Download Bonds

Chapter 10
The Bond Markets
Chapter Preview

We examine how capital markets operate, and then
focus our attention on the bonds and the bond
market. Topics include:

Purpose of the Capital Market

Capital Market Participants

Capital Market Trading

Types of Bonds

Treasury Bonds

Municipal Bonds
2
Chapter Preview (cont.)

Corporate Bonds

Financial Guarantees for Bonds

Bond Yield Calculations

Finding the Value of Coupon Bonds

Investing in Bonds
3
10.1.1 Purpose of the Capital Market

Best known capital market securities:




Stocks
Bonds
The purpose of money market is for warehousing
funds for short term; while the purpose of capital
market is for long term investment;
Original maturity is greater than
one year, typically for long-term financing or
investments
4
10.1.2 Capital Market Participants

Primary issuers of securities:



Federal and local governments: debt issuers
Corporations: equity and debt issuers
Largest purchasers of securities:

Households-You and me
5
10.1.3 Capital Market Trading
1.
Primary market for initial public offerings
(IPO)
2.
Secondary market


Over-the-counter
Organized exchanges (i.e., NYSE)
6
10.1.4 Types of Bonds


Bonds are securities that represent debt
owed by the issuer to the investor, and
typically have specified payments on
specifies dates.
Types of bonds we will examine include longterm government bonds (T-bonds), municipal
bonds, and corporate bonds.
7
10.2 Types of Bonds:
Sample Corporate Bond
Figure 10.1 Sohio/BP Corporate Bond
8
10.2.1 Treasury Bonds

The U.S. Treasury issues notes and bonds to
finance its operations.

The following table summarizes the maturity
differences among the various Treasury
securities.
9
10.2.2 Treasury Bonds
10
10.2.3 Treasury Bond Interest Rates

No default risk since the Treasury can print
money to payoff the debt

Very low interest rates, often considered the
risk-free rate (although inflation risk is still
present)
11
10.2.4 Treasury Bond Interest Rates

The next two figures show historical
rates on Treasury bills, bonds, and the
inflation rate.
12
10.2.5 Treasury Bond Interest Rates
Figure 10.2 Interest Rate on Treasury Bonds and the Inflation Rate, 1973–2004
13
10.2.6 Treasury Bond Interest Rates:
Bills vs. Bonds
Figure 10.3 Interest Rates on Treasury Bills
and Treasury Bonds, 1973–2002 (January of each year)
14
10.2.7 Treasury Bonds:
Recent Innovation

Treasury Inflation-Indexed Securities:
the principal amount is tied to the current rate of
inflation to protect investor purchasing power

Treasury STRIPS (Separate Trading of Registered
Interest and Principal of Securities, 离拆单售债券本
息票): the coupon and principal payments are
“stripped” from a T-Bond and sold as individual zerocoupon bonds.
15
10.2.8 Treasury Bonds: Agency Debt

Congress has authorized a number of US
agencies such as GNMA, FNMA, and
FHLMC, to issue bonds.(p250)

The debt has an “implicit” guarantee that the
U.S. government will not let the debt default.
16
10.3 Municipal Bonds

Issued by local, county, and
state governments

Used to finance public interest projects

Tax-free municipal interest rate =
taxable interest rate  (1  marginal
tax rate)
17
10.3.1 Municipal Bonds: Example
Suppose 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% x (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.
18
10.3.2 Municipal Bonds

Two types (p251)



General obligation bonds (一般信用担保债券) -backed
by “the full faith and credit”of the issurers;
Revenue bonds （收益债券）-backed by the cash
flow of a particular revenue-generating project.
NOT default-free (e.g., Orange County California)

Defaults in 1990 amounted to $1.4 billion in this
market
19
10.3.3 Municipal Bonds
The next slide shows the volume of general
obligation bonds and revenue bonds issued
from 1984 through 2003.
Note that general obligation bonds represent
a higher percentage in the latter part of the
sample.
20
10.3.4 Municipal Bonds: Comparing Revenue
and General Obligation Bonds
Figure 10.4 Issuance of Revenue
and General Obligation Bonds, 1984–2003 (End of year)
21
10.4 Corporate Bonds

Typically have a face value of $1,000,
although some have a face value of $5,000
or $10,000

Pay interest semi-annually
22
10.4.1 Corporate Bonds

Cannot be redeemed (赎回) anytime the
issuer wishes, unless a specific clause states
this (call option 购买选择权).

Degree of risk varies with each bond, even
from the same issue. The required interest
rate varies with level of risk.
23
10.4.2 Corporate Bonds

The next slide shows the interest rate on
various bonds from 1973-2004.

The degree of risk ranges from low-risk (AAA)
to higher risk (BBB). Any bonds rated below
BBB are considered sub-investment grade
debt.
24
10.4.3 Corporate Bonds: Interest Rates
Figure 10.5 Corporate Bond Interest Rates, 1973–2004 (End of year)
25
10.4.4 Corporate Bonds:
Characteristics of Corporate Bonds

Registered Bonds



Replaced “bearer” bonds
IRS (Inland Revenue Service 国税局) can track
interest income this way
Restrictive Covenants 限制性契约

Mitigates conflicts with shareholder interests

May limit dividends, new debt, ratios, etc.
26
10.4.5 Corporate Bonds:
Characteristics of Corporate Bonds

Call Provisions 回购条款





The right for the issuers to force the holders to sell back.
Sinking fund
Interest of the stockholders
Higher yield for the call provision
Conversion

Some debt may be converted to equity

Similar to a stock option, but usually more limited
27
10.4.6 Corporate Bonds:
Characteristics of Corporate Bonds

Secured Bonds



Mortgage bonds
Equipment trust certificates
Unsecured Bonds



Debentures
Subordinated debentures 附属债券 –lower priority
claim
Variable-rate bonds 利率可变债券///
28
10.4.7 Corporate Bonds:
Characteristics of Corporate Bonds

Junk Bonds



Debt that is rated below BBB
Often, trusts and insurance companies are not
permitted to invest in junk debt
Michael Milken developed this market in the mid1980s, although he was convicted of insider
trading
29
10.4.8 Corporate Bonds: Debt Ratings
The next slide explains in further details the
rating scale for corporate debt. The rating
scale is for Moody’s. Both Standard and
Poor’s and Fitch have similar debt
rating scales.
30
10.4.9 Corporate Bonds: Debt Ratings
31
10.4.10 Corporate Bonds:
Debt Ratings (cont.)
32
10.4.11 Financial Guarantees for Bonds

Some 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.

Financial guarantees were developed in 1970s to
insure municipal bonds and expanded to cover
many corporate bonds as well later on.
33
10.5.1 Bond Yield Calculations

Bond yields are quoted using a variety of
conventions, depending on both the type of
issue and the market.

We will examine two bond yield calculations
commonly used for short and long-term debt.
34
10.5.2 Bond Yield Calculations:
Current Yield
What 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% x $1,000 = $109.50
35
10.5.3 Bond Yield Calculations:
Yield on a Discount Basis
What is the discount yield for a one-year
bond with a face value of $1,000, and a
current price of $875?
Answer:
idb = [ (F-P) / F ] x [ 360 / days to maturity]
= [ (1000 – 875) / 1000 ] x [360 / 365] = 12.33%
36
10.5.4 Finding the Value of Coupon
Bonds
Bond pricing is, in theory, no different than
pricing any set of known cash flows – the
current price is the present value of all
future cash flows.
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.
37
10.5.5 Finding the Value of Coupon
Bonds
38
10.5.5 Finding the Value of Coupon
Bonds
Let’s 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%?
39
10.5.6 Finding the Value of Coupon
Bonds
Solution:
Identify the cash flows:
1.
•
•
2.
$50 is received every six months in interest
$1000 is received in two years as principal repayment
Find the present value of the cash flows (calculator
solution):
N = 4, FV = 1000, PMT = 50, I = 6
Computer the PV. PV = 965.35
40
10.6 Investing in Bonds

Bond 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, which
were covered in chapter 3
41
10.6.1 Investing in Bonds
The next slide shows the amount of bonds
and stock issued from 1983 to 2003.
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.
42
10.6.2 Investing in Bonds
Figure 10.6 Bonds and Stocks Issued, 1983–2003
43
Chapter Summary



Purpose of the Capital Market: provide
financing for long-term capital assets
Capital Market Participants: governments and
corporations issue bond, and we
buy them
Capital Market Trading: primary and
secondary markets exist for most securities
of governments and corporations
44
Chapter Summary (cont.)

Types of Bonds: includes Treasury, municipal,
and corporate bonds

Treasury Bonds: issued and backed
by the full faith and credit of the U.S. Federal
government

Municipal Bonds: issued by state and local
governments, tax-exempt, defaultable.
45
Chapter Summary (cont.)

Corporate Bonds: issued by corporations and
have a wide range of features and risk

Financial Guarantees for Bonds: bond
“insurance” should the issuer default

Bond Yield Calculations: calculations for
current yield and discount yield
46
Chapter Summary (cont.)

Finding the Value of Coupon Bonds:
determining the cash flows and discounting
back to the present at an appropriate
discount rate

Investing in Bonds: most popular alternative
to investing in the stock market for long-term
investments
47