Financial Markets and Institutions

PowerPoint Slides for: Financial Markets and Institutions By Jeff Madura Prepared by David R. Durst The University of Akron

Bond Markets 7

Chapter Objectives • Provide informational background on U.S. Treasury, state and municipal, and corporate Bonds • Calculate bond yield from quote • Explain the role of bonds to institutional investors • Discuss the globalization of bond markets

Background on Bonds • Bonds represent long-term debt securities • Contractual • Promise to pay future cash flows to investors • The issuer of the bond is obligated to pay: • Interest (or coupon) payments periodically usually semiannually • Par or face value (principal) at maturity • Primary vs. secondary market for bonds

Background on Bonds The issuer’s cost of financing with bonds is the coupon rate • Determined by current market rates and risk • Usually fixed throughout term • Determines periodic interest payments Bond Interest Rates

Background on Bonds The yield to maturity (TYM) is the yield that equates the future coupon and principal payments with the bond price • The YTM is the investor’s expected rate of return if the bond is held to maturity • The actual YTM may vary from the expected because of risks assumed by the investors Bond Yield to Maturity

Background on Bonds An investor can purchase a ten-year, $1000 par value bond with an 8 percent annualized coupon rate for $936. Determine the yield to maturity for this bond. Bond Yield to Maturity

Issuer Type of Bond Federal Government (U.S. Treasury) Treasury Bonds Federal Agencies Federal Agency Bonds State and Local Governments Municipal Bonds Corporations Corporate Bonds Background on Bonds Bonds by Issuers

U. S. Treasury Bonds • Issued by the U.S. Treasury to finance federal government expenditures • Maturity • Notes, < 10 Years • Bonds, > 10 to 30 Years • Active OTC Secondary Market • Semiannual Interest Payments • Benchmark Debt Security for Any Maturity

Treasury Bonds • Treasury Bond Quotations 8.38 Aug. 2013-18 103:05 103.11 YTM? • Coupon rate • Maturity date • Bid/Ask price as percent of face value • Fractions of price in 32nds • Example: Bid price 103:05, Ask price 103:11 • Yield to Maturity (YTM)

$1033.44 PV* *Ask Price = 103 and 11/32 % of Face Value or $1033.4375 U. S. Treasury Bond Yield To Maturity $83.80 Pmt 2013 – Today = N $1000 Ask Price = FV Calc YTM

Treasury Bonds Cash Flow Variation in T-Bonds • Coupon bonds • Interest paid semiannually • To registered bondholders • Stripped Treasury bonds • Zero-coupon securities are sold with claims on U. S. Treasury bonds held in a trust • One security represents the principal payment (np) at maturity • Other securities represents the interest payments (ci) at interest paying dates

Treasury Bonds Inflation-Indexed Bonds • Intended for investors who seek inflation protection with their investments • Coupon rates less than other Treasuries • Principal value adjusted for the U.S. inflation rate (CPI) every 6 months • Coupon income increases with inflation

Federal Agency Bonds • Government National Mortgage Association (GNMA) • Issues bonds and uses proceeds to purchase insured FHA and VA mortgages • A U.S. Government Agency • Backed by explicit guarantee of Federal Government • Example of social allocation of capital

Federal Agency Bonds • Federal Home Loan Mortgage Association (Freddie Mac) • Issues bonds and uses proceeds to purchase conventional mortgages • A U.S. government-sponsored agency • No explicit guarantee of bonds by federal government, but credit risk is very low • Used to provide liquidity for thrifts and support of home ownership

Municipal Bonds • State and local government obligations • Revenue bonds vs. general obligation Bonds • Investor interest income exempt from federal income tax • Tax Reform Act of 1986 placed limitations on tax-exempt bond issuance for private purposes

Corporate Bonds • When corporations want to borrow for long-term periods they issue corporate bonds • Usually pay semiannual interest • Most have maturities between 10-30 years • Public offering vs. private placement • Limited exchange, larger OTC secondary market • Investors seek safety of principal and steady income

Corporate Bonds Corporate Bond Terminology • Indenture • Legal document specifying rights and obligations of issuer and bondholder • Trustee • Represents bondholders to assure compliance with indenture

Corporate Bonds Corporate Bond Terminology • Sinking Fund Provision • Requirement that the firm retire a certain amount or number of bonds each year • Protects investors with principal reduction • Protective Covenants • Places restrictions on the firm to protect bondholders • Examples: limits dividends and officer salaries, restricts additional debt

Corporate Bonds Corporate Bond Terminology • Call provisions: Ability to pay bonds off early • Call premium • Advantage to issuers; disadvantage to investor • Bond collateral • Usually consists of a mortgage on real property • Unsecured bonds are called debentures and are backed only by the general credit of the issuing firm

Corporate Bonds Corporate Bond Terminology • Low-coupon and zero-coupon bonds • Provide investors known rate of return • Imputed interest income taxed if not in tax-sheltered investment plan • Attractive to pension funds with expected payouts • Variable-rate bonds • Convertible bonds

Corporate Bonds • Junk Bonds • Junk bonds are also called high-yield bonds or noninvestment rated bonds • Popularized in the direct finance boom of the 1980s • The risk premium is between three and seven percent above Treasury bonds and susceptible to contagion effects • Secondary market supported by dealer market

Corporate Bonds Market Quotation ATT 6 ½ 29 7.3 214 88 5/8th +1/4 • AT&T bond quote for 1/13/02 (U.S. Exchange Bond) • 6.5% coupon rate • Maturity in 2029 • 7.3% current yield (annual interest/price) • 214 bonds traded on this day • Bond priced at close of day 88 5/8th % of face ($1000) or $886.25 • Bond price up ¼ point for the day or $2.50

F i n a n c i a l I n s t i t u t i o n P a r t i c i p a t i o n i n B o n d M a r k e t s C o m m e r c i a l b a n k s a n d s a v i n g s • P u r c h a s e b o n d s f o r t h e i r a s s e t p o r t f o l i o . • a n d l o a n a s s o c i a t i o n s ( S & L s ) • S o m e t i m e s p l a c e m u n i c i p a l b o n d s f o r m u n i c i p a l i t i e s . • S o m e t i m e s i s s u e b o n d s a s a s o u r c e o f s e c o n d a r y c a p i t a l . F i n a n c e c o m p a n i e s • C o m m o n l y i s s u e b o n d s a s a s o u r c e o f l o n g - t e r m f u n d s . M u t u a l f u n d s • U s e f u n d s r e c e i v e d f r o m t h e s a l e o f s h a r e s t o p u r c h a s e b o n d s . S o m e b o n d m u t u a l f u n d s s p e c i a l i z e i n p a r t i c u l a r t y p e s o f b o n d s , w h i l e o t h e r s i n v e s t i n a l l t y p e s . B r o k e r a g e r m s • F a c i l i t a t e b o n d t r a d i n g b y m a t c h i n g u p b u y e r s a n d s e l l e r s o f b o n d s i n t h e s e c o n d a r y m a r k e t . I n v e s t m e n t b a n k i n g r m s • P l a c e n e w l y i s s u e d b o n d s f o r g o v e r n m e n t s a n d c o r p o r a t i o n s . T h e y m a y p l a c e t h e b o n d s a n d a s s u m e t h e r i s k o f m a r k e t p r i c e u n c e r t a i n t y o r p l a c e t h e b o n d s o n a b e s t - e f f o r t s b a s i s i n w h i c h t h e y d o n o t g u a r a n t e e a p r i c e f o r t h e i s s u e r . I n s u r a n c e c o m p a n i e s • P u r c h a s e b o n d s f o r t h e i r a s s e t p o r t f o l i o . P e n s i o n f u n d s • P u r c h a s e b o n d s f o r t h e i r a s s e t p o r t f o l i o . Exhibit 7.5

Major Investors in Corporate Bonds, December, 2001 Mutual Funds $420 Bil. Households and Trusts$608 Billion Foreign Investors $1.23 Trillion Life Insurance Companies $1.33 Trillion

Globalization of Bond Markets • Foreign investment in dollar securities • Foreign issuance by U.S. firms • Increased global investment by pension and mutual funds • Development of foreign security markets—24 hour trading • Eurobond market

Globalization of Bond Markets Eurobond Market • In 1960s, U.S. corporations were limited to the amount of funds they could borrow in the U.S. for overseas operations. • They began to issue bonds in the Eurobond market where bonds denominated in various currencies were placed. • About 75 percent are denominated in U.S. dollars

Globalization of Bond Markets Eurobond Market • An underwriting syndicate of investment banks participates in placing the bonds • Issuer can choose the currency in which the bond interest and principal are denominated • Dollar denominated most common • Bearer bonds vs. registered bonds

Financial Markets and Institutions