Financial Markets and InstitutionLecture 6 The Bond Market

Learning Objectives To look at how business firms issue debt securities and negotiate loans in order to raise funds in the money and capital markets.To review the innovation in Treasury notes and bills. To discuss the characteristics and types of corporate bonds.To compute the current yield and the value of coupon bond. 19-*

IntroductionBusiness firms draw on a wide variety of fund sources to finance their daily operations and to carry out long-term investment.In 2006, nonfinancial business firms in the U.S. raised nearly $1.9 trillion, of which approximately $516 billion was supplied from the financial markets through issues of bonds, stocks, notes, and other financial instruments.19-*

Purpose of the Capital MarketOriginal maturity is greater than one year, typically for long-term financing or investments.Use of capital market securities to reduce the interest rate risk. Best known capital market securities:Stocks and bonds

Capital Market ParticipantsPrimary issuers of securities:Federal and local governments: debt issuersCorporations: equity and debt issuersLargest purchasers of securities:You and me

Capital Market TradingPrimary market for initial sale (IPO)Subsequent sale (primary market transaction)Secondary marketOver-the-counterOrganized exchanges (i.e., KLSE) Listed bond bursa Malaysia Unlisted bond OTC facilitated by BNM via FAST system.

Background on BondsLong term debt securities (10 30 years) issued by treasury, federal agencies and corporations.Bonds are securities that represent debt owed by the issuer to the investor, and typically have specified payments on specific dates.The issuer is obligated to pay coupon (or interest) payments periodically and the par value (or principal) at maturity. Malaysia bond market size: $282.3 billion.

Types of BondsLong-term government bondTreasury bondsAgency bondsMunicipal bondsCorporate bonds.

Types of Bonds: Sample Corporate Bond

Treasury Notes and BondsThe U.S. Treasury issues notes and bonds to finance its operations (finance national debts).The following table summarizes the maturity differences among the various Treasury securities.

No default risk low interest rate (risk-free rate)

Treasury Bond Interest Rates

Treasury Bond Interest Rates: Bills vs. Bonds

Treasury Bonds: Recent InnovationTreasury Inflation-Indexed Securities (TIPS): the principal amount is tied to the current rate of inflation to protect investor purchasing powerTreasury STRIPS: the coupon and principal payments are stripped from a T-Bond and sold as individual zero-coupon bonds.

TIPS: interest rate does not change but principal amount change based on the consumer price index. At maturity, the securities are redeemed at the greater of their inflation-adjusted principal (par value). Normally used by retirees. Value wont be eroded by inflation rate.

STRIPS: separate the interest payment and principal payment becomes a separate 0-coupon security. Create interest only or principal only bonds.

Treasury Bonds: Agency DebtAlthough not technically Treasury securities, agency bonds are issued by government-sponsored enterprises (federal agencies). The debt has an implicit guarantee that the U.S. government will not let the debt default. This guarantee was clear during the 2008 bailout (the case of Fannie Mae and Freddie Mac).

The default risk for agency bond is low:Secured by loans that are made with the funds raised by the bond sales. May use agencies credit line with treasury department to meet obligation. Fed would not let it fail. It will bailout those fed agencies.

The 20072009 Financial Crisis:Bailout of Fannie and FreddieBoth Fannie and Freddie managed their political situation effectively (through lobbying), allowing them to engage in risky activities, despite concerns raised.By 2008, the two had purchased or guaranteed over $5 trillion in mortgages or mortgage-backed securities.

The 20072009 Financial Crisis:Bailout of Fannie and FreddiePart of this growth was driven by their Congressional mission to support affordable housing. They did this by purchasing subprime mortgages.As these mortgages defaults, large losses mounted for both agencies.Both agencies also have their capital ratio far lower than the commercial banks.

1. Fannie and Freddic have a mission to promote affordable housing. The best way to help is buying subprime mortgage. 2. But with a weak regulator, they over guarantee over $5 trillion mortgages or mortgage-backed securities. When subprime mortgage default (due to the property sector bubble which cause property price drops tremendously), investors pull out their money from both agencies. Gov cant let it fail as it would have disastrous effect on the availability of mortgage credit. So they provides $200 billion to bailout. Then gov took over and have their regulator oversee their day-to-day operations.

Malaysia Government-Related BondsKhazanah bond: zero-coupon bond, based on Islamic principleCagamas bond: issued by national mortgage corporation, mainly use to finance the purchase of housing loan.

Municipal BondsIssued by local, county, and state governmentsUsed to finance public interest projects at the local level (e.g. school, utilities, transportation system). Tax-free municipal interest rate (ETFR)= taxable interest rate (1marginal tax rate)

Municipal Bonds: ExampleSuppose the rate on a corporate bond is 9% and the rate on a municipal bond is 6.75%. Which should you choose?Answer: Find the marginal tax rate:6.75% = 9% (1 MTR), or MTR = 25%If you are in a marginal tax rate above 25%, the municipal bond offers a higher after-tax cash flow.

Municipal Bonds: ExampleSuppose the rate on a corporate bond is 9% and the rate on a municipal bond is 6.75%. Which should you choose? Your marginal tax rate is 28%.OR Answer: Find the equivalent tax-free rate:ETFR = 9% (1 MTR) = 9% (1 0.28)The ETFR = 6.48%. If the actual muni-rate is above this (it is), choose the muni. ETFR = equivalent tax free rate

Municipal BondsTwo typesGeneral obligation bonds backed by the full faith and credit.Revenue bonds backed by cash flow of a particular revenue-generating project. NOT default-free Local government cannot print money & limited taxes raising.Defaults in 1983 amounted to $225 billion in this market.Liquidity risk

Municipal Bonds: Comparing Revenue and General Obligation Bonds

Corporate BondsTypically have a face value of $1,000, although some have a face value of $5,000 or $10,000Pay interest semi-annually or annually.Cannot be redeemed anytime the issuer wishes, unless a specific clause states this (call option).Degree of risk varies with each bond. Hence, the required interest rate varies with level of risk.

Corporate Bonds: Interest Rates on various bonds from 19732009.

Corporate Bonds: Characteristics of Corporate BondsRegistered BondsReplaced bearer bondsIRS can track interest income this wayRestrictive CovenantsMitigates conflicts with shareholder interestsMay limit dividends, new debt, involvement in M&A, etc.Usually includes a cross-default clause

Corporate Bonds: Characteristics of Corporate BondsCall Provisions Higher yield (call price set at a price higher or equal to par value)Its flexibility promotes the use of callable bonds.Sinking fund Conversion Some debt may be converted to equityPrice of stock must raise substantially. Issue convertible bonds better than issue stock due to asymmetric information.

Corporate Bonds: Characteristics of Corporate BondsSecured Bonds: with collateral attached. Mortgage bonds building as a collateralEquipment trust certificates heavy equipment or airplanes as a collateralUnsecured BondsDebentures backed only by general creditworthiness of issuer. Subordinated debentures lower priority claim than debentures. Variable-rate bonds interest rate tied to other market interest rate

Corporate Bonds: Characteristics of Corporate BondsJunk BondsDebt that is rated below BBBOften, trusts and insurance companies are not permitted to invest in junk debtMichael Milken developed this market in the mid-1980s, although he was subsequently convicted of insider trading

Corporate Bonds: Debt Ratings (a)12-* 2012 Pearson Prentice Hall. All rights reserved.

Corporate Bonds: Debt Ratings (b)12-* 2012 Pearson Prentice Hall. All rights reserved.

Debt Rating in Malaysia There are 2 agencies provide independent opinion on credit risks and potential default risks:Rating Agencies Malaysia (RAM)Malaysian Rating Corporation (MARC)

Financial Guarantees for BondsSome debt issuers purchase financial guarantees to lower the risk of their debt.The guarantee provides for timely payment of interest and principal, and are usually backed by large insurance companies.Malaysia: Danajamin Nasional

Bond Current Yield CalculationWhat is the current yield for a bond with a face value of $1,000, a current price of $921.01, and a coupon rate of 10.95%?Answer:ic = C / P = $109.50 / $921.01 = 11.89%Note: C ( coupon) = 10.95% $1,000 = $109.50

Finding the Value of Coupon BondsBond pricing is, in theory, no different than pricing any set of known cash flows. Once the cash flows have been identified, they should be discounted to time zero at an appropriate discount rate.The table on the next slide outlines some of the terminology unique to debt, which may be necessary to understand to determine the cash flows.

Finding the Value of Coupon Bonds

Finding the Value of Coupon BondsLets use a simple example to illustrate the bond pricing idea.What is the price of two-year, 10% coupon bond (semi-annual coupon payments) with a face value of $1,000 and a required rate of 12%?

Finding the Value of Coupon BondsSolution:Identify the cash flows:$50 is received every six months in interest$1000 is received in two years as principal repaymentFind the present value of the cash flows (calculator solution):N = 4, FV = 1000, PMT = 50, I = 6Computer the PV. PV = 965.35

What is the current yield?

Investing in BondsBonds are the most popular alternative to stocks for long-term investing.Even though the bonds of a corporation are less risky than its equity, investors still have risk: price risk and interest rate risk.

Investing in BondsThe next slide shows the amount of bonds and stock issued from 1983 to 2009.Note how much larger the market for new debt is. Even in the late 1990s, which were boom years for new equity issuances, new debt issuances still outpaced equity by over 5:1.

Investing in Bonds

Tutorial QuestionMishkin & Eakins. 2012. Financial Markets and Institutions, 7th ed. Pearson.Quantitative problem - Questions 1, 2, 3, 4, 9, 11 - (Chapter 12 pg. 340-341) Quantitative Problems 1,2,3,8,10,15

1.Government cannot sell ownership claims.2. Malaysia: BNM will help to issue government bond via competitive auction. Successful bidders are determined according to the lowest yield offered. *Listed bond bursa Malaysia Unlisted bond OTC facilitated by BNM via FAST system. *T-bill mature in 1 yr / lessNotes 1 -10 years Bonds more than 10 yrsMalaysia: Malaysian government securities, sukuk bond (Islamic bond), merdeka savings bond (for retirees),

*Most of the time, the interest rate on T-bond higher than inflation rate. Sometimes, its lower and hence purchasing power has been eroded. *Most of the years, return for ST bills is lower than LT bond. Interest rate on ST bill is more fluctuated as compared to LT bonds. *TIPS: interest rate does not change but principal amount change based on the consumer price index. At maturity, the securities are redeemed at the greater of their inflation-adjusted principal (par value). Normally used by retirees. Value wont be eroded by inflation rate.

STRIPS: separate the interest payment and principal payment becomes a separate 0-coupon security. Create interest only or principal only bonds.

*The default risk for agency bond is low:Secured by loans that are made with the funds raised by the bond sales. May use agencies credit line with treasury department to meet obligation. Fed would not let it fail. It will bailout those fed agencies. *1. Fannie and Freddic have a mission to promote affordable housing. The best way to help is buying subprime mortgage. 2. But with a weak regulator, they over guarantee over $5 trillion mortgages or mortgage-backed securities. *When subprime mortgage default (due to the property sector bubble which cause property price drops tremendously), investors pull out their money from both agencies. Gov cant let it fail as it would have disastrous effect on the availability of mortgage credit. So they provides $200 billion to bailout. Then gov took over and have their regulator oversee their day-to-day operations.

*ETFR = equivalent tax free rate *Revenue bond supported by the revenue from tollway, toll bridge, state college dormitory. Normally, pay semiannual interest payment. *Note that general obligation bonds represent a higher percentage in the latter part of the sample.

*Any bonds rated below BBB are considered sub-investment grade debt.

*IRS = internal revenue serviceRestrictive covenants protect the bondholders as they do not have voting rights on most of the matters.Limit the amount of dividend can be paid to shareholders & additional debt raising. Deemed to be a safe bond with this restrictive covenant lower interest rate earned.

*Call the bond due to:Interest rate fall enough to make the market price higher than the call priceHave to retire the bond if the covenant restrict the firm from some activities. Call the bond if want to change the capital structure. *Floating rate bond interest rate adjusted to the level of money market interest (KLIBOR). Provide protection against rising interest rate. Adjust quarterly, semiannually or annually. *FGI undertake to pay interest and face value when the issuers defaults. Hence, the issuers need to pay a premium upfront. From sub-investment grade to investment grade by purchasing this FG.*