Overview of the Bond Markets

1
Overview of the Bond Markets

• A bond is a promise to make periodic coupon
  payments and to repay principal at maturity
  breech of this promise is an event of default
• carry original maturities greater than one year
  so bonds are instruments of the capital markets
• issuers are corporations and government units

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Bond Market Instruments Outstanding, 1994-1999
(Bn)
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Treasury Notes and Bonds

• T-notes and T-bonds issued by the U.S. treasury
  to finance the national debt and other federal
  government expenditures
• Backed by the full faith and credit of the U.S.
  government and are default risk free
• Pay relatively low rates of interest (yields to
  maturity
• Given their longer maturity, not entirely risk
  free due to interest rate fluctuations
• Pay coupon interest (semiannually), notes have
  maturities from 1-10 yrs, bonds 10-30 yrs

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Composition of the U.S. National Debt (Bn)
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Treasury Strips

• A treasury security in which the periodic
  interest payment is separated from the final
  principal payment
• Effectively creates two sets of securities--one
  for each semiannual interest payment one one for
  the final principal payment
• Often referred to as Treasury zero-coupon bonds
• Created by U.S. treasury in response to separate
  trading of treasury security principal and
  interest that been developed by securities firms,
  only available through FIs and gov securities
  brokers

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The Primary Market in Treasury Notes and Bonds
Similar to the primary market T-bill sales, the
Treasury sells T-notes and bonds through
competitive and noncompetitive auctions

Auction Pattern for Treasury Notes and
bonds Security Purchase Minimum
General Auction Schedule 2-year note
1,000
Monthly 5-year note
1,000 Feb,
May-Aug, Nov 10-year note
1,000 Feb,
May-Aug, Nov
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Secondary Market in Treasury Notes and Bonds

• Most secondary market trading occurs directly
  through brokers and dealers
• Wall Street Journal shows full list of Treasury
  securities that trade daily

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Treasury Inflation Protected Securities

• Coupon rate set at time of auction and fixed for
  life
• Par value adjusted for inflation based on the
  Consumer Price Index
• Semi-annual coupon payments are based on the
  inflation adjusted par value
• At maturity investor receives the inflation
  adjusted par value

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Municipal Bonds (munis)

• Securities issued by state and local governments
  to fund either temporary imbalances between
  operating expenditures and receipts or to finance
  long-term capital outlays for activities such as
  school construction, public utility construction
  or transportation systems
• Tax receipts or revenues generated are the source
  of repayment
• Attractive to household investors because
  interest (but not capital gains) are tax exempt

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Tax Exemption and Muni Yields
im ic(1 ts
- tF) Where im After-tax
(equivalent tax exempt) rate of return on a
municipal bond ib Before-tax
rate of return on a taxable bond ts
Marginal state income tax rate of the bond
holder tF Marginal federal income tax
rate of the bond holder
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Types of Municipal Bonds

• General Obligation Bonds
• bonds backed by the full faith and credit of the
  issuer
• Revenue Bonds
• bonds sold to finance a specific revenue
  generating project and are backed by cash flows
  from that project

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Primary Market Placement Choices for Munis

• General Public Offering
• underwriter is selected either by negotiation or
  by competitive bidding
• the underwriter offers the bonds to the general
  public
• Rule 144A Placement
• bonds are sold on a semi-private basis to
  qualified investors (generally FIs)

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Contracting Choices with the Underwriter

• Firm commitment underwriting
• the issue of securities in which the investment
  bank guarantees the corp. a price for newly
  issued securities by buying the whole issue at a
  fixed price from the corporate issuer then seeks
  to resell to suppliers of funds (investors) at a
  higher price
• Best efforts underwriting
• the issue of securities in which the underwriter
  does not guarantee a price to the issuer and acts
  more as a placing or distribution agent, bank
  acts as agent on a fee basis related to its
  success in placing the issue

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Secondary Market for Munis

• Secondary market is thin (I.e. trades are
  relatively infrequent) due to a lack of
  information on bond issuers, who are generally
  much smaller than corporate bond issuers

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Corporate Bonds

• All long-term bonds issued by corporations
• Minimum denominations publicly traded corporate
  bonds is 1,000
• Generally pay interest semiannually
• Bond indenture
• legal contract that specifies the rights and
  obligations of the bond issuer and the bond holder

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Types of Corporate Bonds

• Bearer bonds
• coupons attached that are presented by the holder
  to the issuer for interest payments when due
• Registered bonds
• the owner of the bond is recorded by the issuer
  and coupon payments are mailed to the registered
  owner
• Term bonds
• entire issue matures on a single date
• Serial bonds
• mature on a series of dates
  (continued)

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Types of Corporate Bonds

• Mortgage bonds
• issued to finance specific projects which are
  pledged as collateral
• Equipment Trust Certificates
• bonds collateralized with tangible non-real
  estate property
• Debentures
• backed solely by the general credit of the
  issuing firm and unsecured by specific assets or
  collateral
• Subordinated debentures
• unsecured debentures that are junior in their
  rights to mortgage bonds and regular debentures
  (continued)

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Types of Corporate Bonds

• Convertible bonds
• may be exchanged for another security of the
  issuing firm at the discretion of the bond holder
• Stock Warrant
• give the bond holder an opportunity to purchase
  common stock at a specified price up to a
  specified date
• Callable bonds
• allow the issuer to force the bond holder to sell
  the bond back to the issuer at a price above the
  par value (call price)
• Sinking Fund Provisions
• bonds that include a requirement that the issuer
  retire a certain amount of the bond issue each
  year

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Primary and Secondary Markets for Corp Bonds

• Primary sales of corp bonds occur through either
  a public sale (issue) or a private placement
  similar to municipal bonds
• Two secondary markets
• the exchange market (e.g., the NYSE)
• the over-the-counter (OTC) market
• OTC electronic market dominates trading in corp
  bonds

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Bond Ratings

• Bonds are rated by the issuers default risk
• Large bond investors, traders and managers
  evaluate default risk by analyzing the issuers
  financial ratios and security prices
• Two major bond rating agencies are Moodys and
  Standard Poors (SP)
• Bonds assigned a letter grade based on perceived
  probability of issuer default

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Bond Credit Ratings

Explanation

Moodys SP Investment
grade categories
Best quality smallest degree of risk
Aaa
AAA High quality slightly more long-term
Aa1 AA
risk than top rating
Aa2 AA

Aa3
AA Upper medium grade possible
A1
AA- impairment in the future
A2
A
A3
A- Medium grade lack
outstanding Baa1
BBB investment
characteristics
Baa2 BBB

Baa3 BBB-
(continued)
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Bond Credit Ratings
Explanation
Moodys
SP Speculative investment grades Speculative
issues protection may
Ba1 BB be very
moderate
Ba2 BB

Ba3
BB- Very speculative may have small
B1 B
assurance of interest and principle
B2 B payment

B3 B- Issues in
poor standing may be in default
Caa CCC Speculative in a
high degree
Ca CC Lowest quality
poor prospects of attaining C
C real investment
standing
D
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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 the broad market 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, mutual funds) are the major
  suppliers of funds for all three types of bonds

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International Aspects of Bond Markets

• International bond market
• trades bonds that are underwritten by an
  international syndicate
• offer bonds simultaneously to investors in
  several countries
• issue bonds outside the jurisdiction of any
  single country
• offer bonds in unregistered form

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Eurobonds, Foreign Bonds, Brady Bonds and
Sovereign Bonds

• Eurobonds
• long-term bonds issued and sold outside the
  country of the currency in which they are
  denominated (e.g., dollar-denominated bonds
  issued in Europe or Asia)
• Foreign Bonds
• long-term bonds issued by firms and governments
  outside of the issuers country, usually
  denominated in the currency of the country in
  which they are issued
• Brady Bonds and Sovereign Bonds
• a bond that is swapped for an outstanding loan to
  a lesser developed country, sovereign bonds carry
  the creditworthiness of the lesser developed
  country