1/34 TOPIC 11 BOND MARKET

Financial Markets Financial Markets Foreign Exchange Market Derivatives Traditional Financial Markets (Long-term) Capital Market (Short-term) Money Market T-Bills CD CP BA Repos/Reverses Federal funds LIBOR market Bonds Stocks T-Notes/Bonds Municipal bonds Corporate Bonds ABS/MBS Wholesale market Retail market Forward Futures Option Swap

3/34 Chapter Preview  We examine market for financial securities which have maturity greater than a year. We discuss how capital markets operate and then focus our attention on the bond market. Topics include: Purpose of the Capital Market Capital Market Participants Capital Market Trading Types of Bonds Financial Guarantees for Bonds Bond Yield Calculations Finding the Value of Coupon Bonds Investing in Bonds

4/34 Purpose of the Capital Market  For long-term financing or investments Money market not suitable: Interest rate change from time to time Using long-term security – interest rate is “locked” for the life of the debt -To reduce borrower’s risk that interest rate will rise before paying- off their debts -Risk reduction to the borrower, thus have to pay higher interest rate to borrow in capital market  Best known capital market securities: Stocks and bonds

5/34 Capital Market Participants Primary issuers of securities Federal and local governments: debt issuers to fund national debt, finance projects Corporations: debt and equity debt issuers  Debt: buyer of bonds is the lender to the issuing firm  Equity: Shareholders/owner of the issuing Make major decisions of the company: Decision on capital structure, expansion, etc

6/34 Capital Market Trading In primary or secondary markets Primary market: new issues of stocks and bonds. The original issuer get proceed from sale through initial public offerings (IPO) Secondary market: sale of previously traded/issued securities. Important because most investors plan to sell their securities before maturities. 2 types:  Organized exchanges: physical building where securities are traded. Bigger volumes are traded  Over-the-counter exchanges: Over telecommunication network

7/34 WHAT IS A BOND? A debt security, similar to an I.O.U When you purchase a bond, you are lending money to the issuer (can be a government, municipality, corporation, federal agency or other entity) You invest to get some returns

8/34 Basics of Bonds  Securities that represent debt owed by issuer to investor  Have specified payments (interest payment) on specific dates – Coupon payment; fixed rate  Upon maturity, issuer must pay face/par/maturity value  If repayment terms not met, bond holder has claim on assets of issuer  Long terms bond traded in capital market are government bonds (T-bonds), municipal bonds, and corporate bonds.

Sample Corporate Bond Certificate

10/34 Major Information  Issuer  Principal amount  Specified interest rate; paid to the holder yearly (also known as the coupon)  Date of maturity

11/34 Variables that Effect Value 1.Maturity: longer maturity, higher return 2.Redemption Features: More redemption provisions, higher return to compensate for the various restrictions 3.Credit Quality: Lesser risk, ensured return, but lower yield 4.Interest Rate: can be fixed, adjustable to market rate, or payable at maturity 5.Price and yield: When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of older bonds into line with higher-interest new issues 6.Tax Status: Preferential tax treatment, lower interest rate

12/34 Types of Bonds 1.Government bonds Treasury bonds Agency debt 2.Municipal bonds 3.Corporate bonds

13/34 1. Treasury Bonds  Government issues notes and bonds to finance its operations and the national debt  Table 1 summarizes the maturity differences among the various Treasury securities

14/34 Treasury Bond  No default risk Government can always pay off its financial obligations Treasury can print money to payoff the debt  Thus, T-bond has very low interest rates. Still, T-bond rate is above money market securities because interest rate and inflation risks  Treasury Inflation-Indexed Securities: the principal amount is tied to the current rate of inflation to protect investor purchasing power  The next two figures show historical rates on Treasury bills, bonds and the inflation rate

Figure 10.2 Interest Rate on Treasury Bonds and the Inflation Rate, 1973–2004 Treasury Bond Interest Rates

Figure 10.3 Interest Rates on Treasury Bills and Treasury Bonds, 1973–2002 (January of each year) Interest Rates: T-Bills vs. T-Bonds Shorter-term less risky, lower return Shorter term more volatile

17/34 Treasury Bonds: Agency Debt  Bonds issued by government-sponsored entities Government National Mortgage Association (GNMA) Syarikat Perumahan Negara Berhad ( SPNB)  Although not technically Treasury securities, this debt has an “implicit” guarantee that the government will not let the debt default  Compared to T-bonds, agency debts normally pay higher interest rate due to secondary market for these debts are not as well-developed as the T-bond market

18/34 2. Municipal/State Govt Bonds  Issued by local, county, and state governments  Used to finance public (local/state) interest projects  Data shows that municipal bonds have lower interest rates (higher price) than Treasury bonds because income from investing in municipal bonds are tax free  How to compare income from investing in municipal bonds and corporate bonds? Equivalent Tax-Free Rate (ETFR) = taxable interest rate  (1  marginal tax rate)

19/34 Municipal Vs Corporate Bonds: Example Suppose the rate on a corporate bond is 9% and the rate on a municipal bond is 6.75%. Which one should you choose? The marginal tax rate is 28%. Answer: Find the ETFR: = 9% x (1 – 28%) = 0.09(0.72) = = 6.48% MB = 6.75% vs CB = 6.48%, so ?

20/34 Municipal/State Govt Bonds  Two types General obligation bonds: no specific source of revenue for repayments Revenue bonds: backed by cashflow of a particular revenue-generating project. Eg: Toll-bridge  NOT default-free (e.g., Orange County California)  Defaults in 1990 amounted to $1.4 billion in this market  New bridge  Next slide shows the volume of general obligation bonds and revenue bonds issued from 1984 through 2003  Note that general obligation bonds represent a higher percentage in the latter part of the sample

Figure 10.4 Issuance of Revenue and General Obligation Bonds, 1984–2003 (End of year) Municipal Bonds: Comparing Revenue and General Obligation Bonds

22/34 3. Corporate Bonds Typically have a face value of $1,000, although some have a face value of $5,000 or $10,000 Pay interest semi-annually/annually Indenture: A contract that states lenders’ rights and privileges and borrowers’ obligations Cannot be redeemed anytime the issuer wishes, unless a specific clause states this (call option). Degree of risk varies with each bond, even from the same issuer. The required interest rate varies with level of risk.

Corporate Bonds: Interest Rates Figure 10.5 Corporate Bond Interest Rates, 1973–2004 (End of year) High risk, high return, high interest rate

24/34 Characteristics of Corporate Bonds  Coupon/interest payment Earlier, coupons being attached to bonds, mail to firm to claim for interest payment-”bearer bonds” Now, “registered bonds”: Owner registers with firms to get interest payment Easier for IRS to track interest income  Restrictive Covenants: Rules & regulations on managers to protect bondholders interests Managers normally serve shareholders interest, so covenants mitigate conflicts with shareholder interests May limit dividends, new debt, ratios, mergers More covenants=Safer=lower risks=lower interest rate

25/34 Characteristics of Corporate Bonds  Call Provisions: Included in indenture=Issuers’ rights to force bondholder to sell back the bond. Call price normally at par or by one year interest cost. Why call back? 1.Raising funds at lower costs: lower interest rate, higher bond price. Issuer can sell new bonds at lower costs. 2.Sinking fund: a requirement in bond indenture that firm must payoff a portion of the bond issue each year. Enable issuer to buy back bonds according to the terms of sinking fund 3.Interest of the stockholders: firm may retire bond if covenant restrict firm from some activities that are in the best interest of the stockholders 4.To alter firms capital structure: when firms have excess cash flow, it might want to retire some debt early  Call provisions are restrictions to buyers, so they have to be paid higher yield

26/34 Characteristics of Corporate Bonds  Conversion Some debt may be converted to equity Bond can be converted to shares when share prices rise Bondholders like this option To avoid sending negative signal to the market  Issuing shares can interpreted as stock price is high  Company’s stock going to fall in the future

27/34 TYPES of Corporate Bonds  Secured Bonds: Backed by collateral; less risky Mortgage bonds: Specific property pledged as collateral Equipment trust certificates: Secured by non-real estate property such as machinery  Unsecured Bonds Debentures: Long-term unsecured bonds backed by general creditworthiness of the firm Subordinated debentures: Similar to debentures but lower priority claim – greater risk of loss Variable-rate bonds: Tie to other market interest rate; adjusted periodically

28/34  Junk Bonds Debt that is rated below BBB- have speculative elements Many investors willing invest in risky firms given higher returns But these firms face liquidity and default problems Michael Milken developed this market in the mid-1977  Liquidity problem – no secondary market for bonds issued by these firms. Milken becomes the market maker (stand ready to buy these junk bonds)  Default problem – Milken becomes the banker for the firms - giving advance and renegotiate firms’ debt to prevent them from defaulting TYPES of Corporate Bonds

Corporate Bonds: Debt Ratings

Corporate Bonds: Debt Ratings (cont.)

Bonds Terminology

32/34 Bond Yield Calculations: 1. Current Yield What is the current yield for a bond with a face value of $1,000, a current price of $921.01, and a coupon rate of 10.95%? Answer: i c = C / P = $ / $ = 11.89% Note: C ( coupon) = 10.95% x $1,000 = $109.50

33/34 Bond Yield Calculations: 2. Yield on a Discount Basis What is the discount yield for a one-year bond with a face value of $1,000, and a current price of $875? Answer: i db = [ (F-P) / P ] x [ 360 / days to maturity] = [ (1000 – 875) / 875] x [360 / 365] = 12.33%

34/34 Finding the Value (Price) of Coupon Bonds  Bond pricing: finding the present value of all future cash flows: Identify the cash flows, Discount the cash flows to time zero at an appropriate discount rate.  Example: What is the price of two-year, 10% coupon bond (semi- annual coupon payments) with a face value of $1,000 and a required rate of 12%? Solution: 1.Identify the cash flows: $50 is received every six months in interest $1000 is received in two years as principal repayment 2.Find the present value of the cash flows (calculator solution): N = 4, FV = 1000, PMT = 50, I = 6 Compute the PV = $965.35

35/34 Investing in Bonds  Bonds are the most popular alternative to stocks for long-term investing.  Even though the bonds of a corporation are less risky than its equity, investors still have risk: price/interest rate risks  The next slide shows the amount of bonds and stock issued from 1983 to  Note how much larger the market for new debt is. Even in the late 1990s, which were boom years for new equity issuances, new debt issuances still outpaced equity by over 5:1.

Figure 10.6 Bonds and Stocks Issued, 1983–2003 Investing in Bonds