Title: Overview of the Bond Markets
1Overview of the Bond Markets
- A bond is a promise to make periodic coupon
payments and to repay principal at maturity
breech of this promise is an event of default - carry original maturities greater than one year
so bonds are instruments of the capital markets - issuers are corporations and government units
2Bond Market Instruments Outstanding, 1994-1999
(Bn)
3Treasury Notes and Bonds
- T-notes and T-bonds issued by the U.S. treasury
to finance the national debt and other federal
government expenditures - Backed by the full faith and credit of the U.S.
government and are default risk free - Pay relatively low rates of interest (yields to
maturity - Given their longer maturity, not entirely risk
free due to interest rate fluctuations - Pay coupon interest (semiannually), notes have
maturities from 1-10 yrs, bonds 10-30 yrs
4Composition of the U.S. National Debt (Bn)
5Treasury Strips
- A treasury security in which the periodic
interest payment is separated from the final
principal payment - Effectively creates two sets of securities--one
for each semiannual interest payment one one for
the final principal payment - Often referred to as Treasury zero-coupon bonds
- Created by U.S. treasury in response to separate
trading of treasury security principal and
interest that been developed by securities firms,
only available through FIs and gov securities
brokers
6The Primary Market in Treasury Notes and Bonds
Similar to the primary market T-bill sales, the
Treasury sells T-notes and bonds through
competitive and noncompetitive auctions
Auction Pattern for Treasury Notes and
bonds Security Purchase Minimum
General Auction Schedule 2-year note
1,000
Monthly 5-year note
1,000 Feb,
May-Aug, Nov 10-year note
1,000 Feb,
May-Aug, Nov
7Secondary Market in Treasury Notes and Bonds
- Most secondary market trading occurs directly
through brokers and dealers - Wall Street Journal shows full list of Treasury
securities that trade daily
8Treasury Inflation Protected Securities
- Coupon rate set at time of auction and fixed for
life - Par value adjusted for inflation based on the
Consumer Price Index - Semi-annual coupon payments are based on the
inflation adjusted par value - At maturity investor receives the inflation
adjusted par value
9Municipal Bonds (munis)
- Securities issued by state and local governments
to fund either temporary imbalances between
operating expenditures and receipts or to finance
long-term capital outlays for activities such as
school construction, public utility construction
or transportation systems - Tax receipts or revenues generated are the source
of repayment - Attractive to household investors because
interest (but not capital gains) are tax exempt
10Tax Exemption and Muni Yields
im ic(1 ts
- tF) Where im After-tax
(equivalent tax exempt) rate of return on a
municipal bond ib Before-tax
rate of return on a taxable bond ts
Marginal state income tax rate of the bond
holder tF Marginal federal income tax
rate of the bond holder
11Types of Municipal Bonds
- General Obligation Bonds
- bonds backed by the full faith and credit of the
issuer - Revenue Bonds
- bonds sold to finance a specific revenue
generating project and are backed by cash flows
from that project
12Primary Market Placement Choices for Munis
- General Public Offering
- underwriter is selected either by negotiation or
by competitive bidding - the underwriter offers the bonds to the general
public - Rule 144A Placement
- bonds are sold on a semi-private basis to
qualified investors (generally FIs)
13Contracting Choices with the Underwriter
- Firm commitment underwriting
- the issue of securities in which the investment
bank guarantees the corp. a price for newly
issued securities by buying the whole issue at a
fixed price from the corporate issuer then seeks
to resell to suppliers of funds (investors) at a
higher price - Best efforts underwriting
- the issue of securities in which the underwriter
does not guarantee a price to the issuer and acts
more as a placing or distribution agent, bank
acts as agent on a fee basis related to its
success in placing the issue
14Secondary Market for Munis
- Secondary market is thin (I.e. trades are
relatively infrequent) due to a lack of
information on bond issuers, who are generally
much smaller than corporate bond issuers
15Corporate Bonds
- All long-term bonds issued by corporations
- Minimum denominations publicly traded corporate
bonds is 1,000 - Generally pay interest semiannually
- Bond indenture
- legal contract that specifies the rights and
obligations of the bond issuer and the bond holder
16Types of Corporate Bonds
- Bearer bonds
- coupons attached that are presented by the holder
to the issuer for interest payments when due - Registered bonds
- the owner of the bond is recorded by the issuer
and coupon payments are mailed to the registered
owner - Term bonds
- entire issue matures on a single date
- Serial bonds
- mature on a series of dates
(continued)
17Types of Corporate Bonds
- Mortgage bonds
- issued to finance specific projects which are
pledged as collateral - Equipment Trust Certificates
- bonds collateralized with tangible non-real
estate property - Debentures
- backed solely by the general credit of the
issuing firm and unsecured by specific assets or
collateral - Subordinated debentures
- unsecured debentures that are junior in their
rights to mortgage bonds and regular debentures
(continued)
18Types of Corporate Bonds
- Convertible bonds
- may be exchanged for another security of the
issuing firm at the discretion of the bond holder - Stock Warrant
- give the bond holder an opportunity to purchase
common stock at a specified price up to a
specified date - Callable bonds
- allow the issuer to force the bond holder to sell
the bond back to the issuer at a price above the
par value (call price) - Sinking Fund Provisions
- bonds that include a requirement that the issuer
retire a certain amount of the bond issue each
year
19Primary and Secondary Markets for Corp Bonds
- Primary sales of corp bonds occur through either
a public sale (issue) or a private placement
similar to municipal bonds - Two secondary markets
- the exchange market (e.g., the NYSE)
- the over-the-counter (OTC) market
- OTC electronic market dominates trading in corp
bonds
20Bond Ratings
- Bonds are rated by the issuers default risk
- Large bond investors, traders and managers
evaluate default risk by analyzing the issuers
financial ratios and security prices - Two major bond rating agencies are Moodys and
Standard Poors (SP) - Bonds assigned a letter grade based on perceived
probability of issuer default
21Bond Credit Ratings
Explanation
Moodys SP Investment
grade categories
Best quality smallest degree of risk
Aaa
AAA High quality slightly more long-term
Aa1 AA
risk than top rating
Aa2 AA
Aa3
AA Upper medium grade possible
A1
AA- impairment in the future
A2
A
A3
A- Medium grade lack
outstanding Baa1
BBB investment
characteristics
Baa2 BBB
Baa3 BBB-
(continued)
22Bond Credit Ratings
Explanation
Moodys
SP Speculative investment grades Speculative
issues protection may
Ba1 BB be very
moderate
Ba2 BB
Ba3
BB- Very speculative may have small
B1 B
assurance of interest and principle
B2 B payment
B3 B- Issues in
poor standing may be in default
Caa CCC Speculative in a
high degree
Ca CC Lowest quality
poor prospects of attaining C
C real investment
standing
D
23Bond Market Indexes
- Managed by major investment banks
- Reflect both the monthly capital gain and loss on
bonds plus any interest (coupon) income earned - Changes in values of the broad market indexes can
be used by bond traders to evaluate changes in
the investment attractiveness of bonds of
different types and maturities
24Bond Market Participants
- The major issuers of debt market securities are
federal, state and local governments and
corporations - The major purchasers of capital market securities
are households, businesses, government units and
foreign investors - Businesses and financial firms (e.g., banks,
insurance companies, mutual funds) are the major
suppliers of funds for all three types of bonds
25International Aspects of Bond Markets
- International bond market
- trades bonds that are underwritten by an
international syndicate - offer bonds simultaneously to investors in
several countries - issue bonds outside the jurisdiction of any
single country - offer bonds in unregistered form
26Eurobonds, Foreign Bonds, Brady Bonds and
Sovereign Bonds
- Eurobonds
- long-term bonds issued and sold outside the
country of the currency in which they are
denominated (e.g., dollar-denominated bonds
issued in Europe or Asia) - Foreign Bonds
- long-term bonds issued by firms and governments
outside of the issuers country, usually
denominated in the currency of the country in
which they are issued - Brady Bonds and Sovereign Bonds
- a bond that is swapped for an outstanding loan to
a lesser developed country, sovereign bonds carry
the creditworthiness of the lesser developed
country