1. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Investments: Theory and Applications Mark Hirschey

2. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Chapter 6 Bond Market

3. 6-3 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Bond Market  The U.S. Bond Market has a market value of roughly $14.1 trillion  One of the largest securities markets in world  Bond prices quickly reflect:  changes in credit quality of issuers  aggregate economic conditions, including interest rates

4. 6-4 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Bond Market  Very efficient market mechanism for large buyers and sellers of debt instruments  Expensive place to trade for small investors  Large Bond Mutual Funds – significant operating expenses  Secondary Market – high commission costs  Difficult to match or beat market interest rates

5. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Bond Market Overview

6. 6-6 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. KEY TERMS Bond Market  Bond Dealers  Bond Issuer  Bond Investors  Primary Bond Market  Secondary Bond Market  Current Yield  Holding-Period Risk  Default Risk  Federal Funds Rate  Discount Rate  Eurodollar Market  LIBOR  Par Value  Round Lot

7. 6-7 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Amount of Public and Private Debt  Bond: promise to pay back principal at some future date, plus periodic interest payments for use of an investor’s money (IOU)  The Bond Market: is the organized trading mechanism through which corporations and government agencies that need to borrow money are matched to investors with funds to lend.

8. 6-8 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Amount of Public and Private Debt  Bond Dealers: are securities firms and banks that act as financial intermediaries between bond issuers and investors.  Bond Issuer: is an entity that supplies new bonds (supply source)  Bond Investors: are individuals and institutions that purchase bonds for interest income and long-term capital gains.

9. 6-9 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Amount of Public and Private Debt  Bond issuers sell newly minted bonds in the primary bond market to dealers who then resell those bonds to investors in the secondary bond market.  Primary Bond Market: Market for new bonds  the issuer-to-investor market  Secondary Bond Market: Market for previously issued bonds  an investor-to-investor market

10. 6-10 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Amount of Public and Private Debt  Once bonds have been issued and sold to individual and institutional investors, bond dealers use their capital to maintain active secondary markets.  Dealers:  Bid for bonds that investors wish to sell  Offer bonds from their own inventory when investors wish to buy

11. 6-11 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Amount of Public and Private Debt  The U.S. bond market is one of the world’s largest securities markets.  Roughly the same size of the U.S. equity market  By way of comparison, at the start of 2000  The market value of common and preferred stock was roughly $15.8 trillion  The U.S. bond market represented roughly $14.1 trillion in outstanding debt obligations

12. 6-12 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Amount of Public and Private Debt  U.S. Treasury obligations: $3.2 trillion (22.7%)  The largest portion of the U.S. debt market is accounted for by Treasury Securities  Corporate bonds: $2.9 trillion (20.6%)  Mortgage-backed securities: $2.2 trillion (15.6%)  Money Market Securities: $2.1 trillion (14.9%)  Municipal bonds: $1.5 trillion (10.6%)  Federal agency obligations: $1.5 trillion (10.6%)  Asset-backed securities: $719.5 billion (5.1%)

13. 6-13 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Outstanding Level of U.S. Public & Private Debt Figure 6.1

14. 6-14 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Amount of Public and Private Debt  The Wall Street Journal and the financial press:  report comprehensive interest rate information  for all major bond indices  on a daily basis in

15. 6-15 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Amount of Public and Private Debt  The U.S. bond market grew rapidly during recent years:  From: $4.5 trillion in 1985  To: More than $14.1 trillion in 1999

16. 6-16 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Amount of Public and Private Debt  Private Sector:  Bonds issued to fund plant and equipment investment for an expanding economy  Private-sector asset-backed bond market grew at a pace of 46.3% per year over this period.  Public Sector:  Debt financing to fund public programs  The Federal Agency mortgage-backed securities market rose at a 42.5% annual rate –Ginnie Mae, Fannie Mae, and Freddie Mac

17. 6-17 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tracking the Bond Market  The trend in long-term interest rates is often summarized through reference to (benchmarked to) changes in the current yield for the 30 year Treasury bond.  Current Yield: Bond’s promised interest payment divided by its current purchase price  If a bond promises an annual interest payment of $100, and the current purchase price of the bond is $1,000, the current yield =  $100 / $1,000 =.10 or 10%  Bond Yields reflect differences in:  Term-to-Maturity and Credit Quality

18. 6-18 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tracking the Bond Market  The 30-year Treasury bond is a “benchmark” for long-term bond yields and captures the holding-period risk typical of long term bonds.  Holding-Period Risk: Chance of loss during periods of adverse change in bond prices.  i.e. bondholders might be forced to liquidate bond holdings during periods of adverse change in bond prices (falling bond prices).

19. 6-19 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tracking the Bond Market  Default Risk: is the chance of nonpayment of interest or principal.  Treasury bonds (like all Treasury securities)  Backed by the full faith and credit of the U.S. Government  Entail no default risk  Therefore, offer the “lowest” interest rates available on any long-term debt security.  High-Grade Corporate Bonds offer a slight risk premium:  Usually 1-2% per year

20. 6-20 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tracking the Bond Market  Individual bond yields reflect differences in term-to-maturity and credit quality.  The market pays premium for:  Holding-Period Risk: (term to maturity)  Chance of loss during periods of falling bond prices  Default Risk: (credit quality)  Chance of nonpayment of interest or principal

21. 6-21 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tracking the Bond Market  Bond price and yield changes are captured by:  Indexes maintained by Dow Jones & Co.  Various brokerages  Merrill Lynch  Lehman Brothers  Salomon Brothers  Bond Buyer Municipal Bond Index

22. 6-22 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tracking the Bond Market  Short-Term Securities involve no holding period or default risk.  Short-Term Security interest rates are captured by (benchmarked to)changes in the yield on:  Three-month Treasury Bills  The overnight Federal Funds Rate

23. 6-23 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tracking the Bond Market  Federal Funds Rate: Overnight bank lending rate  Bank to Bank lending  Member banks are required to keep a certain % of their assets on deposit with the Federal Reserve Bank in their region to provide collateral for savings and checking deposits.  Changes on a daily basis according to credit market demand and supply conditions  Next to the 30-day Treasury bill rate – it’s the lowest but most volatile of all money market rates  Typically a bit lower than rates on bank CD’s and short-term corporate loans (commercial paper)

24. 6-24 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tracking the Bond Market  Discount Rate: Interest rate charged by the Federal Reserve to member banks.  Fed to Member Bank lending  Changes infrequently according to Federal Reserve policy

25. 6-25 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tracking the Bond Market  Modestly higher than the fed funds rate are short-term rates in Europe for dollar- denominated loans:  The Eurodollar market  London Interbank Offered Rates (LIBOR)  Eurodollar: Dollar deposit in a European bank  London Interbank Offered Rates (LIBOR): London fed funds rate

26. 6-26 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trading Activity  The Bond Market:  Functions largely as an OTC Market  A limited amount of trading takes place on the NYSE  Has no primary physical location  Functions largely as a sophisticated electronic information, communications, and processing network  Debt securities are bought and sold from dealer to dealer and in turn bought and sold by individual and institutional investors

27. 6-27 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trading Activity  The Bond Market has “relatively” low trading volume  Annual trading activity in the U.S. bond market is a small fraction of trade volume in the U.S. equity market.  There is an ownership turnover rate of 96% per year in the typical NYSE company (equities)  Treasury Securities are the most actively traded securities in the Bond Market (Figure 6.4)

28. 6-28 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. U.S. Bond Market at a Glance (1999 Data) Figure 6.4

29. 6-29 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trading Activity  Historically:  Small investors have tended to buy and hold bond market investments for current income and long- term capital appreciation  Pension funds and other long-term investors have used bonds as a durable component of a diversified portfolio  Much of the trading activity is driven by hedge funds and speculators seeking to profit from short-term movements

30. 6-30 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trading Activity  For “small” investors, the bond market has been relatively illiquid:  Difficult for small investors to pursue short-term trading strategies  Bid-ask spreads have been too wide  Par value: face amount, usually $1,000  A Round Lot is equal to $1 million of par value

31. 6-31 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Trading Activity  However, due to the Internet, bond market liquidity and efficiency are improving  Standardized market practices  Technology-based innovations improve the competition

32. 6-32 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Bond Ownership  Most bonds are bought by Institutions:  Pension Funds  Insurance Companies  Mutual Funds  Individual investors also buy bonds directly or through the above vehicles  Bonds appeal to investors looking for:  Dependable Income  Relative safety of principle  Diversification

33. 6-33 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Estimated Ownership of U.S. Treasury Securities by Private Investors Figure 6.5, Page 211