Capital Markets: One or more year to maturity, e.g., bonds (CH 6), mortgages (CH 7) and stocks (CH 8). 

BONDS are long-term debt obligations of companies or governments to fund long-term investments in long-term assets, e.g., capital expenditure projects (property, plant, equipment, real estate, highways, etc.).  Bond issuers promise to pay face value ($1000) on maturity, and periodic coupon/interest payments: PMT = Coupon Rate (%) x Face Value ($1000). 

See Table 6-1, p. 152.  In 2001, Corporate bonds (57%), T-Bonds (26%), Municipal bonds (17%). 

See Table 6-2, p. 153, $6T National Debt in 2001, about 50% Treasury securities.  National debt = accumulation of outstanding debt from all previous deficits, see formula on p. 152. 

T-Bills: One-year maturity or less. Sold on a discount from face value basis, like a zero coupon.  

T-Notes: 1-10 year original maturity, semi-annual coupons.  See Figure 6-1 on p. 153.

T-Bonds: 10-30 year original maturity, semi-annual coupons.  Two types: 1) Fixed nominal coupon rate bonds with fixed principal, and 2) Inflation-indexed bonds, fixed real rate with an adjustment of actual inflation for coupons and principal (TIPS). 

See Table 6-3, p. 154, from WSJ in May 2002.  Maturities from May 2002 to April 2032.  Note: Most bonds are selling at a premium.  Why? 

STRIPs are zero-coupon Treasuries, created from a regular coupon T-bonds, where the coupons are separated (stripped) from the original bond, and sold separately, see Figure 6-2, p. 155 and Table 6-4, p. 157.  Before the Treasury issued STRIPs in 1985, investment banks like Merrill-Lynch created zero coupon bonds from regular T-bonds by stripping the coupons and selling them separately. 

Market for STRIPs: Life insurance companies or pension funds who want to invest to guarantee a fixed payoff amount, on a specific maturity date, state lotteries who invest to guarantee a fixed annual amount for payout, etc.  Why not invest in a coupon bond for the same purpose? 

Example 6-2 on p. 157.  5-year zero-coupon bonds are available @8% for

     5           8            ______           0              1000

To make a lump sum payment of $1,469,328 in 5 years, the insurer should invest $1m now in approx. 1469 of these bonds ($680.58 x 1469 bonds ≈ $1m) , to guarantee the payoff in five years and immunize against interest rate risk.    

Example 6-3 (p. 158), solve for YTM on STRIP, P = 92 16/32 (ASKED) or 92.50% of Face Value, maturity in 2.27945 years.  ANNUAL:

  2.27945   ______      (92.5)            0             100

SEMI-ANNUAL

  4.5589   ______     (92.5)            0             100

Example 6-4 (p. 158), Solve for Price on T-Note #1.

   2.3014    1.215      _______      1.9375         100

P = $101.63 (or $1,016.30 per $1000 face value bond).

To quote in 32nds, ignore the $101, and take .63 x 32 = 20.16, round to the closest whole number 20, and therefore:

P = 101 20/32, or 101-20

HP-12C

2.43 = I

3.875 = PMT

5.022002 ENTER 6.302003

YELLOW KEY, PRICE

 Solve for Price on T-Note #2      

   2.3014    1.215   ________       2.6875         100

P = 103 11/32, or 103-11

HP-12C

2.43 = I

5.375 = PMT

5.022002 ENTER 6.302003

YELLOW KEY, PRICE

When coupon bonds are sold, they usually have some Accrued Interest, the interest accrued from the time between the last coupon payment, and the current sale date.  See Figure 6-3 on p. 159.  81 days have past since the last coupon payment on May 15, 2004, there are 103 days until the next payment, and there are 184 days in the entire period between coupon payments. 

Accrued interest = (5.875% / 2)  x  (81 / 184) =  1.29314%.  Current price quoted is 101-11, or 101.34375%.  The accrued interest of 1.29314% is added to the quoted "clean" price of 101.34375%, to get 102.63689% or $10,263.689 per $10,000 face value. 

YTM is based on the current price quoted (101-11), the "clean price":

 11.5616    _______   (101.34375)      2.9375             100

Treasury Auctions

See Table 6-5, p. 160, for auction schedule and min purchases, and p. 161 for auction announcement for $25B of 2-year T-notes at a coupon rate of 3.375%.  Notes: 1) Up to $1B total can be sold to foreign investors, up to $100m per individual account. 2) These T-notes are eligible for the STRIPS program.  Bids are submitted through district Federal Reserve Banks, and can be competitive or noncompetitive (no price quoted, you agree to accept the lowest accepted competitive price bid, highest yield).  See Table 6-6 on p. 163.  All noncompetitive bids accepted, and about 50% of the competitive bids.  See Figure 6-5 on p. 164. Highest bid was 100.086% of face value, YTM of 3.3%.  Lowest bids were below 100% (YTM > 3.375%), but were not accepted.  Single bid auction - all accepted bids pay the same price (lowest accepted bid).   

Secondary Treasury Market - occurs through a network of brokers and dealers, about $300B daily. 

Municipal Bonds -  State and local governments (cities, counties, schools, etc.) bonds issued to fund long-term projects like schools, roads, subways, stadiums, etc.  Payment is made with taxes or revenues generated (toll road, user fees for subways or stadiums, etc.).  Most municipal bonds have favorable tax treatment, interest income (not cap gains) is exempt from state and federal taxes.  Corporate bonds are fully taxable, Treasury bonds are taxable at the federal level, exempt at the state level.  YTMs are lower for municipals, investors pay more, receive lower YTMs, because of the favorable tax treatment.  See formulas on p. 164 and 165. 

Examples 6-6 and 6-7 on p. 165. 

General Obligation (GO) Bonds: No specific assets or collateral, no specific source of revenue, govt. promises to pay using all resources and taxes, makes a blanket or general obligation to pay.  Usually requires taxpayer approval in referendum vote, so volume of GO bonds is only 37% of the market. 

Revenue Bonds (63% of the market) have a specific source of revenue identified to pay for bonds: Toll booths, user fees, etc.  If revenue falls short, bonds go into default.  Revenue bonds are therefore riskier than GO bonds. 

Municipal bonds pay semi-annual interest, sold in denominations of $5000.  Munis can go into default, $1.4B in 1990, during recession, probably which type of default? 

Underwriting Process for Munis: 

Firm Commitment: Investment bank guarantees a firm price for the entire issue, and then sells the bonds to the public at a higher price.  Investment bank takes the risk.  See Figure 6-6 on p. 167. 

Best Efforts: Investment bank does guarantee a price, just offers to sell at the market price for a fee.  No risk to investment bank for best efforts underwriting.  Investors are often more skeptical of best efforts, won't pay as much as Firm Commitment issue. 

Private Placement: Sell the entire issue to a large institutional buyer (pension fund, private foundation, etc.) or a group of buyers (10 or fewer).  Privately placed securities are generally less liquid, compared to public placement.  Why?   

CORPORATE BONDS

Long-term corporate debt, 57% of the market. Generally coupon bonds, semi-annual interest, $1000 face value. 

Bond Indenture is the legal document that outlines the terms, conditions and covenants of the bond issue.  Rights and obligations of the bond issuer and the bondholder, e.g., dividend restrictions, call feature, put feature, sinking fund, etc. 

See Bond Characteristics in Table 6-11 on p. 171. 

Bearer Bonds (unregistered) where coupons are attached to bond certificate, vs. Registered Bonds where ownership is recorded by name or serial number, payments get paid electronically (most common in the U.S.). 

Term bonds have a single maturity date for entire issue (2013) vs. Serial bonds have several or many maturity dates (2009-2013).

Mortgage Bonds is secured debt, where specific real estate property has been pledged as collateral.  Most corporate bonds are unsecured (debentures) and pay higher yields compared to mortgage bonds.   

Subordinated Debt is junior to more senior debt, in some order of priority for payment (secured debt is higher priority than unsecured debt). 

Convertible Bonds are convertible to common stock at a predetermined rate, e.g., 285.71 shares per $1000 bond at a time when the stock is selling for around $3.  Stock price usually must rise by 15-20% before conversion becomes profitable.  Once this stock price rises above $3.50, the bond has a positive conversion value ($1000/285.71 = $3.50).  Bondholders have a valuable option that allows them to become a shareholder if the stock price rises, and they will pay a premium and accept a lower yield, usually 2-5% lower.  See Figure 6-7 on p. 173. 

Stock Warrants (call options) are similar to convertible bonds, but allows the investor to buy shares of stock at a predetermined price on or before a specified date, without giving up the bonds.  Stock warrants can also be detached and sold.

Callable Bonds can be called in at the option of the issuer at a predetermined call price, usually at a premium, after a deferred period, e.g. ten year period.  When do callable bonds get called?  See call schedule of premiums on p. 174.  The closer to maturity, the lower the premium.  Callable bonds have yields of .05%-.25% higher than noncallable bonds. 

Sinking Fund Provision of a bond requires the corporation to put funds into an interest-earning escrow account/fund that will be used to pay off the principal of the bonds upon maturity.  Remember that most bonds are interest only.  Can also be a provision that requires the company to retire bonds early, either by secondary market purchases or by randomly calling in bonds early.  For example, May Dept Stores Co. was required to put $12.5m annually from 1999-2017 into a sinking fund.  Bonds with a sinking fund are less risky, could be issued at a lower YTM. 

Secondary Market for bonds takes place mostly OTC through an interdealer network of bond traders, e.g., investment banks (99%).  Some bonds also trade on NYSE.      

BOND RATINGS

Without credit rating agencies, bond markets and credit markets might not develop, or would be very thin.  Information about creditworthiness would be costly for individual or small investors.  Standard and Poor's and Moody's are the two largest bond rating agencies, using 9 letter grades to assign overall credit risk, and then 1, 2, or 3s for Moody's or +/- for S&P, see Table 6-13 and Figure 6-8 on p. 176.  For example, a staff of 1,250 credit analysts, accountants, economists at S&P conducts research on credit risk for companies, governments, and even countries.  Credit analysis involves reviewing the firm's financial statements, conduct financial ratio analysis, consider the bond features including seniority position, etc., and assess credit risk rating for each bond issue. 

Top four bond ratings are considered investment grade, bottom five are speculative, or junk bonds.  Some FIs are restricted to owning only investment grade bonds. 

Bond Market Indexes are listed in Table 6-14 on p. 178 for corporate, munis and Treasuries, complied by Lehman Brothers and Merrill-Lynch and listed daily in WSJ.

BOND MARKET PARTICIPANTS 

Bond issuers (bond supply) are firms and governments.  Bond buyers/investors (bond demand) are shown on p. 178, Figure 6-9.  Notice: 1) For munis and corporates, the largest buyers are "business financial" (FIs like banks, insurance companies and mutual funds) representing "indirect finance," about 60% in both markets.  2) Foreign investors are about 2/5 of the market for Treasuries and 1/5 corporate bonds.  Why no foreigners in muni bond mkt?

See bond yields on p. 179, Figure 6-10. 

INTERNATIONAL BOND MARKETS

Eurobonds (80%) are long-term bonds issued in a foreign country, but not in the domestic currency of the country where they are issued, e.g. dollar-denominated bonds issued outside the U.S. (Europe, Asia, etc.).  Or it could be Yen-denominated bonds issued outside of Japan, in the U.S. or Europe.  Notice that it doesn't have to strictly be "Europe." 

Eurobonds were originally sold in the 1960s to avoid U.S. security regulations on: 1) amount of debt U.S. MNCs could issue in U.S. to finance overseas operations, and 2) 30% withholding tax on interest income in U.S. These regulations have been abandoned.  Eurobonds were not subject to U.S. regulations or tax laws.  Eurobonds: 1) are bearer bonds, 2) pay interest annually, 3) are sold in amounts of $5,000 and $10,000, 4) trade OTC, 5) are rated by Moody's and S&P, and 6) initially sold/underwritten by investment banks. 

Foreign Bonds (20%) are long-term bonds issued in a foreign country, in the domestic currency of the foreign country, e.g. IBM or GM issues bonds in the U.K. denominated in pounds or bonds in Germany in euros.  Honda or Toyota issue bonds in the U.S. in dollars. 

Note: 1) The three bond markets (Domestic, Foreign and Eurobond) compete with each other, and 2) the international bond market has historically been less regulated and more competitive than the U.S. domestic bond market.