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Chapter 6. Bond Markets. Bond and Bond Markets. Capital markets involve equity and debt instruments with maturities of more than one year Bonds are long-term debt obligations issued by corporations and government units Bond markets are markets in which bonds are issued and traded - PowerPoint PPT Presentation
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Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Chapter 6
Bond Markets
6-2
Bond and Bond MarketsBond and Bond Markets
Capital markets involve equity and debt instruments with maturities of more than one year
Bonds are long-term debt obligations issued by corporations and government units
Bond markets are markets in which bonds are issued and traded Treasury notes (T-notes) and bonds (T-bonds) Municipal bonds (Munis) Corporate bonds
Capital markets involve equity and debt instruments with maturities of more than one year
Bonds are long-term debt obligations issued by corporations and government units
Bond markets are markets in which bonds are issued and traded Treasury notes (T-notes) and bonds (T-bonds) Municipal bonds (Munis) Corporate bonds
6-3
Bond Market Instruments Bond Market Instruments Outstanding, 1994-2010Outstanding, 1994-2010
Bond Market Instruments
6-4
Treasury Notes and BondsTreasury Notes and Bonds
Treasury notes and bonds (T-notes and T-bonds) are issued by the U.S. Treasury to finance the national debt and other government expenditures
The annual federal deficit is equal to annual expenditures (G) less taxes (T) received
The national debt (ND) is the sum of historical annual federal deficits:
Treasury notes and bonds (T-notes and T-bonds) are issued by the U.S. Treasury to finance the national debt and other government expenditures
The annual federal deficit is equal to annual expenditures (G) less taxes (T) received
The national debt (ND) is the sum of historical annual federal deficits:
)(1
t
N
ttt TGND
6-5
Current & Projected Federal Debt Current & Projected Federal Debt LevelsLevels
Data Source: CBO
6-6
Treasury Notes and BondsTreasury Notes and Bonds
Default risk free: backed by the full faith and credit of the U.S. government
Low returns: low interest rates (yields to maturity) reflect low default risk
Interest rate risk: because of their long maturity, T-notes and T-bonds experience wider price fluctuations than money market securities when interest rates change
Liquidity risk: older issued T-bonds and T-notes trade less frequently than newly issued T-bonds and T-notes
Default risk free: backed by the full faith and credit of the U.S. government
Low returns: low interest rates (yields to maturity) reflect low default risk
Interest rate risk: because of their long maturity, T-notes and T-bonds experience wider price fluctuations than money market securities when interest rates change
Liquidity risk: older issued T-bonds and T-notes trade less frequently than newly issued T-bonds and T-notes
6-7
Treasury Notes and BondsTreasury Notes and Bonds
T-notes have original maturities from over 1 to 10 years T-bonds have original maturities from over 10 years Issued in minimum denominations (multiples) of $1,000 May be either fixed principal or inflation-indexed
inflation-indexed bonds are called Treasury Inflation Protection Securities (TIPS)
the principal value of TIPS is adjusted by the percentage change in the Consumer Price Index (CPI) every six months
Trade in very active secondary markets Prices are quoted as percentages of face value, in 32nds
T-notes have original maturities from over 1 to 10 years T-bonds have original maturities from over 10 years Issued in minimum denominations (multiples) of $1,000 May be either fixed principal or inflation-indexed
inflation-indexed bonds are called Treasury Inflation Protection Securities (TIPS)
the principal value of TIPS is adjusted by the percentage change in the Consumer Price Index (CPI) every six months
Trade in very active secondary markets Prices are quoted as percentages of face value, in 32nds
6-8
Sample Treasury Bond QuoteSample Treasury Bond Quote
Maturity mo/yr: Month and year, the bond matures November 15, 2017.
Coupon: Coupon rate of 4.250% or $42.50 per year but paid semiannually ($1,000 face).
Bid: The closing price per $100 of par the dealer will pay to buy the bond; the seller would receive this price from selling to the dealer. Prices are quoted in 32nds. In this case, 112:26 = 112 26/32% of $1,000 or $1,128.125.
Maturity mo/yr: Month and year, the bond matures November 15, 2017.
Coupon: Coupon rate of 4.250% or $42.50 per year but paid semiannually ($1,000 face).
Bid: The closing price per $100 of par the dealer will pay to buy the bond; the seller would receive this price from selling to the dealer. Prices are quoted in 32nds. In this case, 112:26 = 112 26/32% of $1,000 or $1,128.125.
Maturity Coupon Bid Asked Chg Asked Yld2017 Nov 15 4.250 112:26 112:27 +13 2.3316
6-9
Sample Treasury Bond QuoteSample Treasury Bond Quote
Asked: The closing price per $100 of par the dealer requires to sell the bond; the buyer would pay this price to the dealer. In this case, 112:27 = 112 27/32% of $1,000 or $1,128.4375.
Chg: The change from the prior closing ASKED price in 32nds. In this case, the ASKED price increased thirteen 32nds from the prior quoted closing ask price.
Asked: The closing price per $100 of par the dealer requires to sell the bond; the buyer would pay this price to the dealer. In this case, 112:27 = 112 27/32% of $1,000 or $1,128.4375.
Chg: The change from the prior closing ASKED price in 32nds. In this case, the ASKED price increased thirteen 32nds from the prior quoted closing ask price.
Maturity Coupon Bid Asked Chg Asked Yld2017 Nov 15 4.250 112:26 112:27 +13 2.3316
6-10
Sample Treasury Bond QuoteSample Treasury Bond Quote
Asked Yld = Promised compound yield rate if purchased at the Asked price. In this case, the yield is 2.3316%.
Asked Yld = Promised compound yield rate if purchased at the Asked price. In this case, the yield is 2.3316%.
Maturity Coupon Bid Asked Chg Asked Yld2017 Nov 15 4.250 112:26 112:27 +13 2.3316
6-11
Treasury STRIPSTreasury STRIPS
Separate Trading of Registered Interest and Principal Securities (STRIPS), a.k.a. Treasury zero bonds or Treasury zero-coupon bonds
Financial institutions and government securities brokers and dealers create STRIPS from T-notes and T-bonds
STRIPS have the periodic interest payments separated from each other and from the principal payment one set of securities reflects interest payments one set of securities reflects principal payments
STRIPS are used to immunize against interest rate risk
Separate Trading of Registered Interest and Principal Securities (STRIPS), a.k.a. Treasury zero bonds or Treasury zero-coupon bonds
Financial institutions and government securities brokers and dealers create STRIPS from T-notes and T-bonds
STRIPS have the periodic interest payments separated from each other and from the principal payment one set of securities reflects interest payments one set of securities reflects principal payments
STRIPS are used to immunize against interest rate risk
6-12
Accrued Interest and PricesAccrued Interest and Prices
Accrued interest must be paid by the buyer of a bond to the seller of a bond if the bond is purchased between interest payment dates.
The price of the bond with accrued interest is called the full price or the dirty price, the price without accounting for accrued interest is the clean price.
Accrued interest must be paid by the buyer of a bond to the seller of a bond if the bond is purchased between interest payment dates.
The price of the bond with accrued interest is called the full price or the dirty price, the price without accounting for accrued interest is the clean price.
6-13
Accrued Interest and PricesAccrued Interest and Prices
“Clean” prices are calculated as:
Vb = the present value of the bond
M = the par value of the bond
INT = annual interest payment (in dollars)
N = the number of years until the bond matures
m = the number of times per year interest is paid
id = interest rate used to discount cash flows on the bond
“Clean” prices are calculated as:
Vb = the present value of the bond
M = the par value of the bond
INT = annual interest payment (in dollars)
N = the number of years until the bond matures
m = the number of times per year interest is paid
id = interest rate used to discount cash flows on the bond
)()( ,/,/ NmmidNmmidb PVIFMPVIFAm
INTV
6-14
Accrued Interest on BondsAccrued Interest on Bonds
Accrued interest on T-notes and T-bonds is calculated as:
The full (or dirty) price of a T-note or T-bond is the sum of the clean price (Vb) and the accrued interest
Accrued interest on T-notes and T-bonds is calculated as:
The full (or dirty) price of a T-note or T-bond is the sum of the clean price (Vb) and the accrued interest
periodcoupon in days ofnumber Actual
paymentcoupon last since days ofnumber Actual
2 interest Accrued INT
6-15
Accrued Interest ExampleAccrued Interest Example
You buy a 6% coupon $1,000 par T-bond 59 days after the last coupon payment. Settlement occurs in two days. You become the owner 61 days after the last coupon payment (59+2), and there are 121 days remaining until the next coupon payment. The bond’s clean price quote is 120:19. What is the full or dirty price (sometimes called the invoice price)?
The clean price is 120:19 or 120 19/32% of $1,000 or $1,205.9375.
Thus, the dirty price is $1,205.9375 + $10.05 = $1,215.9875.
You buy a 6% coupon $1,000 par T-bond 59 days after the last coupon payment. Settlement occurs in two days. You become the owner 61 days after the last coupon payment (59+2), and there are 121 days remaining until the next coupon payment. The bond’s clean price quote is 120:19. What is the full or dirty price (sometimes called the invoice price)?
The clean price is 120:19 or 120 19/32% of $1,000 or $1,205.9375.
Thus, the dirty price is $1,205.9375 + $10.05 = $1,215.9875.
05.10$)61121(
61
2
60$InterestAccrued
6-16
Notes and Bonds MarketsNotes and Bonds Markets
The primary market of T-notes and T-bonds is similar to that of T-bills; the U.S. Treasury sells T-notes and T-bonds through competitive and noncompetitive single-bid auctions 2-year notes are auctioned monthly 3-, 5-, and 10-year notes are auctioned quarterly (Feb,
May, Aug, and Nov) 30-year bonds are auctioned semi-annually (Feb and Aug)
Most secondary trading occurs directly through brokers and dealers
The primary market of T-notes and T-bonds is similar to that of T-bills; the U.S. Treasury sells T-notes and T-bonds through competitive and noncompetitive single-bid auctions 2-year notes are auctioned monthly 3-, 5-, and 10-year notes are auctioned quarterly (Feb,
May, Aug, and Nov) 30-year bonds are auctioned semi-annually (Feb and Aug)
Most secondary trading occurs directly through brokers and dealers
6-17
Municipal BondsMunicipal Bonds
Municipal bonds (Munis) are securities issued by state and local governments to fund imbalances between expenditures and receipts to finance long-term capital outlays
Attractive to household investors because interest is exempt from federal and most local income taxes
General obligation (GO) bonds are backed by the full faith and credit of the issuing municipality
Revenue bonds are sold to finance specific revenue generating projects
Municipal bonds (Munis) are securities issued by state and local governments to fund imbalances between expenditures and receipts to finance long-term capital outlays
Attractive to household investors because interest is exempt from federal and most local income taxes
General obligation (GO) bonds are backed by the full faith and credit of the issuing municipality
Revenue bonds are sold to finance specific revenue generating projects
6-18
Municipal BondsMunicipal Bonds
Compare Muni returns with fully taxable corporate bonds by finding the after tax return for corporate bonds: ia = ib(1 – t)
ia = after-tax rate of return on a taxable corporate bond
ib = before-tax rate of return on a taxable bondt = marginal total income tax rate of the bond holder
Alternately, convert Muni interest rates to tax equivalent rates of return: ib = ia/(1 – t)
Compare Muni returns with fully taxable corporate bonds by finding the after tax return for corporate bonds: ia = ib(1 – t)
ia = after-tax rate of return on a taxable corporate bond
ib = before-tax rate of return on a taxable bondt = marginal total income tax rate of the bond holder
Alternately, convert Muni interest rates to tax equivalent rates of return: ib = ia/(1 – t)
6-19
Municipal Bond Rates & TaxesMunicipal Bond Rates & Taxes
For a 28% tax bracket, what is the equivalent after tax rate of a 6% corporate yield? ia = 6%(1- 0.28) = 4.32%
For a 28% tax bracket, what corporate taxable yield is equivalent to a 4.5% muni bond rate? ib = 4.5% / (1-0.28) = 6.25%
For a 28% tax bracket, what is the equivalent after tax rate of a 6% corporate yield? ia = 6%(1- 0.28) = 4.32%
For a 28% tax bracket, what corporate taxable yield is equivalent to a 4.5% muni bond rate? ib = 4.5% / (1-0.28) = 6.25%
6-20
Municipal BondsMunicipal Bonds
Primary markets firm commitment underwriting: a public offering of Munis made
through an investment bank, where the investment bank guarantees a price for the newly issued bonds by buying the entire issue and then reselling it to the public
best efforts offering: a public offering in which the investment bank does not guarantee a firm price
private placement: bonds are sold on a semi-private basis to qualified investors (generally FIs)
Secondary markets: Munis trade infrequently due mainly to a lack of information on bond issuers
Primary markets firm commitment underwriting: a public offering of Munis made
through an investment bank, where the investment bank guarantees a price for the newly issued bonds by buying the entire issue and then reselling it to the public
best efforts offering: a public offering in which the investment bank does not guarantee a firm price
private placement: bonds are sold on a semi-private basis to qualified investors (generally FIs)
Secondary markets: Munis trade infrequently due mainly to a lack of information on bond issuers
6-21
Corporate BondsCorporate Bonds
Corporate bonds are long-term bonds issued by corporations
A bond indenture is the legal contract that specifies the rights and obligations of the issuer and the holders
Bearer versus registered bonds Term versus serial bonds Mortgage bonds are secured debt issues
Corporate bonds are long-term bonds issued by corporations
A bond indenture is the legal contract that specifies the rights and obligations of the issuer and the holders
Bearer versus registered bonds Term versus serial bonds Mortgage bonds are secured debt issues
6-22
Corporate BondsCorporate Bonds
Debentures and subordinated debentures Convertible bonds versus non-convertible bonds
icvb = rate of return on a convertible bond
incvb = rate of return on a nonconvertible bond
opcvb = value of the conversion option
Stock warrants give bondholders the opportunity to purchase common stock at a prespecified price
Debentures and subordinated debentures Convertible bonds versus non-convertible bonds
icvb = rate of return on a convertible bond
incvb = rate of return on a nonconvertible bond
opcvb = value of the conversion option
Stock warrants give bondholders the opportunity to purchase common stock at a prespecified price
cvbncvbcvb opii
6-23
Corporate BondsCorporate Bonds
Callable bonds versus non-callable bonds
incb = rate of return on a noncallable bond
icb = rate of return on a callable bond
opcb = value of the call option
A sinking fund provision is a requirement that the issuer retire a certain amount of the bond issue early as the bonds approach maturity
Callable bonds versus non-callable bonds
incb = rate of return on a noncallable bond
icb = rate of return on a callable bond
opcb = value of the call option
A sinking fund provision is a requirement that the issuer retire a certain amount of the bond issue early as the bonds approach maturity
cvbcbncb opii
6-24
Corporate BondsCorporate Bonds
Primary markets are identical to that of Munis Secondary markets
the exchange market (e.g., bond division of the NYSE) the over-the-counter (OTC) market
Bond ratings the three major bond rating agencies are Moody’s,
Standard & Poor’s (S&P), and Fitch bonds are rated by perceived default risk bonds may be either investment or speculative (i.e.,
junk) grade
Primary markets are identical to that of Munis Secondary markets
the exchange market (e.g., bond division of the NYSE) the over-the-counter (OTC) market
Bond ratings the three major bond rating agencies are Moody’s,
Standard & Poor’s (S&P), and Fitch bonds are rated by perceived default risk bonds may be either investment or speculative (i.e.,
junk) grade
6-25
Bond Credit RatingsBond Credit Ratings
Bond Credit Ratings (Source: Text Table 6-10) Explanation Moody’s S&P Best quality; smallest degree of risk Aaa AAA
High quality; slightly more long-term risk than top rating Aa1 AA+ Aa2 AA Aa3 AA-
Upper medium grade; possible impairment in the future A1 A+ A2 A A3 A-
Medium grade; lacks outstanding investment characteristics Baa1 BBB+ Baa2 BBB Baa3 BBB-
Speculative issues; protection may be very moderate Ba1 BB+ Ba2 BB Ba3 BB-
Very speculative; may have small assurance of interest and principal payments
B1 B+ B2 B B3 B-
Issues in poor standing; may be in default Caa CCC Speculative in a high degree; with marked shortcomings Ca CC Lowest quality; poor prospects of attaining real investment standing
C C D
6-26
Bond Yield SpreadsBond Yield Spreads
6-27
Corporate Bond QuotesCorporate Bond Quotes
Issuer name, ticker symbol and coupon Maturity month and year Bond rating by the three major ratings agencies High, Low, and Last prices in decimal form as a percent of par
Daily high price was $1,084.80 Change is the change from the prior day’s last price Yield % is the promised yield to maturity using the last price
Issuer name, ticker symbol and coupon Maturity month and year Bond rating by the three major ratings agencies High, Low, and Last prices in decimal form as a percent of par
Daily high price was $1,084.80 Change is the change from the prior day’s last price Yield % is the promised yield to maturity using the last price
Issuer Name Symbol Coupon Maturity
Moody’s/S&P/ Fitch High Low Last Change
Yield %
Citigroup C.HVK 6.000% Dec 2013 A3/--/A+ 108.480 106.922 107.606 0.466 3.598
6-28
Bond Market IndexesBond 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 bond 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 bond indexes can be used by
bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities
6-29
Bond Market ParticipantsBond 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, and mutual funds) are the major suppliers of funds for Munis and corporate bonds
Foreign investors and governments are the major suppliers of funds for T-notes and T-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, and mutual funds) are the major suppliers of funds for Munis and corporate bonds
Foreign investors and governments are the major suppliers of funds for T-notes and T-bonds
6-30
International Bonds and MarketsInternational Bonds and Markets
International bond markets involve unregistered bonds that are internationally syndicated, offered simultaneously to investors in several countries, and issued outside of the jurisdiction of any single country
Eurobonds are long-term bonds issued outside the country of the currency in which they are denominated
Foreign Bonds are long-term bonds issued outside of the issuer’s home country
Sovereign Bonds are government issued debt
International bond markets involve unregistered bonds that are internationally syndicated, offered simultaneously to investors in several countries, and issued outside of the jurisdiction of any single country
Eurobonds are long-term bonds issued outside the country of the currency in which they are denominated
Foreign Bonds are long-term bonds issued outside of the issuer’s home country
Sovereign Bonds are government issued debt