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Chapter Six
Bond Markets
McGraw-Hill /Irwin
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Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
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
• Bonds carry original maturities greater than
one year so bonds are instruments of the
capital markets
• Issuers are corporations and government units
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Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
Bond Market Instruments
Outstanding, 1994-2001 ($Bn)
10000
8000
6000
4000
2000
0
1994
Treas. bonds
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1997
2000
Muni. securities
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2001
Corp. bonds
Total
Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
Types of Treasury Instruments
•
•
•
•
T-Bills
T-Notes
T-Bonds
Strips
Maturity < 1 Year
Maturity 1 to 10 Years
Maturity 10 to 30 Years
Other Agency Bonds
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Composition of the U.S. National Debt ($Bn)
3000
2500
2000
1500
1000
500
0
1994
T-bills
U.S. savings securities
Other
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1997
2000
T-notes
Foreign series
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2001
T-bonds
Govt. acc. sec.
Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
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
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Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
Tax Exemption and Muni Yields
ia = ib(1 - t)
Where:
ia = After-tax (equivalent tax exempt) rate of return on a taxable
bond
ib = Before-tax rate of return on a taxable bond
t = Income tax rate of the marginal bond holder
Example: You can invest in taxable corporate bonds that are paying
10% annually on munis. Your marginal tax rate is 28%. The aftertax rate of return on the taxable bond is:
10%(1-.28) = 7.2%
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Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
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
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Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
Top Municipal Bond Underwriters
Underwriter
Principal Amount
(in millions $$)
Salomon Smith Barney
UBS Paine Webber
Merrill Lynch
Morgan Stanley
Bear, Stearns
Lehman Brothers
Goldman Sachs
J.P. Morgan Securities
Dresdner Kleinwort Benson
Banc of America Securities
Industry totals
McGraw-Hill /Irwin
$40,049.0
33,587.2
23,902.5
19,811.4
17,513.5
16,978.4
16,854.5
10,298.5
6,720.4
6,390.6
Market
Share
12.1%
10.1%
7.2%
6.0%
15.3%
5.1%
5.1%
3.1%
2.0%
1.9%
No. of
Issues
610
667
273
316
177
231
198
131
12
311
$342 billion
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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
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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
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(continued)
Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
Types of Corporate Bonds
• Mortgage bonds
– issued to finance specific projects which are pledged as
collateral
• Equipment Trust Certificates
– bonds collateralized with tangible non-real estate property
• 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)
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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 bonds
– bonds that include a requirement that the issuer retire a certain
amount of the bond issue each year
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Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
Bond Credit Ratings
Explanation
Moody’s
Investment grade categories:
Best quality; smallest degree of risk
Aaa
High quality; slightly more long-term
Aa1
risk than top rating
Aa2
Aa3
Upper medium grade; possible
A1
impairment in the future
A2
A3
Medium grade; lack outstanding
Baa1
investment characteristics
Baa2
Baa3
S&P
AAA
AA+
AA
AA
AAA+
ABBB+
BBB
BBB(continued)
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Bond Credit Ratings
Explanation
Moody’s
Speculative investment grades:
Speculative issues; protection may
Ba1
be very moderate
Ba2
Ba3
Very speculative; may have small
B1
assurance of interest and principle
B2
payment
B3
Issues in poor standing; may be in default
Caa
Speculative in a high degree
Ca
Lowest quality; poor prospects of attaining
C
real investment standing
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S&P
BB+
BB
BBB+
B
BCCC
CC
C
D
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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
McGraw-Hill /Irwin
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Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.