1. V. Web Links

Chapter Six

Bond Markets
 

 
1.  Definition of Bond Markets: Chapter Overview
Bonds are capital market instruments with original issue maturities greater than one year. Bonds are typically fixed income securities that represent nonamortized loans made to corporate or government borrowers to fund their long term capital needs. Principal is paid at maturity, and interest is typically paid semiannually at one half the ‘coupon’ rate times the face value of the bond. The major types of bonds include Treasury bonds and notes, corporate bonds and municipal bonds.
 
2.  Bond Market Securities
In 2004 there were $11,626.6 billion in bonds outstanding, excluding mortgages. The size of the total credit markets is greater than the equity markets. At times, finance classes seem to spend more time discussing equity markets than debt markets, but the debt markets generally comprise a larger source of funds.
 
a.  Treasury Notes and Bonds
T-notes and bonds comprise about 25% of total bond market securities outstanding (excluding mortgages) and comprise about 39% of the national debt (excluding T-bills). These instruments are default risk free. T-notes have an original issue maturity from 1 to 10 years inclusive, whereas T-bonds have original maturities more than 10 years. Both types pay interest semi-annually. Price quotes are in 32nds as a percent of par. The minimum par or face value is $1,000. The Treasury also issues inflation indexed bonds where the principle is adjusted for inflation.
 
In 1985 the Treasury began its Separate Trading of Registered Interest and Principle Securities (STRIP) program. A STRIP is a Treasury security where each individual coupon payment and the principle payment at maturity can be separated and sold individually. STRIPs are registered securities; a private dealer requests that the Treasury ‘strip’ the individual payments and keep a record of them on the Treasury’s computer system. Each payment will be given its own CUSIP (identification) number. Only certain securities are eligible for stripping. The minimum face value of a stripped payment (such as a single coupon payment) is $1,000. Thus the par amount must be
large enough to yield a semi-annual payment amount of $1,000 (or multiples of $1,000). These stripped payments are then zero coupon bonds that trade at a discount. Prices and yields on quotes follow similar conventions as T-notes and T-bonds.
 
The sum of the sale price of the components of STRIPs is often greater than the fair present value of the original Treasury security. This provides the motivation for dealers to petition the Treasury to create STRIPs. Investors are willing to pay a small premium because the individual payments can be used in duration matching strategies or cash matching strategies that limit the investor’s risk. For instance, maintaining a given duration with coupon paying bonds requires periodic bond trading which generates traThe sum of the sale price of the components of STRIPs is often greater than the fair present value of the original Treasury security. This provides the motivation for dealers to petition the Treasury to create STRIPs. Investors are willing to pay a small premium because the individual payments can be used in duration matching strategies or cash matching strategies that limit the investor’s risk. For instance, maintaining a given duration with coupon paying bonds requires periodic bond trading which generates transaction costs and perhaps tax consequences whereas use of STRIPs avoids these costs.
 
Sample Treasury Bond Quote (Source Text Table 6-3)
RATE
MATURITY
MO/YR
BID
ASKED
CHG
ASK
YLD
6.625%
Feb 27
121:21
121:22
-4
5.00

v   RATE: Coupon rate of 6.625% or $33.125 paid semiannually ($1,000 face)
v   MATURITY MO/YR: Month and year, the bond matures in February of 2027. If an ‘n’ appears after the date the quote is for a T-Note, if an ‘i’ appears the bond is inflation indexed.
v   BID: The closing price per $100 of par the dealer will pay to buy the bond; the seller would receive this price from selling to dealer. Prices are quoted in 32nds. In this case, 121:21 = 121 21/32% of $1,000 or $1,216.5625
v   ASK: The closing price per $100 of par the dealer requires to sell the bond; the buyer would pay this price to the dealer. In this case, 121:22 = 121 22/32% of $1,000 or $1,216.875
v   The Bid Ask spread is calculated as (Ask – Bid) / Ask = ($1,216.875- 1216.5625) / $1,216.875 = 0.026%. The spread is small because these are wholesale quotes for $1 million dollar order sizes or larger.
v   CHG: The change from the prior closing ASKED price in 32nds. In this case the ASKED price fell four 32nds from the prior quoted closing ask price.
v   ASK YLD = Promised compound yield rate if purchased at the ASKED price, in this case the yield is 5%. Note that the yield is yield to call if the price is above par and yield to maturity if below par. The yield calculation uses semiannual compounding.
 
Sample Treasury STRIP Quote (Source Text Table 6-3)
MATURITY
TYPE
BID
ASKED
CHG
ASK
YLD
May 08
np
89:16
89:16
1
3.19

v   MATURITY: May 2008
v   TYPE: np = stripped principle on a T-Note (as in this case), nb = stripped principle on a T-Bond, ci = stripped coupon interest
v   BID and ASKED prices are in 32nds
v   CHG: The change from the prior day’s ASK in 32nds.
v   ASK YLD: Promised compound yield rate if purchased at the ASKED price, in this case the yield is 3.19%. Note that the yield is yield to call if the price is above par and yield to maturity if below par. The yield calculation uses semiannual compounding to maintain consistency with T-bond and T-note quotes.
 
Accrued interest must be paid by the buyer of a bond to the seller of a bond if the bond is purchased between interest payment dates. The price of the bond with accrued interest is called the full price or the dirty price, the price without accounting for accrued interest is the clean price.
 
Accrued interest may be calculated as:
 

where INT = annual dollar coupon interest.
 
For example, you buy a 6% coupon $1,000 par T-bond 59 days after the last coupon payment. Settlement occurs in two days. You become the owner 61 days after the last coupon payment (59+2), and there are 121 days remaining until the next coupon payment. The bond’s clean price quote is 120:19. What is the full or dirty price (sometimes called the invoice price)?

The clean price is 120:19 or 120 19/32% of $1,000 or $1,205.9375.
The dirty price is thus $1,205.9375 + $10.05 = $1,215.9875
 
Treasury Inflation Protection Securities (TIPS)
The Treasury began issuing TIPS in January 1997. TIPS pay a fixed coupon rate (presumably equal to the real rate of interest required by investors at the time of issue assuming the bond is issued at par) for the life of the security. The principle amount of the bond is indexed to inflation however. The principal is adjusted every six months based on changes in the Consumer Price Index (CPI). Because of the principal adjustment, investors are protected from unexpected increases in inflation. Investor rates of return will be reduced by unexpected decreases in inflation.
 
TIPS Example:
An investor buys a $10,000 1 year TIP security with a 3% coupon at par. Suppose that the CPI increases by 2% in the first six month the investor holds the bond and the CPI increases by 1.5% in the second six months. The investor pays or receives the following cash flows:
0
0.5
1
-$10,000
$153
$10,508.295
 
=($10,000*1.02* 0.03/2)
=($10,000*1.02*1.015 0.03/2) + ($10,000*1.02*1.015)

The modified internal rate of return, 1 assuming that the $153 is reinvested at 1.5% can be found as ($10,508.295 + ($153*1.015) - $10,000) / $10,000 = 6.6359%.
Annual inflation = (1.02*1.015) - 1 = 3.53%
Real rate of return = (1+ MIRR) / (1+ Inflation annual) – 1 = (1.066359/ 1.0353) - 1 = 3.00%.
 
In a standard T-bond the equivalent cash flows and rates of return are:
0
0.5
1
-$10,000
$150
$10,150
 
= ($10,000* 0.03/2)
= $10,000 + $150
IRR semi = 1.5%        Note: MIRR = 3.0225%
IRR annual = 3.0225%
Annual inflation = (1.02*1.015) - 1 = 3.53%
Real rate of return = (1+ IRR annual) / (1+ Inflation annual) – 1 = (1.030225 / 1.0353) - 1 = -.49%.
 
Primary market: Treasury note and bond auctions operate similarly to the T-bill process discussed in Chapter 5. Regular auction schedules of notes and bonds are provided in Text Table 6-3. Secondary market activity is large compared to other types of bonds. In 2004 daily trading activity was over $550 billion on average. Although the Treasury market is the most liquid bond market in the U.S. “off the run” (existing) securities may have less liquidity than “on the run” (newly issued) securities.
 
b.  Municipal Bonds
Municipal bonds are bonds issued by state or local governments. The typical par value on a municipal bond is $5,000. Munis comprise about 17% of total bonds outstanding. Interest income on munis is not taxed at the federal level and is usually exempt from state and local taxes if the investor lives in the state in which the muni is issued. Capital gains are taxable. The tax exemption allows municipal governments to obtain lower cost financing. With the tax exemption, investors require lower yields on munis than on equivalent risk taxable bonds. General obligation (G.O.) bonds are munis that are
backed by the full taxing power of the municipality (i.e. the general fund). Revenue bonds are backed only by the revenues of a specific project. General tax revenues cannot be used to make payments on revenue bonds; thus a revenue bond is riskier than a G.O.
 
One cannot directly compare muni bond rates with taxable corporate bond rates without adjusting one or the other. The formula to adjust for taxes is simple:
ia = ib * (1 - t) where the a and b stand for after tax and before tax respectively. Hence a 4% muni bond rate cannot be directly compared to a 6% equivalent risk corporate bond rate. We must put both rates on the same tax basis. If we are in a 28% tax bracket, the after tax corporate bond rate ia = 6%*(1- 0.28) = 4.32%. Now we can see that the investor is better off with the corporate bond rather than the muni. In the summer of 2005, municipal bond rates were between 3.5% and 4.2%
 
Muni bond offerings are generally underwritten by investment bankers in a firm commitment offer. Best efforts are occasionally utilized. 2 The investment bank may be chosen on the basis of a bid process, where the banker that submits the highest bid price will be selected, or on a negotiated basis. Municipal issuers generally consider multiple investment bankers before choosing a lead underwriter. G.O. bonds usually must be issued via competitive bid. Sometimes bonds are privately placed (usually sold to 10 or fewer large (i.e., those with assets over $100 million), usually institutional, investors). In this case the bonds need not be registered. Smaller to mid-size municipal and corporate borrowers typically use private placements. Private placements can now be traded among large investors, but the market is very thin.
 
The secondary market for publicly issued munis is also very thin. The top underwriters of munis are listed in Text Table 6-9.
 
c.  Corporate Bonds
Corporate bonds comprise about 58% of outstanding bonds. The minimum denomination is $1,000 on publicly traded bonds. Corporate bonds are debt instruments issued by corporations to fund long term capital needs. The funds raised can be used for very risky purposes and default risk is measured by one or more ratings agencies. The rights of the bondholders are protected by the bond indenture (contract). The indenture specifies a trustee to ensure enforcement of the contract and specific terms and provisions of the contract (called covenants). The covenants will stipulate collateral, if any, the call features and convertibility features (if any), the interest rate, the interest payment and maturity dates and other restrictions on the bond issuer while the issue is outstanding. There will usually be a maximum dividend specified, a limit on additional debt of equal or higher seniority and limits on certain ratios such as times interest earned and the current ratio.
 
Corporate bond quotes (Source: Text)
COMPANY (TICKER)
COUPON
MATURITY
LAST PRICE
LAST YIELD
*EST SPREAD
UST
EST $ VOL(000’s)
General Electric (GE)
5.000
Feb 01, 2013
102.634
4.610
40
10
107,302
The quote lists the company name and ticker, the annual coupon rate (5%), the maturity date, the closing price as of November 9, 2004 as a % of face value, followed by the promised yield to maturity using the closing or last price. The next column provides the estimated spread in yield over a comparable maturity Treasury bond or note. The estimated spread is in basis points, the UST column gives the maturity of the T bond or note used to calculate the spread. In this case the estimated spread is 40 basis points (or 0.40%) over the 10 year Treasury rate. The final column gives the dollar volume of bonds traded in thousands of dollars. Note that the text quote sheet is for the 40 most actively traded bonds, many bonds will have much lower trading volumes.
 
Bond terminology:
  Bearer bonds versus registered bonds: Payments are made automatically to the owner of record of a registered bond. Bearer bond payments are made at the request of the bearer, usually the investor clips a coupon and mails it to the borrower. In the U.S. borrowers may no longer issue bearer bonds.
  Term vs serial bonds: Term bonds mature all at once at maturity. Serial bonds mature sequentially. For instance with a ten year overall maturity, some serial bonds would mature in five years, some in six years, etc, so that a portion of the outstanding debt is paid off each year.
  Mortgage bonds: With a mortgage bond specific collateral has been pledged as security for the bondholders. In the event of non-payment of interest or principle, the trustee can seize the collateral on behalf of the bondholders and sell it to recover their money.
  Debentures and subordinated (junior) debentures: Debentures have no specific asset pledged as collateral. They are riskier than mortgage bonds and carry higher yields. Subordinated debentures are riskier yet as they are not paid off until debenture holders are paid off.
 
Courts have not always strictly followed the standard bankruptcy priority schedule. The courts have often decided that it is better for junior claimants to get a part of their money back even if this means that senior claimants must bear larger losses than warranted by their priority.
 
  Convertible bonds: Bonds convertible at the option of the bondholder into either preferred or common stock as the contract states. The conversion option allows the issuer to issue the bond at a lower required yield, ceteris paribus. Usually the stock price must increase 15% to 25% before the conversion option becomes profitable to the bondholder. If the stock price increases the convertible bond’s price will begin to act like the stock price.
A firm issues annual payment 6% convertible bonds at par. Each bond can be converted into 250 shares of common stock and the firm’s common stock is trading at $3.20. What percentage increase in share price is needed to justify conversion? If the
bondholder gave up 30 basis points in coupon and yield rate in order to get the conversion feature, and was not able to profitably convert the bonds for three years, how did the investor do relative to a stockholder and an investor who bought an equivalent nonconvertible bond?
 
Percentage increase needed? Common stock price required to make conversion profit neutral: $1,000 bond value / 250 shares = $4.00 per share
Required increase in stock price = $4.00/$3.20 -1 = 25%
The investor received a 6% annual rate of return. An investor in the stock would have received an average annual rate of return of 7.72%, excluding dividends. 3 An investor in an equivalent nonconvertible bond would have received an annual rate of return of 6.3% (30 basis points more the convertible). Think through the value of the convertible option. Is it worth it and if so then in what situations? Is buying a convertible an aggressive or a defensive strategy?
 
Virtually all convertible bonds are callable. The issuer often uses the call feature to force conversion and eliminate the fixed interest payments. Students almost invariably believe that convertible bonds are good deals because they combine the protection of a bond’s fixed income with the stock’s upside potential. In an efficient market however, the embedded option in the bond is priced according to the prospects of the firm’s stock. There is little reason to think that the investor is getting a particularly good deal. For instance, agency theory tells us that convertible bonds will normally be a preferred financing instrument when the bondholders are worried that management will favor stockholders over the bondholders. In the event of a takeover that benefited shareholders and hurt bondholders the conversion option may be a valuable feature but the conversion option doesn’t necessarily mean the convertible is a better deal than straight bonds.
 
  Callable bonds: Bonds that may be redeemed at the option of the issuer at a predetermined price above par (call premium), or according to a predetermined price schedule (the call price often drops as maturity approaches). The call feature results in higher required yields. incb = icb -opcb where incb is the required yield on a noncallable bond and icb is the required yield on a callable band and opcb is the value of the issuer’s option to call the debt early.
Issuers typically call the bonds after interest rates have fallen, which can leave the investor with an overall lower realized yield over a given investment horizon.
 
You have a five year investment horizon. You buy a callable 7% coupon five year bond at par. Rates drop to 5%, the bond is called at a call price of $1,075. You reinvest your funds in 5% coupon bonds for the five years. A 7% annual compound rate of return on a $1,000 initial investment over five years should yield: $1,000 1.075 = $1,402.55. You actually earned $1,075 1.055 = $1,372 or you earned a 6.53% rate of return from your original $1,000 investment.
 
  Sinking fund: A sinking fund requires the bond issuer to ensure that enough money will be available to retire the debt at maturity. This can be done by having the borrower deposit funds with the trustee each year so that at maturity enough money is available to pay off the principle. This is an added safety feature to the bond that allows the bond issuer to offer a lower required rate of return.
 
Sometimes sinking funds allow the bond issuer to randomly select and redeem a given percentage of the bonds each year. Issuers prefer this method because it terminates the interest owed on the retired bonds. This type of sinking fund however may leave the bondholder whose bond is selected for redemption worse off if interest rates have fallen since the bond was issued. Sinking funds of this nature can thus be a mixed blessing to bondholders.
 
  Stock warrants: Warrants are call options attached to the bond that can be detached and exercised or sold separately, unlike the convertible bond which requires the bondholder to give up the bond to acquire the stock. Warrants are often used as ‘sweeteners’ to bond deals to obtain a lower interest rate on the bond.
 
The primary market for corporate bonds operates similarly to the primary market for municipal securities. Both corporates and municipal bonds have lower secondary market activity than Treasuries. There are two secondary markets for corporate bonds, the NYSE Fixed Income Market and the over the counter (OTC) market. Less than 1% of corporate bonds are exchange traded (primarily on the bond division of the NYSE). Trading on the NYSE bond market is mostly automated and occurs through the Automated Bond System (ABS). On the ABS order execution is fully automated. The OTC market consists of large bank dealers and contains most of the actual trading done in bonds. Hence exchange bond price quotes are often behind or inaccurate for large deals.
 
d.  Bond Ratings
Most bonds are rated in terms of default risk by at least one of the major ratings agencies, typically Moody’s and Standard and Poors. Many institutions can hold only limited amounts of unrated or low rated debt, so a favorable rating lowers the interest yield required and increases the amount of potential buyers. Junk bonds are bonds rated below Baa by Moody’s or BBB by S&P. Higher ratings are termed investment grade bonds. Explanations of the ratings may be found in the text. In general ratings agencies evaluate the industry strength, the firm’s position in the industry, liquidity, profitability,
debt capacity and since Sarbanes-Oxley, corporate governance. Each specific rated issue is also examined for protection provided to investors and the firm’s ability to pay.
In the summer of 2005 the average yield on high grade (A or better) was 5.23%, the average yield on medium grade bonds was 6.34%, for a default yield spread of 111 basis points, down from prior years. On a $50 million bond issue, the medium grade debt would cost $550,000 more in pre-tax interest expense per year. Junk yields were more variable but most ranged from 7%-9%, also low. Taking the midpoint of this range gives an additional credit spread over the medium grade of 166 basis points. On the same $50 million bond issue, having a junk rating would add an additional $830,000 more in pre-tax interest expense per year. As you can see, the rating substantially affects bond financing costs. Ratings spreads tend to vary inversely with the phase in the cycle of the economy. From 1980 to 2002 the cumulative default rate (CDFs) on 10 year Aaa rated bonds was 0.03% and the CDF was 9.63% on Baa rated bonds.
 
The CDF for any year t of an N year bond can be calculated as

 
To find the CDF after two years for an N year bond that has a 98% chance of survival in year 1 and a 97% chance of survival thereafter:
      Survive    
      97%    
  Survive        
Year 1
98%
Year 2
  CDF  
        Decision  
      3% Tree  
  2%   Don’t Survive    
  Don’t        
  Survive        

 
 
In May 2005, Standard & Poor’s downgraded almost $300 billion of General Motor’s debt to junk status. GM stock dropped 4% when the news came out. Nissan has been attempting to improve its bond rating out of the medium grade to better compete with Toyota, which has the highest rating. In 2005, Toyota had more than twice the cash reserves of Nissan. Sources: Wall Street Journal email news bulletin, May 5, 2005, and “Heard in Asia, Nissan to Rev Up its Liquidity to Win Higher Credit Ratings,” J Sapsford, Staff Reporter, Wall Street Journal Online, C5, May 3, 2005.
 
Ratings agencies have been criticized for failing to downgrade firms quickly when conditions deteriorate. 4
 
e.  Bond Market Indexes
Bond market indexes are published daily in the Wall Street Journal; indexes are available for the major bond sectors. Table 6-12 in the text highlights the major indexes.
 
3.  Bond Market Participants
Treasury security investments are roughly equally divided among government investors, foreign investors and business financial investors. Municipal and corporate bonds are predominantly held by business financial institutions.
 
Bond market participants by type 2004 (See Text Figure 6–11)
 
Business Financial
Business
Nonfinancial
Governments
Households
Foreign
Treasuries
14%
2%
31%
10%
43%
Municipals
62%
2%
2%
33%
<1%
Corporate
62%
<1%
10%
4%
24%

4.  Comparison of Bond Market Securities
Yield rates on the three major bond types are presented in Text Figure 6-10. Yield rates are highly correlated among the three types, but default risk premiums on muni and corporate bonds can vary over time. In particular, default spreads increased in the early 2000s recession.
 
5.  International Aspects of Bond Markets
From 1995 to 2004 the quantity of international debt securities outstanding grew 431% in total, or at an average annual growth rate of 20.38%. In terms of dollar volume, there are now more euro denominated floating rate and fixed rate debt instruments outstanding than dollar denominated instruments. 5   International bonds are usually bearer bonds placed in multiple countries or in a country other than the issuer’s home country. Financial institutions are the largest issuers of international bonds, other than equity related bonds which are dominated by corporate issuers.
 
6.  Eurobonds, Foreign Bonds, and Brady and Sovereign Bonds
a.  Eurobonds
Eurobonds are long-term bonds sold outside the country of the currency in which they are denominated. This need not be in Europe. For instance Eurodollar bonds may be dollar denominated bonds sold in Japan. They typically have denominations of $5,000 and $10,000 and are traded mostly OTC in London and Luxembourg. Eurobonds are
typically placed by an investment banking syndicate, traditionally the issue costs have been higher than for domestic bonds.
 
b.  Foreign Bonds
Foreign bonds are bonds issued outside the home country and are denominated in the host country’s currency. For example, Samurai bonds are dollar denominated bonds issued by Japanese borrowers in the U.S.
 
c.  Brady Bonds and Sovereign Bonds
Brady bonds were created when a bank restructured an existing loan made to a less developed country (LDC) that could not be repaid in full. The loan was eliminated and in exchange the borrower agreed to accept the liability of the Brady bond. The Brady bonds have longer maturities and lower interest rates than the original loans. The banks were willing to accept the Brady bonds in place of the original loan because 1) the U.S. government strongly urged them to do so, and in some cases borrowers agreed to back the bonds by holding U.S. Treasury assets, 2) the alternative was to receive no payments from the borrowers and, 3) the Brady bonds were saleable, so that the banks could cut their losses if they chose. As some LDC’s credit ratings have improved, countries have removed the backing of U.S. Treasury Bonds, and the bonds then become priced according to the creditworthiness of the respective country. These bonds are called sovereign bonds.
 


V. Web Links



V. Web Links
 
http://www.ml.com/  Merrill Lynch’s website; Merrill first created securities similar to Treasury STRIPs
 
http://www.publicdebt.treas.gov  Bureau of the Public Debt; this site has the current amount of public debt
 
http://www.nyse.com/  An excellent website of the New York Stock Exchange
 
http://www.ustreas.gov/  Website of the U.S. Treasury
 
http://www.ft.com/  Financial Times, won two Espy awards for best new site and best non U.S. news site. Coverage of global events and markets.
 
http://www.moodys.com/  A leading provider of independent credit ratings, research and financial information to the capital markets
http://www.standardandpoors.com/   A leading provider of independent credit ratings, research and financial information to the capital markets
 

http://www.ny.frb.org/ Federal Reserve Bank of New York website, complete with research, links to the Treasury Direct program and job opportunities.


http://www.ny.frb.org /  Federal Reserve Bank of New York website, complete with research, links to the Treasury Direct program and job opportunities.
 
 

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