Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Chapter Six Bond Markets

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Bond Market Instruments Outstanding, ($Bn)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 yrs 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 yrs

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Composition of the U.S. National Debt ($Bn)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 30-year note $1,000 Feb, Aug, Nov 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 30-year note $1,000 Feb, Aug, Nov

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 Most secondary market trading occurs directly through brokers and dealers Wall Street Journal shows full list of Treasury securities that trade daily

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Tax Exemption and Muni Yields i a = i b (1 - t) Where: i a = After-tax (equivalent tax exempt) rate of return on a taxable corp bond i b = Before-tax rate of return on a taxable bond t = Marginal income tax rate of the bond holder Example: You can invest in taxable corporate bonds that are paying 10% annually on munis. Your marginal tax rate is 28%, the after- tax rate of return on the taxable bond is: 10%(1-.28) = 7.2% i a = i b (1 - t) Where: i a = After-tax (equivalent tax exempt) rate of return on a taxable corp bond i b = Before-tax rate of return on a taxable bond t = Marginal income tax rate of the bond holder Example: You can invest in taxable corporate bonds that are paying 10% annually on munis. Your marginal tax rate is 28%, the after- tax rate of return on the taxable bond is: 10%(1-.28) = 7.2%

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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) 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)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Top Municipal Bond Underwriters Principal Amount Market No. of Underwriter (in millions $$) Share Issues Salomon Smith Barney $31, % 403 Merrill Lynch 22, % 312 Paine Webber 22, % 420 Goldman Sachs 17, % 233 Lehman Brothers 11, % 169 Morgan Stanley Dean Witter 9, % 226 Bear, Stearns 7, % 108 First Union 6, % 393 J.P. Morgan 5, % 106 U.S. Bancorp Piper Jaffray 5, % 538 Industry totals $219 billion Principal Amount Market No. of Underwriter (in millions $$) Share Issues Salomon Smith Barney $31, % 403 Merrill Lynch 22, % 312 Paine Webber 22, % 420 Goldman Sachs 17, % 233 Lehman Brothers 11, % 169 Morgan Stanley Dean Witter 9, % 226 Bear, Stearns 7, % 108 First Union 6, % 393 J.P. Morgan 5, % 106 U.S. Bancorp Piper Jaffray 5, % 538 Industry totals $219 billion

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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) 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)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Types of Corporate Bonds Mortgage bonds –issued to finance specific projects which are pledged as collateral 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) Mortgage bonds –issued to finance specific projects which are pledged as collateral 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)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Bond Ratings Bonds are rated by the issuer’s default risk Large bond investors, traders and managers evaluate default risk by analyzing the issuer’s financial ratios and security prices Two major bond rating agencies are Moody’s and Standard & Poor’s (S&P) Bonds assigned a letter grade based on perceived probability of issuer default Bonds are rated by the issuer’s default risk Large bond investors, traders and managers evaluate default risk by analyzing the issuer’s financial ratios and security prices Two major bond rating agencies are Moody’s and Standard & Poor’s (S&P) Bonds assigned a letter grade based on perceived probability of issuer default

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Bond Credit Ratings Explanation Moody’s S&P 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- Explanation Moody’s S&P 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)

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin Bond Credit Ratings Explanation Moody’s S&P 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 Explanation Moody’s S&P 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 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

Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill /Irwin 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 issuer’s 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 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 issuer’s 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