Chapter 6

Bond Markets

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Goals:
 LG 6-1. Describe the major bond markets.
 LG 6-2. Identify the characteristics of the
various bond market securities.
 LG 6-3. List the major bond market
participants.
 LG 6-4. Describe the types of securities
traded in international bond markets.

6-2
Bond and Bond Markets

 Capital
Capital markets
markets involve
involve equity
equity and
and debt
debt
instruments
instruments with
with maturities
maturities of
of more
more than
than one
one year
year
 Bonds are long-term debt obligations issued by
Bonds are long-term debt obligations issued by
corporations
corporations and
and government
government units
units
 Bond markets are markets in which bonds are
Bond markets are markets in which bonds are
issued
issued and
and traded
traded
 Treasury
Treasurynotes
notes(T-notes)
(T-notes)and
andbonds
bonds(T-bonds)
(T-bonds)
 Municipal
Municipalbonds
bonds(Munis)
(Munis)
 Corporate
Corporatebonds
bonds

6-3
Bond Market Instruments
Outstanding, 1994-2010

Bond Market Instruments

6-4
Treasury Notes and Bonds

 Treasury
Treasury notes
notes and
and bonds
bonds (T-notes
(T-notes and
and T-T-
bonds)
bonds) are
are issued
issued byby the
the U.S.
U.S. Treasury
Treasury toto finance
finance
the
the national
national debt
debt and
and other
other government
government
expenditures
expenditures
 The annual federal deficit is equal to annual
The annual federal deficit is equal to annual
expenditures
expenditures (G)(G) less
less taxes
taxes (T)
(T) received
received
 The national debt (ND) is the sum of historical
The national debt (ND) is the sum of historical
annual
annual federal
federal deficits:
deficits: N
NDt   (Gt  Tt )
t 1

6-5
Current & Projected Federal Debt
Levels

Data Source: CBO

6-6
Treasury Notes and Bonds

 Default
Defaultrisk
riskfree:
free:backed
backedby bythe
thefull
fullfaith
faithand
andcredit
creditof
ofthe
the
U.S.
U.S.government
government
 Low
Lowreturns:
returns:lowlowinterest
interestrates
rates(yields
(yieldstotomaturity)
maturity)reflect
reflectlow
low
default
defaultrisk
risk
 Interest
Interestrate
raterisk:
risk:because
becauseof oftheir
theirlong
longmaturity,
maturity,T-notes
T-notesand and
T-bonds
T-bondsexperience
experiencewider
widerprice
pricefluctuations
fluctuationsthan
thanmoney
money
market
marketsecurities
securitieswhen
wheninterest
interestrates
rateschange
change
 Liquidity
Liquidityrisk:
risk:older
olderissued
issuedT-bonds
T-bondsand andT-notes
T-notestrade
tradeless
less
frequently
frequentlythan
thannewly
newlyissued
issuedT-bonds
T-bondsand andT-notes
T-notes

6-7
Treasury Notes and Bonds

 T-notes
T-noteshave
haveoriginal
originalmaturities
maturitiesfrom
fromover
over11to
to10
10years
years
 T-bonds
T-bondshave
haveoriginal
originalmaturities
maturitiesfrom
fromover
over10
10years
years
 Issued
Issuedin
inminimum
minimumdenominations
denominations(multiples)
(multiples)of
of$1,000
$1,000
 May
Maybebeeither
eitherfixed
fixedprincipal
principalor
orinflation-indexed
inflation-indexed
 inflation-indexed
inflation-indexedbonds
bondsare
arecalled
calledTreasury
TreasuryInflation
InflationProtection
Protection
Securities
Securities(TIPS)
(TIPS)
 the
theprincipal
principalvalue
valueof
ofTIPS
TIPSisisadjusted
adjustedby
bythe
thepercentage
percentagechange
change
ininthe
theConsumer
ConsumerPrice
PriceIndex
Index(CPI)
(CPI)every
everysix
sixmonths
months
 Trade
Tradeininvery
veryactive
activesecondary
secondarymarkets
markets
 Prices
Pricesare
arequoted
quotedas
aspercentages
percentagesof
offace
facevalue,
value,in
in32nds
32nds

6-8
Sample Treasury Bond Quote

Maturity Coupon Bid Asked Chg Asked Yld

2017 Nov 15 4.250 112:26 112:27 +13 2.3316

 Maturity
Maturitymo/yr:
mo/yr:Month
Monthand andyear,
year,the
thebond
bondmatures
maturesNovember
November
15,
15,2017.
2017.
 Coupon:
Coupon:Coupon
Couponrate
rateofof4.250%
4.250%or or$42.50
$42.50per
peryear
yearbut
butpaid
paid
semiannually
semiannually($1,000
($1,000face).
face).
 Bid:
Bid:The
Theclosing
closingprice
priceper
per$100
$100ofofpar
parthe
thedealer
dealerwill
willpay
paytoto
buy
buythe
thebond;
bond;the
theseller
sellerwould
wouldreceive
receivethis
thisprice
pricefrom
fromselling
selling
to
tothe
thedealer.
dealer. Prices
Pricesare
arequoted
quotedinin32nds.
32nds. InInthis
thiscase,
case,
112:26
112:26==11211226/32%
26/32%of of$1,000
$1,000oror$1,128.125.
$1,128.125.

6-9
Sample Treasury Bond Quote

Maturity Coupon Bid Asked Chg Asked Yld

2017 Nov 15 4.250 112:26 112:27 +13 2.3316

 Asked:
Asked:TheTheclosing
closingprice
priceper
per$100
$100ofofpar
parthe
thedealer
dealerrequires
requires
to
tosell
sellthe
thebond;
bond;the
thebuyer
buyerwould
wouldpaypaythis
thisprice
priceto
tothe
thedealer.
dealer.
In
Inthis
thiscase,
case,112:27
112:27==11211227/32%
27/32%of of$1,000
$1,000or or$1,128.4375.
$1,128.4375.
 Chg:
Chg:TheThechange
changefromfromthe
theprior
priorclosing
closingASKED
ASKEDprice
priceinin
32nds.
32nds. In Inthis
thiscase,
case,the
theASKED
ASKEDprice
priceincreased
increasedthirteen
thirteen
32nds
32ndsfrom
fromthetheprior
priorquoted
quotedclosing
closingaskaskprice.
price.

6-10
Sample Treasury Bond Quote

Maturity Coupon Bid Asked Chg Asked Yld

2017 Nov 15 4.250 112:26 112:27 +13 2.3316

 Asked
AskedYld
Yld==Promised
Promisedcompound
compoundyield
yieldrate
rateififpurchased
purchasedat
at
the
theAsked
Askedprice.
price.In
Inthis
thiscase,
case,the
theyield
yieldisis2.3316%.
2.3316%.

6-11
Treasury STRIPS

 Separate
SeparateTrading
Tradingof ofRegistered
RegisteredInterest
Interestand
andPrincipal
Principal
Securities
Securities(STRIPS),
(STRIPS),a.k.a.
a.k.a.Treasury
Treasuryzero
zerobonds
bondsor orTreasury
Treasury
zero-coupon
zero-couponbonds
bonds
 Financial
Financialinstitutions
institutionsand
andgovernment
governmentsecurities
securitiesbrokers
brokersand
and
dealers
dealerscreate
createSTRIPS
STRIPSfromfromT-notes
T-notesand
andT-bonds
T-bonds
 STRIPS
STRIPShave
havethetheperiodic
periodicinterest
interestpayments
paymentsseparated
separatedfrom
from
each
eachother
otherand
andfrom
fromthe
theprincipal
principalpayment
payment
 one
oneset
setof
ofsecurities
securitiesreflects
reflectsinterest
interestpayments
payments
 one
oneset
setof
ofsecurities
securitiesreflects
reflectsprincipal
principalpayments
payments
 STRIPS
STRIPSare
areused
usedto
toimmunize
immunizeagainst
againstinterest
interestrate
raterisk
risk

6-12
Accrued Interest and Prices

 Accrued
Accrued interest
interest must
must be be paid
paid by by the
the buyer
buyer ofof aa
bond
bond to
to the
the seller
seller of
of aa bond
bond ifif the
the bond
bond isis purchased
purchased
between
between interest
interest payment
payment dates.
dates.

 The
The price
price of
of the
the bond
bond with
with accrued
accrued interest
interest isis called
called
the
the full
full price
price or or the
the dirty
dirty price,
price, the
the price
price without
without
accounting
accounting for for accrued
accrued interest
interest isis the
the clean
clean price.
price.

6-13
Accrued Interest and Prices

 “Clean”
“Clean” prices
prices are
are calculated
calculated as:
as:
INT
Vb  ( PVIFAid / m , Nm )  M ( PVIFid / m , Nm )
m
VVbb==thethepresent
presentvalue
valueof ofthe
thebond
bond
M M==thethepar
parvalue
valueofofthe
thebond
bond
INT
INT==annual
annualinterest
interestpayment
payment(in (indollars)
dollars)
NN==thethenumber
numberof ofyears
yearsuntil
untilthe
thebond
bondmatures
matures
m m==thethenumber
numberof oftimes
timesperperyear
yearinterest
interestisispaid
paid
idid==interest
interestrate
rateused
usedto todiscount
discountcash
cashflows
flowson onthe
thebond
bond

6-14
Accrued Interest on Bonds

 Accrued
Accrued interest
interest on
on T-notes
T-notes and
and T-bonds
T-bonds isis
calculated
calculated as:
as:
INT Actual number of days since last coupon payment
Accrued interest  
2 Actual number of days in coupon period

 The
The full
full (or
(or dirty)
dirty) price
price of
of aa T-note
T-note or
or T-bond
T-bond isis the
the
sum
sum ofof the
the clean
clean price
price (V
(Vbb)) and
and the
the accrued
accrued interest
interest

6-15
Accrued Interest Example

 You
Youbuy
buyaa6%
6%coupon
coupon$1,000
$1,000parparT-bond
T-bond5959days
daysafter
afterthe
thelast
last
coupon
couponpayment.
payment. Settlement
Settlementoccurs
occursinintwo
twodays.
days. You
Youbecome
become
the
theowner
owner6161days
daysafter
afterthe
thelast
lastcoupon
couponpayment
payment(59+2),
(59+2),andand
there
thereare
are121
121days
daysremaining
remaininguntil
untilthe
thenext
nextcoupon
couponpayment.
payment.
The
Thebond’s
bond’sclean
cleanprice
pricequote
quoteisis120:19.
120:19. What
Whatisisthe
thefull
fullor
ordirty
dirty
price
price(sometimes
(sometimescalled
calledthe
theinvoice
invoiceprice)?
price)?
$60 61
Accrued Interest    $10.05
2 (121  61)

 The
Theclean
cleanprice
priceisis120:19
120:19or or120
12019/32%
19/32%of
of$1,000
$1,000or
or
$1,205.9375.
$1,205.9375.
 Thus,
Thus,the
thedirty
dirtyprice
priceisis$1,205.9375
$1,205.9375++$10.05
$10.05==$1,215.9875.
$1,215.9875.

6-16
Notes and Bonds Markets

 The
The primary
primary market
market of of T-notes
T-notes and
and T-bonds
T-bonds isis
similar
similar to
to that
that of
of T-bills;
T-bills; the
the U.S.
U.S. Treasury
Treasury sells
sells T-
T-
notes
notes and
and T-bonds
T-bonds through
through competitive
competitive and
and
noncompetitive
noncompetitive single-bid
single-bid auctions
auctions
 2-year
2-yearnotes
notesare
areauctioned
auctionedmonthly
monthly
 3-,
3-,5-,
5-,and
and10-year
10-yearnotes
notesare
areauctioned
auctionedquarterly
quarterly(Feb,
(Feb,
May,
May,Aug,
Aug,and
andNov)
Nov)
 30-year
30-yearbonds
bondsare
areauctioned
auctionedsemi-annually
semi-annually(Feb
(Feband
andAug)
Aug)
 Most
Most secondary
secondary trading
trading occurs
occurs directly
directly through
through
brokers
brokers and
and dealers
dealers

6-17
Municipal Bonds

 Municipal
Municipalbonds
bonds(Munis)
(Munis)are
aresecurities
securitiesissued
issuedby
bystate
stateand
and
local
localgovernments
governments
 to
tofund
fundimbalances
imbalancesbetween
betweenexpenditures
expendituresand
andreceipts
receipts
 to
tofinance
financelong-term
long-termcapital
capitaloutlays
outlays
 Attractive
Attractiveto
tohousehold
householdinvestors
investorsbecause
becauseinterest
interestisisexempt
exempt
from
fromfederal
federaland
andmost
mostlocal
localincome
incometaxes
taxes
 General
Generalobligation
obligation(GO)
(GO)bonds
bondsarearebacked
backedby bythe
thefull
fullfaith
faith
and
andcredit
creditof
ofthe
theissuing
issuingmunicipality
municipality
 Revenue
Revenuebonds
bondsare aresold
soldto
tofinance
financespecific
specificrevenue
revenue
generating
generatingprojects
projects

6-18
Municipal Bonds

 Compare
Compare Muni Muni returns
returns with
with fully
fully taxable
taxable
corporate
corporate bonds bonds by by finding
finding the
the after
after tax
tax return
return
for
for corporate
corporate bonds: bonds:
iiaa == iibb(1
(1 –– t)t)
iiaa == after-tax
after-tax rate
rate of
of return
return on
on aa taxable
taxable corporate
corporate
bond
bond
iibb == before-tax
before-tax rate
rate ofof return
return on
on aa taxable
taxable bond
bond
tt == marginal
marginal total
total income
income tax tax rate
rate of
of the
the bond
bond holder
holder
 Alternately,
Alternately, convert
convert Muni
Muni interest
interest rates rates to to tax
tax
equivalent
equivalent rates
rates of
of return:
return: iibb == iiaa/(1
/(1 –– t)t)

6-19
Municipal Bond Rates & Taxes

 For
For aa 28%
28% taxtax bracket,
bracket, what
what isis the
the equivalent
equivalent after
after
tax
tax rate
rate of
of aa 6%
6% corporate
corporate yield?
yield?
 iiaa==6%(1-
6%(1-0.28)
0.28)==4.32%
4.32%

 For
For aa 28%
28% tax
tax bracket,
bracket, what
what corporate
corporate taxable
taxable yield
yield
isis equivalent
equivalent to
to aa 4.5%
4.5% muni
muni bond
bond rate?
rate?
 iibb==4.5%
4.5%//(1-0.28)
(1-0.28)==6.25%
6.25%

6-20
6-21
Municipal Bonds

 Primary
Primarymarkets
markets
 firm
firmcommitment
commitmentunderwriting:
underwriting:aapublic publicoffering
offeringofofMunis
Munismade
made
through
throughananinvestment
investmentbank,
bank,where
wherethetheinvestment
investmentbankbank
guarantees
guaranteesaaprice
pricefor
forthe
thenewly
newlyissued
issuedbonds
bondsbybybuying
buyingthe
the
entire
entireissue
issueand
andthen
thenreselling
resellingititto
tothe
thepublic
public
 best
bestefforts
effortsoffering:
offering:aapublic
publicoffering
offeringininwhich
whichthe
theinvestment
investment
bank
bankdoes
doesnot
notguarantee
guaranteeaafirmfirmprice
price
 private
privateplacement:
placement:bonds
bondsarearesold
soldononaasemi-private
semi-privatebasis
basisto
to
qualified
qualifiedinvestors
investors(generally
(generallyFIs)FIs)
 Secondary
Secondarymarkets:
markets:Munis
Munistrade
tradeinfrequently
infrequentlydue
duemainly
mainlyto
toaa
lack
lackof
ofinformation
informationon
onbond
bondissuers
issuers

6-22
Corporate Bonds

 Corporate
Corporate bonds
bonds are
are long-term
long-term bonds
bonds issued
issued by
by
corporations
corporations
 A bond indenture is the legal contract that specifies
A bond indenture is the legal contract that specifies
the
the rights
rights and
and obligations
obligations of
of the
the issuer
issuer and
and the
the
holders
holders
 Bearer versus registered bonds
Bearer versus registered bonds
 Term versus serial bonds
Term versus serial bonds
 Mortgage bonds are secured debt issues
Mortgage bonds are secured debt issues

6-23
6-24
Corporate Bonds

 Debentures
Debentures and
and subordinated
subordinated debentures
debentures
 Convertible bonds versus non-convertible bonds
Convertible bonds versus non-convertible bonds
icvb  incvb  opcvb
icvb
icvb==rate
rateof
ofreturn
returnon
onaaconvertible
convertiblebond
bond
incvb
incvb==rate
rateof
ofreturn
returnon
onaanonconvertible
nonconvertiblebond
bond
op
opcvb = value of the conversion option
cvb = value of the conversion option

 Stock
Stock warrants
warrants give
give bondholders
bondholders thethe opportunity
opportunity to
to
purchase
purchase common
common stock
stock at
at aa prespecified
prespecified price
price

6-25
6-26
Corporate Bonds

 Callable
Callable bonds
bonds versus
versus non-callable
non-callable bonds
bonds

incb  icb  opcvb

iincb = rate of return on a noncallable bond
ncb = rate of return on a noncallable bond
iicbcb==rate
rateof
ofreturn
returnon
onaacallable
callablebond
bond
op
opcbcb==value
valueofofthe
thecall
calloption
option

 AA sinking
sinking fund
fund provision
provision isis aa requirement
requirement that
that the
the
issuer
issuer retire
retire aa certain
certain amount
amount of of the
the bond
bond issue
issue
early
early as
as the
the bonds
bonds approach
approach maturity
maturity

6-27
6-28
Corporate Bonds

 Primary
Primary markets
markets are
are identical
identical to
to that
that of
of Munis
Munis
 Secondary markets
Secondary markets
 the
theexchange
exchangemarket
market((e.g.,
e.g.,bond
bonddivision
divisionof
ofthe
theNYSE)
NYSE)
 the
theover-the-counter
over-the-counter(OTC)
(OTC)market
market
 Bond
Bond ratings
ratings
 the
thethree
threemajor
majorbond
bondrating
ratingagencies
agenciesare
areMoody’s,
Moody’s,
Standard
Standard&&Poor’s
Poor’s(S&P),
(S&P),and
andFitch
Fitch
 bonds
bondsarearerated
ratedby
byperceived
perceiveddefault
defaultrisk
risk
 bonds
bondsmaymaybebeeither
eitherinvestment
investmentor orspeculative
speculative(i.e.,
(i.e.,
junk)
junk)grade
grade

6-29
Bond Credit Ratings

Bond Credit Ratings (Source: Text Table 6-10)

Explanation Moody’s S&P
Best quality; smallest degree of risk Aaa AAA
Aa1 AA+
High quality; slightly more long-term risk than top rating Aa2 AA
Aa3 AA-
A1 A+
Upper medium grade; possible impairment in the future A2 A
A3 A-
Baa1 BBB+
Medium grade; lacks outstanding investment characteristics Baa2 BBB
Baa3 BBB-
Ba1 BB+
Speculative issues; protection may be very moderate Ba2 BB
Ba3 BB-
B1 B+
Very speculative; may have small assurance of interest and
B2 B
principal payments
B3 B-
Issues in poor standing; may be in default Caa CCC
Speculative in a high degree; with marked shortcomings Ca CC
Lowest quality; poor prospects of attaining real investment C C
standing D

6-30
Bond Yield Spreads

6-31
Corporate Bond Quotes

Issuer Moody’s/S&P/ Yield

Name Symbol Coupon Maturity Fitch High Low Last Change %
Citigroup C.HVK 6.000% Dec 2013 A3/--/A+ 108.480 106.922 107.606 0.466 3.598

 Issuer
Issuername,
name,ticker
tickersymbol
symboland
andcoupon
coupon
 Maturity
Maturitymonth
monthandandyear
year
 Bond
Bondrating
ratingby
bythe
thethree
threemajor
majorratings
ratingsagencies
agencies
 High,
High,Low,
Low,and
andLast
Lastprices
pricesin
indecimal
decimalform
formas
asaapercent
percentof
ofpar
par
 Daily
Dailyhigh
highprice
pricewas
was$1,084.80
$1,084.80
 Change
Changeisisthe
thechange
changefrom
fromthe
theprior
priorday’s
day’slast
lastprice
price
 Yield
Yield%%isisthe
thepromised
promisedyield
yieldto
tomaturity
maturityusing
usingthe
thelast
lastprice
price

6-32
Bond Market Indexes

 Managed
Managed by by major
major investment
investment banks
banks
 Reflect both the monthly capital gain and loss on
Reflect both the monthly capital gain and loss on
bonds
bonds plus
plus any
any interest
interest (coupon)
(coupon) income
income earned
earned
 Changes in values of bond indexes can be used by
Changes in values of bond indexes can be used by
bond
bond traders
traders to
to evaluate
evaluate changes
changes in in the
the investment
investment
attractiveness
attractiveness of of bonds
bonds ofof different
different types
types andand
maturities
maturities

6-33
Bond Market Participants

 The
Themajor
majorissuers
issuersof
ofdebt
debtmarket
marketsecurities
securitiesare
arefederal,
federal,state
state
and
andlocal
localgovernments,
governments,and
andcorporations
corporations
 The
Themajor
majorpurchasers
purchasersof
ofcapital
capitalmarket
marketsecurities
securitiesare
are
households,
households,businesses,
businesses,government
governmentunits,
units,and
andforeign
foreign
investors
investors
 Businesses
Businessesandandfinancial
financialfirms
firms(e.g.,
(e.g.,banks,
banks,insurance
insurance
companies,
companies,andandmutual
mutualfunds)
funds)are
arethe
themajor
majorsuppliers
suppliersof
offunds
funds
for
forMunis
Munisandandcorporate
corporatebonds
bonds
 Foreign
Foreigninvestors
investorsand
andgovernments
governmentsare arethe
themajor
majorsuppliers
suppliersofof
funds
fundsfor
forT-notes
T-notesand
andT-bonds
T-bonds

6-34
International Bonds and Markets

 International
Internationalbond
bondmarkets
marketsinvolve
involveunregistered
unregisteredbonds
bondsthat
thatare
are
internationally
internationallysyndicated,
syndicated,offered
offeredsimultaneously
simultaneouslyto toinvestors
investorsinin
several
severalcountries,
countries,and
andissued
issuedoutside
outsideof
ofthe
thejurisdiction
jurisdictionof
ofany
anysingle
single
country
country

 Eurobonds
Eurobondsare arelong-term
long-termbonds
bondsissued
issuedoutside
outsidethe
thecountry
countryof
ofthe
the
currency in which they are denominated
currency in which they are denominated

 Foreign
ForeignBonds
Bondsare
arelong-term
long-termbonds
bondsissued
issuedoutside
outsideof
ofthe
theissuer’s
issuer’s
home
homecountry
country

 Sovereign
SovereignBonds
Bondsare
aregovernment
governmentissued
issueddebt
debt

6-35