Chapter Six Bond Markets
Overview of the Bond Markets A bond is is a promise to make periodic coupon payments and to repay principal at maturity; breech of this promise is 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
Bond Market Instruments Outstanding, 1994-1999 ($Bn) 10000 8000 6000 4000 2000 0 1994 1995 1996 1997 1998 1999 Treas bonds Muni securities Corp bonds Total
Treasury Notes and Bonds T-notes and T-bonds issued by the U.S. treasury to to finance the national debt and other federal government expenditures Backed by the full faith and credit of of the U.S. government and are default risk free Pay relatively low rates of of interest (yields to to maturity Given their longer maturity, not entirely risk free due to to interest rate fluctuations Pay coupon interest (semiannually), notes have maturities from 1-10 yrs, bonds 10-30 yrs
Composition of the U.S. National Debt ($Bn) 2500 2000 1500 1000 500 0 1994 1995 1996 1997 1998 1999 T-bills T-notes T-bonds U.S. sav sec Foreign series Gov acc sec St. & Loc. Gov sec Domestic sec
Treasury Strips A treasury security in in which the periodic interest payment is is separated from the final principal payment Effectively creates two sets of of securities--one for each semiannual interest payment one one for the final principal payment Often referred to to as as Treasury zero-coupon bonds Created by U.S. treasury in in response to to separate trading of of treasury security principal and interest that been developed by securities firms, only available through FIs and gov securities brokers
The Primary Market in Treasury Notes and Bonds Similar to to the primary market T-bill sales, the treasury sells T-notes and bonds through competitive and noncompetitive auctions Auction Pattern for for Treasury Notes and bonds Security Purchase Minimum 2-year note $1,000 5-year note $1,000 10-year note $1,000 30-year note $1,000 General Auction Schedule Monthly Feb, May-Aug, Nov Feb, May-Aug, Nov Feb, Aug, Nov
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
Municipal Bonds (munis) Securities issued by state and local governments to to fund either temporary imbalances between operating expenditures and receipts or or to to finance long-term capital outlays for activities such as as school construction, public utility construction or or transportation systems Tax receipts or or revenues generated are the source of of repayment Attractive to to household investors because interest (but not capital gains) are tax exempt
Tax Exemption and Muni Yields i a = i b (1 - t) t) Where: ii = a a After-tax (equivalent tax tax exempt) rate of of return on on a taxable corp bond ii b b = Before-tax rate of of return on on a taxable bond t t = Marginal income tax tax rate of of the the bond holder Example: You can invest in in taxable corporate bonds that are are paying 10% annually on on munis. Your marginal tax tax rate is is 28%, the the aftertax rate of of return on on the the taxable bond is: tax is: 10%(1-.28) = 7.2%
Types of Municipal Bonds General Obligation Bonds bonds backed by the full faith and credit of of the issuer Revenue Bonds bonds sold to to finance a specific revenue generating project and are backed by cash flows from that project
Primary Market Placement Choices for Munis General Public Offering underwriter is is selected either by negotiation or or by competitive bidding the underwriter offers the bonds to to the general public Rule 144A Placement bonds are sold on a semi-private basis to to qualified investors (generally FIs)
Top Municipal Bond Underwriters Principal Amount Market No. No. of of Underwriter (in (in millions $$) $$) Share Issues Salomon Smith Barney $31,375.4 12.7% 403 403 Merrill Lynch 22,845.3 9.2% 9.2% 312 312 Paine Webber 22,089.3 8.9% 8.9% 420 420 Goldman Sachs 17,314.8 7.0% 7.0% 233 233 Lehman Brothers 11,039.4 4.5% 4.5% 169 169 Morgan Stanley Dean Witter 9,518.3 3.8% 3.8% 226 226 Bear, Stearns 7,642.9 3.1% 3.1% 108 108 First First Union 6,373.8 2.6% 2.6% 393 393 J.P. J.P. Morgan 5,660.7 2.3% 2.3% 106 106 U.S. U.S. Bancorp Piper Jaffray 5,206.8 2.1% 2.1% 538 538 Industry totals $219 $219 billion
Contracting Choices with the Underwriter Firm commitment underwriting the the issue of of securities in in which the the investment bank guarantees the the corp. a price for for newly issued securities by by buying the the whole issue at at a fixed price from the the corporate issuer then seeks to to resell to to suppliers of of funds (investors) at ata higher price Best efforts underwriting the the issue of of securities in in which the the underwriter does not guarantee a price to to the the issuer and acts more as as a placing or or distribution agent, bank acts as as agent on on a fee fee basis related to to its its success in in placing the the issue
Secondary Market for Munis Secondary market isthin (I.e. trades are relatively infrequent) due to a lack of information on bond issuers, who are generally much smaller than corporate bond issuers
Corporate Bonds All long-term bonds issued by corporations Minimum denominations publicly traded corporate bonds is is $1,000 Generally pay interest semiannually Bond indenture legal contract that specifies the rights and obligations of of the bond issuer and the bond holder
Types of Corporate Bonds Bearer bonds coupons attached that are presented by the holder to to the issuer for interest payments when due Registered bonds the owner of of the bond is is recorded by the issuer and coupon payments are mailed to to the registered owner Term bonds entire issue matures on a single date Serial bonds mature on a series of of dates (continued)
Types of Corporate Bonds Mortgage bonds issued to to finance specific projects which are pledged as as collateral Debentures backed solely by the general credit of of the issuing firm and unsecured by specific assets or or collateral Subordinated debentures unsecured debentures that are junior in in their rights to to mortgage bonds and regular debentures (continued)
Types of Corporate Bonds Convertible bonds may be be exchanged for for another security of of the the issuing firm at at the the discretion of of the the bond holder Stock Warrant give the the bond holder an an opportunity to to purchase common stock at at a specified price up up to to a specified date Callable bonds allow the the issuer to to force the the bond holder to to sell the the bond back to to the the issuer at at a price above the the par value (call price) Sinking Fund Provisions bonds that include a requirement that the the issuer retire a certain amount of of the the bond issue each year
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
Bond Ratings Bonds are rated by the issuer s default risk Large bond investors, traders and managers evaluate default risk by analyzing the issuer s financial ratios and security prices Two major bond rating agencies are Moody s and Standard & Poor s (S&P) Bonds assigned a letter grade based on perceived probability of issuer default
Bond Credit Ratings Explanation Moody s S&P S&P Investment grade categories: Best Best quality; smallest degree of of risk risk Aaa Aaa AAA High High quality; slightly more more long-term Aa1 Aa1 AA+ AA+ risk risk than than top top rating Aa2 Aa2 AA AA Aa3 Aa3 AA AA Upper medium grade; possible A1 A1 AAimpairment in in the the future A2 A2 A+ A+ AA- A3 A3 A- A- Medium grade; lack lack outstanding Baa1 Baa1 BBB+ investment characteristics Baa2 Baa2 BBB BBB Baa3 Baa3 BBB- (continued)
Bond Credit Ratings Explanation Moody s S&P S&P Speculative investment grades: Speculative issues; protection may may Ba1 Ba1 BB+ BB+ be be very very moderate Ba2 Ba2 BB BB Ba3 Ba3 BB- BB- Very Very speculative; may may have have small B1 B1 B+ B+ assurance of of interest and and principle B2 B2 B payment B3 B3 B- B- Issues in in poor poor standing; may may be be in in default Caa Caa CCC CCC Speculative in in a high high degree Ca Ca CC CC Lowest quality; poor poor prospects of of attaining C C real real investment standing D
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
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
International Aspects of Bond Markets International bond market trades bonds that are underwritten by an international syndicate offer bonds simultaneously to to investors in in several countries issue bonds outside the jurisdiction of of any single country offer bonds in in unregistered form
Eurobonds, Foreign Bonds, Brady Bonds and Sovereign Bonds Eurobonds long-term bonds issued and sold outside the the country of of the the currency in in which they are are denominated (e.g., dollardenominated bonds issued in in Europe or or Asia) Foreign Bonds long-term bonds issued by by firms and governments outside of of the the issuer s country, usually denominated in in the the currency of of the the country in in which they are are issued Brady Bonds and Sovereign Bonds a bond that is is swapped for for an an outstanding loan to to a lesser developed country, sovereign bonds carry the the creditworthiness of of the the lesser developed country