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Financial Markets & Institutions Ch06
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Financial Markets & Institutions Ch06

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Financial Markets & Institutions

Financial Markets & Institutions

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  • 1. 6- McGraw-Hill/Irwin Chapter Six Bond Markets
  • 2. Bond and Bond Markets
    • Capital markets involve equity and debt instruments with maturities of more than one year
    • Bonds are long-term debt obligations issued by corporations and government units
    • Bond markets are markets in which bonds are issued and traded
      • Treasury notes (T-notes) and bonds (T-bonds)
      • Municipal bonds (Munis)
      • Corporate bonds
    6- McGraw-Hill/Irwin
  • 3. Bond Market Instruments Outstanding, 1994-2007 6- McGraw-Hill/Irwin
  • 4. Treasury Notes and Bonds
    • Treasury notes and bonds (T-notes and T-bonds) are issued by the U.S. Treasury to finance the national debt and other government expenditures
    • The annual federal deficit is equal to annual expenditures ( G ) less taxes ( T ) received
    • The national debt ( ND ) is the sum of historical annual federal deficits:
    6- McGraw-Hill/Irwin
  • 5. Treasury Notes and Bonds
    • Default risk free : backed by the full faith and credit of the U.S. government
    • Low returns : low interest rates (yields to maturity) reflect low default risk
    • Interest rate risk : because of their long maturity, T-notes and T-bonds experience wider price fluctuations than money market securities when interest rates change
    • Liquidity risk : older issued T-bonds and T-notes trade less frequently than newly issued T-bonds and T-notes
    6- McGraw-Hill/Irwin
  • 6. Treasury Notes and Bonds
    • T-notes have original maturities from over 1 to 10 years
    • T-bonds have original maturities from over 10 years
    • Issued in minimum denominations (multiples) of $1,000
    • May be either fixed principal or inflation-indexed
      • inflation-indexed bonds are called Treasury Inflation Protection Securities (TIPS)
      • the principal value of TIPS is adjusted by the percentage change in the Consumer Price Index (CPI) every six months
    • Trade in very active secondary markets
    • Prices are quoted as percentages of face value, in 32nds
    6- McGraw-Hill/Irwin
  • 7. Treasury STRIPS
    • Separate Trading of Registered Interest and Principal Securities (STRIPS) , a.k.a. Treasury zero bonds or Treasury zero-coupon bonds
    • Financial institutions and government securities brokers and dealers create STRIPS from T-notes and T-bonds
    • STRIPS have the periodic interest payments separated from each other and from the principal payment
      • one set of securities reflects interest payments
      • one set of securities reflects principal payments
    • STRIPS are used to immunize against interest rate risk
    6- McGraw-Hill/Irwin
  • 8. Treasury Notes and Bonds
    • “ Clean” prices are calculated as:
        • V b = the present value of the bond
        • M = the par value of the bond
        • INT = annual interest payment (in dollars)
        • N = the number of years until the bond matures
        • m = the number of times per year interest is paid
        • i d = interest rate used to discount cash flows on the bond
    6- McGraw-Hill/Irwin
  • 9. Treasury Notes and Bonds
    • Accrued interest on T-notes and T-bonds is calculated as:
    • The full (or dirty) price of a T-note or T-bond is the sum of the clean price ( V b ) and the accrued interest
    6- McGraw-Hill/Irwin
  • 10. Treasury Notes and Bonds
    • The primary market of T-notes and T-bonds is similar to that of T-bills; the U.S. Treasury sells T-notes and T-bonds through competitive and noncompetitive single-bid auctions
      • 2-year notes are auctioned monthly
      • 3, 5, and 10-year notes are auctioned quarterly (Feb, May, Aug, and Nov)
      • 30-year bonds are auctioned semi-annually (Feb and Aug)
    • Most secondary trading occurs directly through brokers and dealers
    6- McGraw-Hill/Irwin
  • 11. Municipal Bonds
    • Municipal bonds (Munis) are securities issued by state and local governments
      • to fund imbalances between expenditures and receipts
      • to finance long-term capital outlays
    • Attractive to household investors because interest is exempt from federal and most local income taxes
    • General obligation (GO) bonds are backed by the full faith and credit of the issuing municipality
    • Revenue bonds are sold to finance specific revenue generating projects
    6- McGraw-Hill/Irwin
  • 12. Municipal Bonds
    • Compare Muni returns with fully taxable corporate bonds by finding the after tax return for corporate bonds: i a = i b (1 – t )
        • i a = after-tax rate of return on a taxable corporate bond
        • i b = before-tax rate of return on a taxable bond
        • t = marginal total income tax rate of the bond holder
    • Alternately, convert Muni interest rates to tax equivalent rates of return: i b = i a /(1 – t )
    6- McGraw-Hill/Irwin
  • 13. Municipal Bonds
    • Primary markets
      • firm commitment underwriting : a public offering of Munis made through an investment bank, where the investment bank guarantees a price for the newly issued bonds by buying the entire issue and then reselling it to the public
      • best efforts offering : a public offering in which the investment bank does not guarantee a firm price
      • private placement : bonds are sold on a semi-private basis to qualified investors (generally FIs)
    • Secondary markets : Munis trade infrequently due mainly to a lack of information on bond issuers
    6- McGraw-Hill/Irwin
  • 14. Corporate Bonds
    • Corporate bonds are long-term bonds issued by corporations
    • A bond indenture is the legal contract that specifies the rights and obligations of the issuer and the holders
    • Bearer versus registered bonds
    • Term versus serial bonds
    • Mortgage bonds are secured debt issues
    6- McGraw-Hill/Irwin
  • 15. Corporate Bonds
    • Debentures and subordinated debentures
    • Convertible bonds versus non-convertible bonds
        • i cvb = rate of return on a convertible bond
        • i ncvb = rate of return on a nonconvertible bond
        • op cvb = value of the conversion option
    • Stock warrants give bondholders the opportunity to purchase common stock at a prespecified price
    6- McGraw-Hill/Irwin
  • 16. Corporate Bonds
    • Callable bonds versus non-callable bonds
      • i ncb = rate of return on a noncallable bond
      • i cb = rate of return on a callable bond
      • op cb = value of the call option
    • A Sinking fund provision is a requirement that the issuer retire a certain amount of the bond issue early as the bonds approach maturity
    6- McGraw-Hill/Irwin
  • 17. Corporate Bonds
    • Primary markets are identical to that of Munis
    • Secondary markets
      • the exchange market (e.g., NYSE)
      • the over-the-counter (OTC) market
    • Bond ratings
      • the two major bond rating agencies are Moody’s and Standard & Poor’s (S&P)
      • bonds are rated by perceived default risk
      • bonds may be either investment or speculative (i.e., junk ) grade
    6- McGraw-Hill/Irwin
  • 18. Bond Market Indexes
    • Managed by major investment banks
    • Reflect both the monthly capital gain and loss on bonds plus any interest (coupon) income earned
    • Changes in values of bond indexes can be used by bond traders to evaluate changes in the investment attractiveness of bonds of different types and maturities
    6- McGraw-Hill/Irwin
  • 19. Bond Market Participants
    • The major issuers of debt market securities are federal, state and local governments, and corporations
    • The major purchasers of capital market securities are households, businesses, government units, and foreign investors
      • businesses and financial firms (e.g., banks, insurance companies, and mutual funds) are the major suppliers of funds for Munis and corporate bonds
      • foreign investors and governments are the major suppliers of funds for T-notes and T-bonds
    6- McGraw-Hill/Irwin
  • 20. International Bonds and Markets
    • International bond markets involve unregistered bonds that are internationally syndicated, offered simultaneously to investors in several countries, and issued outside of the jurisdiction of any single country
    • Eurobonds are long-term bonds issued outside the country of the currency in which they are denominated
    • Foreign Bonds are long-term bonds issued outside of the issuer’s home country
    • Brady Bonds are bonds swapped for an outstanding loan to a less developed country
    • Sovereign Bonds are Brady Bonds that have had their underlying collateral removed and the creditworthiness of the country is substituted instead
    6- McGraw-Hill/Irwin