Chapter 7

Bond Markets

1
 Chapter Outline
• Background on bonds
• Treasury and federal agency bonds
• Municipal bonds
• Corporate bonds
• Institutional use of bond markets
• Globalization of bond markets

2
 Background on Bonds
• Bonds represents long-term debt securities that are
issued by government agencies or corporations
• Interest payments occur annually or semiannually
• Par value is repaid at maturity
• Most bonds have maturities between 10 and 30 years
• Bearer bonds require the owner to clip coupons
attached to the bonds and send them to the issuer to
receive coupon payments
• Registered bonds require the issuer to maintain records
of who owns the bond and automatically send coupon
payments to the owners

3
 Background on Bonds (cont’d)
• Bond yields
– The issuer’s cost of financing is measured by the yield to
maturity (YTM)
• The annualized yield that is paid by the issuer over the life of the
bond
• Equates the future coupon and principal payments to the initial
proceeds received
• Does not include transaction costs associated with issuing the bond
– YTM is earned by an investor who invests in a bond when
it is issued and holds it until maturity
• The holding period return is used by investors who do not hold a bond to
maturity
– If they hold the bond for a very short time period (such as less than one year), they may
estimate their holding period return as the sum of the coupon payments plus the difference
between the selling price and the purchase price of the bond, as a percentage of the purchase
price.
– For relatively long holding periods, a better approximation of the holding period yield is the
annualized discount rate that equates the payments received to the initial investment.

4
 EXAMPLE
• Consider an investor who can purchase
bonds with 10 years until maturity, a par
value of $1,000, and an 8 percent
annualized coupon rate for $936. The yield
to maturity on these bonds can be
determined by using a financial calculator
as 9%.
𝑨𝒑𝒓𝒙 𝒀𝑻𝑴 =
𝑪+ [𝑷𝒂𝒓 − 𝑷𝒓𝒊𝒄𝒆
𝒏 ]
[ ]
𝑷𝒂𝒓 + 𝑷𝒓𝒊𝒄𝒆
2
5
 Treasury and Federal Agency
Bonds
• The U.S. Treasury issues Treasury notes
or bonds to finance federal government
expenditures
– Note maturities are usually less than 10 years
– Bonds maturities are 10 years or more
– An active secondary market exists
– Semiannual interest payments

6
 Treasury and Federal Agency
Bonds (cont’d)
• Treasury bond auction
– Normally held in the middle of each quarter
– Financial institutions submit bids for their own
accounts or for clients
– Bids can be competitive or noncompetitive
• Competitive bids specify a price the bidder is willing to pay
and a dollar amount of securities to be purchased
• Noncompetitive bids specify only a dollar amount of
securities to be purchased

7
 Treasury and Federal Agency
Bonds (cont’d)
• Trading Treasury bonds
– Bond dealers serve as intermediaries in the
secondary market and also take positions in the
bonds
– Profit from the bid-ask spread
– Conduct trading with the Fed during open market
operations
– Online trading
• TreasuryDirect program (http://www.treasurydirect.gov)

8
 Treasury and Federal Agency
Bonds (cont’d)
• Treasury bond quotations
– Published in financial newspapers
– Bond quotations are organized according to their maturity, with
the shortest maturity listed first
– Bid and ask prices are quoted per hundreds of dollars of par
value
– Online quotations at
• http://www.investinginbonds.com
• http://www.federalreserve.gov/releases/H15/

9
 Treasury and Federal Agency
Bonds (cont’d)
• Stripped Treasury bonds
– One security represents the principal payment and a second
security represents the interest payments
• Investors who desire a lump sum payment can choose the PO part
• Investors desiring periodic cash flows can select the IO part
• Degrees of interest rate sensitivity vary
– Stripped Treasury securities are commonly called STRIPS
(Separate Trading of Registered Interest and Principal of
Securities).
• The Treasury does not issue STRIPS, instead they are created and
sold by various financial institutions. Several securities firms create
their own versions of stripped securities
• Active secondary market

10
 Treasury and Federal Agency
Bonds (cont’d)
• Inflation-indexed Treasury bonds
– TIPS (Treasury Inflation-Protected Securities)
– Provide a return tied to the inflation rate
– The coupon rate is lower than the rate on regular
Treasuries, but the principal value increases by the
amount of the inflation rate every six months
– Inflation-indexed bonds are popular in high-inflation
countries

11
 Treasury and Federal Agency
Bonds (cont’d)
• Inflation-indexed Treasury bonds
– Example (Part A): A 10-year bond (semi-
annual payment) has a par value of $10,000
and a coupon rate of 4%. During the first six
months after the bond was issued, the
inflation rate was 1%. By how much does the
principal of the bond increase? What is the
coupon payment after six months?

Principal = $10,000 x 1.01 = $10,100

13
 Treasury and Federal Agency
Bonds (cont’d)
• Savings bonds
– Issued by the Treasury but can be purchased from
financial institutions
– Small denominations up to $25 make it attractive to
small investors. Larger denominations are also
available.
– Have a 30-year maturity and no secondary market
– Series EE bonds provide a market-based interest rate
– Series I bonds provide a rate of interest tied to
inflation
– The interest accumulates monthly and adds value to
the amount received at the time of redemption
– Interest on savings bonds is not subject to state and
local taxes
14
 Treasury and Federal Agency
Bonds (cont’d)
• Federal agency bonds
– Federal agency bonds are issued by federal
agencies.
– The Federal National Mortgage Association (Fannie
Mae) and the Federal Home Loan Mortgage
Association (Freddie Mac) issue bonds and use the
proceeds to purchase mortgages in the secondary
market.
– They channel funds into the mortgage market,
thereby ensuring that there is sufficient financing for
homeowners who wish to obtain mortgages.

15
 Municipal Bonds
• Issued by state and local governments
• Municipal bonds (or “munis” for short) can be classified as either
general obligation bonds or revenue bonds
– General obligation bonds are supported by the municipal government’s
ability to tax
– Revenue bonds are supported by the revenues of the project for which
the bonds were issued
• Municipal bonds typically pay interest semiannually with a minimum
denomination of municipal bonds usually $5,000
• Municipal bonds have a secondary market but are less active than
Treasury bonds
• Most municipal bonds contain a call provision
• Municipal bonds have rarely defaulted, but large budget deficits
raise concerns about a municipal bond credit crisis.
• Very limited disclosure about the financial condition of the state and
local governments makes it difficult to assess potential default risks.
16
 Municipal Bonds (cont’d)
• Variable-rate municipal bonds
– Coupon payments adjust to movements in a
benchmark interest rate
– Some variable-rate municipal bonds are convertible
to a fixed rate under specified conditions
– desirable to investors who expect that interest rates
will rise (risk a decline in interest rates)
• Trading and quotations
– Investors can buy or sell Municipal Bonds by
contacting US brokerage firms
– Electronic trading has become popular (online
quotations) 17
 Municipal Bonds (cont’d)
• Tax advantages
– Interest income is normally exempt from federal taxes
– Interest income earned on bonds that are issued by a
municipality within a particular state is exempt from
state income taxes
– Interest income earned on bonds issued by a
municipality within a city in which the local
government imposes taxes is normally exempt from
the local taxes

18
 Municipal Bonds (cont’d)
• Yields offered on municipal bonds
– Differs from the yield on a Treasury bond with
the same maturity because:
1. Of a risk premium to compensate for default risk
2. Of a liquidity premium to compensate for less
liquidity
3. The federal tax exemption of municipal bonds.
This tax advantage of municipal bonds more than
offsets their two disadvantages and allows
municipal bonds to offer a lower yield than
Treasury bonds.
19
 Municipal Bonds (cont’d)
• Yield curve on municipal bonds
– the Treasury yield curve because of the
taTypically lower than x differential
– The municipal yield curve has a similar shape
as the Treasury yield curve because:
• It is influenced similarly by interest rate
expectations
• Investors require a premium for longer-term
securities with lower liquidity in both markets

20
 Corporate Bonds
• Corporations issue corporate bonds to borrow for long-term
periods
• Corporate bonds have a minimum denomination of $1,000
• Larger bonds offerings are achieved through public offerings
registered with the SEC
• Secondary market activity varies
• Financial and nonfinancial institutions as well as individuals are
common purchasers
• Most corporate bonds have maturities between 10 and 30 years
• Interest paid by corporations is tax-deductible, which reduces the
corporate cost of financing with bonds (tax advantage of debt)

21
 Corporate Bonds (cont’d)
• Private placement of corporate bonds
– Often, insurance companies, pension funds
and mutual funds purchase privately-placed
bonds
– Bonds can be placed with the help of a
securities firm
– Bonds do not have to be registered with the
SEC
– Do not have an active secondary market

22
 Corporate Bonds (cont’d)
• Corporate bond yields and risk
– Interest income earned on corporate represents
ordinary income
– Yield curve
• Affected by interest rate expectations, a liquidity premium,
and maturity preferences of corporations
• Similar shape as the municipal bond yield curve
– Default rate
• conditions
• In 2008 when the Depends on economic credit crisis began,
the value of bonds that defaulted exceeded $100 billion (25%
junk bonds), versus only $3.5 billion in 2007. The default rate
exceeded 3%.

23
 Corporate Bonds (cont’d)
• Corporate bond yields and risk (cont’d)
– Investor assessment of risk
• Investors may only consider purchasing corporate bonds after
assessing the issuing firm’s financial condition and ability to cover
its debt payments
• Investors may rely heavily on financial statements created by the
issuing firm, which may be misleading
– Bond ratings
• Bonds with higher ratings have lower yields
• Corporations seek investment-grade ratings, since commercial
banks will only invest in bonds with that status
• Rating agencies will not necessarily detect any misleading
information contained in financial statements

24
 Corporate Bonds (cont’d)
• Junk bonds
– Junk bonds have a high degree of credit risk
– The primary investors are mutual funds, life insurance
companies, and pension funds.
– Risk premium of junk bonds
• The typical premium is between 3 and 7 percent above Treasury
bonds with the same maturity

25
 Corporate Bonds (cont’d)
• Characteristics of corporate bonds
– The bond indenture specifies the rights and obligations of the
issuer and the bondholder.
– A trustee, a third party, represents the bondholders in all matters
concerning the bond issue. Required by Federal law for bond
issuance of significant size.
– Sinking-fund provision
• A requirement to retire a certain amount of the bond issue each
year.
– Protective covenants
• Are restrictions placed on the issuing firm designed to protect the
bondholders from being exposed to increasing risk during the
investment period.
• Often limit the amount of dividends and corporate officers’ salaries
the firm can pay.
• Protective covenants can prevent managers from taking excessive
risk and, therefore cater to the preferences of bondholders.

26
 Corporate Bonds (cont’d)
• Characteristics of corporate bonds (cont’d)
– Call provisions:
• Require the firm to pay a price above par value
when it calls its bonds
– The difference between the call price and par value is
the call premium
• Are used to:
– Issue bonds with a lower interest rate
– Retire bonds as required by a sinking-fund provision
• Are a disadvantage to bondholders. Firms pay
slightly higher rates of interest on bonds that are
callable, other things being equal.
27
 Corporate Bonds (cont’d)
• Bond collateral
– Typically, collateral is a mortgage on real property
• A first mortgage bond has first claim on the specified
assets
• A chattel mortgage bond is secured by personal property
– Unsecured bonds are debentures
– Subordinated debentures have claims against the
firm’s assets that are junior to the claims of mortgage
bonds and regular debentures

28
 Corporate Bonds (cont’d)
• Low- and zero-coupon bonds:
– Are issued at a deep discount from par value
– Require annual tax payments although the interest will not be received
until maturity
– are purchased mainly for tax-exempt investment accounts (such as
pension funds and individual retirement accounts)
– advantage to the issuer by requiring low or no cash outflow during their
life. The issuing firm can deduct the amortised discount as interest
expense for federal income tax purposes, even though it does not pay
interest – increases cash flow.
• Variable-rate bonds:
– Allow investors to benefit from rising market interest rates over time
– Allow issuers of bonds to benefit from declining rates over time
• Convertibility
– Convertible bonds allow investors to exchange the bond for a stated
number of shares of common stock
– Investors are willing to accept a lower rate of interest on convertible
bonds
29
 Corporate Bonds (cont’d)
• Trading corporate bonds (secondary market)
– Bonds are traded through brokers, who communicate orders to
bond dealers
– A market order transaction occurs at the prevailing market price
– A limit order transaction will occur only if the price reaches a
specified limit
– Bonds listed on the NYSE are traded through the automated
Bond System (ABS)
– Online trading is also possible
– Corporate bond quotations normally include the volume of trading and
the yield to maturity

30
 Corporate Bonds (cont’d)
• How corporate bonds facilitate
restructuring
– Using bonds to finance a leveraged buyout
• A leveraged buyout (LBO) involves the use of debt
to purchase shares and take a company private
• An LBO is typically financed with senior debt and
subordinated debt
• Many firms engaged in an LBO go public once
they have improved their operating performance.

31
 Corporate Bonds (cont’d)
• How corporate bonds facilitate restructuring
(cont’d)
– Using bonds to revise the capital structure
• Debt is perceived to be a cheaper source of capital than
equity as long as the corporation can meet its debt payments
• Sometimes, corporations issue bonds and use the proceeds
for a debt-for-equity swap (repurchase some of their existing
stock)
• Corporations with an excessive amount of debt can conduct
an equity-for-debt swap (issue stock and use the proceeds to
retire existing debt)

32
 Institutional Use of Bond Markets
• All financial institutions participate in bond
markets
– On any given day, commercial banks, bond mutual
funds, insurance companies, and pension funds are
dominant participants
• A financial institution’s investment decisions will
often simultaneously affect bond market and
other financial market activity

33
 Globalization of Bond Markets
• The global development of the bond market is primarily
attributed to bond offerings by country governments
(sovereign bonds)
• Sovereign bonds are attractive to investors because of
the government’s ability to meet debt obligations,
although some country governments have defaulted on
their bonds.
• Moody’s and Standard & Poor’s assign credit ratings to
government bonds.
• Low-quality bonds issued globally by governments and
large corporations are global junk bonds

34
 Globalization of Bond Markets
(cont’d)
• Eurobond market
– Bonds denominated in various currencies are
placed in the Eurobond market
– Dollar-denominated bearer bonds are
available in the Eurobond market
– Underwriting syndicates help place Eurobond
issues

35