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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
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

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
9

PV PMT FV
936 80 1000

Background on Bonds
Bonds by Issuers
Issuer

Type of Bond

Federal Government
(U.S. Treasury)

Treasury Bonds

Federal Agencies

Federal Agency Bonds

State and Local


Governments

Municipal Bonds

Corporations

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

U. S. Treasury Bond Yield To Maturity

$83.80
Pmt

2013
Today
=N

$1000
Ask
Price =
FV

Ask Price = 103 and 11/32 % of


Face Value or $1033.4375

$1033.44
PV*

Calc
YTM

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

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

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

Trustee
Represents

indenture

bondholders to assure compliance with

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
Places

Covenants

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

Exhibit 7.5

Financial Institution

Participation in Bond Markets

Commercial banks and savings


and loan associations (S&Ls)

Purchase bonds for their asset portfolio.

Sometimes
place municipal bonds for municipalities.
Sometimes issue bonds as a source of secondary capital.

Finance companies

Commonly issue bonds as a source of long-term funds.

Mutual 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.

Brokerage rms

Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.

Investment banking rms

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.

Insurance companies

Purchase bonds for their asset portfolio.

Pension funds

Purchase bonds for their asset portfolio.

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