bond markets
DESCRIPTION
chapter 7 bond marketTRANSCRIPT
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Chapter 7
Bond Markets
Financial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
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Chapter Outline
Background on bonds Treasury and federal agency bonds Municipal bonds Corporate bonds Institutional use of bond markets Globalization of bond markets
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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
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Background on Bonds (cont’d)
Bond yields The issuer’s cost of financing is measured by the yield to
maturity 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
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Treasury and Federal Agency Bonds The U.S. Treasury issues Treasury notes
or bonds to finance federal government expendituresNote maturities are usually less than 10 yearsBonds maturities are 10 years or moreAn active secondary market existsThe 30-year bond was discontinued in
October 2001
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Treasury and Federal Agency Bonds (cont’d) Treasury bond auction
Normally 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
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Treasury and Federal Agency Bonds (cont’d) Treasury bond auction (cont’d)
The Salomon Brothers scandal In a 1990 bond auction, Salomon Brothers purchased 65
percent of the bonds issued (exceeding the 35 percent maximum)
Salomon resold the bonds at higher prices to other institutions
In August of 1991, the Treasury Department temporarily barred Salomon Brothers from bidding on Treasury securities
In May 1992 Salomon paid fines of $190 million to the SEC and Justice Department
Salomon created a reserve fund of $100 million to cover claims from civil lawsuits
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Treasury and Federal Agency Bonds (cont’d) Trading Treasury bonds
Bond 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
Online trading TreasuryDirect program (http://www.treasurydirect.gov)
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Treasury and Federal Agency Bonds (cont’d) Treasury bond quotations
Published in financial newspapers The Wall Street Journal Barron’s Investor’s Business Daily
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/
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Treasury and Federal Agency Bonds (cont’d) Stripped Treasury bonds
One 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 securities firms create their own versions of stripped securities
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Treasury and Federal Agency Bonds (cont’d) Inflation-indexed Treasury bonds
In 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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Computing the Interest Payment of an Inflation-Indexed BondA 10-year bond has a par value of $1,000 and a coupon rate of 5 percent. During the first six months after the bond was issued, the inflation rate was 1.3 percent. By how much does the principal of the bond increase? What is the coupon payment after six months?
65.50$$1,0135%Payment Coupon
013,1$1.013$1,000Principal
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Treasury and Federal Agency Bonds (cont’d) Savings bonds
Issued by the Treasury Denomination is as small as $25 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
Federal agency bonds 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 the municipal
government’s 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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Municipal Bonds (cont’d)
Credit riskLess than .5 percent of all municipal bonds
issued since 1940 have defaultedMoody’s, Standard and Poor’s, and Fitch
Investor Service assign ratings to municipal bonds
Some municipal bonds are insured against default
Results in a higher cost for the investor
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Municipal Bonds (cont’d)
Variable-rate municipal bondsCoupon payments adjust to movements in a
benchmark interest rateSome variable-rate munis are convertible to a
fixed rate under specified conditions
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Municipal Bonds (cont’d)
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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Municipal Bonds (cont’d)
Trading and quotations Investors can buy or sell munis by contacting
brokerage firmsElectronic trading has become popular
http://www.tradingedge.com
Online quotations are available at http://www.munidirect.com and http://www.investinginbonds.com
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Municipal Bonds (cont’d)
Yields offered on municipal bondsDiffers 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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Municipal Bonds (cont’d)
Yield curve on municipal bondsTypically lower than the Treasury yield curve
because of the tax differentialThe 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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Corporate Bonds (cont’d)
Corporate bond yields and risk Interest income earned on corporate represents
ordinary income Yield curve
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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Corporate Bonds (cont’d)
Corporate bond yields and risk (cont’d) Investor assessment of risk
Investors may only consider purchasing corporate bonds after assessing the issuing firm’s 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
Bond ratings 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
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Corporate Bonds (cont’d)
Private placement of corporate bondsOften, insurance companies and pension
funds purchase privately-placed bondsBonds can be placed with the help of a
securities firmBonds do not have to be registered with the
SEC
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Corporate Bonds (cont’d)
Characteristics of corporate bonds 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 Protective covenants:
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
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Corporate Bonds (cont’d)
Characteristics of corporate bonds (cont’d)Call provisions:
Require the firm to pay a price above par value when it calls its bonds
The difference between the call price and par value is the call premium
Are used to: Issue bonds with a lower interest rate Retire bonds as required by a sinking-fund provision
Are a disadvantage to bondholders
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Corporate Bonds (cont’d)
Bond collateral Typically, collateral is a mortgage on real property
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
firm’s assets that are junior to the claims of mortgage bonds and regular debentures
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Corporate Bonds (cont’d)
Low- and zero-coupon bonds: 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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Corporate Bonds (cont’d)
Trading corporate bonds 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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Corporate Bonds (cont’d)
Corporate bond quotationsMore than 2,000 bonds are traded on the
NYSE with a market value of more than $2 trillion
Corporate bond prices are reported in eighthsCorporate bond quotations normally include
the volume of trading and the yield to maturity
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Corporate Bonds (cont’d)
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
Participation in the junk bond market 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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Corporate Bonds (cont’d)
Junk bonds (cont’d) Risk premium of junk bonds
The typical premium is between 3 and 7 percent above Treasury bonds with the same maturity
Performance of junk bonds In the early 1990s, the popularity of junk bonds declined
because of Insider trading allegations The financial problems of a few major issuers of junk bonds The financial problems in the thrift industry
In the late-1990s, junk bonds performed well with few defaults
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Corporate Bonds (cont’d)
Junk bonds (cont’d)Contagion effects in the junk bond market
Specific adverse information may discourage investors from investment in junk bonds
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Corporate Bonds (cont’d)
How corporate bonds facilitate restructuringUsing bonds to finance a leveraged buyout
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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Corporate Bonds (cont’d)
How corporate bonds facilitate restructuring (cont’d) Using bonds to revise the capital structure
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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Institutional Use of Bond Markets
All financial institutions participate in bond markets On any given day, commercial banks, bond mutual
funds, insurance companies, and pension funds are dominant participants
A financial institution’s investment decisions will often simultaneously affect bond market and other financial market activity
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Globalization of Bond Markets
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)