©2009, The McGraw-Hill Companies, All Rights Reserved 6-1 McGraw-Hill/Irwin Chapter Six Bond Markets

©2009, The McGraw-Hill Companies, All Rights Reserved 6-2 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-3 McGraw-Hill/Irwin Bond Market Instruments Outstanding,

©2009, The McGraw-Hill Companies, All Rights Reserved 6-4 McGraw-Hill/Irwin 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:

©2009, The McGraw-Hill Companies, All Rights Reserved 6-5 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-6 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-7 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-8 McGraw-Hill/Irwin Treasury Notes and Bonds “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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-9 McGraw-Hill/Irwin Treasury Notes and 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-10 McGraw-Hill/Irwin Treasury Notes and Bonds 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-11 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-12 McGraw-Hill/Irwin 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)

©2009, The McGraw-Hill Companies, All Rights Reserved 6-13 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-14 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-15 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-16 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-17 McGraw-Hill/Irwin Corporate Bonds Primary markets are identical to that of Munis Secondary markets –the exchange market (e.g., NYSE) –the over-the-counter (OTC) market Bond ratings –the two major bond rating agencies are Moody’s and Standard & Poor’s (S&P) –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., NYSE) –the over-the-counter (OTC) market Bond ratings –the two major bond rating agencies are Moody’s and Standard & Poor’s (S&P) –bonds are rated by perceived default risk –bonds may be either investment or speculative (i.e., junk) grade

©2009, The McGraw-Hill Companies, All Rights Reserved 6-18 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-19 McGraw-Hill/Irwin 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

©2009, The McGraw-Hill Companies, All Rights Reserved 6-20 McGraw-Hill/Irwin 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 Brady Bonds are bonds swapped for an outstanding loan to a less developed country Sovereign Bonds are Brady Bonds that have had their underlying collateral removed and the creditworthiness of the country is substituted instead 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 Brady Bonds are bonds swapped for an outstanding loan to a less developed country Sovereign Bonds are Brady Bonds that have had their underlying collateral removed and the creditworthiness of the country is substituted instead