1. Financial Markets and Institutions
PowerPoint Slides for:
Financial Markets and Institutions
By Jeff Madura
Prepared by
David R. Durst
The University of Akron

2. Bond
Markets 7

3. Chapter Objectives
Provide informational background on U.S. Treasury, state and municipal, and corporate Bonds
Calculate bond yield from quote
Explain the role of bonds to institutional investors
Discuss the globalization of bond markets

4. Background on Bonds Bonds represent long-term debt securities
Contractual
Promise to pay future cash flows to investors
The issuer of the bond is obligated to pay:
Interest (or coupon) payments periodically usually semiannually
Par or face value (principal) at maturity
Primary vs. secondary market for bonds

5. Background on Bonds Bond Interest Rates
The issuer’s cost of financing with bonds is the coupon rate
Determined by current market rates and risk
Usually fixed throughout term
Determines periodic interest payments

6. Background on Bonds Bond Yield to Maturity
The yield to maturity (TYM) is the yield that equates the future coupon and principal payments with the bond price
The YTM is the investor’s expected rate of return if the bond is held to maturity
The actual YTM may vary from the expected because of risks assumed by the investors

7. Background on Bonds Bond Yield to Maturity
An investor can purchase a ten-year, $1000 par value bond with an 8 percent annualized coupon rate for $936. Determine the yield to maturity for this bond.
Bond Yield to Maturity N I PV
PMT FV 10
–936 80
1000

8. Background on Bonds Bond Yield to Maturity
An investor can purchase a ten-year, $1000 par value bond with an 8 percent annualized coupon rate for $936. Determine the yield to maturity for this bond.
Bond Yield to Maturity N I PV
PMT FV 10 9
–936 80
1000

9. Background on Bonds Bonds by Issuers Corporate Bonds Corporations
Municipal Bonds
State and Local Governments
Federal Agency Bonds
Federal Agencies
Treasury Bonds
Federal Government (U.S. Treasury)
Type of Bond
Issuer

10. U. S. Treasury Bonds
Issued by the U.S. Treasury to finance federal government expenditures
Maturity
Notes, < 10 Years
Bonds, > 10 to 30 Years
Active OTC Secondary Market
Semiannual Interest Payments
Benchmark Debt Security for Any Maturity

11. Treasury Bonds Treasury Bond Quotations
8.38 Aug : YTM?
Coupon rate
Maturity date
Bid/Ask price as percent of face value
Fractions of price in 32nds
Example: Bid price 103:05, Ask price 103:11
Yield to Maturity (YTM)

12. U. S. Treasury Bond Yield To Maturity
$83.80
Pmt
2013 –
Today
= N $
PV*
*Ask Price = 103 and 11/32 % of
Face Value or $
$1000
Ask
Price = FV
Calc
YTM

13. Cash Flow Variation in T-Bonds
Treasury Bonds
Coupon bonds
Interest paid semiannually
To registered bondholders
Stripped Treasury bonds
Zero-coupon securities are sold with claims on U. S. Treasury bonds held in a trust
One security represents the principal payment (np) at maturity
Other securities represents the interest payments (ci) at interest paying dates
Cash Flow Variation in T-Bonds

14. Inflation-Indexed Bonds
Treasury Bonds
Intended for investors who seek inflation protection with their investments
Coupon rates less than other Treasuries
Principal value adjusted for the U.S. inflation rate (CPI) every 6 months
Coupon income increases with inflation
Inflation-Indexed Bonds

15. Federal Agency Bonds Government National Mortgage Association (GNMA)
Issues bonds and uses proceeds to purchase insured FHA and VA mortgages
A U.S. Government Agency
Backed by explicit guarantee of Federal Government
Example of social allocation of capital

16. Federal Agency Bonds
Federal Home Loan Mortgage Association (Freddie Mac)
Issues bonds and uses proceeds to purchase conventional mortgages
A U.S. government-sponsored agency
No explicit guarantee of bonds by federal government, but credit risk is very low
Used to provide liquidity for thrifts and support of home ownership

17. Municipal Bonds State and local government obligations
Revenue bonds vs. general obligation Bonds
Investor interest income exempt from federal income tax
Tax Reform Act of 1986 placed limitations on tax-exempt bond issuance for private purposes

18. Corporate Bonds
When corporations want to borrow for long-term periods they issue corporate bonds
Usually pay semiannual interest
Most have maturities between years
Public offering vs. private placement
Limited exchange, larger OTC secondary market
Investors seek safety of principal and steady income

19. Corporate Bond Terminology
Corporate Bonds
Indenture
Legal document specifying rights and obligations of issuer and bondholder
Trustee
Represents bondholders to assure compliance with indenture
Corporate Bond Terminology

20. Corporate Bond Terminology
Corporate Bonds
Sinking Fund Provision
Requirement that the firm retire a certain amount or number of bonds each year
Protects investors with principal reduction
Protective Covenants
Places restrictions on the firm to protect bondholders
Examples: limits dividends and officer salaries, restricts additional debt
Corporate Bond Terminology

21. Corporate Bond Terminology
Corporate Bonds
Call provisions: Ability to pay bonds off early
Call premium
Advantage to issuers; disadvantage to investor
Bond collateral
Usually consists of a mortgage on real property
Unsecured bonds are called debentures and are backed only by the general credit of the issuing firm
Corporate Bond Terminology

22. Corporate Bond Terminology
Corporate Bonds
Low-coupon and zero-coupon bonds
Provide investors known rate of return
Imputed interest income taxed if not in tax-sheltered investment plan
Attractive to pension funds with expected payouts
Variable-rate bonds
Convertible bonds
Corporate Bond Terminology

23. Corporate Bonds Junk Bonds
Junk bonds are also called high-yield bonds or noninvestment rated bonds
Popularized in the direct finance boom of the 1980s
The risk premium is between three and seven percent above Treasury bonds and susceptible to contagion effects
Secondary market supported by dealer market

24. Corporate Bonds Market Quotation
ATT 6 ½ /8th +1/4
AT&T bond quote for 1/13/02 (U.S. Exchange Bond)
6.5% coupon rate
Maturity in 2029
7.3% current yield (annual interest/price)
214 bonds traded on this day
Bond priced at close of day 88 5/8th % of face ($1000) or $886.25
Bond price up ¼ point for the day or $2.50

25. Exhibit 7.5 F i n a c l I s t u o P r p B d M k e C m b v g • h f . (
& L ) y - U z , w T

26. Major Investors in Corporate Bonds, December, 2001
Mutual
Funds
$420 Bil.
Households and
Trusts$608 Billion
Foreign Investors $1.23 Trillion
Life Insurance Companies
$1.33 Trillion

27. Globalization of Bond Markets
Foreign investment in dollar securities
Foreign issuance by U.S. firms
Increased global investment by pension and mutual funds
Development of foreign security markets—24 hour trading
Eurobond market

28. Globalization of Bond Markets
In 1960s, U.S. corporations were limited to the amount of funds they could borrow in the U.S. for overseas operations.
They began to issue bonds in the Eurobond market where bonds denominated in various currencies were placed.
About 75 percent are denominated in U.S. dollars
Eurobond Market

29. Globalization of Bond Markets
An underwriting syndicate of investment banks participates in placing the bonds
Issuer can choose the currency in which the bond interest and principal are denominated
Dollar denominated most common
Bearer bonds vs. registered bonds
Eurobond Market