©2007, The McGraw-Hill Companies, All Rights Reserved 6-1 McGraw-Hill/Irwin Chapter Six Bond Markets

©2007, The McGraw-Hill Companies, All Rights Reserved 6-2 McGraw-Hill/Irwin Overview of the Bond Markets A bond is a promise to make periodic coupon payments and to repay principal at maturity; breech of this promise is an event of default Bonds carry original maturities greater than one year so bonds are instruments of the capital markets Issuers are corporations and government units A bond is a promise to make periodic coupon payments and to repay principal at maturity; breech of this promise is an event of default Bonds carry original maturities greater than one year so bonds are instruments of the capital markets Issuers are corporations and government units

©2007, The McGraw-Hill Companies, All Rights Reserved 6-3 McGraw-Hill/Irwin Bond Market Instruments Outstanding, ($Bn)

©2007, The McGraw-Hill Companies, All Rights Reserved 6-4 McGraw-Hill/Irwin Treasury Notes and Bonds T-notes and T-bonds issued by the U.S. Treasury to finance the national debt and other federal government expenditures Backed by the full faith and credit of the U.S. government and are default risk free Pay relatively low rates of interest (yields to maturity) Given their longer maturity, not entirely risk free due to interest rate fluctuations Pay coupon interest (semiannually): notes have maturities from 1-10 years; bonds years T-notes and T-bonds issued by the U.S. Treasury to finance the national debt and other federal government expenditures Backed by the full faith and credit of the U.S. government and are default risk free Pay relatively low rates of interest (yields to maturity) Given their longer maturity, not entirely risk free due to interest rate fluctuations Pay coupon interest (semiannually): notes have maturities from 1-10 years; bonds years

©2007, The McGraw-Hill Companies, All Rights Reserved 6-5 McGraw-Hill/Irwin Composition of the U.S. National Debt ($Bn)

©2007, The McGraw-Hill Companies, All Rights Reserved 6-6 McGraw-Hill/Irwin Treasury Strips A treasury security in which the individual interest payments are separated from the principal payment Effectively creates sets of securities--one for each semiannual interest payment one one for the final principal payment Often referred to as “Treasury zero-coupon bonds” Created by U.S. Treasury in response to separate trading of treasury security principal and interest developed by securities firms; only available through FIs and government securities brokers A treasury security in which the individual interest payments are separated from the principal payment Effectively creates sets of securities--one for each semiannual interest payment one one for the final principal payment Often referred to as “Treasury zero-coupon bonds” Created by U.S. Treasury in response to separate trading of treasury security principal and interest developed by securities firms; only available through FIs and government securities brokers

©2007, The McGraw-Hill Companies, All Rights Reserved 6-7 McGraw-Hill/Irwin The Primary Market in Treasury Notes and Bonds Similar to the primary market T-bill sales, the Treasury sells T-notes and bonds through competitive and noncompetitive auctions Auction Pattern for Treasury Notes and bonds Security Purchase Minimum General Auction Schedule 2-year note $1,000 Monthly 5-year note $1,000 Feb, May-Aug, Nov 10-year note $1,000 Feb, May-Aug, Nov Similar to the primary market T-bill sales, the Treasury sells T-notes and bonds through competitive and noncompetitive auctions Auction Pattern for Treasury Notes and bonds Security Purchase Minimum General Auction Schedule 2-year note $1,000 Monthly 5-year note $1,000 Feb, May-Aug, Nov 10-year note $1,000 Feb, May-Aug, Nov

©2007, The McGraw-Hill Companies, All Rights Reserved 6-8 McGraw-Hill/Irwin Secondary Market in Treasury Notes and Bonds Most secondary market trading occurs directly through brokers and dealers Wall Street Journal shows full list of Treasury securities that trade daily Most secondary market trading occurs directly through brokers and dealers Wall Street Journal shows full list of Treasury securities that trade daily

©2007, The McGraw-Hill Companies, All Rights Reserved 6-9 McGraw-Hill/Irwin Municipal Bonds (Munis) Securities issued by state and local governments Tax receipts or revenues generated are the source of repayment Attractive to household investors because interest (but not capital gains) are tax exempt Securities issued by state and local governments Tax receipts or revenues generated are the source of repayment Attractive to household investors because interest (but not capital gains) are tax exempt

©2007, The McGraw-Hill Companies, All Rights Reserved 6-10 McGraw-Hill/Irwin Tax Exemption and Muni Yields i a = i b (1 - t) Where: i a = After-tax (equivalent tax exempt) rate of return on a taxable bond i b = Before-tax rate of return on a taxable bond t = Income tax rate of the marginal bond holder Example: You can invest in taxable corporate bonds that are paying 10% annually on munis. Your marginal tax rate is 28%. The after- tax rate of return on the taxable bond is: 10%(1-.28) = 7.2% i a = i b (1 - t) Where: i a = After-tax (equivalent tax exempt) rate of return on a taxable bond i b = Before-tax rate of return on a taxable bond t = Income tax rate of the marginal bond holder Example: You can invest in taxable corporate bonds that are paying 10% annually on munis. Your marginal tax rate is 28%. The after- tax rate of return on the taxable bond is: 10%(1-.28) = 7.2%

©2007, The McGraw-Hill Companies, All Rights Reserved 6-11 McGraw-Hill/Irwin Types of Municipal Bonds General Obligation Bonds –bonds backed by the full faith and credit of the issuer Revenue Bonds –bonds sold to finance a specific revenue generating project and are backed by cash flows from that project General Obligation Bonds –bonds backed by the full faith and credit of the issuer Revenue Bonds –bonds sold to finance a specific revenue generating project and are backed by cash flows from that project

©2007, The McGraw-Hill Companies, All Rights Reserved 6-12 McGraw-Hill/Irwin Primary Market Placement Choices for Munis General Public Offering –underwriter is selected either by negotiation or by competitive bidding –the underwriter offers the bonds to the general public Rule 144A Placement –bonds are sold on a semi-private basis to qualified investors (generally FIs) General Public Offering –underwriter is selected either by negotiation or by competitive bidding –the underwriter offers the bonds to the general public Rule 144A Placement –bonds are sold on a semi-private basis to qualified investors (generally FIs)

©2007, The McGraw-Hill Companies, All Rights Reserved 6-13 McGraw-Hill/Irwin Top Municipal Bond Underwriters Principal Amount Market No. of Underwriter (in millions $$) Share Issues UBS Financial Services $35, % 631 Citigroup 30, % 476 Lehman Brothers 22, % 170 Merrill Lynch 18, % 208 Goldman Sachs 18, % 132 J.P. Morgan Securities 17, % 324 Bear, Stearns 15, % 133 Morgan Stanley 14, % 179 RBC Dain Rauscher 11, % 533 Banc of America Securities 10, % 327 Industry totals $265.5 billion Principal Amount Market No. of Underwriter (in millions $$) Share Issues UBS Financial Services $35, % 631 Citigroup 30, % 476 Lehman Brothers 22, % 170 Merrill Lynch 18, % 208 Goldman Sachs 18, % 132 J.P. Morgan Securities 17, % 324 Bear, Stearns 15, % 133 Morgan Stanley 14, % 179 RBC Dain Rauscher 11, % 533 Banc of America Securities 10, % 327 Industry totals $265.5 billion

©2007, The McGraw-Hill Companies, All Rights Reserved 6-14 McGraw-Hill/Irwin Contracting Choices with the Underwriter Firm commitment underwriting Best efforts underwriting Firm commitment underwriting Best efforts underwriting

©2007, The McGraw-Hill Companies, All Rights Reserved 6-15 McGraw-Hill/Irwin Secondary Market for Munis Secondary market is thin (i.e. trades are relatively infrequent) due to a lack of information on bond issuers, who are generally much smaller than corporate bond issuers

©2007, The McGraw-Hill Companies, All Rights Reserved 6-16 McGraw-Hill/Irwin Corporate Bonds All long-term bonds issued by corporations Minimum denominations publicly traded corporate bonds is $1,000 Generally pay interest semiannually Bond indenture All long-term bonds issued by corporations Minimum denominations publicly traded corporate bonds is $1,000 Generally pay interest semiannually Bond indenture

©2007, The McGraw-Hill Companies, All Rights Reserved 6-17 McGraw-Hill/Irwin Types of Corporate Bonds Bearer bonds Registered bonds Term bonds Serial bonds Mortgage bonds Equipment Trust Certificates Debentures (continued) Bearer bonds Registered bonds Term bonds Serial bonds Mortgage bonds Equipment Trust Certificates Debentures (continued)

©2007, The McGraw-Hill Companies, All Rights Reserved 6-18 McGraw-Hill/Irwin Types of Corporate Bonds Subordinated debentures Convertible bonds Stock Warrant Callable bonds Sinking Fund bonds Subordinated debentures Convertible bonds Stock Warrant Callable bonds Sinking Fund bonds

©2007, The McGraw-Hill Companies, All Rights Reserved 6-19 McGraw-Hill/Irwin Primary and Secondary Markets for Corp Bonds Primary sales of corp bonds occur through either a public sale (issue) or a private placement similar to municipal bonds Two secondary markets –the exchange market (e.g., the NYSE) –the over-the-counter (OTC) market OTC electronic market dominates trading in corp bonds Primary sales of corp bonds occur through either a public sale (issue) or a private placement similar to municipal bonds Two secondary markets –the exchange market (e.g., the NYSE) –the over-the-counter (OTC) market OTC electronic market dominates trading in corp bonds

©2007, The McGraw-Hill Companies, All Rights Reserved 6-20 McGraw-Hill/Irwin Bond Ratings Bonds are rated by the issuer’s default risk Large bond investors, traders and managers evaluate default risk by analyzing the issuer’s financial ratios and security prices Two major bond rating agencies are Moody’s and Standard & Poor’s (S&P) Bonds assigned a letter grade based on perceived probability of issuer default Bonds are rated by the issuer’s default risk Large bond investors, traders and managers evaluate default risk by analyzing the issuer’s financial ratios and security prices Two major bond rating agencies are Moody’s and Standard & Poor’s (S&P) Bonds assigned a letter grade based on perceived probability of issuer default

©2007, The McGraw-Hill Companies, All Rights Reserved 6-21 McGraw-Hill/Irwin Bond Credit Ratings Explanation Moody’s S&P Investment grade categories: Best quality; smallest degree of risk Aaa AAA High quality; slightly more long-term Aa1 AA+ risk than top rating Aa2 AA Aa3 AA Upper medium grade; possible A1 AA- impairment in the future A2 A+ A3 A- Medium grade; lack outstanding Baa1 BBB+ investment characteristics Baa2 BBB Baa3 BBB- Explanation Moody’s S&P Investment grade categories: Best quality; smallest degree of risk Aaa AAA High quality; slightly more long-term Aa1 AA+ risk than top rating Aa2 AA Aa3 AA Upper medium grade; possible A1 AA- impairment in the future A2 A+ A3 A- Medium grade; lack outstanding Baa1 BBB+ investment characteristics Baa2 BBB Baa3 BBB- (continued)

©2007, The McGraw-Hill Companies, All Rights Reserved 6-22 McGraw-Hill/Irwin Bond Credit Ratings Explanation Moody’s S&P Speculative investment grades: Speculative issues; protection may Ba1 BB+ be very moderate Ba2 BB Ba3 BB- Very speculative; may have small B1 B+ assurance of interest and principle B2 B payment B3 B- Issues in poor standing; may be in default Caa CCC Speculative in a high degree Ca CC Lowest quality; poor prospects of attaining C C real investment standing D Explanation Moody’s S&P Speculative investment grades: Speculative issues; protection may Ba1 BB+ be very moderate Ba2 BB Ba3 BB- Very speculative; may have small B1 B+ assurance of interest and principle B2 B payment B3 B- Issues in poor standing; may be in default Caa CCC Speculative in a high degree Ca CC Lowest quality; poor prospects of attaining C C real investment standing D

©2007, The McGraw-Hill Companies, All Rights Reserved 6-23 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 the broad market 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 the broad market indexes can be used by bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities

©2007, The McGraw-Hill Companies, All Rights Reserved 6-24 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, mutual funds) are the major suppliers of funds for all three types of 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, mutual funds) are the major suppliers of funds for all three types of bonds

©2007, The McGraw-Hill Companies, All Rights Reserved 6-25 McGraw-Hill/Irwin International Aspects of Bond Markets International bond market –trades bonds that are underwritten by an international syndicate –offer bonds simultaneously to investors in several countries –issue bonds outside the jurisdiction of any single country –offer bonds in unregistered form International bond market –trades bonds that are underwritten by an international syndicate –offer bonds simultaneously to investors in several countries –issue bonds outside the jurisdiction of any single country –offer bonds in unregistered form

©2007, The McGraw-Hill Companies, All Rights Reserved 6-26 McGraw-Hill/Irwin Eurobonds, Foreign Bonds, Brady Bonds and Sovereign Bonds Eurobonds Foreign Bonds Brady Bonds and Sovereign Bonds Eurobonds Foreign Bonds Brady Bonds and Sovereign Bonds