Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 6 Bond Markets

6-2 Bond and Bond Markets Capital markets involve equity and debt instruments with maturities of more than one year Bonds are long-term debt obligations issued by corporations and government units Bond markets are markets in which bonds are issued and traded Treasury notes (T-notes) and bonds (T-bonds) Municipal bonds (Munis) Corporate bonds Capital markets involve equity and debt instruments with maturities of more than one year Bonds are long-term debt obligations issued by corporations and government units Bond markets are markets in which bonds are issued and traded Treasury notes (T-notes) and bonds (T-bonds) Municipal bonds (Munis) Corporate bonds

6-3 Bond Market Instruments Outstanding, Bond Market Instruments

6-4 Treasury Notes and Bonds Treasury notes and bonds (T-notes and T- bonds) are issued by the U.S. Treasury to finance the national debt and other government expenditures The annual federal deficit is equal to annual expenditures (G) less taxes (T) received The national debt (ND) is the sum of historical annual federal deficits: Treasury notes and bonds (T-notes and T- bonds) are issued by the U.S. Treasury to finance the national debt and other government expenditures The annual federal deficit is equal to annual expenditures (G) less taxes (T) received The national debt (ND) is the sum of historical annual federal deficits:

6-5 Current & Projected Federal Debt Levels Data Source: CBO

6-6 Treasury Notes and Bonds Default risk free: backed by the full faith and credit of the U.S. government Low returns: low interest rates (yields to maturity) reflect low default risk Interest rate risk: because of their long maturity, T-notes and T-bonds experience wider price fluctuations than money market securities when interest rates change Liquidity risk: older issued T-bonds and T-notes trade less frequently than newly issued T-bonds and T-notes Default risk free: backed by the full faith and credit of the U.S. government Low returns: low interest rates (yields to maturity) reflect low default risk Interest rate risk: because of their long maturity, T-notes and T-bonds experience wider price fluctuations than money market securities when interest rates change Liquidity risk: older issued T-bonds and T-notes trade less frequently than newly issued T-bonds and T-notes

6-7 Treasury Notes and Bonds T-notes have original maturities from over 1 to 10 years T-bonds have original maturities from over 10 years Issued in minimum denominations (multiples) of $1,000 May be either fixed principal or inflation-indexed inflation-indexed bonds are called Treasury Inflation Protection Securities (TIPS) the principal value of TIPS is adjusted by the percentage change in the Consumer Price Index (CPI) every six months Trade in very active secondary markets Prices are quoted as percentages of face value, in 32nds T-notes have original maturities from over 1 to 10 years T-bonds have original maturities from over 10 years Issued in minimum denominations (multiples) of $1,000 May be either fixed principal or inflation-indexed inflation-indexed bonds are called Treasury Inflation Protection Securities (TIPS) the principal value of TIPS is adjusted by the percentage change in the Consumer Price Index (CPI) every six months Trade in very active secondary markets Prices are quoted as percentages of face value, in 32nds

6-8 Sample Treasury Bond Quote Maturity mo/yr: Month and year, the bond matures November 15, Coupon: Coupon rate of 4.250% or $42.50 per year but paid semiannually ($1,000 face). Bid: The closing price per $100 of par the dealer will pay to buy the bond; the seller would receive this price from selling to the dealer. Prices are quoted in 32nds. In this case, 112:26 = /32% of $1,000 or $1, Maturity mo/yr: Month and year, the bond matures November 15, Coupon: Coupon rate of 4.250% or $42.50 per year but paid semiannually ($1,000 face). Bid: The closing price per $100 of par the dealer will pay to buy the bond; the seller would receive this price from selling to the dealer. Prices are quoted in 32nds. In this case, 112:26 = /32% of $1,000 or $1, MaturityCouponBidAskedChgAsked Yld 2017 Nov :26112:

6-9 Sample Treasury Bond Quote Asked: The closing price per $100 of par the dealer requires to sell the bond; the buyer would pay this price to the dealer. In this case, 112:27 = /32% of $1,000 or $1, Chg: The change from the prior closing ASKED price in 32nds. In this case, the ASKED price increased thirteen 32nds from the prior quoted closing ask price. Asked: The closing price per $100 of par the dealer requires to sell the bond; the buyer would pay this price to the dealer. In this case, 112:27 = /32% of $1,000 or $1, Chg: The change from the prior closing ASKED price in 32nds. In this case, the ASKED price increased thirteen 32nds from the prior quoted closing ask price. MaturityCouponBidAskedChgAsked Yld 2017 Nov :26112:

6-10 Sample Treasury Bond Quote Asked Yld = Promised compound yield rate if purchased at the Asked price. In this case, the yield is %. MaturityCouponBidAskedChgAsked Yld 2017 Nov :26112:

6-11 Treasury STRIPS Separate Trading of Registered Interest and Principal Securities (STRIPS), a.k.a. Treasury zero bonds or Treasury zero-coupon bonds Financial institutions and government securities brokers and dealers create STRIPS from T-notes and T-bonds STRIPS have the periodic interest payments separated from each other and from the principal payment one set of securities reflects interest payments one set of securities reflects principal payments STRIPS are used to immunize against interest rate risk Separate Trading of Registered Interest and Principal Securities (STRIPS), a.k.a. Treasury zero bonds or Treasury zero-coupon bonds Financial institutions and government securities brokers and dealers create STRIPS from T-notes and T-bonds STRIPS have the periodic interest payments separated from each other and from the principal payment one set of securities reflects interest payments one set of securities reflects principal payments STRIPS are used to immunize against interest rate risk

6-12 Accrued Interest and Prices Accrued interest must be paid by the buyer of a bond to the seller of a bond if the bond is purchased between interest payment dates. The price of the bond with accrued interest is called the full price or the dirty price, the price without accounting for accrued interest is the clean price. Accrued interest must be paid by the buyer of a bond to the seller of a bond if the bond is purchased between interest payment dates. The price of the bond with accrued interest is called the full price or the dirty price, the price without accounting for accrued interest is the clean price.

6-13 Accrued Interest and Prices “Clean” prices are calculated as: V b = the present value of the bond M = the par value of the bond INT = annual interest payment (in dollars) N = the number of years until the bond matures m = the number of times per year interest is paid i d = interest rate used to discount cash flows on the bond “Clean” prices are calculated as: V b = the present value of the bond M = the par value of the bond INT = annual interest payment (in dollars) N = the number of years until the bond matures m = the number of times per year interest is paid i d = interest rate used to discount cash flows on the bond

6-14 Accrued Interest on Bonds Accrued interest on T-notes and T-bonds is calculated as: The full (or dirty) price of a T-note or T-bond is the sum of the clean price (V b ) and the accrued interest Accrued interest on T-notes and T-bonds is calculated as: The full (or dirty) price of a T-note or T-bond is the sum of the clean price (V b ) and the accrued interest

6-15 Accrued Interest Example You buy a 6% coupon $1,000 par T-bond 59 days after the last coupon payment. Settlement occurs in two days. You become the owner 61 days after the last coupon payment (59+2), and there are 121 days remaining until the next coupon payment. The bond’s clean price quote is 120:19. What is the full or dirty price (sometimes called the invoice price)? The clean price is 120:19 or /32% of $1,000 or $1, Thus, the dirty price is $1, $10.05 = $1, You buy a 6% coupon $1,000 par T-bond 59 days after the last coupon payment. Settlement occurs in two days. You become the owner 61 days after the last coupon payment (59+2), and there are 121 days remaining until the next coupon payment. The bond’s clean price quote is 120:19. What is the full or dirty price (sometimes called the invoice price)? The clean price is 120:19 or /32% of $1,000 or $1, Thus, the dirty price is $1, $10.05 = $1,

6-16 Notes and Bonds Markets The primary market of T-notes and T-bonds is similar to that of T-bills; the U.S. Treasury sells T- notes and T-bonds through competitive and noncompetitive single-bid auctions 2-year notes are auctioned monthly 3-, 5-, and 10-year notes are auctioned quarterly (Feb, May, Aug, and Nov) 30-year bonds are auctioned semi-annually (Feb and Aug) Most secondary trading occurs directly through brokers and dealers The primary market of T-notes and T-bonds is similar to that of T-bills; the U.S. Treasury sells T- notes and T-bonds through competitive and noncompetitive single-bid auctions 2-year notes are auctioned monthly 3-, 5-, and 10-year notes are auctioned quarterly (Feb, May, Aug, and Nov) 30-year bonds are auctioned semi-annually (Feb and Aug) Most secondary trading occurs directly through brokers and dealers

6-17 Municipal Bonds Municipal bonds (Munis) are securities issued by state and local governments to fund imbalances between expenditures and receipts to finance long-term capital outlays Attractive to household investors because interest is exempt from federal and most local income taxes General obligation (GO) bonds are backed by the full faith and credit of the issuing municipality Revenue bonds are sold to finance specific revenue generating projects Municipal bonds (Munis) are securities issued by state and local governments to fund imbalances between expenditures and receipts to finance long-term capital outlays Attractive to household investors because interest is exempt from federal and most local income taxes General obligation (GO) bonds are backed by the full faith and credit of the issuing municipality Revenue bonds are sold to finance specific revenue generating projects

6-18 Municipal Bonds Compare Muni returns with fully taxable corporate bonds by finding the after tax return for corporate bonds: i a = i b (1 – t) i a = after-tax rate of return on a taxable corporate bond i b = before-tax rate of return on a taxable bond t = marginal total income tax rate of the bond holder Alternately, convert Muni interest rates to tax equivalent rates of return: i b = i a /(1 – t) Compare Muni returns with fully taxable corporate bonds by finding the after tax return for corporate bonds: i a = i b (1 – t) i a = after-tax rate of return on a taxable corporate bond i b = before-tax rate of return on a taxable bond t = marginal total income tax rate of the bond holder Alternately, convert Muni interest rates to tax equivalent rates of return: i b = i a /(1 – t)

6-19 Municipal Bond Rates & Taxes For a 28% tax bracket, what is the equivalent after tax rate of a 6% corporate yield? i a = 6%( ) = 4.32% For a 28% tax bracket, what corporate taxable yield is equivalent to a 4.5% muni bond rate? i b = 4.5% / (1-0.28) = 6.25% For a 28% tax bracket, what is the equivalent after tax rate of a 6% corporate yield? i a = 6%( ) = 4.32% For a 28% tax bracket, what corporate taxable yield is equivalent to a 4.5% muni bond rate? i b = 4.5% / (1-0.28) = 6.25%

6-20 Municipal Bonds Primary markets firm commitment underwriting: a public offering of Munis made through an investment bank, where the investment bank guarantees a price for the newly issued bonds by buying the entire issue and then reselling it to the public best efforts offering: a public offering in which the investment bank does not guarantee a firm price private placement: bonds are sold on a semi-private basis to qualified investors (generally FIs) Secondary markets: Munis trade infrequently due mainly to a lack of information on bond issuers Primary markets firm commitment underwriting: a public offering of Munis made through an investment bank, where the investment bank guarantees a price for the newly issued bonds by buying the entire issue and then reselling it to the public best efforts offering: a public offering in which the investment bank does not guarantee a firm price private placement: bonds are sold on a semi-private basis to qualified investors (generally FIs) Secondary markets: Munis trade infrequently due mainly to a lack of information on bond issuers

6-21 Corporate Bonds Corporate bonds are long-term bonds issued by corporations A bond indenture is the legal contract that specifies the rights and obligations of the issuer and the holders Bearer versus registered bonds Term versus serial bonds Mortgage bonds are secured debt issues Corporate bonds are long-term bonds issued by corporations A bond indenture is the legal contract that specifies the rights and obligations of the issuer and the holders Bearer versus registered bonds Term versus serial bonds Mortgage bonds are secured debt issues

6-22 Corporate Bonds Debentures and subordinated debentures Convertible bonds versus non-convertible bonds i cvb = rate of return on a convertible bond i ncvb = rate of return on a nonconvertible bond op cvb = value of the conversion option Stock warrants give bondholders the opportunity to purchase common stock at a prespecified price Debentures and subordinated debentures Convertible bonds versus non-convertible bonds i cvb = rate of return on a convertible bond i ncvb = rate of return on a nonconvertible bond op cvb = value of the conversion option Stock warrants give bondholders the opportunity to purchase common stock at a prespecified price

6-23 Corporate Bonds Callable bonds versus non-callable bonds i ncb = rate of return on a noncallable bond i cb = rate of return on a callable bond op cb = value of the call option A sinking fund provision is a requirement that the issuer retire a certain amount of the bond issue early as the bonds approach maturity Callable bonds versus non-callable bonds i ncb = rate of return on a noncallable bond i cb = rate of return on a callable bond op cb = value of the call option A sinking fund provision is a requirement that the issuer retire a certain amount of the bond issue early as the bonds approach maturity

6-24 Corporate Bonds Primary markets are identical to that of Munis Secondary markets the exchange market ( e.g., bond division of the NYSE) the over-the-counter (OTC) market Bond ratings the three major bond rating agencies are Moody’s, Standard & Poor’s (S&P), and Fitch bonds are rated by perceived default risk bonds may be either investment or speculative (i.e., junk) grade Primary markets are identical to that of Munis Secondary markets the exchange market ( e.g., bond division of the NYSE) the over-the-counter (OTC) market Bond ratings the three major bond rating agencies are Moody’s, Standard & Poor’s (S&P), and Fitch bonds are rated by perceived default risk bonds may be either investment or speculative (i.e., junk) grade

6-25 Bond Credit Ratings

6-26 Bond Yield Spreads

6-27 Corporate Bond Quotes Issuer name, ticker symbol and coupon Maturity month and year Bond rating by the three major ratings agencies High, Low, and Last prices in decimal form as a percent of par Daily high price was $1, Change is the change from the prior day’s last price Yield % is the promised yield to maturity using the last price Issuer name, ticker symbol and coupon Maturity month and year Bond rating by the three major ratings agencies High, Low, and Last prices in decimal form as a percent of par Daily high price was $1, Change is the change from the prior day’s last price Yield % is the promised yield to maturity using the last price Issuer NameSymbolCouponMaturity Moody’s/S&P/ FitchHighLowLastChange Yield % CitigroupC.HVK6.000%Dec 2013A3/--/A

6-28 Bond Market Indexes Managed by major investment banks Reflect both the monthly capital gain and loss on bonds plus any interest (coupon) income earned Changes in values of bond indexes can be used by bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities Managed by major investment banks Reflect both the monthly capital gain and loss on bonds plus any interest (coupon) income earned Changes in values of bond indexes can be used by bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities

6-29 Bond Market Participants The major issuers of debt market securities are federal, state and local governments, and corporations The major purchasers of capital market securities are households, businesses, government units, and foreign investors Businesses and financial firms (e.g., banks, insurance companies, and mutual funds) are the major suppliers of funds for Munis and corporate bonds Foreign investors and governments are the major suppliers of funds for T-notes and T-bonds The major issuers of debt market securities are federal, state and local governments, and corporations The major purchasers of capital market securities are households, businesses, government units, and foreign investors Businesses and financial firms (e.g., banks, insurance companies, and mutual funds) are the major suppliers of funds for Munis and corporate bonds Foreign investors and governments are the major suppliers of funds for T-notes and T-bonds

6-30 International Bonds and Markets International bond markets involve unregistered bonds that are internationally syndicated, offered simultaneously to investors in several countries, and issued outside of the jurisdiction of any single country Eurobonds are long-term bonds issued outside the country of the currency in which they are denominated Foreign Bonds are long-term bonds issued outside of the issuer’s home country Sovereign Bonds are government issued debt International bond markets involve unregistered bonds that are internationally syndicated, offered simultaneously to investors in several countries, and issued outside of the jurisdiction of any single country Eurobonds are long-term bonds issued outside the country of the currency in which they are denominated Foreign Bonds are long-term bonds issued outside of the issuer’s home country Sovereign Bonds are government issued debt