PowerPoint Slides for:

Financial Markets and Institutions 6th Edition

By Jeff Madura Prepared by David R. Durst The University of Akron

CHAPTER

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

Copyright 2002 Thomson Publishing. All rights reserved.

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

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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

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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
Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

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 9 PV 936 PMT 80 FV 1000
Copyright 2002 Thomson Publishing. All rights reserved.

Background on Bonds
Bonds by Issuers

Issuer Federal Government (U.S. Treasury)

Federal Agencies

Type of Bond Treasury Bonds

Federal Agency Bonds

State and Local Governments

Corporations

Municipal Bonds
Corporate Bonds
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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

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Treasury Bonds

Treasury Bond Quotations

8.38 Aug. 2013-18 103:05 103.11 YTM?
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)

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U. S. Treasury Bond Yield To Maturity

$83.80 Pmt

2013 Today =N

$1000 Ask Price = FV

$1033.44 PV*

Calc YTM

*Ask

Price = 103 and 11/32 % of Face Value or $1033.4375

Copyright 2002 Thomson Publishing. All rights reserved.

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
Copyright 2002 Thomson Publishing. All rights reserved.

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

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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

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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

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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

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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

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Corporate Bonds
Corporate Bond Terminology

Indenture
Legal

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

Trustee
Represents

indenture

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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
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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
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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

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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

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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
Copyright 2002 Thomson Publishing. All rights reserved.

Exhibit 7.5

Financial Institution

Participation in Bond Markets

Commercial banks and savings and loan associations (S&Ls)

Purchase bonds for their asset portfolio. ometimes place municipal bonds for municipalities. S Sometimes issue bonds as a source of secondary capital.

Finance companies Mutual funds

Commonly issue bonds as a source of long-term funds. Use funds received from the sale of shares to purchase bonds. Some bond mutual funds specialize in particular types of bonds, while others invest in all types. Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market. Place newly issued bonds for governments and corporations. They may place the bonds and assume the risk of market price uncertainty or place the bonds on a best-efforts basis in which they do not guarantee a price for the issuer. Purchase bonds for their asset portfolio. Purchase bonds for their asset portfolio.

Brokerage rms Investment banking rms

Insurance companies Pension funds

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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

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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

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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

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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

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