Bond Market

Bond Markets
Background on Bonds
Bonds represent long-term debt securities

Contractual
Promise
to pay future cash flows to investors
The issuer of the bond is obligated to pay:

Interest
(or coupon) payments periodically usually

semiannually
Par or face value (principal) at maturity
Primary vs. secondary market for bonds
Background on Bonds
Bond Interest Rates

The issuers cost of financing with bonds
is the coupon rate
Determined
by current market rates and risk

Usually fixed throughout term
Determines periodic interest payments
Background on Bonds
Bond Yield to Maturity

The yield to maturity (TYM) is the yield that
equates the future coupon and principal payments
with the bond price
The YTM is the investors expected rate of return if the

bond is held to maturity
The actual YTM may vary from the expected because
of risks assumed by the investors
Background on Bonds
An investor can purchase a ten-year, $1000 par
value bond with an 8 percent annualized coupon
rate for $936. Determine the yield to maturity for
this bond.
N
10
PV PMT FV
936 80 1000
Background on Bonds
An investor can purchase a ten-year, $1000 par
value bond with an 8 percent annualized coupon
rate for $936. Determine the yield to maturity for
this bond.
N
10
I
9
PV PMT FV
936 80 1000
Background on Bonds
Bonds by Issuers
Issuer
Type of Bond
Federal Government
(U.S. Treasury)
Treasury Bonds
Federal Agencies
Federal Agency Bonds
State and Local

Governments
Municipal Bonds
Corporations
Corporate Bonds
U. S. Treasury Bonds
Issued by the U.S. Treasury to finance federal
government expenditures
Maturity
Notes,
< 10 Years
Bonds, > 10 to 30 Years
Active OTC Secondary Market

Semiannual Interest Payments
Benchmark Debt Security for Any Maturity
U. S. Treasury Bond Yield To Maturity
$83.80
Pmt
2013
Today
=N
$1000
Ask
Price =
FV
Ask Price = 103 and 11/32 % of

Face Value or $1033.4375
$1033.44
PV*
Calc
YTM
Treasury Bonds
Cash Flow Variation in T-Bonds
Coupon
bonds
Interest
paid semiannually
To registered bondholders
Stripped
Treasury bonds
Zero-coupon
securities are sold with claims on U. S.

Treasury bonds held in a trust
One security represents the principal payment (np) at maturity

Other securities represents the interest payments (ci) at
interest paying dates
Federal Agency Bonds
Government National Mortgage Association

(GNMA)
Issues
bonds and uses proceeds to purchase

insured FHA and VA mortgages
A U.S. Government Agency
Backed by explicit guarantee of Federal
Government
Example of social allocation of capital
Municipal Bonds
State and local government obligations
Revenue bonds vs. general obligation Bonds
Investor interest income exempt from federal

income tax
Tax Reform Act of 1986 placed limitations on

tax-exempt bond issuance for private purposes
Corporate Bonds
When corporations want to borrow for longterm periods they issue corporate bonds
Usually
pay semiannual interest

Most have maturities between 10-30 years
Public offering vs. private placement
Limited exchange, larger OTC secondary market
Investors seek safety of principal and steady
income
Corporate Bonds
Corporate Bond Terminology
Indenture
Legal
document specifying rights and obligations of

issuer and bondholder
Trustee
Represents
indenture
bondholders to assure compliance with
Corporate Bonds
Sinking
Fund Provision
Requirement
that the firm retire a certain amount or

number of bonds each year
Protects investors with principal reduction
Protective
Places
Covenants
restrictions on the firm to protect bondholders

Examples: limits dividends and officer salaries, restricts
additional debt
Corporate Bonds
Call
provisions: Ability to pay bonds off early
Call
premium
Advantage to issuers; disadvantage to investor
Bond
collateral
Usually
consists of a mortgage on real property

Unsecured bonds are called debentures and are backed only
by the general credit of the issuing firm
Corporate Bonds
Low-coupon
and zero-coupon bonds
Provide
investors known rate of return

Imputed interest income taxed if not in tax-sheltered
investment plan
Attractive to pension funds with expected payouts
Variable-rate
bonds
Convertible bonds
Corporate Bonds
Junk Bonds
Junk
bonds are also called high-yield bonds or

noninvestment rated bonds
Popularized in the direct finance boom of the
1980s
The risk premium is between three and seven
percent above Treasury bonds and susceptible to
contagion effects
Secondary market supported by dealer market
Corporate Bonds Market Quotation

ATT 6 29 7.3 214 88 5/8th +1/4
AT&T bond quote for 1/13/02 (U.S. Exchange Bond)

6.5% coupon rate
Maturity in 2029
7.3% current yield (annual interest/price)
214 bonds traded on this day
Bond priced at close of day 88 5/8th % of face
($1000) or $886.25
Bond price up point for the day or $2.50
Exhibit 7.5
Financial Institution
Participation in Bond Markets
Commercial banks and savings

and loan associations (S&Ls)
Purchase bonds for their asset portfolio.
Sometimes
place municipal bonds for municipalities.
Sometimes issue bonds as a source of secondary capital.
Finance companies
Commonly issue bonds as a source of long-term funds.
Mutual funds
Use funds received from the sale of shares to purchase bonds. Some bond mutual funds
specialize in particular types of bonds, while others invest in all types.
Brokerage rms
Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.
Investment banking rms
Place newly issued bonds for governments and corporations. They may place the bonds
and assume the risk of market price uncertainty or place the bonds on a best-efforts basis
in which they do not guarantee a price for the issuer.
Insurance companies
Pension funds
Globalization of Bond Markets

Eurobond Market
In
1960s, U.S. corporations were limited to the

amount of funds they could borrow in the U.S. for
overseas operations.
They began to issue bonds in the Eurobond market
where bonds denominated in various currencies
were placed.
About
75 percent are denominated in U.S. dollars
Globalization of Bond Markets

Eurobond Market
An underwriting syndicate of investment banks

participates in placing the bonds
Issuer
can choose the currency in which the bond

interest and principal are denominated
Dollar denominated most common
Bearer bonds vs. registered bonds

Bond Market

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Bond Markets

Bonds represent long-term debt securities

to pay future cash flows to investors

The issuer of the bond is obligated to pay:

(or coupon) payments periodically usually

Primary vs. secondary market for bonds

Bond Interest Rates

by current market rates and risk

Bond Yield to Maturity

The YTM is the investors expected rate of return if the

Federal Agency Bonds

State and Local

Active OTC Secondary Market

U. S. Treasury Bond Yield To Maturity

Ask Price = 103 and 11/32 % of

securities are sold with claims on U. S.

One security represents the principal payment (np) at maturity

Federal Agency Bonds

Government National Mortgage Association

bonds and uses proceeds to purchase

State and local government obligations

Revenue bonds vs. general obligation Bonds

Investor interest income exempt from federal

Tax Reform Act of 1986 placed limitations on

pay semiannual interest

document specifying rights and obligations of

bondholders to assure compliance with

that the firm retire a certain amount or

restrictions on the firm to protect bondholders

provisions: Ability to pay bonds off early

consists of a mortgage on real property

and zero-coupon bonds

investors known rate of return

bonds are also called high-yield bonds or

Corporate Bonds Market Quotation

AT&T bond quote for 1/13/02 (U.S. Exchange Bond)

Participation in Bond Markets

Commercial banks and savings

Purchase bonds for their asset portfolio.

Commonly issue bonds as a source of long-term funds.

Investment banking rms

Purchase bonds for their asset portfolio.

Purchase bonds for their asset portfolio.

Globalization of Bond Markets

1960s, U.S. corporations were limited to the

75 percent are denominated in U.S. dollars

Globalization of Bond Markets

An underwriting syndicate of investment banks

can choose the currency in which the bond

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