financial markets and institutions 6th edition

Financial Markets and Institutions6th Edition

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By Jeff Madura

Prepared by

David R. Durst

The University of Akron

CHAPTER

77Bond

Markets

Copyright© 2002 Thomson Publishing. All rights reserved.

Chapter ObjectivesChapter Objectives

Provide informational background on U.S. Treasury, state and municipal, and corporate Bonds

Calculate bond yield from quote Explain the role of bonds to institutional

investors Discuss the globalization of bond markets


Background on BondsBackground on Bonds

Bonds represent long-term debt securities Contractual Promise to pay future cash flows to investors

The issuer of the bond is obligated to pay: Interest (or coupon) payments periodically usually

semiannually Par or face value (principal) at maturity

Primary vs. secondary market for bonds



The issuer’s cost of financing with bonds is the coupon rate

Determined by current market rates and risk Usually fixed throughout term Determines periodic interest payments

Bond Interest Rates



The yield to maturity (TYM) is the yield that equates the future coupon and principal payments with the bond price The YTM is the investor’s expected rate of return if

the bond is held to maturity The actual YTM may vary from the expected because

of risks assumed by the investors

Bond Yield to Maturity



An investor can purchase a ten-year, $1000 par value bond with an 8 percent annualized coupon rate for $936. Determine the yield to maturity for this bond.

N I PV PMT FV

10 –936 80 1000




An investor can purchase a ten-year, $1000 par value bond with an 8 percent annualized coupon rate for $936. Determine the yield to maturity for this bond.

N I PV PMT FV

10 9 –936 80 1000




Corporate BondsCorporations

Municipal BondsState and Local Governments

Federal Agency BondsFederal Agencies

Treasury BondsFederal Government (U.S. Treasury)

Type of BondIssuer

Bonds by Issuers


U. S. Treasury BondsU. S. Treasury Bonds

Issued by the U.S. Treasury to finance federal government expenditures

Maturity Notes, < 10 Years Bonds, > 10 to 30 Years

Active OTC Secondary Market Semiannual Interest Payments Benchmark Debt Security for Any Maturity


Treasury BondsTreasury Bonds

Treasury Bond Quotations

8.38 Aug. 2013-18 103:05 103.11 YTM? Coupon rate Maturity date Bid/Ask price as percent of face value Fractions of price in 32nds

Example: Bid price 103:05, Ask price 103:11

Yield to Maturity (YTM)


U. S. Treasury Bond Yield To MaturityU. S. Treasury Bond Yield To Maturity

$83.80 Pmt

2013 – Today

= N

$1000Ask

Price =FV

$1033.44 PV*

*Ask Price = 103 and 11/32 % ofFace Value or $1033.4375

Calc YTM



Coupon bonds Interest paid semiannually To registered bondholders

Stripped Treasury bonds Zero-coupon securities are sold with claims on U. S.

Treasury bonds held in a trust One security represents the principal payment (np) at maturity Other securities represents the interest payments (ci) at

interest paying dates

Cash Flow Variation in T-Bonds



Intended for investors who seek inflation protection with their investments

Coupon rates less than other Treasuries Principal value adjusted for the U.S. inflation rate

(CPI) every 6 months Coupon income increases with inflation

Inflation-Indexed Bonds


Federal Agency BondsFederal Agency Bonds

Government National Mortgage Association (GNMA) Issues bonds and uses proceeds to purchase

insured FHA and VA mortgages A U.S. Government Agency Backed by explicit guarantee of Federal

Government Example of social allocation of capital


Federal Agency BondsFederal Agency Bonds

Federal Home Loan Mortgage Association (Freddie Mac) Issues bonds and uses proceeds to purchase

conventional mortgages A U.S. government-sponsored agency No explicit guarantee of bonds by federal

government, but credit risk is very low Used to provide liquidity for thrifts and support of

home ownership


Municipal BondsMunicipal Bonds

State and local government obligations

Revenue bonds vs. general obligation Bonds

Investor interest income exempt from federal

income tax

Tax Reform Act of 1986 placed limitations on

tax-exempt bond issuance for private purposes


Corporate BondsCorporate Bonds

When corporations want to borrow for long-term periods they issue corporate bonds Usually pay semiannual interest Most have maturities between 10-30 years Public offering vs. private placement Limited exchange, larger OTC secondary market Investors seek safety of principal and steady

income



Indenture Legal document specifying rights and obligations of

issuer and bondholder

Trustee Represents bondholders to assure compliance with

indenture

Corporate Bond Terminology



Sinking Fund Provision Requirement that the firm retire a certain amount or

number of bonds each year Protects investors with principal reduction

Protective Covenants Places restrictions on the firm to protect bondholders Examples: limits dividends and officer salaries, restricts

additional debt




Call provisions: Ability to pay bonds off early Call premium Advantage to issuers; disadvantage to investor

Bond collateral Usually consists of a mortgage on real property Unsecured bonds are called debentures and are backed only

by the general credit of the issuing firm




Low-coupon and zero-coupon bonds Provide investors known rate of return Imputed interest income taxed if not in tax-sheltered

investment plan Attractive to pension funds with expected payouts

Variable-rate bonds Convertible bonds




Junk Bonds Junk bonds are also called high-yield bonds or

noninvestment rated bonds Popularized in the direct finance boom of the

1980s The risk premium is between three and seven

percent above Treasury bonds and susceptible to contagion effects

Secondary market supported by dealer market


Corporate Bonds Market QuotationCorporate Bonds Market Quotation

ATT 6 ½ 29 7.3 214 88 5/8th +1/4

AT&T bond quote for 1/13/02 (U.S. Exchange Bond) 6.5% coupon rate Maturity in 2029 7.3% current yield (annual interest/price) 214 bonds traded on this day Bond priced at close of day 88 5/8th % of face

($1000) or $886.25 Bond price up ¼ point for the day or $2.50


Exhibit 7.5Exhibit 7.5

Financial Institution Participation in Bond Markets

Commercial banks and savings • Purchase bonds for their asset portfolio.and loan associations (S&Ls) • Sometimes place municipal bonds for municipalities.

• Sometimes issue bonds as a source of secondary capital.

Finance companies • Commonly issue bonds as a source of long-term funds.

Mutual funds • Use funds received from the sale of shares to purchase bonds. Some bond mutual fundsspecialize in particular types of bonds, while others invest in all types.

Brokerage rms • Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.

Investment banking rms • Place newly issued bonds for governments and corporations. They may place the bondsand assume the risk of market price uncertainty or place the bonds on a best-effor ts basisin which they do not guarantee a price for the issuer.

Insurance companies • Purchase bonds for their asset portfolio.

Pension funds • Purchase bonds for their asset portfolio.

•


Major Investors in Corporate Bonds, Major Investors in Corporate Bonds, December, 2001December, 2001

Life Insurance Companies $1.33 Trillion

Foreign Investors $1.23 Trillion

Households and Trusts$608 Billion

MutualFunds

$420 Bil.


Globalization of Bond MarketsGlobalization of Bond Markets

Foreign investment in dollar securities Foreign issuance by U.S. firms Increased global investment by pension and

mutual funds Development of foreign security markets—24

hour trading Eurobond market



In 1960s, U.S. corporations were limited to the amount of funds they could borrow in the U.S. for overseas operations.

They began to issue bonds in the Eurobond market where bonds denominated in various currencies were placed. About 75 percent are denominated in U.S. dollars

Eurobond Market



An underwriting syndicate of investment banks participates in placing the bonds Issuer can choose the currency in which the bond

interest and principal are denominated Dollar denominated most common Bearer bonds vs. registered bonds

Eurobond Market

financial markets and institutions 6th edition

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