Bond Market

Chapter Preview
Chapter 10
The Bond Market
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.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
Chapter Preview
Chapter Preview (cont.)
We examine how capital markets operate, and

then focus our attention on the bonds and the
bond market. We will conclude this topic with
Chapter 12 on mortgages. Topics include:
Corporate Bonds
Financial Guarantees for Bonds
Current Yield Calculation
Purpose of the Capital Market

Capital Market Participants
Capital Market Trading
Types of Bonds
Treasury Notes and Bonds
Municipal Bonds
10-2
Finding the Value of Coupon Bonds

Investing in Bonds
10-3
10-4
Purpose of the Capital Market
Capital Market Participants
Original maturity is greater than

one year, typically for long-term financing
or investments
Primary issuers of securities:
Best known capital market securities:
Largest purchasers of securities:
Federal and local governments: debt issuers

Corporations: equity and debt issuers
Stocks and bonds
You and me
10-5
Capital Market Trading
10-6
Types of Bonds
1. Primary market for initial sale (IPO)
Bonds are securities that represent debt

owed by the issuer to the investor, and
typically have specified payments on
specific dates.
To be discussed further with securities firms
2. Secondary market
Over-the-counter
Types of bonds we will examine include

long-term government bonds (T-bonds),
municipal bonds, and corporate bonds.
Organized exchanges (i.e., NYSE)
10-7
10-8
Types of Bonds:
Sample Corporate Bond

The U.S. Treasury issues notes and bonds
to finance its operations.
The following table summarizes the
maturity differences among the various
Treasury securities.
10-10
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)
10-11
10-12
The next two figures show historical

rates on Treasury bills, bonds, and the
inflation rate.
10-13
Treasury Bond Interest Rates:

Bills vs. Bonds
10-14
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.
10-15
10-16
Treasury Bonds: Agency Debt
Municipal Bonds
Although not technically Treasury

securities, agency bonds are issued by
government-sponsored entities, such as
GNMA, FNMA, and FHLMC.
Issued by local, county, and

state governments
The debt has an implicit guarantee that

the U.S. government will not let the
debt default.
Tax-free municipal interest rate =

taxable interest rate (1 marginal
tax rate)
Used to finance public interest projects
10-17
Municipal Bonds: Example
10-18
Municipal Bonds
Suppose the rate on a corporate bond is 9% and

the rate on a municipal bond is 6.75%. Which
should you choose?
Two types
General obligation bonds
Revenue bonds
Answer: Find the marginal tax rate:
NOT default-free (e.g., Orange

County California)
6.75% = 9% x (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.
Defaults in 1990 amounted to $1.4 billion in

this market
10-19
10-20
Municipal Bonds: Comparing Revenue and

General Obligation Bonds
Municipal Bonds
The next slide shows the volume of
general obligation bonds and revue bonds
issued from 1984 through 2006.
Note that general obligation bonds
represent a higher percentage in the latter
part of the sample.
10-21
10-22
Corporate Bonds
Corporate Bonds
Typically have a face value of $1,000,

although some have a face value of $5,000
or $10,000
Cannot be redeemed anytime the issuer

wishes, unless a specific clause states this
(call option).
Pay interest semi-annually
Degree of risk varies with each bond, even

from the same issuer. The required
interest rate varies with level
of risk.
10-23
10-24
High Yield
Investment
Corporate Bonds
Grade
The next slide shows the interest rate on
various bonds from 1973-2007.
Corporate Bonds
Leases
The degree of risk ranges from low-risk

(AAA) to higher risk (BBB). Any bonds
rated below BBB are considered subinvestment grade debt.
Commercial Paper
High Yield Bonds
Leases
Syndicated Bank Loan

Syndicated Bank Loan
10-25
10-26
Corporate Bonds:
Characteristics of Corporate Bonds
Corporate Bonds: Interest Rates
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
10-27
10-28
Corporate Bonds:
Call/Refunding
Call Provisions
Higher yield
Refunding
Sinking fund
Interest of the stockholders
Capital structure flexibility
Convertibility
All Calls
Some debt may be converted to equity

Similar to a stock option, but usually more limited
10-29
Corporate Bonds:
10-30
Corporate Bonds:
Secured Bonds
Junk Bonds
Mortgage bonds
Debt that is rated below BBB
Equipment trust certificates
Often, trusts and insurance companies are not

permitted to invest in junk debt
Unsecured Bonds
Michael Milken developed this market in the

mid-1980s, although he was convicted of
insider trading
Debentures
Subordinated debentures
Variable-rate bonds
10-31
10-32
Corporate Bonds: Debt Ratings

The next slide explains in further details the
rating scale for corporate debt. The rating
scale is for Moodys. Both Standard and
Poors and Fitch have similar debt
rating scales.
Corporate
Bonds:
Debt Ratings
10-33
Ratings Transition Matrix
Credit Risk
Default Risk
Risk that issuer will default on its obligation to the lender.
Downgrade Risk
Risk that credit quality of issuer declines.
Credit Spread Risk

Risk that the value of a debt obligation will decline due to
an increase in the credit spread.
(Reflects all credit risks)
35
Probability Of Rating One Year Later (percent)

Original
Rating
AAA
AA
A
BBB
BB
B
CCC
Default
AAA
93.7
0.66
0.07
0.03
0.03
0
0.16
0
AA
5.83
91.7
2.25
0.25
0.07
0.1
0
0
A
0.4
6.94
91.8
4.83
0.44
0.33
0.31
0
BBB
0.08
0.49
5.19
89.3
6.67
0.46
0.93
0
BB
0.03
0.06
0.49
4.44
83.3
5.77
2
0
B
0
0.09
0.2
0.81
7.47
84.2
10.7
0
CCC Default
0
0
0.02 0.01
0.01 0.04
0.16 0.22
1.05 0.98
3.87
5.3
64 21.94
0 100
10-36
Financial Guarantees for Bonds
Bond Yield Calculations
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.
10-37
Bond Current Yield Calculation
We will examine the current yield

calculation that is commonly used for longterm debt.
10-38
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% x $1,000 = $109.50
Bond yields are quoted using a variety of

conventions, depending on both the type of
issue and the market.
10-39
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.
The table on the next slide outlines some of
the terminology unique to debt, which may
be necessary to understand to determine
the cash flows.
10-40

Lets 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%?
10-41
10-42
Solution:
Solution:
1. Identify the cash flows:

$50 is received every six months in interest
1. Find the present value of the cash flows

for an annual yield of 12%:
$1000 is received in two years as principal

repayment
Annual Yield of 12%: $50/(1.12)^.5 + $50/1.12^1

+$50/1.12^1.5 + $1050/(1.12)^2 = $971.25
2. Find the present value of the cash flows based

on a BEQ of 12%:
BEQ of 12%: $50/1.06 + $50/1.06^2 +$50/1.06^3
+$1050/(1.06)^4 = $965.41
10-43
10-44
Investing in Bonds
Investing in Bonds
Bonds are the most popular alternative to

stocks for long-term investing.
The next slide shows the amount of bonds

and stock issued from 1983 to 2006.
Even though the bonds of a corporation are

less risky than its equity, investors still have
risk: credit risk and interest rate risk, which
were covered in chapter 3
Note how much larger the market for new

debt is. Even in the late 1990s, which were
boom years for new equity issuances, new
debt issuances still outpaced equity by
over 5:1.
10-45
Investing in Bonds
10-46
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
10-47
10-48
Chapter Summary (cont.)
Types of Bonds: includes Treasury,

municipal, and corporate bonds
Corporate Bonds: issued by corporations

and have a wide range of features and risk
Treasury Notes and Bonds: issued and

backed by the full faith and credit of the
U.S. Federal government
Financial Guarantees for Bonds: bond

insurance should the issuer default
Municipal Bonds: issued by state and local

governments, tax-exempt, defaultable.
10-49

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 long-term investments
10-51
Bond Current Yield Calculation: how to

calculation the current yield for a bond
10-50

Bond Market

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Chapter Preview

In this chapter, we focus on longer-term

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Chapter Preview (cont.)

We examine how capital markets operate, and

Purpose of the Capital Market

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Finding the Value of Coupon Bonds

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Purpose of the Capital Market

Capital Market Participants

Original maturity is greater than

Primary issuers of securities:

Best known capital market securities:

Largest purchasers of securities:

Federal and local governments: debt issuers

Stocks and bonds

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Capital Market Trading

1. Primary market for initial sale (IPO)

Bonds are securities that represent debt

To be discussed further with securities firms

Types of bonds we will examine include

Organized exchanges (i.e., NYSE)

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Treasury Notes and Bonds

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Treasury Notes and Bonds

Treasury Bond Interest Rates

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Treasury Bond Interest Rates

Treasury Bond Interest Rates

The next two figures show historical

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Treasury Bond Interest Rates:

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Treasury Bonds: Agency Debt

Although not technically Treasury

Issued by local, county, and

The debt has an implicit guarantee that

Tax-free municipal interest rate =

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Used to finance public interest projects

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Municipal Bonds: Example

Suppose the rate on a corporate bond is 9% and

Answer: Find the marginal tax rate:

NOT default-free (e.g., Orange

6.75% = 9% x (1 MTR), or MTR = 25%

Defaults in 1990 amounted to $1.4 billion in

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Municipal Bonds: Comparing Revenue and

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Typically have a face value of $1,000,

Cannot be redeemed anytime the issuer

Pay interest semi-annually

Degree of risk varies with each bond, even

Copyright 2009 Pearson Prentice Hall. All rights reserved.