CHAPTER 8 BOND MARKETS

Copyright© 2008 John Wiley & Sons, Inc.2 Capital Markets Capital market instruments are long term securities issued to finance capital goods and/ or long term projects. They are not highly marketable. Using them reduce the refinancing problems. Their interest rates are higher than those of short term securities.

Capital markets bring together the borrowers and suppliers of long-term funds and also allow people with previously issued securities to trade them for cash in secondary capital markets. Major Issuers (borrowers) Households - mortgages. Business - bonds and stock Governments - federal, state, and local bonds. Major Investors Households (directly or indirectly through financial intermediaries). Foreign investors. Copyright© 2006 John Wiley & Sons, Inc. 3

Copyright© 2008 John Wiley & Sons, Inc.4 U.S. Government Issues and Agency Securities 1. U.S. Treasury Notes and Bonds Coupon bearing issues (has coupon payment and is usually paid semiannually). Notes - one to ten-year maturity. Bonds - over ten-year maturity. Sold in auction by the Treasury Department. Trend is now toward more short-term market financing and less long-term financing.

Copyright© 2008 John Wiley & Sons, Inc.5 2. Inflation-Indexed Notes and Bonds : Treasury also issue notes and bonds adjusted for inflation called Treasury Inflation Protection Securities (TIPS). Principal adjusts for inflation Minimum denomination is $1,000. Example : An investor bought a TIP with original principal of $100,000, 3% annual coupon rate compounded semiannual (1.5% semiannual) and 10 years maturity. If the semiannual inflation rate during the first 6 months is 1%, the principal amount will be adjusted upward by 1 % to $101,000 and hence the first coupon payment will be $ 1,515(101,000*1.5%). The principal will be adjusted before every coupon payment and the investor receives at maturity the greater of either the final principal or the initial par amount.

TIPS are used for 1.Provide investors with a way to protect their investments against inflation. 2.The yield on TIPS provides a direct measure for real interest rate. Therefore expected inflation can be calculate through subtracting the yield on TIPS from the yield of comparable security. Example : yield on 5 –year TIPS= 1.10%.yield on 5- year Treasury note =3.49% Expected inflation = = 2.39% Copyright© 2006 John Wiley & Sons, Inc. 6

3. Separate Trading of Registered Interest and Principal (STRIP). A strip is just a Treasury security that has been separated into its component parts : coupon payment and principal payment. Each coupon and principal of a U.S. Treasury note or bond is sold separately by a dealer. Each separated security is a zero-coupon bond. The price of the original T-note/bond is lower than the price of the strips securities because the zero-coupon bonds are highly desired by investors as they are used in managing the interest rate risk. Dealers engage in creating STRIPs created because investors value zero- coupon default risk-free securities and are willing to pay more for STRIPs than original bonds. Copyright© 2006 John Wiley & Sons, Inc. 7

Example:10 year Treasury note if coupon is paid semi-annually can be divided into 21 strips.(20 coupon payments and 1 principal) Strips can be used to manage interest rate risk as they are zero coupon bond, if you hold it to maturity you get rid of price risk and it already does not have reinvestment risk as it is zero coupon bond. Copyright© 2006 John Wiley & Sons, Inc. 8

Copyright© 2008 John Wiley & Sons, Inc.9 State and Local Government Bonds Known as municipal bonds Types of Municipal Bonds 1. General Obligation (GO) Bonds- backed by taxing power of political entity. In case of default, the city or local government will raise tax to pay the principal and coupon payments. They are issued to provide basic services to communities such as education, health services etc. 2. Revenue Bonds - financed and paid back with cash flows from a specific project. In case of default, only the revenue generated from the project backs these bonds. Projects like bridges, water treatment.

3. Industrial Development Bonds (IDB) - public financing of private business. 4. Mortgage-backed bonds: Issued by city housing authorities to finance homes for low and moderate income people. Because these bonds are tax exempt the issuer use them to borrow funds at low interest and then make low interest mortgage loans. Copyright© 2006 John Wiley & Sons, Inc. 10

Copyright© 2008 John Wiley & Sons, Inc.11 Municipal Bonds (continued) The Relation between Municipals and Taxable Yields Interest on municipal bonds is exempt from federal income tax. The yield on municipals equals the yield on taxables times one minus the marginal tax rate. i m = i t (1-T) If investor’s marginal tax rate is high then municipal will generate higher after tax yield than taxable securities and vice versa.

Copyright© 2008 John Wiley & Sons, Inc.12 Corporate vs. Municipal Bond An investor has the choice of an AA-rated corporate bond with a yield of 6% or an AA-rated municipal yielding 4%. If the investor has a marginal tax rate of 30%, which bond should he/she select?

Copyright© 2008 John Wiley & Sons, Inc.13 Corporate vs. Municipal-Bond The after-tax rate on the corporate is 6%( ) = 4.2% > 4% on the municipal bond or The pretax equivalent rate on the municipal bond would be 4%/( ) = 5.7% < 6% on the corporate  Select the corporate bond!

Copyright© 2008 John Wiley & Sons, Inc.14 Municipal Bonds (continued) Three groups of investors in municipal bonds whose demands are affected by their high federal tax exposure are: High income Households - affected by income level and marginal tax rates. Casualty insurance companies - determined by industry profitability. Commercial banks. Commercial banks and casualty insurance companies tend to buy tax-exempt securities with maturities that meets their preferences, such as high credit quality shorter term securities for commercial banks and higher yield, lower credit rating, longer maturities for casualty insurance companies.

Copyright© 2008 John Wiley & Sons, Inc.15 Municipal Bonds (continued) The Market for Municipal Bonds Primary market. Large number of relatively small bond issues. Underwritten by investment bankers from local to national markets. Most general obligation (GO) bonds are sold by competitive bid. Secondary market not well-developed - OTC market made by dealers. thin secondary markets lead to larger bid-ask spreads because it is difficult to match the buyer and seller. limited marketability may leads to higher yields

Copyright© 2008 John Wiley & Sons, Inc.16 Corporate Bonds Debt contracts require borrowers to make periodic payments of interest (usually semiannually) and repay principal, usually $1,000, at maturity date. Types of ownership record Bearer bonds - coupon bond owned by bearer. Registered bonds - owner noted by records. Maturity Term bonds - all bonds in the issue mature on one date. Most corporate bonds are term bonds. Serial bonds - bonds in the issue mature on different dates. Most municipal bonds are serial issues.

Copyright© 2008 John Wiley & Sons, Inc.17 The Bond Indenture Corporate bonds have an indenture( bond legal contract) which states the rights, privileges and obligations of the bond issuer and the bondholder. Some bonds have collateral assets or securities to which the bondholders have prior claim in the event of default of the issuer. Mortgage bond - real assets pledged. Equipment trust certificates – cars, trucks or identifiable equipment. Collateral bonds - secured by financial assets (e.g. stocks).

I f no assets are pledged, the bonds are secured only by the firm’s potential to generate cash flows are called Debentures – (unsecured bonds) and such bonds will have higher yields than similar secured bonds. Debentures can be Senior debt –In the event of default, giving the bondholders first priority to firm’s assets after the secured claims. Subordinated (junior) debt– Bondholder’s claims to the company’s assets rank behind the senior debt. Copyright© 2006 John Wiley & Sons, Inc. 18

Copyright© 2008 John Wiley & Sons, Inc.19 Corporate Bonds Provisions Many corporate bonds have provisions such as : Sinking fund Provisions – Rather than the issuer repaying the entire principal of a bond issue on the maturity date, the issuer provide funds to another company(trustee) retire a portion of the issue annually. The retirements of the bonds (which is must as promised in indenture) could be through purchasing them in open market or calling them if a call provision is present. Call provision - borrower right to buy back bond before maturity. Convertible bonds are bonds that can be converted to another security at the discretion(choice) of the bondholder.

Copyright© 2008 John Wiley & Sons, Inc.20 Investors in Corporate Bonds Major investors include: Life insurance companies. Pension funds. Corporate bonds are attractive to life insurance and pension funds because such bonds are long term, high yields and since they in low marginal tax brackets and thus these bonds provide them with higher yields than the tax exempt bonds. Households. Foreign Investors. Investor requirements: Long-term investment horizon. Liquidity not always needed - hold to maturity. Safety - investment grade. Tax considerations.

Copyright© 2008 John Wiley & Sons, Inc.21 Primary Market for Corporate Bonds 1. Public sale - open to all interested buyers, which is done through investment banks that acts as underwriters. Competitive sale - public auction among underwriters and the issue is sold to the underwriter with the bid that results with lowest borrowing cost to the issuer. Negotiated sale - underwriting contract signed with specific underwriters. The main difference between the two methods of sale is that in negotiated sale the investment banker provides the origination and advising services as part of the negotiated package, while in the competitive sale the investment banker does not provide these services.

Copyright© 2008 John Wiley & Sons, Inc.22 Primary Market for Corporate Bonds 2. Private placement - sold to limited number (< 35) of sophisticated buyers, avoiding registration and disclosure requirements. private placements have increased relative to public sale. when interest rates are high and/or when capital market conditions are unstable, private placements increase.

Secondary Market for Corporate Bonds Most secondary trading of corporate bonds occurs through dealers. the volume of trading is low – a thin market, thus there is a wide bid/ask differential in the market. corporate bonds are less marketable than money market instruments because they are long term, in general longer-term securities are riskier and less marketable. Corporate bonds have special features such as call provision that make them difficult to value. Copyright© 2006 John Wiley & Sons, Inc. 23

Copyright© 2008 John Wiley & Sons, Inc.24 Junk bond issuance in the late 1990’s Junk bonds are low rated (high default risk) corporate bonds. Development of the junk bond primary market was enhanced by the secondary market maintained by Drexel, Burnham and Lambert in the early 1980s. Higher risk firms found they could issue longer term, more flexible securities in the high-yield market rather than borrow from commercial banks and demand for junk bonds came from financial institutions such as life insurance, pension funds, mutual funds.