7

Bond Markets

Chapter Objectives
Provide informational background on U.S. Treasury, state and municipal, and corporate Bonds Calculate bond yield from quote Explain the role of bonds to institutional investors Discuss the globalization of bond markets

Background on Bonds

Bonds represent long-term debt securities

Contractual Promise to pay future cash flows to investors

The issuer of the bond is obligated to pay:

Interest (or coupon) payments periodically usually semiannually Par or face value (principal) at maturity

Primary vs. secondary market for bonds

Background on Bonds
Bond Interest Rates The issuers cost of financing with bonds is the coupon rate Determined by current market rates and risk Usually fixed throughout term Determines periodic interest payments

Background on Bonds
Bond Yield to Maturity
The yield to maturity (TYM) is the yield that equates the future coupon and principal payments with the bond price
The YTM is the investors expected rate of return if the bond is held to maturity The actual YTM may vary from the expected because of risks assumed by the investors

Background on Bonds
Let us take a bond that has 10 (N) years to maturity with the interest coupon paid each year of $80 (Pmt) and a par value of $1,000 (FV) to be paid at maturity. Given a k (I/Y) at 9%, what is the present value (PV) of the bond?

PV = Pmt1 / (1 + k )1 + Pmt2 / (1 + k )2 + FV2 / (1 + k )2 =$801/(1 + .09 )1 ++ $8010/(1 + .09 )10 +$1,00010/(1 + .09 )10

= $801 (0.9174) +... + $8010 (0.4224)

= $73.39 ++ $33.79 + $422.40 = $935.82

+ $1,000 (0.4224)

Background on Bonds
Bond Yield to Maturity
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. N 10 I PV PMT FV 936 80 1000

Background on Bonds
Bond Yield to Maturity

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. N 10 I PV PMT 80 FV 1000 8.997 936

Background on Bonds
Bonds by Issuers
Issuer Federal Government (U.S. Treasury) Federal Agencies State and Local Governments Corporations Type of Bond Treasury Bonds Federal Agency Bonds Municipal Bonds Corporate Bonds

U. S. Treasury Bonds
Issued by the U.S. Treasury to finance federal government expenditures Maturity

Notes, < 10 Years Bonds, > 10 to 30 Years

Active OTC Secondary Market Semiannual Interest Payments Benchmark Debt Security for Any Maturity

Treasury Bonds

Treasury Bond Quotations

103:05 103.11 YTM?

8.38 Aug. 2013-18

Coupon rate Maturity date Bid/Ask price as percent of face value Fractions of price in 32nds
Example:

Bid price 103:05, Ask price 103:11

Yield to Maturity (YTM)

U. S. Treasury Bond Yield To Maturity

$83.80 Pmt

2013 2005 =8

$1000 Maturity Value = FV

$1033.44 PV*

Calc YTM

*Ask

Price = 103 and 11/32 % of Face Value or $1,033.4375

YTM = 7.8025%

Treasury Bonds
Cash Flow Variation in T-Bonds

Coupon bonds
Interest paid semiannually To registered bondholders

Stripped Treasury bonds

Zero-coupon securities are sold with claims on U. S. Treasury bonds held in a trust
One

security represents the principal payment (np) at maturity Other securities represents the interest payments (ci) at interest paying dates

Treasury Bonds
Inflation-Indexed Bonds

Intended for investors who seek inflation protection with their investments Coupon rates less than other Treasuries Principal value adjusted for the U.S. inflation rate (CPI) every 6 months Coupon income increases with inflation

Federal Agency Bonds

Government National Mortgage Association (GNMA)

Issues bonds and uses proceeds to purchase insured FHA and VA mortgages A U.S. Government Agency Backed by explicit guarantee of Federal Government Example of social allocation of capital

Federal Agency Bonds

Federal Home Loan Mortgage Association (Freddie Mac)

Issues bonds and uses proceeds to purchase conventional mortgages A U.S. government-sponsored agency No explicit guarantee of bonds by federal government, but credit risk is very low Used to provide liquidity for thrifts and support of home ownership

Municipal Bonds

State and local government obligations

Revenue bonds vs. general obligation Bonds Investor interest income exempt from federal income tax Tax Reform Act of 1986 placed limitations on tax-exempt bond issuance for private purposes

Corporate Bonds

When corporations want to borrow for longterm periods they issue corporate bonds
Usually pay semiannual interest Most have maturities between 10-30 years Public offering vs. private placement Limited exchange, larger OTC secondary market Investors seek safety of principal and steady income

Corporate Bonds
Corporate Bond Terminology

Indenture
Legal

document specifying rights and obligations of issuer and bondholder bondholders to assure compliance with

Trustee
Represents

indenture

Corporate Bonds
Corporate Bond Terminology
Sinking Fund Provision Requirement that the firm retire a certain amount or number of bonds each year Protects investors with principal reduction Protective Covenants Places restrictions on the firm to protect bondholders Examples: limits dividends and officer salaries, restricts additional debt

Corporate Bonds
Corporate Bond Terminology

Call provisions: Ability to pay bonds off early

Call

premium Advantage to issuers; disadvantage to investor

Bond collateral
Usually

consists of a mortgage on real property Unsecured bonds are called debentures and are backed only by the general credit of the issuing firm

Corporate Bonds
Corporate Bond Terminology

Low-coupon and zero-coupon bonds

Provide

investors known rate of return Imputed interest income taxed if not in tax-sheltered investment plan Attractive to pension funds with expected payouts

Variable-rate bonds Convertible bonds

Corporate Bonds

Junk Bonds
Junk bonds are also called high-yield bonds or noninvestment rated bonds Popularized in the direct finance boom of the 1980s The risk premium is between three and seven percent above Treasury bonds and susceptible to contagion effects Secondary market supported by dealer market

Corporate Bonds Market Quotation

ATT 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 2029 7.3% current yield (annual interest/price) 214 bonds traded on this day Bond priced at close of day 88 5/8th % of face ($1000) or $886.25 Bond price up point for the day or $2.50

Corporate Bonds Market Quotation

ATT 6 29 7.3 214 88 5/8th +1/4

7.3% current yield is $65/886.25 Using your financial calculator: PV = -886.25 Pmt = $32.5 semiannually FV = $1,000 N = 24X2 = 48 CPT I/Y = 7.53% = Yield to Maturity

Major Investors in Corporate Bonds, December, 2001

Mutual Funds $420 Bil.

Households and Trusts$608 Billion

Foreign Investors $1.23 Trillion Life Insurance Companies $1.33 Trillion

Globalization of Bond Markets

Foreign investment in dollar securities Foreign issuance by U.S. firms Increased global investment by pension and mutual funds Development of foreign security markets24 hour trading Eurobond market

Globalization of Bond Markets

Eurobond Market

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

Globalization of Bond Markets

Eurobond Market
An underwriting syndicate of investment banks participates in placing the bonds
Issuer

can choose the currency in which the bond interest and principal are denominated Dollar denominated most common Bearer bonds vs. registered bonds