CHAPTER 7 BOND MARKETS All Rights Reserved Dr David P Echevarria

CAPITAL MARKET INSTRUMENTS Treasury Bonds Fed is a large buyer of T-Bonds Tool for implementing monetary policy Dealer-dominated secondary market Semi-annual coupons are typical Main asset of the FED Strips (IO or PO): Interest streams repackaged as separate security (TIGR) TIPS (1996) inflation-indexed maturity values All Rights Reserved Dr David P Echevarria

Federal Reserve Balance Sheet All Rights Reserved Dr David P Echevarria

Federal Reserve Balance Sheet 1/21/2016 All Rights Reserved Dr David P Echevarria

Federal Reserve Balance Sheet 1/21/2016 All Rights Reserved Dr David P Echevarria

CAPITAL MARKET INSTRUMENTS Municipal Bonds Issued by states, counties, cities and state agencies Interest is exempt from Federal taxation Some types, i.e. industrial development bonds, may be completely tax-exempt Tax-preference results in lower offered yields (rationale for computing before-tax equivalent yields) All Rights Reserved Dr David P Echevarria

CAPITAL MARKET INSTRUMENTS Corporate Bonds Terms spelled out in the Indenture Agreement; face value, maturity, coupon, form of collateral if any, Callable, Sinking Fund required Insurance Cos are principal buyers of corporate bonds w/ households second Sold through public offerings; About half are privately-placed Proceeds may be used to fund expansion, finance acquisitions or LBO or to refund maturing bond issues or to refund higher interest rate debt All Rights Reserved Dr David P Echevarria

CAPITAL MARKET INSTRUMENTS Zero-Coupon bonds pay no coupons; sold at PV of maturity value; result is very much like a T-bill except the maturity can be up to 30 years A favorite vehicle for in substance defeasance of debt for corps seeking to restructure their balance sheets, High risk uncollateralized bonds are frequently called "junk bonds" The US Tax Code favors debt financing; interest paid with pre-tax dollars All Rights Reserved Dr David P Echevarria

EVALUATING BOND RISK Interest Rate Risk Reinvestment Rate Risk Change in price of seasoned bonds as rates change over time Sensitivity a function of coupon and term to maturity Reinvestment Rate Risk Valuation formulas assume future cash flows reinvested at the expected rate of return If rates drop, future cash flows are invested at lower rates, reducing the future value of reinvested cash flows All Rights Reserved Dr David P Echevarria

EVALUATING BOND RISK Default (or business) Risk Maturity Risk Risk that payments may not be made Importance of indenture agreement Maturity Risk The longer the maturity, the greater the risk Liquidity Risk The inability or difficulty in selling for cash All Rights Reserved Dr David P Echevarria

EVALUATING BOND RISK Companies' debt issues are rated for riskiness Standard & Poor's, Moody's, Fitch's Ratings: AAA to D (S&P scheme) Ratings are important for many reasons; cost to borrow, legal list requirements High Quality (AAA - AA), Investment Grade (AAA - BBB), Speculative (BB and B), Highly speculative (C's), Default (D's) Public Utilities are the single largest issuer of bonds All Rights Reserved Dr David P Echevarria

FINANCIAL INSTITUTIONS IN BOND MARKETS Insurance Companies are largest buyer of Bonds Attractiveness of bonds are their known payouts over time Bonds offer frequent opportunities for capital gain strategies with relatively low risk All Rights Reserved Dr David P Echevarria

GLOBALIZATION OF BOND MARKETS Impact of Exchange Rates on Foreign Bond Returns Dealing with the double problems of Interest-Rate and Currency Parity Use of interest rate swaps in international bond markets Use of currency swaps in international bond markets Economic growth rate differentials as well as government policy Always a good idea to diversify international bond portfolios All Rights Reserved Dr David P Echevarria

HOMEWORK QUESTIONS How is buying and selling accomplished in the T-Bond market? How does the Fed use its inventory of treasury securities? Who issues municipals? What is their principal attraction to an investor? What type of investor should be most interested in municipals? What are zero-coupon bonds? Why might borrowers prefer them? What are the main sources of risk in a bond investment? What are the two sources of risk when investing in foreign bonds? How might we minimize the risk addressed in the previous question? All Rights Reserved Dr David P Echevarria