Understanding the Bond Market I. Overview of the Bond Market

1. Understanding the Bond Market • I. Overview of the Bond Market • The bond market brings together borrowers and lenders with long term time horizons. • It is comprised of two sectors: government and corporate bonds. • The government sector includes national sovereign, foreign sovereign, agency, and state and local debt issues. • Features of bonds, such as call provisions, seniority, and credit rating, greatly affect their value. • Insert 12.1

2. II. Instruments of the Bond Market • A. Treasury Debt • Treasury debt can be classified by its maturity. Bills are one year or less. Notes are ten years or less. Bonds are greater than 10 years in length. • Treasury debt is auctioned on a yield basis. • Insert 12.2 & 12.3 • The most recently issued notes and bonds within a maturity class are referred to as on-the-run issues. • Primary Dealers • Stripping is the process of splitting off the coupons from the principal. • Insert 12.4

3. B. Agency Debt • Federal agencies are entities that are owned or managed by the federal government, federally sponsored but privately owned agencies, and international organizations. • There four different levels of federal backing: 1) full backing of the US Government 2) US Treasury guarantee 3) US Treasury borrowing privileges 4) implicit claims to government assistance Agencies • Farm Credit System • Farm Credit System Financial Assistance Corporation • Federal Home Loan Banks • Federal National Mortgage Association • Financing Corporation • Maritime Administration • Resolution Funding Corporation • Student Loan Marketing Association

4. International Organizations • Asian Development Bank • Inter-American Development Bank • World Bank Mortgage-Backed Debt • Federal Home Loan Mortgage Corporation • Federal National Mortgage Association • Government National Mortgage Association • Federal Agricultural Mortgage Corporation Other federal agencies seek their financing from the Federal Financing Bank. • C. Municipal Bonds • Long term capital needs of state and local governments are met through the issuance of municipal bonds. • Municipal bonds are exempt from federal taxes and interest payments are exempt from local taxes. • Typically, long-term municipal debt is sold as serial bonds. • The majority of municipal bonds are revenue bonds, as opposed to general obligation debt.

5. D. Corporate Bonds • Private firms obtain their long term debt capital in the corporate bond market. • Investors in the corporate bond market generally hold securities until maturity. • Most corporate bonds contain call provisions which allow the issuer to retire the bonds beyond some specific call date, but prior to maturity. • Corporate bond backing comes in the following forms: • debentures • equipment obligations • subordinated debentures • collateral trust bonds • mortgage bonds • The bond indenture details the type of backing and other legal technicalities associated with the bond. • A sinking fund provision requires the corporation to retire a certain percentage of outstanding debt each year.

6. III. Determining Bond Value • A. Callability Provisions • The call feature grows in importance to the firm as interest rates drop. • If the bond is called, the investor loses all future cash flows. She is compensated for this loss by a lower initial price. • Insert 12.5 & 12.6 • The value of the call option is the difference between an otherwise equivalent noncallable bond price and the callable bond. The value of the call option increases as the volatility of interest rates increases. • Insert 12.7 & 12.8 • Duration is also affected by callability. The amount that duration shortens due to callability depends on the volatility of interest rates. • Insert 12.9

7. B. Default Risk and Bond Ratings 1. Corporate Bond Ratings • Rating agencies use elaborate systems of financial ratio analysis in the assessment of a firm’s ability to repay its debt. Examples of ratios: • Coverage Ratios • Profitability Ratios • Financial Leverage Ratios • Rate of Return On Total Assets • Liquidity Ratios • Current Ratio • Quick Ratio • Insert 12.10 & 12.11 2. Municipal Bond Ratings • When assessing general obligation bonds, the municipality’s general financial condition is assessed along with its ability to raise funds. • The quality of a revenue bond is dependent upon the quality (its fundraising ability) of the underlying project. • IV. Summary • Insert 12.12