidelines for avoiding registration and
disclosure requirements of the SEC and state laws; (b) asset-backed securities are the financial claims
issued when loans are securitized; (c) callable securities can be retired by the issuer's option prior to their
stated maturity; (d) sinking fund is a provision that requires the issuer to retire a percentage of a bond
issue on an annual basis; and (e) convertible features of securities are options of the investor to convert
the security into another form of security.

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9.
Explain how securities are brought to market under (a) a competitive sale and (b) a
negotiated sale. How do the two methods of sale differ?
In a competitive sale, investment bankers bid on the securities as per a public notice. In a
negotiated sale, a single investment banker and the issuer negotiate a deal; the investment banker often
provides financial advice to the issuer and helps design the security issue.
10.

List and describe the different forms of financial guarantees seen in the bond markets?

Financial guarantees are credit enhancements offered by a high quality credit risk to a lower
credit risk. Insurance companies write insurance policies to back bond issues in case of default;
commercial banks back commercial paper with lines of credit (paying off the commercial paper in case of
credit deterioration) or SWAP transactions.
ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS
DO YOU UNDERSTAND?
1. Why do businesses use the capital markets?
Solution: Businesses use the capital market to finance long-term investments and to provide a "market
value" evaluation of company performance.
2. What is the difference between a T-bill, T-note, and T-bond?
Solution: There are two major factors that differentiate T-bill, T-notes, and T-bonds: term and interest
payments and denomination. T-bills are offered at varied maturities out to one year and are zero-coupon
or discount securities at a minimum denomination of $10,000. T-notes, five and ten-year maturities, are
coupon securities with $1000 denominations. T-bonds, with maturities greater than 10 years, are $1000
face value, coupon securities.
3. What is a strip? Explain how they are created?
Solution: A Separate Trading of Registered Interest and Principal (STRIPS) are zero-coupon claims on a
either the interest (every six months) or principal of a standard T-note or bond, provided the investing
public's demand for zero-coupon securities.
4. Explain how strips can be used to immunize portfolios against interest rate risk?
Solution: STRIPS are zero-coupon bonds and a portfolio of STRIPS will have a portfolio duration equal
to the maturity of the portfolio. If a bond is held to its duration, the realized YYM equals the expected
YTM, eliminating reinvestment and price risk.
DO YOU UNDERSTAND?

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1. Explain why sinking funds on corporate bond issues play the same role as the serial structure found on
municipal bond issues.
Solution: Sinking funds, an old term dating back to the days when companies accumulated funds to pay
off bonds at maturity, today effectively pay off bonds periodically (called or purchased in market). Serial
bonds are bonds issued with varying maturities, so that part of the bond issues matures every year,
beginning in a certain year.
2. When buying bonds, explain why investors should always make a tax-exempt and taxable
comparison? What are the ground rules for making the comparison?
Solution: Everything else the same the investor is seeking the higher after-tax return. Calculate the aftertax return of the corporate or the pre-tax equivalent rate on the municipal bond, using the investor's
marginal tax rate.
3. Why are commercial banks large investors in municipal bonds and property and casualty insurance
companies are not?
Solution: Until the Tax Reform Acts in the 1980's commercial banks were major investors in muni's.
Households are the major investor in muni's today with mutual funds second and property/casualty
insurance companies third. P/c companies have high tax exposure and seek tax sheltering via preferred
stock and muni bonds. Life insurance companies, with considerable tax shelters coming from whole life
policies, invest in taxable corporate bonds.
4. How do the secondary markets differ between municipal bonds and corporate bonds?
Explain how and why the junk bond market had an impact on commercial bank lending?
Solution: The secondary market for municipals is a dealer market and is quite thin, as are many corporate
bond issues. There are more large-issues of corporates, some listed on exchanges, that trade more
frequently in dealer markets.
DO YOU UNDERSTAND?
1. Why are asset-backed securities becoming increasingly important in the capital markets?
Solution: Many of them are tailored to provide characteristics, such as products with financial
guarantees, predictable cash flows, or floating rate characteristics, that some buyers of capital market
securities value highly, and thus are willing to pay a premium price to obtain. Since those tailored
products are highly desirable, more of them are being created.
2. Why are financial guarantees becoming increasingly important in the financial markets both
domestically and internationally?
Solution: People need only to ascertain the creditworthiness of the guarantor and not the creditworthiness
of each underlying asset. Furthermore, the interest cost saving from the improved credit-enhanced credit
rating exceeds the cost of the guarantee. Financial guarantees are increasingly important in international
markets as the credit-worthiness of the guarantor is often easier to assess than the creditworthiness of the
borrower. Also, because collection activities across borders are problematic, it often will be easier to
collect

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from a guarantor that has a financial reputation to protect than from a defaulting borrower in another
country.
3. What types of credit enhancement can be obtained to make asset-backed securities more desirable?
Solution: Financial guarantees such as bond insurance, standby letters of credit, the use of cash collateral
accounts, the use of subordinated tranches that enhance senior tranches by bearing the default risk, and
the set-aside of profits and servicing fee accruals to protect buyers of tranches against future losses.
4. Why are financial markets regulated, and who is the principal U.S. regulator?
Solution: Financial markets are regulated so people will retain confidence in them and continue to supply
money to them. The SEC is the principal regulator.

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CHAPTER EIGHT
TRUE-FALSE QUESTIONS
(F)

1.

Capital market securities usually finance business working capital.

(T)

2.

Bonds are contractual obligation and do not represent ownership.

(T)

3.

Capital market securities usually finance real capital investment.

(T)

4.

Businesses, governments, and individuals issue capital market securities.

(F)

5.
Capital market securities have better liquidity than money market
securities.

(T)

6.
Money market securities are all debt securities; capital market securities are
either debt or equity securities.

(T)

7.

Capital market interest rates tend to be higher than money market rates
for any issuer.

(T)
8.
Life insurance companies are more likely to invest in corporate capital
market securities than commercial banks.
(T)

9.

Investors may invest in capital market securities either directly or indirectly.

(F)

10.
Both governments and businesses issue both debt and equity capital
market securities.

(F)

11.

Households owe more financially than they own.

(T)
12.
Financial institutions and households own about the same amount of
financial assets.
(T)

13.

In the U.S. there more mortgages outstanding than corporate bonds.

(F)

14.

Yields on U.S. Treasury "ask" prices are higher than yields quoted on "bid"
prices.

(T)

15.

A U.S. Treasury STRIP is a zero-coupon bond.

(T)

16.

Most State and Local government bonds are sold to finance education.

(T)

17.

A serial bond issue matures over a period of years.

(T)

18.

Households are the major investor in municipal bonds.

(F)

19.

U.S. Treasury TIPS protect investors primarily from default risk.

(T)
20.
A state turnpike authority is more likely to issue revenue bonds than
general obligation bonds.
(F)
(T)

21.
Lower marginal tax rates increase the demand for tax-exempt securities.
22.
The money market provides liquidity for deficit units; the capital market
finances economic growth.

(T)

23.
The primary market for junk bonds expanded for higher risk firms as the
secondary market for junk bonds developed.

(T)

24.
Capital market borrowing by businesses is generally repaid from the cash
flow generated by the assets financed.

(F)

25.
Commercial banks purchase more tax-exempt securities when loan losses
increase.

(F)

26.
One of the fastest growing loan areas for commercial banks in the 1980s
was financial guarantees.

(T)

27.
Revenue bonds are generally considered more risky than general
obligation bonds.

(F)

28.
The after-tax return on a 9 percent tax-exempt municipal bond to a
commercial bank in the 34 percent tax bracket is 5.94 percent.

MULTIPLE-CHOICE QUESTIONS
(c)

1.

Which of the following is not an example of capital market securities?

a.
common stocks
b.
convertible bonds
c.
commercial paper
d.
mortgages

(c)

2.

Most general obligation bonds are sold through

a.
direct placement.
b.
negotiated bids.
c.
competitive bids.
d.
all of the above.

(b)

3.

Which of the following firms is least likely to hold tax-exempt municipal bonds?
a.
commercial banks
b.
pension funds
c.
mutual funds
d.
households

(d)

4.

The secondary markets for capital market securities have facilitated economic
growth in our country because
a.
they help provide marketability for capital market claims.
b.
they have increased people's willingness to buy capital market claims.
c.
they make people more willing to invest because they can more easily
diversify their risk.
d.
all of the above

(a)

5.

Everything else being equal, a bond will sell at a higher yield if it

a.
has a call provision.
b.
has low default risk.
c.
can be converted to stock.
d.
is listed on an exchange.

(d)

6.

Which of the following would be least likely to purchase a tax-exempt municipal

bond?
a.
commercial bank
b.
casualty insurance company
c.
mutual fund
d.
individuals in low tax brackets

(b)

7.

Security exchanges provide a valuable function in that they

a.
create interest in stocks.
b.
increase the marketability of securities.
c.
provide a legal way to gamble.
d.
supply money to deficit spending units.

(d)

8.

Regulators provide a valuable function for the capital markets because they
a.
try to keep the market participants honest.
b.
try to prevent excessive speculation from destabilizing the market.
c.
make sure all pertinent information about publicly traded securities is
disclosed.
d.
all of the above

(b)

9.

In the 1980s low credit quality businesses were able to first issue their new bond
securities in which market?
a.
municipal bond market
b.
junk bond market
c.
stock market
d.
secondary market

(a)

10.

A capital market financing is most likely to finance

a.
new plant and equipment.
b.
seasonal inventory needs.
c.
a quarterly dividend payment.
d.
the sale of common stock.