Finance 300 Financial Markets Lecture 16 Professor J. Petry, Fall, 2002©

2 Housekeeping Agenda –Please note that your first Stewardship Report is due the class period after the next exam. The next exam is Tuesday, November 5 th. –Will cover chapters VI, VII and VIII. Stewardship report are due Thursday, November 7 th. –Bond Analysis Project Begins a week from today. Be sure your groups are set by this Thursday, October 24 th. Sign-up form will be posted at 12:50, Tuesday, October 29 th. It will be the same place as before.

3 Chapter VI – Government Bonds

4 Government Bond Market Components –US Treasury is single largest debt issuer in the world. Treasury Notes and Bonds account for nearly $3 trillion in debt, this does not count short term money market issuance of the US government, nor government sponsored agency debt. –Until recently, debt issuance had been fueled by large government deficits. –Federal Agencies (Freddie Mac, Fannie Mae) and Municipalities (state and local governments) make up the remainder of government related debt. –Corporate, asset backed and mortgage backed fixed income securities are the next two chapters.

5 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Primary Market –There are ~40 primary market dealers. To become a dealer you must meet Federal Reserve Standards and capital requirements. You must also agree to bid in all Treasury market auctions and to make a market in Treasury Securities. –Auctions are held on a regular basis. They are similar to T-bill auctions, but Notes and Bonds are awarded on at the same market clearing yields for all participants—all purchases are at the same price.

6 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market –The secondary market is principally OTC (Over the Counter). OTC is an informal network of brokers and dealers who negotiate sales of securities, as opposed to them trading on a formal exchange (e.g. NYSE). –Inside Market: the market where treasury dealers trade with one another through brokers. –Government brokers: trade not for their own accounts, but for dealers. This provides the dealers anonymity. –Outside Market: the market where dealers trade with investors in the retail market. –When-Issued Market: An investor buys a security after the announcement of a bond issue, but before the bond is actually issued by the Treasury. The seller obtains and delivers the bond to the purchaser as soon as it is issued.

7 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market – Dealer’s Profit Come from three sources: bid-ask spread, inventory profits & carry. – Pricing of T-Notes & T-Bonds Specified in dollars per $100 face value, in 32nds. Occasionally you will see + after quote, which means to add 1/64. 98:12+ would therefore mean, 98 and 12/32 plus 1/64 = 98 and 25/64s. Maturity is always on the 15 th of the month.

8 Chapter VI – Government Bonds

9 Treasury Notes & Treasury Bonds: Secondary Market – Accrued Accounting When government bonds/notes change hands between coupon payments, the spoils need to be divided between the seller and purchaser of the bond. Accrued accounting on government issues are based on the actual number of days in the month and in the year--including leap years. – Example: You buy 6 of ‘05 on June 13, 2004 Note that the quote on previous page was for June 12 th, there is a one day delay for transaction to settle. You receive the bond June 13 th. Since buyer will receive the full coupon, must compensate the seller in purchase price. It pays coupons on August 15 th and February 15 th of $60,000/2=30,000. (The prices quoted in the WSJ are for round lots of $1,000,000.) The coupon period from Feb 15 th to Aug 15 th is 182 (2004 is a leap year = 182; would be 181 in non-leap years) and from Aug 15 th to Feb 15 th is 184 days for total of 366 (365 in non-leap years). –Feb to Aug: 28-15, 31, 30, 31, 30, 31, 15 = 182; –Aug to Feb: 31-15, 30, 31, 30, 31, 31, 15 = 184

10 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market – Accrued Accounting Example (cont’d) The last coupon payment was Feb 15; the seller held for 119 days: (29- 15) ; You will hold for 63 days: (30-13) The coupon proceeds are divided accordingly. $30,000 x 63/182 = $10, $30,000 x 119/182 = $19, The Invoice Price is the base price of the bond plus accrued interest $987,500.00base price $19,615.38accrued interest $1,007,115.38invoice price

11 Chapter VI – Government Bonds

12 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market – Example: Things to Do: VI-1 On June 12, 2004 (the day of the price quote above) you put in an order for a $1,000, /8% May 2011 bond. 1.What is the price of this bond before accrued interest? 2.Accrued interest for how many days adds how much to the price of the bond? 3.What is the total invoice price of the bond? 4.When will you receive your first coupon? 5.How much will you receive on this first coupon date? 6.On the first coupon payment date you will have earned how much interest over how many days? 7.Calculate the yield to maturity.

13 Chapter VI – Government Bonds Treasury Notes & Treasury Bonds: Secondary Market –Call Features Some T-bonds had been issued with a call feature 5 years prior to maturity. These bonds are no longer issued, though some remain outstanding. There have never been callable notes. –For callable bonds trading at a premium to face value, yields are calculated to the nearest call date. For callable bonds trading at a discount, yields are calculated to maturity. –Flower Bonds Certain government issues which had tax advantages to investors because they could be par to pay Federal Estate Taxes. These bonds are no longer being issued, and all issues have matured as of –Stripped Treasuries As we saw in Chapter VI, coupon bonds can be taken apart and sold separately. This becomes a stripped treasury bond. You then have individual prices and yields for each coupon payment and the principal.

14 Chapter VI – Government Bonds Federal Agencies –Some Federal Agencies issue their own securities to finance their own activities. There is about 1.9 trillion in outstanding debt of this type. –Agencies generally formed for public policy reasons to channel credit to a particular sector of the economy that congress believes is not receiving adequate credit through normal private sources. –Most debt is issued to support home mortgages and farm credit. –Agency debt is not regulated by the SEC.

15 Chapter VI – Government Bonds Muni’s –Tax exempt bonds issued by state and local governments. There are about 88,000 such government entities in the US with about 1.6 trillion in debt outstanding. –Muni’s are similar to treasury and corporate bonds, but interest income is exempt from federal income taxation, as well as taxation from state and local taxes of the home state. The exception to this tax exemption regards federal capital gains taxes—which still applies. –The wide variety of muni bonds (callable, differing maturities, etc) is a function of the large number of issues. No SEC regulation of this market. –There are a number of different types of Muni’s General Obligation Bonds: backed by “the full faith and credit” (I.e. taxing power) of the issuer. These bonds are generally viewed as nearly free of default risk.

16 Chapter VI – Government Bonds Muni’s (cont’d) Revenue Bonds: issued to finance particular projects and are backed by either revenues from that project or by the municipal agency operating the project. –Typical issues of revenue bonds include airports, hospitals, turnpikes and port authorities. Revenue bonds are have a higher default risk than do GO bonds. Industrial Development Bonds are a particular type of Revenue bond. IDBs are issued to finance commercial enterprises, such as the construction of a factory that can then be operated by a private firm. In effect, this allows the firm access to the municipalities ability to borrow at tax free rates. –The tax treatment of muni’s allows them to be issued at a much lower yield than would be acceptable to purchasers if they were not tax advantaged.

17 Chapter VI – Government Bonds Muni’s (cont’d) –y ( 1 – t ) = y m or y = y m / ( 1 - t ) y = traditional taxable yield t = marginal tax rate of the borrower y m = the equivalent yield on a tax-free municipal bond What yield should the City of Champaign place on its next 20 year GO bond if the equivalent Treasury bond yields 4.5%, and marginal tax rates in Champaign average 25%? 4.5% (1-.25) = 3.38% If an investor is considering a federal Treasury bond which yields 5.0% or a municipal bond which yields 3.8%, and the investors marginal tax rate is.20%, which bond is preferable? What if the investor’s marginal tax rate goes to 30%? –Tax Risk: The additional risk of investing in muni’s which arises by the possibility that the tax exemption might change. Changes might involve the marginal tax rate of the investor, or the tax status of a particular municipal bond issue.

18 Chapter VI – Government Bonds Muni’s –Muni’s are traded over-the-counter, and are generally qouted on a yield basis. –Bond Buyer: A daily publication of fixed income statistics and indeces including new issue information –Munifacts: on line access to BondBuyer data. –Blue List: Short for “The Blue List of Current Municipal Offerings put out daily by S&P. Contains prices, yields and other market information.