1. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ■provide a background on bonds ■describe the different types of bonds and their characteristics 1 7 Bond Markets Chapter Objectives

2. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 7.1 Flow of funds in bond markets 2

3. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bearer bonds vs. Registered bonds 1. Bearer bonds: the owner clip coupons attached to the bond and send them to the issuer to received coupon payments. 2. Registered bonds: the issuer maintains records of the owners and automatically sends coupon payments to the owners. 3

4. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Bond backgrounds 1. Bonds: long-term debt securities, over 10 years 2. Yields to Maturity (YTM): Given the prices, the annual rate of return if the investor hold the bond until maturity. 3. Price, face value (par value), coupon payment, time to maturity, YTM. example 4

5. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Treasury bonds 1. Treasury and Federal Agency Bonds treasury notes: <10 year maturity treasury bonds: >=10 year maturity semiannual interest payments; interest income is exempt from state and local taxes 2. Trading Treasury Bonds Auctions; over-the-counter in the secondary market 3. Bid-Ask prices from bond dealers 5

6. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Inflation-Indexed Treasury Bonds 10-year, par value of $10,000. annual coupon rate of 4%, coupon paid every 6 months. (page 168).  If inflation rate is 1% during the first six month since the bond was issued, then new par =10,000x(1+1%)=$10,100 coupon payment =10,100x2%=$202 2. If inflation increase to 3% in the following 6 months, then new par =10,100x(1+3%)=$10,403 coupon payment =10,403x2%=$208.06 6

7. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Problems (page 185) Inflation-Indexed Treasury Bond. Assume that the U.S. economy experienced deflation during the year, and that the consumer price index decreased by 1 percent in the first six months of the year, and by 2 percent during the second six months of the year. If an investor had purchased inflation-indexed Treasury bonds with a par value of $10,000 and a coupon rate of 5 percent, how much would she have received in interest during the year? 1. Principal of bond after six months: $10,000 – (1% × $10,000) = $9900 2. Interest received during first six months: $9900 × 2.5% = $247.50 3. Principal of bond at the end of the year: $9900 – (2% × $9900) = $9702 4. Interest received during the last six months: $9702 × 2.5% = $242.55 5. Total interest received: $247.50 + $242.55 = $490.05 7

8. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stripped Treasury bonds 1. STRIPS(separate trading of registered interest and principal of securities) 2. Not issued by Treasury but are created and sold by financial institutions. 8

9. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Municipal Bonds 1. Issued by state and local governments 2. General obligation bonds 3. Revenue bonds 4. Interest income is exempt from federal and state taxes 9

10. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Corporate bonds 1. indenture: legal document specifying the rights and obligations of both the issuing firm and the bondholders 2. Protective Covenants: limit the amount of dividends and officers’ salaries and restrict the amount of additional debt the firm can issue. 3. Call Provisions 10

11. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Zero-coupon Bonds 1. Bonds that are issued at a deep discount from par value. 2. Advantages to issuer: no cash outflow until maturity date. Can deduct the amortized discount as interest expense for federal income tax purpose. 11

12. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Junk bonds Junk (high-yield) Bonds Risk Premium of Junk Bonds 12

13. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Homework Assignment 6 Chapter 7 questions and applications: 1,2,3,4,5,6,7,9. Problems: 1, 13