chapter 8 bond markets. capital markets capital market securities are long term securities issued to...

CHAPTER 8

BOND MARKETS

Capital Markets

• Capital market securities are long term securities issued to finance capital goods/projects to lock in the cost of borrowing for the life of the project.

• Capital market securities are not highly marketable.

• Therefore, the interest rates of capital market securities are higher than those of money market securities.

Copyright© 2006 John Wiley & Sons, Inc. 2

Capital Markets• Economic purpose - brings together long-

term (over 1 year) borrowers and investors.• Major Issuers (borrowers)– Households - mortgages.– Business - bonds and stock– Governments - federal, state, and local bonds.

• Major Investors– Households (directly or indirectly through

financial intermediaries).– Foreign investors.


Types of Capital Market Claims

• Corporate stock.• Bonds.• Mortgages.


U.S. Treasury and Agency Securities

• U.S. Government Issues - Notes and Bonds– Coupon issues: involve coupon rate usually

paid semiannually.– Notes - one to ten-year maturity.– Bonds - over ten-year maturity.– Sold in auction by the Treasury Department.– Notes and bonds have become a less

important financing vehicle because the trend is toward more short-term market financing and less long-term financing.


U.S. Treasury and Agency Securities (continued)

• Inflation-Indexed Notes and Bonds (TIPS)– Principal adjusts for inflation– Fixed coupon rate determined by auction process– Minimum denomination is $1,000.– Designed to protect investments against inflation.

Example:Consider an investor who purchases a 10-years TIP with

an original principal of $100,000, a 3% coupon rate paid semiannually. If the semiannual inflation rate during the first 6 months is 1%, how much will be the first coupon payment?


U.S. Treasury and Agency Securities (continued)• Separate Trading of Registered Interest and Principal

(STRIP).– Each coupon and principal of a U.S. Treasury note or bond is sold

separately by a dealer.– Each separated security is a zero-coupon bond.– Dealers engage in creating STRIPs created because investors value

zero-coupon default risk-free securities and are willing to pay more for STRIPs than underlying bonds.

– Strips can be used to manage interest rate risk as they are zero coupon bond, if it is held to maturity, you get rid of price risk and it already does not have reinvestment risk as it is a zero coupon bond.

Example: – A 10- year Treasury note consists of 1 principal payment and 20

semiannual coupon payments. If this note is STRIP, 21 separate securities are created.


State and Local Government Bonds• Known as municipal bonds or munis• Types of Municipal Bonds– General Obligation (GO) bond - backed by

taxing power of political entity. Issued to provide basic services such as education and health-care.

– Revenue bond - financed and paid back with cash flows from a specific project. Issued to finance revenue-producing projects such as barking facilities.


State and Local Government Bonds

Industrial Development Bonds (IDB) - public financing of private business.

• Mortgage-backed bonds – issued to fund homes for low- and moderate-income people.

• Because of the abuses of IDB and mortgage-backed bonds, government has restricted the uses of them.


Municipal Bonds (continued)

• The Relation between Municipals and Taxable Yields– Interest on municipal bonds is exempt from

federal income tax.– Munis and taxable corporate bonds are similar

except for the taxation of interest.– The yield on municipals equals the yield on

taxables times one minus the marginal tax rate. im = it (1-T)


Corporate vs. Muni Bond

• An investor has the choice of an AA-rated corporate bond with a yield of 6% or an AA-rated muni yielding 4%. If the investor has a marginal tax rate of 30%, which bond should he/she select?


Corporate vs. Muni-Bond

The after-tax rate on the corporate is 6%(1 - 0.3) = 4.2% > 4% on the muni bond or

The pretax equivalent rate on the muni bond would be 4%/(1 - 0.3) = 5.7% < 6% on the corporate

Select the corporate bond!



• Three groups of investors in municipal bonds whose demands are affected by their high federal tax exposure are:– Households - affected by income level and

marginal tax rates.– Casualty insurance companies – Demand for

munis is determined by industry profitability and the need to obtain munis.

– Commercial banks – demand for munis is influenced by the ability to deduct from the taxable income the interest on debt used to purchase munis.



• The Market for Municipal Bonds– Primary market.• Many individual smaller issuers.• Underwritten by investment bankers from local to

national markets.• Most general obligation (GO) bonds are sold by

competitive bid.– Secondary market not well-developed - OTC

market made by dealers.• thin secondary markets lead to larger bid-ask

spreads.• limited marketability leads to higher yields


Corporate Bonds• Debt contracts (indentures) require

borrowers to make periodic payments of interest and repay principal, usually $1,000, at maturity date.

• Types of ownership record– Bearer bonds - coupon bond owned by bearer.– Registered bonds - owner noted by records.

• Maturity– Term bonds - all bonds mature on one date.– Serial bonds - bonds in the issue mature on

different dates.• Most munis are serial issues.


The Bond Indenture• Indenture: legal contract states the rights,

privileges and obligations of the bond issuer and the bondholder.

• Indenture specifies the Collateral in event of default:– Mortgage bond - real assets pledged.– Equipment trust certificates - specific, titled, or

identifiable equipment.– Collateral bonds - secured by financial assets.– Debentures - unsecured bonds.


The Bond Indenture (concluded)• Claim on assets can be either:– Senior debt - first priority to general assets.– Subordinated - asset claim ranking of unsecured

debentures below senior or specific general creditors.• Corporate bonds can have provisions:– Sinking fund – instead of paying the entire principal of

a bond at maturity, the issuer can provide funds to another company which retires a portion of the issue annually. The retirements of the bonds could be by purchasing them in open market or calling them.

– Call provision - borrower right to retire bond before maturity.

– Convertible bonds - are bonds that can be converted to another security at the discretion of the bondholder.


Investors in Corporate Bonds• Major investors include:– Life insurance companies.– Pension funds.– Households.– Foreign Investors.

• Investor requirements:– Long-term investment horizon.– Liquidity not always needed - hold to maturity.– Safety - investment grade.– Tax considerations.


Market for Corporate Bonds• Public sale - open to all interested buyers

through investment banks.– Competitive sale - public auction among

underwriters.– Negotiated sale - underwriting contract

signed with specific underwriters.in negotiated sale the investment bank provides the origination and advising services as part of the negotiated package, while in the competitive sale the investment bank does not provide these services and this is he main difference between the two methods.


Market for Corporate Bonds• Private placement - sold to limited number (< 35) of

sophisticated buyers.– private placements have increased relative to public

sale.– when interest rates are high and/or when capital

market conditions are unstable, private placements increase.

• Most secondary trading of corporate bonds occurs through dealers vs. exchanges.– the volume of trading is low – a thin market, thus there

is a wide bid/ask differential in the market.– corporate bonds are less marketable than money

market instruments.


Junk bonds• Junk bonds are low rated (high default risk)

corporate bonds.• Development of the junk bond primary market

was enhanced by the secondary market maintained by Drexel, Burnham and Lambert in the early 1980s.

• Higher risk firms found they could issue longer term, more flexible securities in the high-yield market rather than borrow from commercial banks.


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