12

Chapter 12
The Bond Market
Chapter Preview
In this chapter, we focus on longer-term
securities: bonds. Bonds are like money
market instruments, but they have maturities
that exceed one year. These include Treasury
bonds, corporate bonds, mortgages, and the
like.
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Chapter Preview
•
•
•
•
Corporate Bonds
•
Current Yield
Calculation
Types of Bonds
•
Treasury Notes and
Bonds
Finding the Value of
Coupon Bonds
•
Investing in Bonds
Purpose of the Capital
Market
Capital Market
Participants
•
•
•
Capital Market Trading
•
Municipal Bonds
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Financial Guarantees
for Bonds
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Purpose of the Capital Market
• Original maturity is greater than one year,
typically for long-term financing or
investments
• Best known capital market securities:
─ Stocks and bonds
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Capital Market Participants
• Primary issuers of securities:
─ Federal and local governments: debt issuers
─ Corporations: equity and debt issuers
• Largest purchasers of securities:
─ You and me
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Capital Market Trading
1. Primary market for initial sale (IPO)
2. Secondary market
─ Over-the-counter
─ Organized exchanges (i.e., NYSE)
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Types of Bonds
• Bonds are securities that represent debt
owed by the issuer to the investor, and
typically have specified payments on specific
dates.
• Types of bonds we will examine include
long-term government bonds (T-bonds),
municipal bonds, and corporate bonds.
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Types of Bonds:
Sample Corporate Bond
Figure 12.1 Hamilton/BP Corporate Bond
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Treasury Notes and 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.
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Treasury Notes and Bonds
Table 12.1 Treasury Securities
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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)
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Treasury Bond Interest Rates
Figure 12.2 Interest Rate on Treasury Bonds and the Inflation Rate,
1973–2013 (January of each year)
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Treasury Bond Interest Rates:
Bills vs. Bonds
Figure 12.3 Interest Rate on Treasury Bills and
Treasury Bonds, 1974–2013 (January of each year)
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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: the coupon and principal
payments are “stripped” from a T-Bond and
sold as individual zero-coupon bonds.
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Treasury Bonds: Agency Debt
• Although not technically Treasury securities,
agency bonds are issued by governmentsponsored entities, such as GNMA, FNMA,
and FHLMC.
• The debt has an “implicit” guarantee that
the U.S. government will not let the
debt default. This “guarantee” was clear
during the 2008 bailout…
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The 2007–2009 Financial Crisis:
Bailout of Fannie and Freddie
• Both Fannie and Freddie managed their
political situation effectively, allowing them
to engage in risky activities, despite
concerns raised.
• By 2008, the two had purchased or
guaranteed over $5 trillion in mortgages or
mortgage-backed securities.
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The 2007–2009 Financial Crisis:
Bailout of Fannie and Freddie
• Part of this growth was driven by their
Congressional mission to support affordable
housing. They did this by purchasing
subprime and Alt-A mortgages.
• As these mortgages defaults, large losses
mounted for both agencies.
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The 2007–2009 Financial Crisis:
Bailout of Fannie and Freddie
• In 2013, Fannie Mae repaid $59.4 billion of
its $117 billion in bailout.
• Freddie Mac has paid back about $37 billion
of the $72 billion it received.
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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)
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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%  (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.
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Municipal Bonds: Example
Suppose the rate on a corporate bond is 5%
and the rate on a municipal bond is 3.5%.
Which should you choose? Your marginal tax
rate is 28%.
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Municipal Bonds: Example
Suppose the rate on a corporate bond is 5%
and the rate on a municipal bond is 3.5%.
Which should you choose? Your marginal tax
rate is 28%.
Find the equivalent tax-free rate (ETFR):
ETFR = 5%  (1 – MTR) = 5%  (1 – 0.28)
The ETFR = 3.36%. If the actual muni-rate is
above this (it is), choose the muni.
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Municipal Bonds
• Two types
─ General obligation bonds
─ Revenue bonds
• NOT default-free (e.g., Orange County
California)
─ Defaults in 1990 amounted to $1.4 billion in this
market
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Municipal Bonds: Comparing Revenue
and General Obligation Bonds
Figure 12.4 Issuance of Revenue and General Obligation
Bonds, 1984–2012 (End of year)
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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
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Corporate Bonds
• Cannot be redeemed anytime the issuer
wishes, unless a specific clause states this
(call option).
• Degree of risk varies with each bond, even
from the same issuer. Following suite, the
required interest rate varies with level
of risk.
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Corporate Bonds
• The degree of risk ranges from low-risk
(AAA) to higher risk (BBB). Any bonds rated
below BBB are considered sub-investment
grade debt.
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Corporate Bonds: Interest Rates
Figure 12.5 Corporate Bond Interest Rates, 1973–2012
(End of year)
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Characteristics of Corporate
Bonds
• Registered Bonds
─ Replaced “bearer” bonds
─ IRS can track interest income this way
• Restrictive Covenants
─ Mitigates conflicts with shareholder interests
─ May limit dividends, new debt, ratios, etc.
─ Usually includes a cross-default clause
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Characteristics of Corporate
Bonds
• Call Provisions
─ Higher required yield
─ Mechanism to adhere to a sinking fund provision
─ Interest of the stockholders
─ Alternative opportunities
• Conversion
─ Some debt may be converted to equity
─ Similar to a stock option, but usually more limited
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Corporate Bonds: Characteristics
of Corporate Bonds
• Secured Bonds
─ Mortgage bonds
─ Equipment trust certificates
• Unsecured Bonds
─ Debentures
─ Subordinated debentures
─ Variable-rate bonds
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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 subsequently convicted
of insider trading
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Corporate Bonds: Debt Ratings
(a)
Table 12.2 Debt Rating Descriptions
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Corporate Bonds: Debt Ratings
(b)
Table 12.2 Debt Rating Descriptions
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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.
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Financial Guarantees for Bonds
• As it turns out, not all guarantees actually
make sense!
─ In 1995, JPMorgan created the credit default
swap (CDS), a type of insurance on bonds.
─ In 2000, Congress removed CDSs from any
oversight.
─ By 2008, the CDS market was over $62 trillion!
─ 2008 losses on mortgages lead to huge payouts
on this insurance.
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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 the current yield calculation
that is commonly used for
long-term debt.
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Bond Current Yield Calculation
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%  $1,000
= $109.50
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Finding the Value of Coupon
Bonds
• Bond pricing is, in theory, no different than
pricing any set of known cash flows.
• Once the cash flows have been identified,
they should be discounted to time zero at an
appropriate discount rate.
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Finding the Value of Coupon
Bonds
Table 12.3 Bond Terminology
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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%?
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Finding the Value of Coupon
Bonds
Solution:
1. Identify the cash flows:
─ $50 is received every six months in interest
─ $1000 is received in two years as principal
repayment
2. Find the present value of the cash flows
(calculator solution):
─ N = 4, FV = 1000, PMT = 50, I = 6
─ Computer the PV. PV = 965.35
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Investing in Bonds
• Bonds 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
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Investing in Bonds
Figure 12.6 Bonds and Stocks Issued, 1983–2012
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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
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Chapter Summary (cont.)
• Types of Bonds: includes Treasury,
municipal, and corporate bonds
• Treasury Notes and 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.
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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 Current Yield Calculation: how to
calculation the current yield for a bond
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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 longterm investments
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