BOND MARKETS

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Long-term debt securities issued by government agencies or corporations.

The issuer is obligated to pay interest (or coupon) payments periodically (such as annually or semiannually) and the par value (principal) at maturity.

Bonds are often classified according to the type of issuer: treasury bonds, federal agency bonds, municipal bonds, and corporate bonds.

Most bonds have maturities of between 10 and 30 years.

Can be issued as bearer bonds or registered bonds.

Bonds are issued in the primary market through a telecommunications network.

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) (Separate Trading of Registered

Interest and Principal of Securities): Interest streams repackaged as separate security (TIGR)

TIPS (1996) inflation-indexed maturity values

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The U.S. Treasury commonly issues Treasury notes and Treasury bonds to finance federal government expenditures.

The minimum denomination for Treasury notes and bonds is now $100.

Note maturities are less than 10 years whereas bond maturities are 10 years or more.

Receive semiannual interest payments from the Treasury.

Interest is taxed by the federal government as ordinary income, but it is exempt from any state and local taxes.

Federal Agency bonds

a. Issued by federal agencies such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) who use the proceeds to purchase mortgages in the secondary market.

b.During the credit crisis in 2008, Fannie Mae and Freddie Mac experienced financial problems because they had purchased risky subprime mortgages that had a high frequency of defaults.

c. The federal government rescued Fannie Mae and Freddie Mac so that they could resume issuing bonds and continue to channel funds into the mortgage market.

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Municipal Bonds Issued by states, counties, cities and state agencies

Interest is exempt from Federal taxation

General obligation bonds are supported by the municipal government’s ability to tax.

Revenue bonds are supported by revenues of the project (tollway, toll bridge, state college dormitory, etc.) for which the bonds were issued.

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)

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Credit Risk of Municipal Bonds

Ratings of Municipal Bonds

Moody’s, Standard & Poor’s, and Fitch Investors Service assign ratings to municipal bonds based on the ability of the issuer to repay the debt.

Impact of the Credit Crisis on Municipal Bond Risk

During weak economic conditions, some state and local governments with large budget deficits may not be able to sell additional bonds, even when offering a higher yield, if investors are concerned that the governments may default on their debt.

Insurance against Credit Risk of Municipal Bonds

Some municipal bonds are insured to protect against default.

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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

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1. Corporate Bond Offeringsa.Public offering: Underwriters try to place newly issued

bonds with institutional investors.b.Private placement

Small firms that borrow small amounts of funds (such as $30 million) may consider private placements rather than public offerings.

The institutional investors that purchase a private placement include insurance companies, pension funds, and bond mutual funds.

2. Characteristics of Corporate Bondsa.Sinking fund provision - a requirement that the firm

retire a certain amount of the bond issue each year.b.Protective covenants – restrictions placed on the

issuing firm that are designed to protect bondholders from being exposed to increasing risk during the investment period.

2. Characteristics of Corporate Bonds (Cont.)c.Call provisions

Normally requires a price above par value when bonds are called. The difference between the bond’s call price and par value is the call premium.

Call when rates drop or rise??????

d.Bond collateral - Bonds can be classified according to whether they are secured by collateral and by the nature of that collateral.

e.Low and zero-coupon bonds

i. Issued at a deep discount from par value.

ii. Are purchased mainly for tax-exempt investment accounts.

2. Characteristics of Corporate Bonds (Cont.)f. Variable rate bonds – Long term debt securities

with a coupon rate that is periodically adjusted.

g.Convertibility - Allows investors to exchange the bond for a stated number of shares of the firm’s common stock.

h.Default Rate - The general level of defaults on corporate bonds is a function of economic conditions.

i. Bond Ratings Corporate bonds that receive higher ratings can be

placed at higher prices (lower yields). As a result of the Financial Reform Act of 2010, rating

agencies are subject to oversight by a newly established Office of Credit Ratings.

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

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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

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C.Default (or business) Risk Risk that payments may not be made Importance of indenture agreement

D.Maturity Risk The longer the maturity, the greater the risk

E.Liquidity Risk The inability or difficulty in selling for cash

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F.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 - BBB), Speculative (BB and B), Highly speculative (C's), Default (D's)

Public Utilities are the single largest issuer of bonds

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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

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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 happens to yeild/price as risk increases?

What are the two sources of risk when investing in foreign bonds?

How might the risk be minimized??

Q&A: 2, 4, 8, 9, 14, 15 Interp: a, b, c

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