FNCE 3020 Financial Markets and Institutions

1
FNCE 3020Financial Markets and Institutions

• Lecture 10
• The U.S. Bond Markets

2
Quick Facts

• The U.S. bond market (at 27 trillion) is almost
  one and a half times the size of the combined
  market capitalization of all U.S. stock markets.
• The U.S. corporate debt market is about 4 times
  larger than the U.S. Treasury bond and municipal
  bond markets combined.

3
U.S. Bond Markets, 2005 - 2006

• Bond Bond
• Markets (2006) Markets
  (2005) Change
• World 68.7 59.0
• Developed 62.7 (91) 54.5 (92)
  16.5
• Emerging 6.0 ( 9) 4.5 ( 8)
  33.3
• U.S. 26.7 (39) 23.8
  (40) 12.2
• EU 23.2 (34) 18.7 (32)
  24.1
• Euro 18.8 (27) 15.2
  (26) 23.7
• U.K. 3.3 ( 5) 3.3
  ( 6) -----
• Japan 8.7 (13) 8.7 (15)
  -----
• Note Trillions of U.S. dollars, and () of
  total.
• Source IMF, Global Financial Stability Reports

4
U.S. Bond Markets Government and Corporate, 2005
- 2006

• Bonds (2006) Bonds (2005)
• Government Corporate Government
  Corporate
• World 25.6 43.1 25.1 35.9
• Developed 21.8 (85) 40.9 (95) 22.2 (89)
  34.0 (95)
• Emerging 3.8 (15) 2.2 ( 5) 2.9
  (11) 1.9 ( 5)
• U.S. 6.2 (24) 20.5 (48) 5.9 (24)
  17.9 (50)
• EU 7.7 (30) 15.5 (36) 6.7 (27)
  12.0 (33)
• Euro 6.6 (26) 12.2 (28)
  5.6 (23) 9.4 (26)
• UK .8 ( 3) 2.5 (
  6) .7 ( 3) 1.9 ( 5)
• Japan 6.7 (26) 2.0 ( 5) 6.6 (26)
  2.1 ( 6)
• Note Trillions of U.S. dollars, and () of
  total.
• Source IMF, Global Financial Stability Reports

5
Summary of U.S. Bond Market Data

• Although the U.S. bond market is currently the
  largest in the world (at 39), the bond market in
  Europe has been growing faster and thus
  increasing in relative size (currently at 34).
• Within the U.S. market, the corporate sector
  denominates the government sector, by more than a
  factor of 3.

6
U.S. Bearer Bonds and Registered Bonds

• Earliest corporate bonds issued in the United
  States were usually bearer bonds.
• Whoever held the companys bonds (i.e., the
  bearer) could collect interest and/or sell the
  bonds.
• Bearer bonds, however, had significant problems.
• Companies never knew who held their bonds, so
  communication was inefficiently limited to
  notices in newspapers.
• Thus, registered corporate bonds started
  increasing in popularity in the 1880s and
  dominated U.S. capital markets by the early
  1900s.
• Under this arrangement, companies keep records of
  owners names by corresponding bond serial
  numbers.
• Actually done by banks for companies.
• By 1982, registered bonds became a U.S.
  government requirement for bonds issued in the
  United States.

7
Bearer and Registered Bonds
8
Bond Covenants (Binding Agreements)

• Bond covenants are binding agreements as noted in
  the bonds indenture that are listed to protect
  the interests of bond holders by restricting
  certain activities of the issuer that could
  endanger the bond holder's position.
• The indenture is the legal contract between the
  issuing company and the bond holders.
• A typical indenture will include
• Basic terms of the bond (coupon rate, coupon
  payment dates, maturity date)
• Amount of bonds to be issued.
• Description of property to be used as collateral
  (if any).
• Sinking fund provisions.
• Call provisions (if any)
• And details of any restrictive covenants

9
Categories of Bond Covenants

• Bond covenants can be divided into four basic
  categories
• (1) those restricting the issuance of new debt
• (2) those restricting dividend payments
• (3) those restricting merger activities and
• (4) those restricting the disposition of the
  firms assets.
• Bond covenants that restrict subsequent debt
  financing are by far the most common type.
• These covenants are typically stated in terms of
  accounting measures in order to make them easier
  to monitor.
• For example Debt-to-equity ratios

10
Call Provision on Bonds

• Callable provision gives the issuer the right to
  call (i.e., buy back) the bond before the
  maturity date.
• Thus it allows for early redemption of a bond.
• If a band is callable, the indenture will specify
  the dates and corresponding prices prior to
  maturity at which the bond can be called
  (referred to as the call schedule).
• Most corporate bonds today include a call
  provision.
• 70 of municipal bonds are callable.
• The Treasury has not issued callable bonds since
  1985.

11
Call Provision on Bonds

• This option may turn out to be particularly
  valuable to the issuer should interest rates
  fall.
• The issuer can then call in its bonds (redeem
  then) and refinance at the lower market interest
  rate.
• However, holders of these bonds face call risk,
  which is the risk that a bond may be called when
  the investor does not want it to be called.
• Since bond are often called when interest rates
  decline, these investors get their cash back but
  have to reinvest it at the lower rates.
• Because of the call risk associated with these
  bonds, they will generally carry higher coupon
  rates.

12
Convertible Bonds

• Convertible bonds permit the bond holder the
  right to exchange the bond for the common stock
  of the issuing corporation.
• An investor in a convertible security receives
  the upside potential of the common stock of the
  issuer, combined with the safety of principal in
  terms of a prior claim to assets over equity
  security holders.
• The investor, however, pays for this conversion
  privilege by accepting a lower yield-to-maturity
  than that offered on comparable non-convertible
  bonds.
• Also, if anticipated corporate growth is not
  realized, the investor sacrifices current yield
  and risks of not converting.

13
Conversion Ratio

• An essential part of convertible bonds is the
  conversion ratio.
• This expresses the number of shares of stock
  which each bond can be converted into.
• For Example A conversion ratio of 501 means
  that each bond can be converted into 50 shares of
  common stock.
• At this ratio the bondholder, who paid par for
  the bond (par 1,000), will be able to exchange
  the bonds into 50 shares of stock.
• The conversion price for this bond holder would
  be 20.00 per share (1,000/50 20.00).

14
Out of the Money and In the Money Convertible
Bonds

• Whether a convertible bond in out of the money or
  in the money depends upon
• The conversion ratio
• The market price of the bond
• The price per share of the common stock.
• If a 501 convertible bond is selling for 1,000
  (at par), and if the market price of the stock is
  10 per share, the convertible bond is said to be
  out of the money.
• Because you would be paying 20 a share for a
  stock trading at 10 per share.
• If the market price of the stock is 25 per
  share, the convertible bond is said to be in the
  money.

15
Conversion Period

• Convertible bonds will be initially priced
  (conversion ratio) so as to be out of the
  money.
• The time periods for convertibility can be
• Limited by the indenture (occurring during a
  specified time period in the future), or
• Unlimited up to the maturity date of the bond
• This is the usual case
• Convertible bonds will generally carry a callable
  feature as well, so that the issuer can force
  conversion if so desired.
• If there is a callable feature, it will usually
  be delayed so as to give the convertible bond
  time to trade in the money.

16
3 Types of Corporate Bonds

• Secured Bonds (backed by collateral)
• Mortgage bonds (real estate)
• Equipment trust certificates (airplanes)
• Unsecured Bonds (backed by the general
  creditworthiness of issuer)
• Debentures
• Subordinated debentures
• Lower priority claim than debentures
• Credit ratings become important in the case of
  unsecured bonds.
• Junk Bonds
• Speculative grade
• Moderate to low ability to repay high chance of
  default.

17
Sample Corporate Bond
18
Selling New Bonds

• New corporate bonds are offered to investors
  through bond dealers.
• Major bond dealers include Major corporate bond
  dealers include Citibank, Goldman Sachs,
  JPMorgan, Lehman Brothers, Merrill Lynch, UBS,
  and Morgan Stanley.
• The most common approach is for the issuer to
  sell the bonds to bond dealers, which then
  re-sell to investors.
• In this case bond dealers assume the risk of
  re-selling them into the market.
• Sometimes bond dealers act merely as agents, on a
  best efforts basis.

19
Secondary Markets for Corporate Bonds

• Most corporate bonds trade OTC (through bond
  dealers).
• Bond dealers make a market in particular bonds
  and offer buy and sell prices to investors.
• Some corporate bonds trade on organized
  exchanges the largest of which is the NYSE.
• NYSE electronically trades around 5,000 corporate
  bonds (including the bonds of most NYSE listed
  companies).
• See http//www.nyse.com/productservices/securitie
  s/1095449059236.html

20
Bond Investors

• Institutional Market Major bond investors are
  financial institutions, pension funds, mutual
  funds and governments, from around the world.
• Trades generally involve large amounts where
  large blocks of bonds are traded. Typical trading
  amounts range from 500 million up to a 1
  billion.
• Retail Market Essentially involves individual
  investors. There are no size restrictions in the
  "retail market.

21
U.S. Bond Performance, 1992-2007

• Lehman Brothers U.S. Aggregate Bond Index
  includes government securities, mortgage-backed
  securities, asset-backed securities and corporate
  securities. Return comprises price
  appreciation/depreciation and income as a
  percentage of the original investment.