Copyright© 2006 John Wiley & Sons, Inc.1 Power Point Slides for: Financial Institutions, Markets, and Money, 9 th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson University and Lanny R. Martindale, Texas A&M University

CHAPTER 8 BOND MARKETS

Copyright© 2006 John Wiley & Sons, Inc.3 Capital Markets Economic purpose - brings together long- term (over 1 year) borrowers and long-term investors. Major Issuers (borrowers) Households - mortgages. Business - bonds and stock Governments - federal, state, and local bonds. Major Investors Households (directly or indirectly through financial intermediaries). Foreign investors.

Copyright© 2006 John Wiley & Sons, Inc.4 Economic Sectors

Copyright© 2006 John Wiley & Sons, Inc.5 Capital Market Instruments Outstanding

Copyright© 2006 John Wiley & Sons, Inc.6 Types of Capital Market Claims Corporate stock - studied in Chapter 9 Bonds - studied here in Chapter 8 Mortgages - studied in Chapter 10

Copyright© 2006 John Wiley & Sons, Inc.7 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 by auction by the Federal Reserve banks. Trend is toward more money market financing and less capital market financing – 30-year T- bond issues discontinued.

Copyright© 2006 John Wiley & Sons, Inc.8 How to Read Treasury Quotes

Copyright© 2006 John Wiley & Sons, Inc.9 U.S. Treasury and Agency Securities (continued) Inflation-Indexed Notes and Bonds (TIPS) – see example on p Principal adjusts for inflation Fixed coupon rate determined by auction process Minimum denomination is $1,000. Separate Trading of Registered Interest and Principal (STRIPS). Securitized U.S. Treasury note or bond Interest and principal zero coupon securities sold based on interest and principal cash flows of underlying bond. Market values total value of STRIPS created more than underlying bonds.

Copyright© 2006 John Wiley & Sons, Inc.10 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.

Copyright© 2006 John Wiley & Sons, Inc.11 Municipal Bonds (continued) The Relation between Municipals and Taxable Yields Interest on municipal bonds is exempt from federal tax on coupon interest payments. Muni bonds 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© 2006 John Wiley & Sons, Inc.12 Corporate vs. Muni Bond An investor has the choice of a Aa rated corporate bond with a yield of 6% or a Aa rated muni-bond yielding 4%. If the investor has a marginal tax rate of 30%, which bond should he/she select?

Copyright© 2006 John Wiley & Sons, Inc.13 Corporate vs. Muni-Bond The after-tax rate on the corporate 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  Select the corporate bond!

Copyright© 2006 John Wiley & Sons, Inc.14 Municipal Bonds (continued) 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© 2006 John Wiley & Sons, Inc.15 Who Invests in Municipal Bonds?

Copyright© 2006 John Wiley & Sons, Inc.16 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© 2006 John Wiley & Sons, Inc.17 Corporate Bonds Debt contracts (indenture) requiring borrower 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 at future date. Serial bonds - bonds mature at varying future dates.

Copyright© 2006 John Wiley & Sons, Inc.18 The Bond Indenture Collateral Mortgage bond - 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 - asset claim ranking of unsecured debentures below senior or specific general creditors.

Copyright© 2006 John Wiley & Sons, Inc.19 The Bond Indenture (concluded) Means of principal payment Sinking fund – building a sum for retirement the periodic retirement of a number of bonds selected randomly. Call provision - borrower right to retire bond before maturity.

Copyright© 2006 John Wiley & Sons, Inc.20 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© 2006 John Wiley & Sons, Inc.21 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© 2006 John Wiley & Sons, Inc.22 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© 2006 John Wiley & Sons, Inc.23 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 borrowing from commercial banks.

Copyright© 2006 John Wiley & Sons, Inc.24 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 security 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© 2006 John Wiley & Sons, Inc.25 Securitized Credit Instruments Securitization is the packaging loans and selling the claims to the future cash flows of the loans is called securitization. The originator designs securities (claims) desired by investors. The returns are derived from the cash flows of the loans packaged in a trust arrangement. The sum of the value of the new securities exceeds the value of the loan cash flows, providing incentives to unbundle the loan cash flows. A variety of asset-backed securities have been created, beginning in the mortgage market and now extending to other types of loans. mortgage-backed securities (MBS) are issued by both federal agencies as well as by private investor groups (see Chapter 9). 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© 2006 John Wiley & Sons, Inc.26 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© 2006 John Wiley & Sons, Inc.27 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© 2006 John Wiley & Sons, Inc.28 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 the foremost 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© 2006 John Wiley & Sons, Inc.29 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 (Swiss) 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 confirm to the regulations imposed in the country of issue, denominated in the currency of that country, are brought to the market by investment bankers of that country, and sold only to investors of that country.

Copyright© 2006 John Wiley & Sons, Inc.30 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. Eurobond 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. Floating rate Eurobonds are referred to as Floating Rate Notes (FRNs), and is based on LIBOR.

Copyright© 2006 John Wiley & Sons, Inc.31 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.