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CHAPTER 7

CHAPTER 7. BOND MARKETS. CAPITAL MARKET INSTRUMENTS. Treasury Bonds Fed is a large buyer of T-Bonds Tool for implementing monetary policy Dealer-dominated secondary market Semi-annual coupons are typical Main asset of the FED

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CHAPTER 7

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  1. CHAPTER 7 BOND MARKETS Dr David P Echevarria

  2. CAPITAL MARKET INSTRUMENTS • Treasury Bonds • Fed is a large buyer of T-Bonds • Tool for implementing monetary policy • Dealer-dominated secondary market • Semi-annual coupons are typical • Main asset of the FED • Strips (IO or PO): Interest streams repackaged as separate security (TIGR) • TIPS (1996) inflation-indexed maturity values Dr David P Echevarria

  3. CAPITAL MARKET INSTRUMENTS • Municipal Bonds • Issued by states, counties, cities and state agencies • Interest is exempt from Federal taxation • Some types, i.e. industrial development bonds, may be completely tax-exempt • Tax-preference results in lower offered yields (rationale for computing before-tax equivalent yields) Dr David P Echevarria

  4. CAPITAL MARKET INSTRUMENTS • Corporate Bonds • Terms spelled out in the Indenture Agreement; face value, maturity, coupon, form of collateral if any • Insurance Cos are principal buyers of corporate bonds w/ households second Sold through public offerings; About half are privately-placed • Proceeds may be used to fund expansion, finance acquisitions or LBO or to refund maturing bond issues or to refund higher interest rate debt Dr David P Echevarria

  5. CAPITAL MARKET INSTRUMENTS • Zero-Coupon bonds pay no coupons; sold at PV of maturity value; result is very much like a T-bill except the maturity can be up to 30 years • A favorite vehicle for in substance defeasance of debt for corps seeking to restructure their balance sheets, • High risk uncollateralized bonds are frequently called "junk bonds" • The US Tax Code favors debt financing; interest paid with pre-tax dollars Dr David P Echevarria

  6. EVALUATING BOND RISK • Interest Rate Risk • Change in price of seasoned bonds as rates change over time • Sensitivity a function of coupon and term to maturity • Reinvestment Rate Risk • Valuation formulas assume future cash flows reinvested at the expected rate of return • If rates drop, future cash flows are invested at lower rates, reducing the future value of reinvested cash flows Dr David P Echevarria

  7. EVALUATING BOND RISK • Default (or business) Risk • Risk that payments may not be made • Importance of indenture agreement • Maturity Risk • The longer the maturity, the greater the risk • Liquidity Risk • The inability or difficulty in selling for cash Dr David P Echevarria

  8. EVALUATING BOND RISK • Companies' debt issues are rated for riskiness • Standard & Poor's, Moody's, Fitch's • Ratings: AAA to D (S&P scheme) • Ratings are important for many reasons; cost to borrow, legal list requirements High Quality (AAA - AA), Investment Grade (AAA - BB), Speculative (BB and B), Highly speculative (C's), Default (D's) • Public Utilities are the single largest issuer of bonds Dr David P Echevarria

  9. FINANCIAL INSTITUTIONS IN BOND MARKETS • Insurance Companies are largest buyer of Bonds • Attractiveness of bonds are their known payouts over time • Bonds offer frequent opportunities for capital gain strategies with relatively low risk Dr David P Echevarria

  10. GLOBALIZATION OF BOND MARKETS • Impact of Exchange Rates on Foreign Bond Returns • Dealing with the double problems of Interest-Rate and Currency Parity • Use of interest rate swaps in international bond markets • Use of currency swaps in international bond markets • Economic growth rate differentials as well as government policy • Always a good idea to diversify international bond portfolios Dr David P Echevarria

  11. HOMEWORK QUESTIONS • How is buying and selling accomplished in the T-Bond market? • How does the Fed use its inventory of treasury securities? • Who issues municipals? What is their principal attraction to an investor? • What type of investor should be most interested in municipals? • What are zero-coupon bonds? Why might borrowers prefer them? • What are the main sources of risk in a bond investment? • What are the two sources of risk when investing in foreign bonds? • How might we minimize the risk addressed in the previous question? Dr David P Echevarria

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