S

Study Notes on Bond Markets and Institutions

1. Chapter Objectives

  • Provide a background on bonds
  • Describe the different types of bonds and their characteristics
  • Explain how bond markets have become globally integrated
  • Describe other types of long-term debt securities

2. Background on Bonds

  • Definition: Long-term debt securities issued by government agencies or corporations.
  • Obligations: The issuer is obligated to make periodic interest (or coupon) payments (such as annually or semiannually) and repay the par value (principal) at maturity.
  • Classification: Bonds are classified based on the issuer type:
    • Treasury bonds
    • Federal agency bonds
    • Municipal bonds
    • Corporate bonds
  • Maturity: Most bonds have maturities ranging from 10 to 30 years.
  • Types: Issued as bearer bonds (not registered to an owner) or registered bonds.
  • Market Issuance: Bonds are issued in the primary market using a telecommunications network.

3. Institutional Participation in Bond Markets

  • Bond Issuers:

    • Commercial banks
    • Saving institutions
    • Finance companies

  • Investors:

    • Commercial banks
    • Saving institutions
    • Bond mutual funds
    • Insurance companies
    • Pension funds

4. Bond Yields

4.1 From Issuer’s Perspective

  • Yield Measurement: Commonly measured by the yield to maturity, which is the annualized discount rate that equates the future coupon and principal payments to the initial proceeds from the bond offering.

4.2 From Investor’s Perspective

  • Holding Period Return: Used by bond investors who may not hold the bond until maturity.
  • Yield Composition: Comprises two components:
    • A set of coupon payments
    • The difference between the par value at maturity and the initial price received when selling the bonds.

5. Treasury and Federal Agency Bonds

  • Purpose: The U.S. Treasury issues Treasury notes and bonds to manage federal government expenditures.
  • Minimum Denomination: $100 for Treasury notes and bonds.
  • Maturity Difference:
    • Notes: Less than 10 years
    • Bonds: 10 years or more
  • Interest Payments: Receive semiannual payments; interest is taxed as ordinary income federally but exempt from state and local taxes.

5.1 Treasury Bond Auctions

  • Schedule: Typically held mid-quarter.
  • Bidding Types:
    • Competitive bids: Specify a price and dollar amount to purchase.
    • Noncompetitive bids: Specify only the dollar amount of securities to purchase.

5.2 Trading Treasury Bonds

  • Role of Dealers: Serve as intermediaries matching buyers and sellers in the secondary market, profiting from the bid-ask spread.
  • Trading Venue: Treasury bonds are registered on the New York Stock Exchange; secondary trading occurs over the counter.
  • Online Trading: Bonds can be purchased through the Treasury Direct program. Bond prices available on various online platforms.

5.3 Stripped Treasury Bonds

  • Definition: Cash flows transformed into principal-only and interest-only bonds.
  • Common Name: STRIPS (Separate Trading of Registered Interest and Principal of Securities).
  • Issuance: Created by financial institutions, not directly by the Treasury.

5.4 Inflation-Indexed Treasury Bonds

  • Description: Provide returns linked to inflation rates, commonly known as TIPS (Treasury Inflation-Protected Securities).
  • Principle Adjustment: The principal value adjusts with the U.S. inflation rate.
  • Savings Bonds: Issued by the Treasury, can be purchased from various financial institutions, starting at $25. Interest is taxable at the federal level but exempt from state and local taxes.

5.5 Federal Agency Bonds

  • Issuers: Federal agencies like Fannie Mae and Freddie Mac issue bonds using proceeds to purchase mortgages.
  • 2008 Credit Crisis: Financial troubles arose from purchasing risky subprime mortgages, leading to government intervention for stability.

6. Municipal Bonds

  • Issuers: Issued by state and local governments.
  • Bond Types:
    • General obligation bonds: backed by the municipality's tax ability.
    • Revenue bonds: supported by project revenues (e.g., toll roads).
  • Interest Payments: Typically promise semiannual payments; minimum denomination is usually $5,000.
  • Call Provisions: Most municipal bonds include provisions allowing issuers to redeem bonds before maturity.

6.1 Credit Risk of Municipal Bonds

  • Ratings: Assigned by agencies like Moody’s, Standard & Poor’s, and Fitch based on repayment ability.
  • Insurance: Some municipal bonds are insured to cover against defaults.

6.2 Variable-Rate Municipal Bonds

  • Characteristics: Feature a floating interest rate tied to a benchmark.

6.3 Tax Advantages of Municipal Bonds

  • Tax Considerations: Interest typically exempt from federal taxes, and often exempt from state taxes within the state of issuance.

6.4 Trading and Quotations of Municipal Bonds

  • Market Composition: Over 1 million municipal bonds issued by over 50,000 different issuers; market can be inactive.
  • Electronic Trading: Increasingly popular in recent years.

6.5 Yields Offered on Municipal Bonds

  • Risk Premium: Must offer a risk premium for default risk.
  • Liquidity Premium: Must compensate for being less liquid than Treasury bonds with similar maturities.
  • Tax Exemption: Income is exempt from federal taxes, allowing lower yields compared to Treasury bonds.

7. Corporate Bonds

  • Definition: Long-term debt securities issued by corporations, offering coupon payments.
  • Minimum Denomination: $1,000.
  • Maturity Range: Generally between 10 to 30 years.
  • Tax Implications: Interest paid is tax-deductible for corporations, while bondholders face tax obligations on interest earned.

7.1 Corporate Bond Offerings

  • Public Offerings: Underwriters facilitate the placement of newly issued bonds with institutional investors.
  • Private Placements: Smaller firms may opt for private placements rather than public offerings, with investors including insurance companies and pension funds.
  • Credit Risk: Corporate bonds are subject to default risk; yields include a risk premium.

7.2 Bond Ratings and Credit Risk

  • Credit Ratings: Corporations obtain ratings to assess credit risk; higher-rated bonds fetch higher prices due to perceived lower risk.
  • Financial Reforms: Post-2010 reforms include oversight by the Office of Credit Ratings within the SEC.
  • Junk Bonds: High-risk corporate bonds, attracting specific investors seeking higher yields compared to Treasuries.

7.3 Secondary Market for Corporate Bonds

  • Dealer Role: Dealers act as brokers between buyers and sellers.
  • Market Liquidity: Bonds from large, well-known firms tend to be more liquid than those from smaller companies.
  • Electronic Trading Networks: Facilitate bond trading with reduced transaction costs.
  • Order Types:
    • Market orders execute at current market prices.
    • Limit orders execute only at specified prices.

7.4 Trading Online

  • Online Trading Growth: There is a rise in online transactions for buying and selling corporate bonds, with varying commission structures.

7.5 Characteristics of Corporate Bonds

  • Sinking Fund Provision: Firms must retire part of the bond issue annually.
  • Protective Covenants: Restrictions to protect bondholders from rising risks during the investment period.
  • Call Provisions: Often require repayment above par value when bonds are called, with a call premium.
  • Collateral Types: Classification based on collateral existence and type.
  • Low/Zero-Coupon Bonds: Issued at significant discounts, primarily for tax-exempt investments.
  • Variable Rate Bonds: Coupon rates periodically adjusted.
  • Convertibility: Allows bond exchanges for a specific number of common stock shares.

7.6 Using Bonds for Restructuring

  • Leveraged Buyouts: Bonds fund the acquisition of stock for fewer owners.
  • Capital Structure Revision: Debt is seen as cheaper than equity, provided corporations can meet payment obligations.
  • Debt-for-Equity Swap: Issuing bonds to repurchase existing stock.

8. Globalization of Bond Markets

8.1 Global Government Debt Markets

  • Attractiveness: Bonds from foreign governments appeal due to debt obligation fulfillment capabilities.
  • Greek Debt Crisis: Highlighted in 2010 when Greece faced instability due to economic conditions; severe credit rating downgrades occurred, influencing markets in Spain and Portugal.

8.2 Eurobond Market

  • Definition: Securities syndicates place bonds in this market; issuers can select bond currency.

9. Other Types of Long-Term Debt Securities

9.1 Structured Notes

  • Characteristic: Payment amounts are based on specific market conditions.
  • Risk: Notable case: Orange County, California filed for bankruptcy due to structured notes; credit ratings sometimes misleading.

9.2 Exchange-Traded Notes

  • Structure: Debt instruments matching returns to specific debt index performances.
  • Maturity: Typically 10 to 30 years, unsecured by assets.

9.3 Auction-Rate Securities

  • Description: Allow borrowers to leverage short-term investments for long-term borrowing.
  • Auction Mechanism: Securities auctioned every 7 to 35 days to reset interest rates based on winning bids.

10. Summary and Review

  • Focus on Key Questions and Problems: Q&A 1-7, 9, 10, 11, 14, 16; Problems 1 & 2.