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Overview of the Bond Markets

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... maturities greater than one year so bonds are instruments of the capital markets ... investors because interest (but not capital gains) are tax exempt ... – PowerPoint PPT presentation

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Title: Overview of the Bond Markets


1
Overview 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

2
Bond Market Instruments Outstanding, 1994-1999
(Bn)
3
Treasury 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

4
Composition of the U.S. National Debt (Bn)
5
Treasury 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

6
The 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
7
Secondary 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

8
Treasury 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

9
Municipal 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

10
Tax 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
11
Types 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

12
Primary 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)

13
Contracting 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

14
Secondary 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

15
Corporate 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

16
Types 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)

17
Types 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)

18
Types 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

19
Primary 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

20
Bond 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

21
Bond 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)
22
Bond 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
23
Bond 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

24
Bond 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

25
International 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

26
Eurobonds, 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
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