1. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Investments: Theory and Applications Mark Hirschey

2. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Chapter 6 Part 2 Bond Market

3. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How to Read Bond Tables

4. 6-4 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Bond Listings  Due to the number of debt securities, it’s not possible for newspapers to list “every” bond outstanding in the debt markets.  Bonds are not as actively traded as stocks  Only a small fraction of outstanding bonds trade on any given day  Most retail bond investors purchase debt securities to:  receive regular interest income and  hold until maturity: time when bond principal and all interest will be paid in full.

5. 6-5 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Bond Listings  To find precise bid-ask information for any given fixed-income security:  Bond investors supply their broker with the bond’s CUSIP number: Unique code to identify financial securities.  Developed by: the Committee on Uniform Security Identification Procedures as a method or identifying corporate, U.S. government, and municipal securities.

6. 6-6 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bonds  Corporate Bond tables provide basic information:  Bond coupon rate: Bond interest rate expressed as a % of par value  Term-to-maturity  Call information  Recent price  Current yield  Volume traded – on corporate bond listings  Figure 6.6 and Table 6.1, Panel A. (pages 213-14)

7. 6-7 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Bonds  Bid and ask prices are stated in terms of percentages of the bond’s $1,000 Face Amount: Stated bond principal obligation  Sometimes referred to as the Principal Amount or par value  Table 6.1, Panel B, Page 214  Bid: 97:09 = $972.8125  Ask: 97:10 = $973.125 –The numbers after the colons represent 32nds –09 = 9/32% =.28125 –.9728125 x 1000 = $972.8125 –This bond is selling at a discount to par »(less than the $1,000 face amount)

8. 6-8 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Bonds  Discount to Par: Mark down from par value  Bond sells for less than $1,000 par value  Occurs when: current interest rate > bond coupon rate  For instance: Ask of 97:10 means the bond is selling for approximately 97% of face value  Example:  Original $1000 Bond Issued with a 10% coupon rate = $100 coupon payment  If the current interest rate is 12%  Bond will sell for less than $1,000 par value

9. 6-9 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Bonds  Premium to Par: Excess of market price over face amount.  Bond sells for more than $1,000 par value  Occurs when: current interest rate < bond coupon rate  For instance: Ask of 101:21 means the bond is selling for approximately 101% of face value  Example:  Original $1000 Bond Issued with a 10% coupon rate = $100 coupon payment  If the current interest rate is 8%  Bond will sell for more than $1,000 par value

10. 6-10 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Municipal Bond Market  Tax-exempt bond market  Not federally taxed  Most popular bond market sector for individual investors  30% - held by individual investors  Table 6.1, Panel C, Page 214

11. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bonds

12. 6-12 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Uses of Corporate Debt  Corporations raise capital to finance investments in:  Inventory  Plant and equipment  Research and development  General business expansion

13. 6-13 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Uses of Corporate Debt  In deciding how to raise capital for investment, corporations can issue:  Debt (Bonds)  Equity (Stock)  A mixture of both  The driving force that determines the method of raising capital is the desire to “minimize cost of capital”  Match their financing requirements with investor needs

14. 6-14 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Uses of Corporate Debt  Most corporate debt securities offer bond investors:  Predictable cash flows and rates of return  Generally secure investments  Bondholders have a significant claim on corporate cash flow and assets, as creditors of the issuing corporation.

15. 6-15 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Uses of Corporate Debt  Most corporate bonds are purchased by underwriters:  who then make them available to investors  Following issuance:  Many corporate bonds trade in an efficient OTC market  Maintained by national and regional bond dealers

16. 6-16 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Uses of Corporate Debt  “Unlike” common stock:  Which features a certificate that signifies ownership  Corporate bonds are commonly issued in book- entry form only.  Book-Entry Form: Computer record of ownership for bonds with no certificate.  A brokerage statement is the bond investor’s only “proof of ownership”

17. 6-17 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Uses of Corporate Debt  Corporations typically issue long-term debt  But also, issue debt for short term needs:  Finance imports  Meet seasonal cash-flow needs  Create bridge financing until conditions are right for longer-term debt issues.  Bridge Financing: Short-term loans to satisfy temporary borrowing needs.

18. 6-18 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bond Characteristics  The precise terms of the legal agreement between the corporation and the bondholder are called the Indenture: Legal terms of bond agreement  Specifies the duties and obligations of the trustee  Usually a bank or trust company hired by the corporation  How and when the principal will be repaid  The rate of interest  Interest on corporate bonds is usually paid twice a year  A description of any property to be pledged as collateral  Callable features  Steps the bondholder can take in the event of default

19. 6-19 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bond Characteristics  In the past, many corporate bonds were sold as:  Bearer Bonds: Bonds with ownership defined by possession  Coupon Bonds: Bonds with physical interest vouchers.  Both Bearer and Coupon Bonds:  Featured coupons that were submitted twice a year to an authorized bank for the payment of interest  Highly negotiable (could be used like cash)  Made tracking interest difficult for the IRS  The Tax Reform Act of 1982 ended the practice of issuing bearer bonds  Still some in circulation

20. 6-20 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bond Characteristics  Today, all fixed-income securities are sold as Registered Bonds: bonds sold in book-entry form.  They come with the name of the bondholder  Interest income comes twice a year in the form of a check  At maturity, the registered owner receives a check for the principal.

21. 6-21 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bond Characteristics  Since 1986, all U.S. government bonds have been sold in book-entry form.  The owner of book-entry bonds has no certificate  The Federal Reserve Board computer keeps track of:  bond ownership and  required interest payments  A growing number of corporate bonds are also being sold in book-entry form.

22. 6-22 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bond Characteristics  An Unsecured Corporate Bond: is debt backed only by the corporation’s:  Reputation  Credit record  Financial stability  Sometimes referred to as debentures – unsecured corporate bonds  Generally issued by the largest and most creditworthy corporations.

23. 6-23 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bond Characteristics  A Senior Bond: has prior claim to other junior securities in the event of default of bankruptcy.  Every debt security has priority or senior claim to preferred stock, which has priority to common stock.  Debt  Preferred Stock  Common Stock

24. 6-24 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bond Characteristics  Mortgage Bond: Debt backed by a property lien  Pledged assets typically have a market value greater than the bond issue  If the company defaults, real assets are sold off to satisfy the mortgage bondholders  Closed-End Mortgage Bond: Debt secured by assets pledged to that specific bond issue.  Pledged assets can only be sold to pay off a specific bond issue  Open-End Mortgage Bond: Debt with pledged assets that can be sold to pay off multiple bond issues.

25. 6-25 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bond Characteristics  Equipment Trust Certificates: Debt backed by an equipment lien  The corporate equivalent of a personal auto loan  Usually 20-50% of the purchase price is paid as a form of down payment  The balance is paid off over a term of three to 10 years  When the loan is fully paid, the company receives clear title from the trustee  If the company defaults on its loan, equipment is sold and the bondholders are paid off.

26. 6-26 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bond Characteristics  Many equipment trust certificates are Serial Bonds: a series of bonds to be retired in sequence.  Each payment represents both interest and a repayment of principal.  A debenture (unsecured debt) that is subordinated (less important) comes behind every other creditor, but still ahead of preferred and common stock  Creditors, Subordinated Debentures, Preferred Stock Holders, Common Stock Holders.

27. 6-27 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Corporate Bond Characteristics  Income Bond: Bonds with interest that must be paid “only” in the event of positive earnings.  Only pay interest to the extent that the issuing corporation has earned income  Usually issued by the least creditworthy corporate borrowers or by companies already in bankruptcy.  The only bond type in which failure to pay interest in a timely fashion does not lead to immediate default

28. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. U.S. Treasury Securities

29. 6-29 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Securities Market  The federal government has three potential sources of funds to support various projects:  Tax revenues  Printing money  Inflation  Undermine economic confidence  Issue public debt

30. 6-30 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Securities Market  When the federal government spends more than:  it receives in tax revenues  or can be financed through an increase in the money supply  it must borrow in the bond market.

31. 6-31 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Securities Market  The Federal Reserve tries to:  Manage growth in the economy and  Tame the rate of inflation.  The Federal Reserve System, through its New York branch, uses the Treasury securities market to implement monetary policy.  An efficient means for financing federal deficits at the lowest possible cost.

32. 6-32 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Securities Market  If the Fed wishes to increase the money supply, it buys Treasury securities  Injects funds into the financial system  Reduces interest rates  If the Fed wishes to decrease the money supply, it sells Treasury securities  Withdraws funds from the financial system  Increase interest rates

33. 6-33 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Securities Market  Treasury securities carry the “full faith and credit” backing of the U.S. government  Considered among the safest fixed-income investments in the world  The Wall Street Journal and other leading financial publications provide Treasury securities interest rate quotes

34. 6-34 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Securities Market  The Treasury issues securities through regularly scheduled public auctions.  Primary Dealers: Investment bankers that buy new Treasury securities

35. 6-35 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Securities Market  Primary Dealers:  Key participants in the auctions  Obligated to bid at every auction for their own account and on behalf of customers  Obligated to make a continuous secondary market in Treasury securities  Provide bids and offers in the secondary market  Maintain a working inventory of bonds once Treasury securities are issued  Act in conjunction with bond-brokers, who act as intermediaries between dealers and institutional and individual customers.

36. 6-36 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Securities Market  The largest portion of the U.S. debt market is accounted for by Treasury securities.  Trading volume in the Treasury securities market is enormous:  Averages roughly $190.7 billion a day  The world’s most liquid securities market  The liquidity and efficiency of this market:  help maintain the value of the U.S. dollar in world trade  allow the dollar to remain the world’s preeminent exchange currency

37. 6-37 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Treasury Securities Market  The U.S. Treasury is the largest issuer of debt securities in the world:  An estimated $3.2 trillion in marketable Treasury securities are outstanding  Principle buyers include:  Institutional investors  Pension funds  Mutual funds  Insurance companies  International investors  Many large institutional investors such as mutual funds hold Treasury securities on behalf of individuals

38. 6-38 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. T-Bills, T-Notes, T-Bonds  Treasury securities are the safest of all bonds in circulation:  Full-faith-and-credit backing of the U.S. government  Rely on the interest and principal paying might of the U.S. taxpayer  Seasoned Treasury securities trade in the secondary or capital market

39. 6-39 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. T-Bills, T-Notes, T-Bonds  T-bills:  Very actively traded, highly liquid direct short-term obligations of the U.S. Government  Sold by government auction on a once-a-week basis  Mature in less than one year, usually 3 and 6 months  Face amount can vary from $10,000 to $1 million  Do not pay interest; purchased at a discount from par  The “implied” interest rate is determined at auction through the forces of supply and demand  If government borrowing needs rise, the supply of T-bills will increase, T-bill prices will fall, investor yields will rise.  Only offered in book-entry form

40. 6-40 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. T-Bills, T-Notes, T-Bonds  T-notes:  Direct obligations of the U.S. Government  Maturities range from 1 to 10 yrs  Pay semiannual interest  Always expire at par value which may vary from: $5,000 to $10,000 to $1 million  Different length T-notes are auctioned at various periods throughout the year

41. 6-41 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. T-Bills, T-Notes, T-Bonds  T-bonds:  Direct obligations of the U.S. Government  Maturities of 10 to 30 yrs.  Pay semiannual interest  Callable beginning 5 years prior to maturity

42. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Agency and Asset- Backed Securities Markets

43. 6-43 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Agency Securities  Certain U.S. Government agencies and government-sponsored enterprises issue debt securities to help finance desirable private- sector activities such as:  Home ownership  Farming  Education

44. 6-44 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Agency Securities  Government Sponsored Enterprises: “Private” corporations with a “Public” purpose.  These bond issuers are able to:  Borrow at favorable rates  Funnel proceeds into sectors of the economy that would not otherwise enjoy such affordable financing

45. 6-45 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Agency Securities  The Federal Agency Market includes debt securities issued by:  Fannie Mae  Freddie Mac  The Federal Farm Credit System  Federal Home Loan Banks  Student Loan Marketing Association (Sallie Mae)  The Small Business Administration

46. 6-46 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Agency Securities  Most Agency Securities:  Do not carry the government’s full-faith-and-credit guarantee  But their credit quality is enhanced by their government sponsored status  The Agency Securities market is:  Much smaller than the Treasury securities market  But highly efficient and liquid

47. 6-47 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Agency Securities  Most Agency Securities are purchased by Institutional investors:  Pension funds  Insurance companies  Many individual investors hold indirectly through mutual funds.

48. 6-48 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Mortgage-Backed Securities  Both Fannie Mae and Freddie Mac supply “lenders” with money:  Purchase home mortgages in the secondary market  Initial Lenders sell the mortgage loans they generate  Use the proceeds to make new mortgage loans  Results in a constant replenishment of the supply of mortgage funds  Makes mortgages more affordable  Assemble these mortgages into diversified packages or Pools (diversified loan portfolios) of such loans  Then issue securities that represent a proportionate share in the interest and principal payments derived on that pool

49. 6-49 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Mortgage-Backed Securities  Mortgage Securitization Process: process of creating diversified loan portfolios and selling proportionate share to investors.  Mortgage-backed securities:  Are bought by dealers and sold to investors around the world  As the underlying mortgage loans are paid off by homeowners, investors receive monthly payments of interest and principal

50. 6-50 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Mortgage-Backed Securities  Fannie Mae and Freddie Mac trade on the NYSE and get their resources from:  Equity investors  Borrowing from both private investors and the Treasury Department  Both earn a profit: the interest paid on the mortgage- backed securities tends to be about 1% per year less than the amount earned on the underlying pool of mortgages.  Fannie Mae and Freddie Mac purchase more than 50% of all residential loans originated during a given year.

51. 6-51 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Mortgage-Backed Securities  Ginnie Mae is a government agency within HUD created by Congress to ensure adequate funds for government loans  insured by the Federal Housing Administration (FHA) and guaranteed by the Department of Veterans Affairs (VA) and Veterans Administration.  Ginnie Mae issues modified pass-through certificates that represent an interest in a given pool of FHA and VA mortgages  Ginnie Mae bonds are backed by the full faith and credit of the U.S. Government.

52. 6-52 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Mortgage-Backed Securities  Most mortgage securities are issued and/or guaranteed by:  Ginnie Mae  Fannie Mae  Freddie Mac  Regarded as safe  Pay relatively low semiannual interest  Exempt from state and local income taxes

53. 6-53 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Mortgage-Backed Securities  Other private institutions have also built a profitable business packaging mortgage pools:  Subsidiaries of investment banks  Financial institutions  Home builders

54. 6-54 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Other Asset-Backed Securities  Transforming individual loans into diversified pools of related securities has been extended from home mortgages to a broad range of consumer and commercial debt:  Credit card debt  Auto loans  Home equity loans  Equipment leases

55. 6-55 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Other Asset-Backed Securities  Provides a ready source of funds for lending to consumers and other borrowers.  Like mortgage-backed securities, asset-backed securities are:  Underwritten by dealers  Sold to investors around the world  One of the fastest-growing areas in the financial services sector.

56. 6-56 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Repurchase (or Repo) Market  Repo Market: Securities lending market  A means through which securities dealers can finance their bond “inventories”.  A securities dealer sells bonds to a cash investor (Large institutional investor) and simultaneously agrees to repurchase them at a later date for an agreed- on price to finance a bond position.  Large institutional investors can often earn better short- term yields by investing idle cash in the repo market than from bank deposits or money market instruments.

57. 6-57 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Repurchase (or Repo) Market  The repo market is used as a relatively safe haven for cash investments by:  Securities firms  Pension funds  State and local governments  Mutual funds  Repo agreements are relatively safe because they’re typically executed in conjunction with:  U.S. Treasury Bonds  Mortgage Securities  Other forms of highly liquid debt securities

58. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Money Market

59. 6-59 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Market Characteristics  The Money Market: is the market used for buying and selling short-term debt securities that can be quickly converted into cash.  The buyer of a money market instrument is the lender.  The seller of a money market instrument is the borrower.

60. 6-60 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Market Characteristics  Money market instruments  Have a term-to-maturity of one year or less  Typically issued at a discount from par or face value  Typically, $100,000 is the minimum face amount traded in the money market  Dominated by Institutional Investors

61. 6-61 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Market Characteristics  Smaller investors participate via money-market mutual funds that have minimum investment requirements as low as $1,000  Generally regarded as safe  Free from interest-rate risk, due to very short maturities  Only blue-chip private sector and government issuers  Only government-issued money market instruments are default risk free

62. 6-62 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Money Market Instruments  Huge trading volume ensures low dealer bid-ask spreads and low customer trading costs.  Dealer spreads spreads in the T-bill market, for example, often range as low as six to eight basis points, or.06 to.08%  Basis Point: 1/100 th of 1%  1% is 100 basis points  ½% is 50 basis points

63. 6-63 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Money Market Instruments  Commercial Paper: Money Market instruments issued by private entities.  Finance dealer paper  Industrial dealer paper  Bankers’ Acceptances: Time drafts drawn on an accepted banking institutions  The bank substitutes their credit for that of an importer or other holder of merchandise.

64. 6-64 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Money Market Instruments  Negotiable Certificates of Deposit: Time deposits at commercial banks.  Project Notes: Local public housing agency issues secured by the full faith and credit of the U.S. government  Tax Anticipation Notes: Municipal bonds issued on the expectation of the near-term receipt of additional tax revenues.

65. 6-65 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Money Market Instruments  Bond Anticipation Notes: Municipal bonds issued on the expectation of the near-term receipt of funds from a bond issue.  Revenue Anticipation Notes: Municipal bonds issued on the expectation of the near-term receipt of revenue from the state or federal government.

66. 6-66 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Money Market Instruments  Due to the short maturities of money market instruments:  “Borrowers” receive great flexibility in funding short-term cash needs.  “Investors” obtain a liquid,low-risk investment that generally offers a higher yield than bank deposits.  The rising popularity of money market mutual funds has been a major factor in the growth of demand for money market instruments.  Extremely cost-effective source of corporate finance.

67. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Municipal Bonds

68. 6-68 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tax Advantages  State and local governments and their agencies borrow money by issuing Municipal Bonds: Debt issued by state or local governments.  Funds are used to build, repair, and improve:  Schools  Streets  Highways  Hospitals  Sewer Systems, etc.

69. 6-69 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tax Advantages  Projects that benefit the entire community (schools, courthouses, municipal office buildings) are typically funded by general obligation bonds:  Repaid with tax revenues  Projects that benefit only certain users or user groups (utilities, toll roads) are typically funded by revenue bonds:  Repaid for with user fees

70. 6-70 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tax Advantages  “Interest” (not capital gains) on municipal bonds is excluded from “federal” taxation on the basis: improper for the federal government to tax state and local operations  In most states, “interest income” received from securities issued by governmental units within the state is also exempt from state and local taxes.  If a resident of New York City buys a municipal bond issued by the City of New York, “interest income” is not subject to income taxes imposed by the: federal government, New York State, or New York City.

71. 6-71 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tax Advantages  Municipal bond investors are willing to accept lower yields due to federal tax relief  Therefore, state and local governments are able to borrow at interest rates that are lower than would otherwise be possible.  Capital gains realized from the sale of municipal bonds are not exempt from tax.

72. 6-72 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tax Advantages  The favorable tax treatment of municipal bond interest income creates a Clientele Effect: Ownership influence resulting when specific securities have special appeal to certain investors.  Municipal Securities are of primary appeal to those investors with the highest taxable income.  High-Income Individuals, investing directly or through mutual funds, etc., hold about three-quarters of the roughly $1.5 trillion of municipal debt outstanding.

73. 6-73 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Tax Advantages  The municipal securities market:  Is generally regarded as having relatively high quality, given the taxing authority of state and local governments  Has a safety record that is second only to the U.S. Treasury bond market  Appeals to a wide variety of bond investors

74. 6-74 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Municipal Bond Types  A wide variety of municipal bonds are issued by state and local governments to support general and specific financing needs:  General Obligation Bonds: Municipal bonds backed by the full faith and credit of the issuer.  Issued by cities, counties, and school districts  Among the most creditworthy of all municipal bond instruments  Backed by the full faith and credit of the issuer  Issuing authorities can raise property taxes to ensure payment  Property and other assets can be sold to satisfy legal claims

75. 6-75 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Municipal Bond Types  Limited Tax Bonds: Bonds payable from the proceeds of a specific tax.  Special Tax Bonds: Limited tax bonds  Gasoline tax  Special assessment levy  Ad valorem tax  Based on values  In proportion to the value

76. 6-76 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Municipal Bond Types  Revenue Bonds: Bonds payable from the earnings of revenue-producing government agencies or public enterprises.  Water and Sewer Utilities  School Districts  Airport authorities  Many such agencies or enterprises have the ability to levy service charges or fees  i.e. landing fees at the local airport

77. 6-77 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Municipal Bond Types  Industrial Revenue Bonds: Bonds used to develop industrial and/or commercial property for the benefit of private users.  Money raised is used to pay for the construction of new facilities which are then leased to a corporate guarantor  The safety of industrial revenue bonds depends on the creditworthiness of the issuing municipality and the corporate guarantor.  The yield is generally somewhat higher

78. 6-78 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Municipal Bond Types  Moral Obligation Bonds: Bonds backed by the good name of the issuer.  Double-Barreled Bonds: Tax-exempt municipal bonds backed by a pledge of two or more sources.  Backed by a second source of revenue to increase their safety.

79. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Sources of Bond Market Information

80. 6-80 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Print and Broadcast Media  Print Media:  The Wall Street Journal  Investor’s Business Daily  Barron’s  All have:  Extensive tables  Commentary about factors influencing the fixed- income securities market  Historical snapshots

81. 6-81 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Print and Broadcast Media  Broadcast Media:  CNBC  CNNfn  Treasury bond prices during the day  Economic releases that effect bond yields  The Internet:  www.bondmarket.com www.bondmarket.com  Maintained by the Bond Market Association

82. 6-82 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Bond Market Association  The Bond Market Association:  A nonprofit organization  Headquartered in New York City  Represents securities firms and banks that underwrite, trade, and sell debt securities  Membership is open to bona fide dealers in bonds and other debt securities

83. 6-83 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Answers to Selected End of Chapter 6 Questions and Suggested Study  Study the following end-of- chapter questions:  1. (c)  3. (a)  4. (d)  5. (a)  6. (c)  7. (d)  8. (b)  9. (c)  13. (a)  14. (d)  17. (d)  18. (a)  19. (d)  20. (d)  Read the Chapter  Read the Chapter “Summary”  Review the Power Point Presentation