1 Chapter 7 Bond Markets © 2001 South-Western College Publishing Company

2 Chapter Objectives nProvide Informational Background On Treasury, Municipal, and Corporate Bonds nExplain The Role Of Bonds To Institutional Investor nDiscuss The Globalization Of Bond Markets

3 Background on Bonds nBonds represent long-term debt securities nThe issuer of the bond is obligated to pay 4Interest (or coupon) payments periodically 4Par value (principal) at maturity

4 Background on Bonds nBond Yields 4The issuer’s cost of financing with bonds is commonly measured by the yield to maturity 4The yield to maturity is the annualized discount rate that equates the future coupon and principal payments to the bond’s price (or proceeds received from the bond offering)

5 Background on Bonds nBond Yields 4Consider an investor who can purchase bonds with 10 years until maturity, a par value of $1,000, and an 8 percent annualized coupon rate for $936. Determine the yield to maturity for this bond. NIPVPMTFV

6 Background on Bonds nBond Yields 4If an investor holds a bond until maturity they will earn the yield to maturity. 4If they sell the bond before maturity, they may receive more or less than the YTM.

7 Background on Bonds nBonds are often classified according to the type of issuer IssuerType of Bond Federal Government (Treasury) Treasury Bonds Federal AgencyFederal Agency Bonds State and Local Governments Municipal Bonds CorporationsCorporate Bonds

8 Treasury Bonds nIssued by the U.S. Treasury to finance federal government expenditures nMaturity 4Notes, < 10 Years 4Bonds, > 10 To 30 Years nActive OTC Secondary Market nSemiannual Interest Payment nBenchmark Debt Security For Any Maturity

9 Treasury Bonds nTypes of Treasury Bonds 4Coupon 4Stripped Treasury Bonds Cash flows of bonds are stripped by securities firms –One security represents the principal payment only –Second security represents the interest payments only

10 Treasury Bonds nInflation-Indexed Bonds 4Began in Intended for investors who want to ensure their returns keep up with inflation 4Principal value adjusted for the U.S. inflation rate every 6 months 4Still not very popular in U.S. due to low inflation rate

11 Federal Agency Bonds nGovernment National Mortgage Association (GNMA) 4Issues bonds and uses proceeds to purchase FHA and VA mortgages 4Backed by mortgages and federal government

12 Federal Agency Bonds nFederal Home Loan Mortgage Association (Freddie Mac) 4Issues bonds and uses proceeds to purchase conventional mortgages 4Not backed by federal government, but have low credit risk

13 Municipal Bonds nState and local government obligations nRevenue Bonds vs. General Obligation Bonds nInvestor interest income exempt from federal income tax nTax Reform Act of 1986 placed limitations on tax-exempt bond issuance for private purposes

14 Corporate Bonds nWhen corporations want to borrow for long-term periods they issue corporate bonds 4Usually pay semiannual interest 4Most have maturities between years Recently, Coca-Cola and Walt Disney issued 100-year bonds

15 Corporate Bonds nCharacteristics of Corporate Bonds 4Indenture Legal document specifying rights and obligations of issuer and bondholder –Several hundred pages 4Trustee Represents bondholders, ensures compliance

16 Corporate Bonds nCharacteristics of Corporate Bonds 4Sinking Fund Provision Requirement that the firm retire a certain amount of the bond issue each year 4Protective Covenants Places restrictions on the firm to protect bondholders Examples: limits dividends and officer salaries, restricts additional debt

17 Corporate Bonds nCharacteristics of Corporate Bonds 4Call Provisions Call premium Advantage to issuers 4Bond 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

18 Corporate Bonds nCharacteristics of Corporate Bonds 4Low- and Zero-Coupon Bonds Early 1980s Deep discount 4Variable-rate bonds 4Convertibility

19 Corporate Bonds nJunk Bonds 4Junk bonds are also called high-yield bonds 4Original-issue junk bonds became popular in the 1980s 4Size of the market: junk bonds represent about 25 percent of the market value of all corporate bonds (around $145 billion in 1998) 4The risk premium is between 3 and 7 percent above Treasury bonds

20 Institutional Use of Bond Markets nCommercial banks and S&Ls nFinance companies nBrokerage firms nInvestment banking firms nInsurance companies nPension funds

21 Globalization of Bond Markets nForeign investment in dollar securities nForeign issuance by U.S. firms nIncreased global investment by pension and mutual funds nDevelopment of foreign security markets--24 hour trading nEurobond market

22 Globalization of Bond Markets nEurobond market 4In 1960s, U.S. corporations were limited to the amount of funds they could borrow in the U.S. for overseas operations. 4They 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

23 Globalization of Bond Markets nEurobond market 4An underwriting syndicate on investment banks participates in placing the bonds Issuer can choose the currency in which the bonds are denominated