1. All Rights ReservedDr David P Echevarria1 CHAPTER 7 BOND MARKETS

2. All Rights ReservedDr David P Echevarria2 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

3. Federal Reserve Balance Sheet 9/5/2013 All Rights ReservedDr David P Echevarria3

4. All Rights ReservedDr David P Echevarria4 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)

5. All Rights ReservedDr David P Echevarria5 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

6. All Rights ReservedDr David P Echevarria6 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

7. All Rights ReservedDr David P Echevarria7 EVALUATING BOND RISK  Interest 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

8. All Rights ReservedDr David P Echevarria8 EVALUATING BOND RISK  Default (or business) 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

9. All Rights ReservedDr David P Echevarria9 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

10. All Rights ReservedDr David P Echevarria10 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

11. All Rights ReservedDr David P Echevarria11 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

12. All Rights ReservedDr David P Echevarria12 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?