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Chapter 8
Bond Markets
Functions of the Capital Markets
• Economic purpose - brings together long-term
(over 1 year) borrowers and investors.
• Capital goods such as planets and equipment's
to produce products to earn profits.
• These are core activities for a firm
• They are usually long term needs.
• Capital assets are not highly marketable
• So firms will finance these needs with longterm debt or equity.
• The cost of these long term financing means is
known for the life of the asset
• Less refinancing problems
• Long terms rates are higher
Capital Market Participants
• 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.
Capital Market Participants
Size of Capital Markets
• They are massive in scope ($50 trillion)
Capital Markets Instruments
1. U.S Government and Agency Securities
2. State and local Government bonds
3. Corporate bonds
U.S Government and Agency
Securities
A. U.S Treasury Notes and Bonds
1. Coupon issues ( they pay semiannual interest)
2. Treasury Notes - one to ten-year maturity.
3. Treasury Bonds - over ten-year maturity.
4. Sold in auction by the Treasury Department.
5. Trend is toward more short-term market
financing and less long-term financing.
U.S Government and Agency
Securities
B. Inflation-Indexed Notes and Bonds (TIPS)
1. Principal amount on which the coupon payments are
based ,adjusts for inflation
2. Adjustment takes place before coupon payments
3. If inflation increases by 1%, the principle amount for
the coupon payment is adjusted upward by 1%
4. Fixed coupon rate determined by auction process
5. Minimum denomination is $1,000.
6. Sold three times a year
U.S Government and Agency
Securities
C. Separate Trading of Registered Interest and
Principal (STRIP).
• 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.
• Dealers engage in creating STRIPs created
because investors value zero-coupon default
risk-free securities and are willing to pay
more for STRIPs than underlying bonds.
U.S Government and Agency
Securities
C. Separate Trading of Registered Interest and
Principal (STRIP).
- Using STRIPS to Hedge against Interest Rate Risk:
- Similar to matching duration to portfolio maturity.
- If we have a holding period of 5 years and we buy
a STRIP that matures in 5 years, we are assured to
receiving the face amount of the STRIP in 5 years.
U.S Government and Agency
Securities
D. Government Agency Securities
- Federal agency is an independent federal department
or corporation established by Congress and owned or
written by the U.S government.
- Selected government lending programs
- Initially designed to attract private capital to sectors of
the economy where credit flows were insufficient.
- Recently: social and economic goals, and to promote
resource utilization
State and local Government
bonds
- Often called municipals bonds
- Issues of state governments, political
subdivisions.
- One of the largest fixed income securities
market
- Special feature: number of issuers is very large
State and local Government
bonds
• The Type and Use of Municipal Bonds
a.
General obligation bonds:
- backed by full faith and credit (power of tax) of
the issuing political entity.
- There are no assets pledged in the event of
default
- Full faith: in the event of default, court will require
city to increase tax to pay defaulted coupon.
State and local Government
bonds
• The Type and Use of Municipal Bonds
a. General obligation bonds:
- Creditworthiness of these bonds depends on the
income levels of households and financial strength of
businesses.
- Issued to provide basic services to communities:
education, health care, etc.
State and local Government
bonds
• The Type and Use of Municipal Bonds
b. Revenue bonds:
- Sold to finance a specific revenue-producing
project
- In the event of default, only revenues generated
from that particular project backs these bonds.
- Depending on the type of projects, these bonds
might be riskers than the general obligation
bonds.
State and local Government
bonds
• The Type and Use of Municipal Bonds
b. Revenue bonds:
i.
Industrial Development Bonds (IDBs): a
controversial use of revenue bonds.
-
Used after the Great Depression
Assumes no legal liability in the event of default
Lower borrowing cost
Only a limited amount is sold because it abuses the tax
exempt interest privilege
State and local Government
bonds
• The Type and Use of Municipal Bonds
b. Revenue bonds:
ii. Mortgage backed bonds: issued by city housing
authorities based on mortgage pools generated under
their powers.
- another area of abuse in the tax exempt market.
- Because it is tax exempt, the borrower can make low
interest mortgage loans.
- Congress intend to use these bonds to low and
moderate income people.
- Now, It has a restricted use.
State and local Government
bonds
• The Characteristics of Municipal Bonds
- Minimum denomination of $5,000
- Sold a serial bond issues: contains a range of
maturities instead of all the bonds in the issue
having the same maturity.
- Coupon rates are assigned in accordance with
the term structure.
State and local Government
bonds
• The Tax- Exempt Feature
- The special feature of municipal bonds is that
coupon payments are tax-exempt from federal
income tax.
- This lowers the cost of the borrowing because
they accept a lower pretax yield compared to
taxable securities.
State and local Government
bonds
• Investors in Municipal Bonds
- It concentrated on three investor groups:
1. Commercial Bank
2. Property and Casualty Insurance
3. High Income Individuals
State and local Government
bonds
• After Tax Yield Comparison
- An investor should compare between between
similar taxable and tax exempt securities to
see which option has the highest after tax
yield
- ia = iab (1-t)
- similar: same default risk, marketability, maturity.
State and local Government
bonds
• The Market For Municipal Bonds
- Primary Market:
1.
2.
3.
4.
5.
Large number of relatively small bond issue.
Written by small regional underwriter
Issues of well-known governmental units are sold in a
national market
The reason of the existence of local markets: High cost of
gathering information
Sold at a competitive bid
State and local Government
bonds
• The Market For Municipal Bonds
- Secondary Market:
1.
2.
3.
4.
5.
6.
Very thin market
Over the counter market
Small local issues are traded infrequently
Dealers find it difficult to match buyers and sellers
Limited marketability
Municipal bonds have higher yields than one
might otherwise expect.
Corporate Bonds
• “ Debt contracts requiring borrowers to make
periodic payments of interest and to repay
principle at the maturity date”
Bearer bonds: bonds with attached coupons the
holder presents for payment when due.
Registered bonds: owner is recorded and
payment is mailed to the owner.
Corporate Bonds
• Term bonds: all of the bonds that comprise a
particular issue mature on a single date.
- characteristics:
1.
2.
3.
4.
5.
Issued in domination of $1,000
Coupon-paying bonds
Pay interest semiannually
Coupon payments are taxable
Sold in domestic bond market or in Eurobond
market
Corporate Bonds
• Corporate bonds have an indenture or bond contract.
• Indenture: the legal contract that states the rights,
privilege, and obligations of the bond issuer and the
bondholder.
• It is overseen by a trustee (trust department) who is
appointed as the bondholder's representative.
• It specifies the security or the asset to which bondholders
have prior claim in the event of default. i.e. land,
equipment, rolling stock. It has lower yields.
• Debenture bond: no assets are pledged, the bond is only
secured by the firm potential to generate cash flows.
Corporate Bonds
• Debenture senior debt: gives the bondholder’s
first priority to the firm’s assets in the event of
default.
• Subordinated (junior) debt: bondholder's
claims to the company’s asset rank behind
senior debt.
Corporate Bonds
• Corporate bonds have a sinking fund provision
• Sinking fund: it requires that the bond issuers
provide funds to a trustee to retire a specific dollar
amount (face amount) of bonds each year.
• The trustee may retire the bond by:
1. Purchasing them in the open market
2. Calling them ( if call provision is present)
Corporate Bonds
• A bond with a sinking fund provision: the
issuer must retire a portion of the bond as
promised in the indenture.
• While the call provision gives the right (option)
to retire the bond before maturity.
Corporate Bonds
• Investopedia explanation:
• Rather than the issuer repaying the entire principal of a bond issue on
the maturity date, another company buys back a portion of the issue
annually and usually at a fixed par value or at the current market value of
the bonds, whichever is less. Should interest rates decline following a
bond issue, sinking-fund provisions allow a firm to lessen the interest
rate risk of its bonds as it essentially replaces a portion of existing debt
with lower-yielding bonds.
From the investor's point of view, a sinking fund adds safety to a
corporate bond issue: with it, the issuing company is less likely to default
on the repayment of the remaining principal upon maturity since the
amount of the final repayment is substantially less. This added safety
affects the interest rate at which the company is able to offer bonds in
the marketplace.
Corporate Bonds
• Convertible bonds: bonds that can be
converted into shares of common stock at the
discretion of bondholders
- An attractive feature to bondholder
- have lower yields
- Usually include a call provision
Corporate Bonds
• Investors in Corporate Bonds
1.
Life Insurance
2. Pension funds
For the following reasons:
a.
Stability of cash flows
b. Long-term nature of insurance and pension funds
c.
Both are in low marginal tax brackets
d. They are required to by low to invest in investment-grade
bonds.
3. Households
4. Foreign investors
• The Primary Market For Corporate Bonds
New Corporate Bonds are
issued by
Public Sale
The bond issue is offered publicly
in the open market to all
interested buyers.
Private
Placement
The bond are sold privately to a
limited number of investors.
• The Primary Market For Corporate Bonds
• Private sale:
1.
Usually through an investment banking firm
2.
The investment banking firms underwrites (purchase
them from issuer at a fixed price and resell them to
investors and institutions)
3.
Investment banker purchase bonds by:
a.
b.
Competitive sale: a Public auction, does not provide advisory services.
A negotiated sale: a contractual arrangement between the underwriter and
issuer whereby the underwriter obtain exclusive rights to underwrite,
distribute and originate. Provides advisory services.
• The Primary Market For Corporate Bonds
• Private Placements:
1. It does not require Publicly sold securities to be
registered with the Securities and Exchange
Commission (SEC).
2.
sold only to a small number (less than 35) large,
financially sophisticated investors.
3.
currently, the trend is toward private
placements rather than publics sales.
• The Primary Market For Corporate Bonds
• Number of private sales and public offerings is
sensitive to the business cycle:
Low interest rates or stable
market periods:
High interest rates or
unstable market periods:
-
-
-
Small companies with
low credit quality
Obtain financing via
public sale.
-
Small companies with
low credit quality
Sell debts privately
• The Secondary Market For Corporate Bonds
-
Most secondary trading of corporate bonds occurs through dealers.
-
It is a thin (trade is infrequent) market when compared to the markets
for money market securities or corporate stock.
-
As a result, bid-ask spread is high. It compensates the dealer for holding
illiquid risky securities.
-
Corporate bonds are less marketable for these two reasons:
a.
b.
Special features ( call provision, sinking funds), make them difficult to value.
Long term securities.
- If you want to sell or buy a corporate bond, you should call a broker who
will contact a broker to provide quotes.
Corporate Bonds
• Junk Bonds:
-
“ Corporate bonds with high default risk”
-
There were not common in the primary markets in the 1970s and
1980s.
-
They were bonds that were originally issued at a low investment
grade (Baa/BBB) and downgraded afterwards.
-
They were issued in the primary market after the innovative
marketing of Drexel Burnham Lambert.
-
It promised investors that they would act as dealers for junk
bonds in the secondary market. ( meaning, Drexel Burnham
Lambert will buy bonds back.)
Corporate Bonds
• Junk Bonds:
-
The supply of junk bonds was part of the disintermediation trend.
-
Disintermediation: the process by which firms raise capital in the
direct financial markets rather than from financial intermediaries.
-
High-quality firms were able to borrow cheaply in the commercial
paper market rather than loans from commercial banks.
-
Low quality firms with speculative credit rating were able to issue
marketable debt as well. (previously, they relied on short-term
bank loans)
Corporate Bonds
• Junk Bonds:
Demand for junk bonds: from insurance companies, pension
funds, savings and loans associations, and mutual funds.
• They were attractive because:
1.
2.
Junk bonds used to outperform (generate better returns)
high-rated and Treasury securities)
In the 1980s, number of defaults was fewer than expected.
However,
1. Number of defaults increased later on.
2. Reducing capital of many financial institutions
3. Causing thrift crisis
4. And failure of several major life insurance.
Corporate Bonds
• Junk Bonds:
- Many critics blamed junk bonds for:
1. Merger mania of the 1980s.
2. Overall rise in the corporate leverage
3. Increase in the volatility of the financial
markets in the 1980s.
And that called for law to limit corporate use of
junk bonds.
End of Chapter 8