Download - FIN226 Summer 2011 Lectures Ch 6 Slides
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Chapter SixBond Markets
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Bond and Bond Markets
Capital markets involve equity and debtinstruments with maturities of more than one year
Bonds are long-term debt obligations issued bycorporations and government units
Bond markets are markets in which bonds areissued and traded
Treasury notes (T-notes) and bonds (T-bonds) Municipal bonds (Munis)
Corporate bonds
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Bond Market Instruments
Outstanding, 1994-2007
$0
$2
$4
$6
$8
$10
$12
Trillions
1994 2007
Corporate Treasuries Munis
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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 governmentexpenditures
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: )(1
t
N
ttt
TGND
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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
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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
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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
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Treasury Notes and Bonds
Clean prices are calculated as:
Vb = 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
id= interest rate used to discount cash flows on the bond
)()(,/,/ NmmidNmmidb
PVIFMPVIFA
m
INTV
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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 (Vb) and the accruedinterest
periodcouponindaysofnumberActual
paymentcouponlastsincedaysofnumberActual
2interestAccrued INT
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Treasury Notes and Bonds
The primary market of T-notes and T-bonds issimilar 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 andAug)
Most secondary trading occurs directly throughbrokers and dealers
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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 aresold to finance specific revenue
generating projects
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Municipal Bonds
Compare Muni returns with fully taxable
corporate bonds by finding the after tax return for
corporate bonds: ia= ib(1t)ia = after-tax rate of return on a taxable corporate bond
ib = 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 taxequivalent rates of return: ib= ia/(1t)
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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 andthen 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
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Corporate Bonds
Corporate bonds are long-term bonds issued by
corporations
A bond indenture is the legal contract thatspecifies the rights and obligations of the issuer
and the holders
Bearer versus registeredbonds
Term versus serialbonds
Mortgage bonds are secured debt issues
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Corporate Bonds
Debentures and subordinated debentures
Convertible bonds versus non-convertible
bonds
icvb = rate of return on a convertible bond
incvb = rate of return on a nonconvertible bond
opcvb = value of the conversion option
Stock warrants give bondholders the opportunity
to purchase common stock at a prespecified price
cvbncvbcvbopii
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Corporate Bonds
Callable bonds versus non-callable bonds
incb = rate of return on a noncallable bond
icb = rate of return on a callable bond
opcb = value of the call option
A Sinking fund provision is a requirement thatthe issuer retire a certain amount of the bond issue
early as the bonds approach maturity
cvbcbncbopii
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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 Moodys and
Standard & Poors (S&P) bonds are rated by perceived default risk
bonds may be either investment or speculative (i.e.,junk) grade
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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
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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
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International Bonds and Markets
International bond markets involve unregistered bonds that areinternationally syndicated, offered simultaneously to investors inseveral countries, and issued outside of the jurisdiction of any singlecountry
Eurobonds are long-term bonds issued outside the country of thecurrency in which they are denominated
Foreign Bonds are long-term bonds issued outside of the issuershome 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 issubstituted instead