The Corporate and Government Bond Markets Chapter 10 © 2003 South-Western/Thomson Learning

Slide 2 Learning Objectives  Characteristics of bond market and how market has changed in recent years  How corporate and government bond markets function  Characteristics and advantages of municipals  What government agency securities and government sponsored enterprises are  Factors that affect bond prices  Types of international bonds

Slide 3 Bond Market  Coupon Rate-  Fixed interest rate stated on face of bond  Bearer Bonds- the owner:  Clips coupon from bond  Sends coupon to issuer, who returns coupon payment  Registered Bonds- the issuer:  Keeps records of ownership  Automatically sends coupon payment to bondholder

Slide 4 Corporate Bond Market  Bond Indenture Document stating terms under which a bond is issued  Provisions bond indenture may include:  Sinking Fund Provisions  Specify whether corporation is required to pay off portion of newly issued bonds each year  Call Provisions  Specify whether corporation can pay off bonds before they mature (if so, under what terms)  Convertible Bonds  Bondholder has right to covert bonds to a predetermined number of shares of common stock

Slide 5 Corporate Bond Market  Bond Indenture  Provisions bond indenture may include:  Issuance of Warrants  Contracts sometimes issued with newly issued bonds  Give holder right to purchase a designated security at a price set today  May be sold to a third party  Restrictive Covenants  Stipulations within bond indenture that limit ability of corporation with regards to certain activities  Coupon payment on bond be increased if the credit rating of corporation is downgraded by a certain amount during the life of the bond

Slide 6 Corporate Bond Market  Mortgage Bonds  Backed by real personal property  Collateral Bonds  Backed by financial assets  Debenture Bonds  No specific collateral backing  Have general claim on other unpledged assets of issuer  Subordinated Debenture Bonds  No collateral backing  Have general claim after debenture bondholders have been paid

Slide 7 Corporate Bond Market  Zero-Coupon Bonds  Corporate bonds sold at discount  Difference between amount paid for bond and amount received at maturity equal to interest  Over-the-Counter Market  Secondary market of loosely connected array of brokers and dealers who buy, sell, and take positions in bonds  Brokers and dealers buy and sell bonds over computer links and telephone lines

Slide 8 Treasury Bond Market  U.S. Government Bonds-Treasury Bonds  Issued in primary market  Issued by Bureau of Public Debt  Issued in minimum amounts of $1,000  Make periodic coupon payments (usually every 6 months)  Primary Dealers  Large banks and government securities dealers approved by Fed to be main participants in auctions of Treasury securities conducted by Fed

Slide 9 Treasury Bond Market  Treasury STRIPS  Type of government security that allows investors to register and trade ownership of interest (coupon) payments and principal separately  Inflation-Indexed Bonds  Principal amount is adjusted for inflation at time when coupon payments are made (usually every 6 months)

Slide 10 Municipal and Government Agency Securities  Municipal Bonds (munis)  Issued by state, county, and local governments to finance public projects such as schools, utilities, roads and transportation ventures  Interest is exempt from federal and state taxes for investors living in issuing state  Government Agency Securities  Issued by private enterprises that were publicly chartered by Congress to reduce the cost of borrowing to certain sectors of economy such as farming, housing and student loans

Slide 11 Municipal and Government Agency Securities  Government-Sponsored Enterprises  Private enterprises that have been chartered by Congress to reduce the cost of borrowing in such sectors as housing, farming, the savings and loan industry and student loans

Slide 12 Determinants of Bond Prices Where: P = the price (present value) of the bond C = the coupon payment on the bond (C 1 in year 1, C 2 in year 2, etc.) F = the face or par value of the bond i = the interest rate n = the number of years to maturity (on a 5-year bond, n = 5) Price of previously issued bond will be equal to present value of future stream of income from that bond.

Slide 13 Determinants of Bond Prices Many factors affect risk-free rate:  In case of bonds that are not default- risk free, investors require that a premium be added to risk-free return d = R F + R P Where: d = discount factor R F = the risk-free rate R P = the risk premium

Slide 14 Determinants of Bond Prices  Leverage Ratio  Ratio of the firm’s debt relative to its equity

Slide 15 Exhibit 10–5 Factors that Affect Bond Prices