CHAPTER 8 BOND MARKETS Copyright© 2012 John Wiley & Sons, Inc.

Capital Markets Economic purpose - brings together long- term (over 1 year) borrowers and investors. Major Issuers Corporations - bonds and stocks Governments - federal, state, and local bonds Major Investors Households (directly or indirectly through financial intermediaries) Financial intermediaries Copyright© 2012 John Wiley & Sons, Inc. 2

Economic Sectors Copyright© 2012 John Wiley & Sons, Inc. 3

Capital Market Instruments Outstanding Copyright© 2012 John Wiley & Sons, Inc. 4

U.S. Treasury and Agency Securities U.S. Government Issues - Notes and Bonds Coupon issues. Notes - one to ten-year maturity. Bonds - over ten-year maturity. Sold in auction by the Treasury Department. Trend is toward more short-term market financing and less long-term financing. Copyright© 2012 John Wiley & Sons, Inc. 5

How to Read Treasury Quotes Copyright© 2012 John Wiley & Sons, Inc. 6

U.S. Treasury and Agency Securities (continued) Inflation-Indexed Notes and Bonds (TIPS) Principal adjusts for inflation Fixed coupon rate determined by auction process Minimum denomination is $1,000. Separate Trading of Registered Interest and Principal (STRIP) Each coupon and principal of a U.S. Treasury note or bond is sold separately by a dealer. Each separated security is a zero-coupon bond. Dealers engage in creating STRIPs because investors value zero-coupon default risk-free securities and are willing to pay more for STRIPs than underlying bonds. Copyright© 2012 John Wiley & Sons, Inc. 7

State and Local Government Bonds Known as municipal bonds or munis Types of municipal bonds General Obligation (GO) - backed by taxing power of political entity. Revenue - financed and paid back with cash flows from a specific project. Industrial Development Bonds (IDB) - public financing of private business. Mortgage-backed bonds – issued by city housing authorities. Copyright© 2012 John Wiley & Sons, Inc. 8

Municipal Bonds (continued) The Relation between Municipals and Taxable Yields Interest on municipal bonds is exempt from federal income tax. Munis and taxable corporates are similar except for the taxation of interest. The yield on municipals equals the yield on taxables times one minus the marginal tax rate. i m = i t (1-t) Copyright© 2012 John Wiley & Sons, Inc. 9

Corporate vs. Muni Bond An investor has the choice of an AA-rated corporate bond with a yield of 6% or an AA-rated muni yielding 4%. If the investor has a marginal tax rate of 30%, which bond should he/she select? Copyright© 2012 John Wiley & Sons, Inc. 10

Corporate vs. Muni-Bond The after-tax rate on the corporate bond is 6% ( ) = 4.2% > 4% on the muni bond or The pretax equivalent rate on the muni bond would be 4% / ( ) = 5.7% < 6% on the corporate bond.  Select the corporate bond! Copyright© 2012 John Wiley & Sons, Inc. 11

Investors in Municipal Bonds Three groups of investors in municipal bonds whose demands are affected by their high federal tax exposure are: Households - affected by income level and marginal tax rates. Casualty insurance companies - investment determined by industry profitability. Commercial banks - the Tax Reform Act of 1986 ended the tax deductibility of interest expense incurred on borrowing for the purchase of tax-exempt securities. Copyright© 2012 John Wiley & Sons, Inc. 12

Who Invests in Municipal Bonds? Copyright© 2012 John Wiley & Sons, Inc. 13

Municipal Bonds (continued) The Market for Municipal Bonds Primary market Many individual smaller issuers. Underwritten by investment bankers from local to national markets. Most general obligation (GO) bonds are sold by competitive bid. Secondary market Not well-developed, OTC market made by dealers. Thin secondary markets lead to larger bid-ask spreads. Limited marketability leads to higher yields. Copyright© 2012 John Wiley & Sons, Inc. 14

Corporate Bonds Debt contracts (indentures) that require borrowers to make periodic payments of interest and repay principal, usually $1,000, at maturity date. Types of ownership record Bearer bonds - coupon bond owned by bearer. Registered bonds - owner noted by records. Maturity Term bonds - all bonds mature on one date. Serial bonds - bonds in the issue mature on different dates. Most munis are serial issues. Copyright© 2012 John Wiley & Sons, Inc. 15

The Bond Indenture Collateral Mortgage bonds - real assets pledged. Equipment trust certificates - specific, titled, or identifiable equipment. Collateral bonds - secured by financial assets. Debentures - unsecured bonds. Claim on assets Senior debt - first priority to general assets. Subordinated debt - asset claim ranking of unsecured debentures below senior or specific general creditors. Copyright© 2012 John Wiley & Sons, Inc. 16

The Bond Indenture (continued) Provisions Sinking fund provision the periodic retirement of a number of bonds Call provision gives issuer right to retire bonds before maturity Convertible Bonds Bonds that can be converted into common stock Copyright© 2012 John Wiley & Sons, Inc. 17

Investors in Corporate Bonds Major investors include: Life insurance companies. Pension funds. Households. Foreign Investors. Investor requirements: Long-term investment horizon. Liquidity not always needed - hold to maturity. Safety - investment grade. Tax considerations. Copyright© 2012 John Wiley & Sons, Inc. 18

Market for Corporate Bonds Public sale - open to all interested buyers. Competitive sale - public auction among underwriters. Negotiated sale - underwriting contract signed with specific underwriters. Most secondary trading of corporate bonds occurs through dealers vs. exchanges. the volume of trading is low – a thin market, thus there is a wide bid/ask differential in the market. corporate bonds are less marketable than money market instruments. Copyright© 2012 John Wiley & Sons, Inc. 19

Market for Corporate Bonds Private placement - sold to limited number (< 35) of sophisticated buyers, avoiding SEC registration. private placements have increased relative to public sale. when interest rates are high and/or when capital market conditions are unstable, private placements increase. SEC Rule 144a (1990) liberalized the regulation of private placements. It allows secondary market trading of private placements. Copyright© 2012 John Wiley & Sons, Inc. 20

Junk bond issuance in the late 1990’s Junk bonds are low rated (high default risk) corporate bonds. Development of the junk bond primary market was enhanced by the secondary market maintained by Drexel Burnham and Lambert in the early 1980s. Higher risk firms found they could issue longer term, more flexible securities in the high-yield market rather than borrow from commercial banks. Copyright© 2012 John Wiley & Sons, Inc. 21

The Role of Financial Guarantees Cover the payment of principal and interest in the event of default. Substitutes the credit standing of the guarantor for that of the issuer. The quality of a financial guarantee depends on the reputation and financial strength of the guarantor. Provided for a fee by Commercial banks - letters of credit to back commercial paper or swaps. Insurance companies - insurance policies to back bond issues. Guarantee lowers the default risk of the issue and increases marketability leading to a lower yield to investors. Copyright© 2012 John Wiley & Sons, Inc. 22

Securitized Credit Instruments Securitization is packaging loans and selling claims to future cash flows of the loans. Originator designs securities (claims) desired by investors. Returns are derived from the cash flows of the loans packaged in a trust arrangement. Value of new securities exceeds value of loan cash flows, providing incentives to securitize. A variety of asset-backed securities have been created, beginning in the mortgage market and now extending to other types of loans. Very often, privately originated asset-backed securities have been made more attractive to investors by a variety of “credit enhancements”, which lower costs to issuers and default risk to investors. Copyright© 2012 John Wiley & Sons, Inc. 23

Securitized Credit Instruments (continued) Tranches - The variety of claims, called in some cases tranches vary from low to very high risk. Financial guarantees enhance the value of the low risk end tranches. The residual or non-guaranteed tranches have a higher risk/return profile. Copyright© 2012 John Wiley & Sons, Inc. 24

Financial Markets Regulators The Securities and Exchange Commission (SEC) is the principle regulator of financial markets. SEC established in Federal Securities Act of Scope ranges from disclosure requirements to proper operation of capital markets. Public firms file regular reports with the SEC. Copyright© 2012 John Wiley & Sons, Inc. 25

Financial Markets Regulators (continued) Information filing is costly and time consuming; some firms prefer private placements or borrowing from a few sophisticated investors. Registration and prospectus are not required, as in a "general public" security offering. All states have security laws related to issuing and trading securities. The securities industry has had a good record of self- regulation, with the SEC watching to step in when the public's interest is not served. The National Association of Security Dealers (NASD) is one of prominent private regulatory bodies. They assist in maintaining the trust of the general public, which is the major source of funds for the capital markets. Copyright© 2012 John Wiley & Sons, Inc. 26

Global Bond Markets Foreign Bonds – issued in a financial market of a nation by a foreign company in that country. When a foreign company like Nestle (Switzerland) issues a bond in the U. S. corporate bond market, it is considered to be a foreign bond and is referred to as “Yankee bonds”. Similarly, foreign firms issuing corporate bonds in the Japanese market will have their bonds referred to as “Samurai bonds”. Foreign bonds must conform to the regulations imposed in the country of issue, denominated in the currency of that country, be brought to the market by investment bankers of that country, and sold only to investors of that country. Copyright© 2012 John Wiley & Sons, Inc. 27

Global Bond Markets (continued) Eurobonds – issued by an entity in one or more countries denominated in a currency other than the currency of the country where the bonds are issued. IBM issues a dollar denominated bond outside of the U.S. - Eurobond. Eurobonds are brought to the market by a multinational syndicate of investment banks. Eurobonds are often bearer bonds and do not have to be registered. Interest or coupon payments are annual. Some Eurobonds are convertible, while call provisions are common even in short-maturity Eurobonds. Copyright© 2012 John Wiley & Sons, Inc. 28

Global Bond Markets (continued) International credit ratings have become a more significant influence than domestic ratings on the interest rates of debt. International credit ratings also take country or political risk into consideration. Copyright© 2012 John Wiley & Sons, Inc. 29

The impact of Crisis on Bond Markets Copyright© 2012 John Wiley & Sons, Inc. 30