1. CHAPTER 7
BOND MARKETS
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Dr David P Echevarria

2. CAPITAL MARKET INSTRUMENTS
Treasury Bonds
Fed is a large buyer of T-Bonds
Tool for implementing monetary policy
Dealer-dominated secondary market
Semi-annual coupons are typical
Main asset of the FED
Strips (IO or PO): Interest streams repackaged as separate security (TIGR)
TIPS (1996) inflation-indexed maturity values
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Dr David P Echevarria

3. Federal Reserve Balance Sheet
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Dr David P Echevarria

4. Federal Reserve Balance Sheet 1/21/2016
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Dr David P Echevarria

5. Federal Reserve Balance Sheet 1/21/2016
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Dr David P Echevarria

6. CAPITAL MARKET INSTRUMENTS
Municipal Bonds
Issued by states, counties, cities and state agencies
Interest is exempt from Federal taxation
Some types, i.e. industrial development bonds, may be completely tax-exempt
Tax-preference results in lower offered yields (rationale for computing before-tax equivalent yields)
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Dr David P Echevarria

7. CAPITAL MARKET INSTRUMENTS
Corporate Bonds
Terms spelled out in the Indenture Agreement; face value, maturity, coupon, form of collateral if any, Callable, Sinking Fund required
Insurance Cos are principal buyers of corporate bonds w/ households second Sold through public offerings; About half are privately-placed
Proceeds may be used to fund expansion, finance acquisitions or LBO or to refund maturing bond issues or to refund higher interest rate debt
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Dr David P Echevarria

8. CAPITAL MARKET INSTRUMENTS
Zero-Coupon bonds pay no coupons; sold at PV of maturity value; result is very much like a T-bill except the maturity can be up to 30 years
A favorite vehicle for in substance defeasance of debt for corps seeking to restructure their balance sheets,
High risk uncollateralized bonds are frequently called "junk bonds"
The US Tax Code favors debt financing; interest paid with pre-tax dollars
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Dr David P Echevarria

9. EVALUATING BOND RISK Interest Rate Risk Reinvestment Rate Risk
Change in price of seasoned bonds as rates change over time
Sensitivity a function of coupon and term to maturity
Reinvestment Rate Risk
Valuation formulas assume future cash flows reinvested at the expected rate of return
If rates drop, future cash flows are invested at lower rates, reducing the future value of reinvested cash flows
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Dr David P Echevarria

10. EVALUATING BOND RISK Default (or business) Risk Maturity Risk
Risk that payments may not be made
Importance of indenture agreement
Maturity Risk
The longer the maturity, the greater the risk
Liquidity Risk
The inability or difficulty in selling for cash
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Dr David P Echevarria

11. EVALUATING BOND RISK Companies' debt issues are rated for riskiness
Standard & Poor's, Moody's, Fitch's
Ratings: AAA to D (S&P scheme)
Ratings are important for many reasons; cost to borrow, legal list requirements High Quality (AAA - AA), Investment Grade (AAA - BBB), Speculative (BB and B), Highly speculative (C's), Default (D's)
Public Utilities are the single largest issuer of bonds
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Dr David P Echevarria

12. FINANCIAL INSTITUTIONS IN BOND MARKETS
Insurance Companies are largest buyer of Bonds
Attractiveness of bonds are their known payouts over time
Bonds offer frequent opportunities for capital gain strategies with relatively low risk
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Dr David P Echevarria

13. GLOBALIZATION OF BOND MARKETS
Impact of Exchange Rates on Foreign Bond Returns
Dealing with the double problems of Interest-Rate and Currency Parity
Use of interest rate swaps in international bond markets
Use of currency swaps in international bond markets
Economic growth rate differentials as well as government policy
Always a good idea to diversify international bond portfolios
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Dr David P Echevarria

14. HOMEWORK QUESTIONS
How is buying and selling accomplished in the T-Bond market?
How does the Fed use its inventory of treasury securities?
Who issues municipals? What is their principal attraction to an investor?
What type of investor should be most interested in municipals?
What are zero-coupon bonds? Why might borrowers prefer them?
What are the main sources of risk in a bond investment?
What are the two sources of risk when investing in foreign bonds?
How might we minimize the risk addressed in the previous question?
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Dr David P Echevarria