Chapter 6 Bond Markets McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Bonds are are long-term long-term debt debt obligations obligations issued issued by by corporations corporations and and government government units units Bond Bond markets markets are are markets markets in in which which bonds bonds are 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 6-2 Bond Market Instruments Outstanding, 1994-2010 Bond Market Instruments 6-3 Treasury Notes and Bonds Treasury Treasury notes notes and and bonds bonds (T-notes (T-notes and and TT- bonds) bonds) are are issued issued by by the the U.S. U.S. Treasury Treasury to to finance finance the the national national debt debt and and other other government government expenditures expenditures The The annual annual federal federal deficit deficit isis equal equal to to annual annual expenditures expenditures (G) (G) less less taxes taxes (T) (T) received received The The national national debt debt (ND) (ND) isis the the sum sum of of historical

historical annual annual federal federal deficits: deficits: N NDt (Gt Tt ) t 1 6-4 Current & Projected Federal Debt Levels Data Source: CBO 6-5 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:low lowinterest interestrates rates(yields (yieldsto tomaturity) 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 6-6 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 Maybe beeither

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 Tradein invery veryactive activesecondary secondarymarkets markets Prices Pricesare arequoted quotedas aspercentages percentagesof offace facevalue, value,in in32nds 32nds 6-7

Sample Treasury Bond Quote Maturity 2017 Nov 15 Coupon 4.250 Bid 112:26 Asked 112:27 Chg +13 Asked Yld 2.3316 Maturity Maturitymo/yr: mo/yr:Month Monthand andyear, year,the thebond bondmatures maturesNovember November 15, 15,2017. 2017. Coupon: Coupon:Coupon Couponrate rateof of4.250% 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 $100of ofpar parthe thedealer dealerwill willpay payto to buy buythe

thebond; bond;the theseller sellerwould wouldreceive receivethis thisprice pricefrom fromselling selling to tothe thedealer. dealer. Prices Pricesare arequoted quotedin in32nds. 32nds. In Inthis thiscase, case, 112:26 112:26==112 11226/32% 26/32%of of$1,000 $1,000or or$1,128.125. $1,128.125. 6-8 Sample Treasury Bond Quote Maturity 2017 Nov 15 Coupon 4.250 Bid 112:26 Asked 112:27 Chg +13 Asked Yld 2.3316 Asked: Asked:The Theclosing closingprice priceper per$100 $100of ofpar parthe thedealer dealerrequires requires to

tosell sellthe thebond; bond;the thebuyer buyerwould wouldpay paythis thisprice priceto tothe thedealer. dealer. In Inthis thiscase, case,112:27 112:27==112 11227/32% 27/32%of of$1,000 $1,000or or$1,128.4375. $1,128.4375. Chg: Chg:The Thechange changefrom fromthe theprior priorclosing closingASKED ASKEDprice pricein in 32nds. 32nds. In Inthis thiscase, case,the theASKED ASKEDprice priceincreased increasedthirteen thirteen 32nds 32ndsfrom fromthe theprior priorquoted quotedclosing closingask askprice. price. 6-9 Sample Treasury Bond Quote Maturity 2017 Nov 15

Coupon 4.250 Bid 112:26 Asked 112:27 Chg +13 Asked Yld 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%. 6-10 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 STRIPSfrom fromT-notes T-notesand andT-bonds T-bonds STRIPS STRIPShave havethe theperiodic 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 6-11 Accrued Interest and Prices

Accrued Accrued interest interest must must be be paid paid by by the the buyer buyer of of 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. 6-12 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==the thepresent presentvalue valueof ofthe thebond bond M M==the thepar parvalue valueof ofthe thebond bond INT INT==annual annualinterest interestpayment payment(in (indollars) dollars) NN==the thenumber numberof ofyears yearsuntil untilthe thebond bondmatures matures m m==the thenumber numberof oftimes timesper peryear yearinterest interestisispaid paid idid==interest interestrate rateused usedto todiscount discountcash cashflows flowson onthe thebond bond 6-13 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: Accrued interest INT Actual number of days since last coupon payment 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 of of the the clean clean price price (V (Vbb)) and and the the accrued accrued interest interest 6-14 Accrued Interest Example You Youbuy buyaa6% 6%coupon coupon$1,000 $1,000par parT-bond T-bond59 59days daysafter afterthe thelast last coupon couponpayment. payment. Settlement Settlementoccurs occursinintwo twodays. days. You Youbecome become the

theowner owner61 61days daysafter afterthe thelast lastcoupon couponpayment payment(59+2), (59+2),and and there thereare are121 121days daysremaining remaininguntil untilthe thenext nextcoupon couponpayment. payment. The Thebonds bondsclean cleanprice pricequote quoteisis120:19. 120:19. What Whatisisthe thefull fullor ordirty dirty price price(sometimes (sometimescalled calledthe theinvoice invoiceprice)? price)? Accrued Interest $60 61 $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. 6-15 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 TTnotes 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 6-16 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 bondsare arebacked backedby bythe thefull fullfaith faith and andcredit creditof ofthe theissuing issuingmunicipality municipality Revenue Revenuebonds bondsare aresold soldto tofinance financespecific specificrevenue revenue generating generatingprojects projects 6-17 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 of of 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) 6-18 Municipal Bond Rates & Taxes For For aa 28% 28% tax tax 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%(16%(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% 6-19 Municipal Bonds Primary Primarymarkets markets firm firmcommitment commitmentunderwriting: underwriting:aapublic publicoffering offeringof ofMunis Munismade made through throughan aninvestment investmentbank, bank,where

wherethe theinvestment investmentbank bank guarantees guaranteesaaprice pricefor forthe thenewly newlyissued issuedbonds bondsby bybuying 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 guaranteeaafirm firmprice price private privateplacement: placement:bonds bondsare aresold soldon onaasemi-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 6-20 Corporate Bonds Corporate Corporate bonds bonds are are long-term long-term bonds bonds issued issued by by corporations corporations A A bond bond indenture indenture isis the the legal legal contract contract that that specifies specifies the the rights rights and and obligations obligations of of the the issuer issuer and and the the holders holders Bearer Bearer versus versus registered registered bonds bonds Term Term versus versus serial serial bonds bonds Mortgage Mortgage bonds bonds are are secured secured debt debt issues issues 6-21 Corporate Bonds Debentures

Debentures and and subordinated subordinated debentures debentures Convertible Convertible bonds bonds versus versus non-convertible non-convertible bonds bonds icvb incvb opcvb icvb icvb==rate rateof ofreturn returnon onaaconvertible convertiblebond bond incvb incvb==rate rateof ofreturn returnon onaanonconvertible nonconvertiblebond bond op = value of the conversion option opcvb cvb = value of the conversion option Stock Stock warrants warrants give give bondholders bondholders the the opportunity opportunity to to purchase purchase common common stock stock at at aa prespecified prespecified price price 6-22 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 valueof ofthe thecall calloption option A A 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 6-23 Corporate Bonds Primary Primary markets markets are are identical identical to to that that of of Munis Munis Secondary Secondary markets 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 areMoodys, Moodys, Standard Standard&&Poors Poors(S&P), (S&P),and andFitch Fitch bonds bondsare arerated ratedby byperceived perceiveddefault defaultrisk risk bonds bondsmay maybe beeither eitherinvestment investmentor orspeculative speculative(i.e., (i.e., junk) junk)grade grade 6-24 Bond Credit Ratings Bond Credit Ratings (Source: Text Table 6-10) Explanation Moodys Best quality; smallest degree of risk Aaa Aa1 High quality; slightly more long-term risk than top rating Aa2 Aa3 A1 Upper medium grade; possible impairment in the future A2

A3 Baa1 Medium grade; lacks outstanding investment characteristics Baa2 Baa3 Ba1 Speculative issues; protection may be very moderate Ba2 Ba3 B1 Very speculative; may have small assurance of interest and B2 principal payments B3 Issues in poor standing; may be in default Caa Speculative in a high degree; with marked shortcomings Ca Lowest quality; poor prospects of attaining real investment C standing S&P AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC CC C D 6-25 Bond Yield Spreads 6-26 Corporate Bond Quotes Issuer Name Symbol Coupon Maturity Moodys/S&P/ Fitch High Low Last Citigroup C.HVK

6.000% Dec 2013 A3/--/A+ 108.480 106.922 107.606 Change 0.466 Yield % 3.598 Issuer Issuername, name,ticker tickersymbol symboland andcoupon coupon Maturity Maturitymonth monthand andyear 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 priordays dayslast lastprice price Yield Yield% %isisthe thepromised promisedyield yieldto tomaturity maturityusing usingthe thelast lastprice price 6-27 Bond Market Indexes Managed Managed by by major major investment investment banks banks Reflect Reflect both both the the monthly monthly capital capital gain gain and and loss loss on on bonds bonds plus plus any any interest interest (coupon) (coupon) income income earned earned Changes Changes in in values values of of bond bond indexes indexes can can be be used

used by by bond bond traders traders to to evaluate evaluate changes changes in in the the investment investment attractiveness attractiveness of of bonds bonds of of different different types types and and maturities maturities 6-28 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 Businessesand andfinancial financialfirms firms(e.g., (e.g.,banks, banks,insurance insurance companies, companies,and andmutual mutualfunds) funds)are arethe themajor majorsuppliers suppliersof offunds funds for forMunis Munisand andcorporate corporatebonds bonds Foreign Foreigninvestors investorsand andgovernments governmentsare arethe themajor majorsuppliers suppliersof of funds fundsfor forT-notes T-notesand andT-bonds T-bonds 6-29 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 currencyininwhich whichthey theyare aredenominated denominated Foreign ForeignBonds Bondsare arelong-term long-termbonds bondsissued issuedoutside outsideof ofthe theissuers issuers home homecountry country Sovereign SovereignBonds Bondsare aregovernment governmentissued issueddebt debt 6-30

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