Chapter 4: Bond Market Instruments: Financial Markets and Institutions Chapter 4 1
Chapter 4: Bond Market Instruments: Financial Markets and Institutions Chapter 4 1
Chapter 4: Bond Market Instruments: Financial Markets and Institutions Chapter 4 1
instruments
Chapter Objectives
Provide Informational Background On
Treasury, Municipal, and Corporate Bonds
Explain The Role Of Bonds To Institutional
Investor
Discuss The Globalization Of Bond
Markets
FINANCIAL MARKETS
MONEY MARKETS
Short-term, very liquid,
Low risk debt
T-bills, CDs,
Com papers,
Fed Funds, Repos
(cash equivalent)
Long-term
Fixed-Income
markets
T bonds and Notes,
Municipal bonds,
Corporate bonds,
Mortgage-backed
CAPITAL MARKETS
Long-term, risky
securities
Equity
markets
Derivatives
markets
Common
stock
Preferred
stock
Options,
Futures,
Forwards
Background on Bonds
Bonds are often classified according to the
type of issuer
Issuer
Type of Bond
Federal Government
(Treasury)
Treasury Bonds
Federal Agency
Federal Agency
Bonds
Municipal Bonds
Corporations
Corporate Bonds
Issuers of Bonds
Lower Risk
Lower Discount Rates
Higher Bond Prices
Note Inverse
Relationship Between
Risk and Bond Prices
C
PV =
(1+ i)1
C + Par
C
+
(1+ i)2
(1+ i)n
10
12
PV
PM
T
FV
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950.82
50
1000
12
13
14
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Treasury Bonds
Types of Treasury Bonds
Coupon
Stripped Treasury Bonds
Cash flows of bonds are stripped by securities firms
One security represents the principal payment only
Second security represents the interest payments
only
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Inflation-Indexed Bonds
Inflation-indexed bonds deliver coupons and principal
that are indexed on the future inflation rates
They are structured so as to protect and increase an
investor's purchasing power
- They are mainly issued by governments to make it
clear they are willing to maintain a low inflation level
- They are more developed in the UK where they
represent more than 20% of outstanding government
bonds, versus only 7% in the US (1999)
Financial Markets and
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Inflation-Indexed Bonds
An inflation-indexed bond can be used to
hedge a portfolio against a rise in the inflation
rate
diversify a portfolio based on low correlation with
stocks, fixed-coupon bonds and cash
- Principal value adjusted for the U.S. inflation
rate every 6 months
- Still not very popular in U.S. due to low inflation
rate
Financial Markets and
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Cash Outflows:
Schools and other
educational facilities
Transportation facilities
(highways, airports,
commuter systems, etc.)
States, Cities,
Social services (income
Counties,
and medical support,
School
housing, public safety)
Districts, and
Industrial development
Other Local
incentives
Governments
Administration and
employee payrolls
Interest and debt
repayments
Financial Markets and
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Motivations for
State and Local Government Borrowing
State and local governments borrow
money
to satisfy short-term cash needs and maintain
adequate levels of working capital,
to finance long-term capital investment like
building schools and highways, and
for advance refunding of higher cost
securities.
Financial Markets and
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Municipal Bonds
Municipals (i.e., "munis") are debt securities issued by
states, counties, cities, school districts, and other local
units of government.
General obligation bonds (GOs), the least risky of
municipal bonds, are backed by the "full faith and credit"
of the issuing government and are paid back from any
government revenue source.
General obligation bonds usually must be approved by
referendum.
Revenue bonds are paid back from the revenue of the
financed project and do not require a public referendum.
Examples include hospital revenue bonds, industrial
development bonds, and lottery bonds.
Financial Markets and
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Municipal Bonds
Exempt from federal income taxes and often state
income taxes
The tax-exempt status makes municipal securities
most attractive to high income investors (i.e., those in
the 31% marginal tax bracket or above).
Tax Reform Act of 1986 placed limitations on taxexempt bond issuance for private purposes
Since 1988 each state is allowed to issue mortgage
revenue and private-purposes tax-exempt bonds only
up to limit of $150 mln
Financial Markets and
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Municipal Bonds
To see how the tax-exempt status affects
the relationship between yields on munis
and other bonds, consider the after tax
yield.
The after tax yield (ATY) on a Treasury or
corporate bond is:
ATY = Y (1 MTR)
where Y is the before tax yield
MTR is the investors marginal tax rate.
Financial Markets and
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Municipal Bonds
Consider two bonds, a taxable bond
earning 10% and a tax-exempt municipal
bond earning 8%.
For an investor in the 31% tax bracket, the
after tax yield on the corporate bond is:
ATY = 0.10 (1 0.31) = 0.069 or 6.9%
The investor will prefer the municipal bond
earning a tax free 8%, all else equal.
Financial Markets and
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Municipal Bonds
The "tax equivalent" yield of a municipal bond
(Y*) is the after tax yield of taxable bond will
be equal to the tax-exempt yield of the munis.
The tax equivalent formula is based on the
after tax yield formula above, solving for Y:
Y = ATY (1 - MTR)
Substitution of Y* for Y and Ym for ATY gives
the tax equivalent formula:
Y* = Ym (1 - MTR)
Financial Markets and
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Example
For example, if the municipal bond yield
is 5%, to a taxpayer in a 31% tax bracket,
this bond would provide a taxable
equivalent yield of 7.25%:
Y = 0.05 (1 - 0.31)= 0.0725 or 7.25%
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10% 15%
27%
30%
35% 38.6%
2%
2.22 2.35
2.74
2.86
3.08
3.26
5%
5.56 5.88
6.85
7.14
7.69
8.14
7%
7.78 8.24
9.59
10
10.77
11.4
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Corporate Bonds
When corporations want to borrow for
long-term periods they issue corporate
bonds
Usually pay semiannual interest
Most have maturities between 10-30 years
Recently, Coca-Cola and Walt Disney issued
100-year bonds
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Corporate Bonds
Debt securities issued by corporations.
Vary by:
Level of claim (security)
Credit quality
Term to maturity
Special features
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Corporate Bonds
Characteristics of Corporate Bonds
Indenture
Legal document specifying rights and
obligations of issuer and bondholder
Several hundred pages
Trustee
Represents bondholders, ensures
compliance
Financial Markets and
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Corporate Bonds
Characteristics of Corporate Bonds
Sinking Fund Provision
Requirement that the firm retire a certain amount of
the bond issue each year
Protective Covenants
Places restrictions on the firm to protect bondholders
Examples: limits dividends and officer salaries,
restricts additional debt
Call Provisions
Call premium
Advantage to issuers
Financial Markets and
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Corporate Bonds
Zero coupon bonds: bonds that pay low
or no coupon interest, and instead
provide their return only in the form of
price appreciation.
Sell at a discount from par, mature to par
value
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Corporate Bonds
Junk Bonds
Junk bonds are also called high-yield bonds
Original-issue junk bonds became popular in
the 1980s
Size of the market: junk bonds represent
about 25 percent of the market value of all
corporate bonds (around $145 billion in 2001)
The risk premium is between 3 and 7 percent
above Treasury bonds
Financial Markets and
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Corporate Bonds
Corporate Bond Quotations
Priced in eighths
Example: a quote of 101 5/8 for a Disney bond
means $101.62 per $100 par value
Coupon rate
Maturity
Yield To Maturity (YTM)
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Bond Ratings
Most bonds are rated for default, or credit risk by
one or more rating agency.
Duff and Phelps, Fitch Investors Service, Moodys,
Standard & Poors (S & P)
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Bond Ratings
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