Tài chính doanh nghiệp - Chapter 7: Bond markets

Chapter 7Bond MarketsFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineBackground on bondsTreasury and federal agency bondsMunicipal bondsCorporate bondsInstitutional use of bond marketsGlobalization of bond markets2Background on BondsBonds represents long-term debt securities that are issued by government agencies or corporationsInterest payments occur annually or semiannuallyPar value is repaid at maturityMost bonds have maturities between 10 and 30 yearsBearer bonds require the owner to clip coupons attached to the bondsRegistered bonds require the issuer to maintain records of who owns the bond and automatically send coupon payments to the owners3Background on Bonds (cont’d)Bond yieldsThe issuer’s cost of financing is measured by the yield to maturityThe annualized yield that is paid by the issuer over the life of the bondEquates the future coupon and principal payments to the initial proceeds receivedDoes not include transaction costs associated with issuing the bondEarned by an investor who invests in a bond when it is issued and holds it until maturityThe holding period return is used by investors who do not hold a bond to maturity4Treasury and Federal Agency BondsThe U.S. Treasury issues Treasury notes or bonds to finance federal government expendituresNote maturities are usually less than 10 yearsBonds maturities are 10 years or moreAn active secondary market existsThe 30-year bond was discontinued in October 20015Treasury and Federal Agency Bonds (cont’d)Treasury bond auctionNormally held in the middle of each quarterFinancial institutions submit bids for their own accounts or for clientsBids can be competitive or noncompetitiveCompetitive bids specify a price the bidder is willing to pay and a dollar amount of securities to be purchasedNoncompetitive bids specify only a dollar amount of securities to be purchased6Treasury and Federal Agency Bonds (cont’d)Treasury bond auction (cont’d)The Salomon Brothers scandalIn a 1990 bond auction, Salomon Brothers purchased 65 percent of the bonds issued (exceeding the 35 percent maximum)Salomon resold the bonds at higher prices to other institutionsIn August of 1991, the Treasury Department temporarily barred Salomon Brothers from bidding on Treasury securitiesIn May 1992 Salomon paid fines of $190 million to the SEC and Justice DepartmentSalomon created a reserve fund of $100 million to cover claims from civil lawsuits7Treasury and Federal Agency Bonds (cont’d)Trading Treasury bondsBond dealers serve as intermediaries in the secondary market and also take positions in the bonds30 primary dealers dominate the tradingProfit from the bid-ask spreadConduct trading with the Fed during open market operationsTypical daily volume is about $200 billionOnline tradingTreasuryDirect program ( 8Treasury and Federal Agency Bonds (cont’d)Treasury bond quotationsPublished in financial newspapersThe Wall Street JournalBarron’sInvestor’s Business DailyBond quotations are organized according to their maturity, with the shortest maturity listed firstBid and ask prices are quoted per hundreds of dollars of par valueOnline quotations at and Federal Agency Bonds (cont’d)Stripped Treasury bondsOne security represents the principal payment and a second security represents the interest paymentsInvestors who desire a lump sum payment can choose the PO partInvestors desiring periodic cash flows can select the IO partDegrees of interest rate sensitivity varySeveral securities firms create their own versions of stripped securitiesMerrill Lynch’s TIGRsThe Treasury created the STRIPS program in 198510Treasury and Federal Agency Bonds (cont’d)Inflation-indexed Treasury bondsIn 1996, the Treasury started issuing inflation-indexed bonds that provide a return tied to the inflation rateThe coupon rate is lower than the rate on regular Treasuries, but the principal value increases by the amount of the inflation rate every six monthsInflation-indexed bonds are popular in high-inflation countries such as Brazil11Computing the Interest Payment of an Inflation-Indexed BondA 10-year bond has a par value of $1,000 and a coupon rate of 5 percent. During the first six months after the bond was issued, the inflation rate was 1.3 percent. By how much does the principal of the bond increase? What is the coupon payment after six months?12Treasury and Federal Agency Bonds (cont’d)Savings bondsIssued by the TreasuryHave a 30-year maturity and no secondary marketSeries EE bonds provide a market-based interest rateSeries I bonds provide a rate of interest tied to inflationInterest on savings bonds is not subject to state and local taxesFederal agency bondsGinnie Mae issues bonds and purchases mortgages that are insured by the FHA and the VAFreddie Mac issues bonds and purchases conventional mortgagesFannie Mae issues bonds and purchases residential mortgages13Municipal BondsMunicipal bonds can be classified as either general obligation bonds or revenue bondsGeneral obligation bonds are supported by he municipal government’s ability to taxRevenue bonds are supported by the revenues of the project for which the bonds were issuedMunicipal bonds typically pay interest semiannually, with minimum denominations of $5,000Municipal bonds have a secondary marketMost municipal bonds contain a call provision14Municipal Bonds (cont’d)Credit riskLess than .5 percent of all municipal bonds issued since 1940 have defaultedMoody’s, Standard and Poor’s, and Fitch Investor Service assign ratings to municipal bondsSome municipal bonds are insured against defaultResults in a higher cost for the investor15Municipal Bonds (cont’d)Variable-rate municipal bondsCoupon payments adjust to movements in a benchmark interest rateSome variable-rate munis are convertible to a fixed rate under specified conditions16Municipal Bonds (cont’d)Tax advantagesInterest income is normally exempt from federal taxesInterest income earned on bonds that are issued by a municipality within a particular state is exempt from state income taxesInterest income earned on bonds issued by a municipality within a city in which the local government imposes taxes is normally exempt from the local taxes17Municipal Bonds (cont’d)Trading and quotationsInvestors can buy or sell munis by contacting brokerage firmsElectronic trading has become popular quotations are available at and Bonds (cont’d)Yields offered on municipal bondsDiffers from the yield on a Treasury bond with the same maturity because:Of a risk premium to compensate for default riskOf a liquidity premium to compensate for less liquidityThe federal tax exemption of municipal bonds19Municipal Bonds (cont’d)Yield curve on municipal bondsTypically lower than the Treasury yield curve because of the tax differentialThe municipal yield curve has a similar shape as the Treasury yield curve because:It is influenced similarly by interest rate expectationsInvestors require a premium for longer-term securities with lower liquidity in both markets20Corporate BondsCorporations issue corporate bonds to borrow for long-term periodsCorporate bonds have a minimum denomination of $1,000Larger bonds offerings are achieved through public offerings registered with the SECSecondary market activity variesFinancial and nonfinancial institutions as well as individuals are common purchasersMost corporate bonds have maturities between 10 and 30 yearsInterest paid by corporations is tax-deductible, which reduces the corporate cost of financing with bonds21Corporate Bonds (cont’d)Corporate bond yields and riskInterest income earned on corporate represents ordinary incomeYield curveAffected by interest rate expectations, a liquidity premium, and maturity preferences of corporationsSimilar shape as the municipal bond yield curveDefault rateDepends on economic conditionsLess than 1 percent in the late 1990sExceeded 3 percent in 200222Corporate Bonds (cont’d)Corporate bond yields and risk (cont’d)Investor assessment of riskInvestors may only consider purchasing corporate bonds after assessing the issuing firm’s financial condition and ability to cover its debt paymentsInvestors may rely heavily on financial statements created by the issuing firm, which may be misleadingBond ratingsBonds with higher ratings have lower yieldsCorporations seek investment-grade ratings, since commercial banks will only invest in bonds with that statusRating agencies will not necessarily detect any misleading information contained in financial statements23Corporate Bonds (cont’d)Private placement of corporate bondsOften, insurance companies and pension funds purchase privately-placed bondsBonds can be placed with the help of a securities firmBonds do not have to be registered with the SEC24Corporate Bonds (cont’d)Characteristics of corporate bondsThe bond indenture specifies the rights and obligations of the issuer and the bondholderA trustee represents the bondholders in all matters concerning the bond issueSinking-fund provisionA requirement to retire a certain amount of the bond issue each yearProtective covenants:Are restrictions placed on the issuing firm designed to protect the bondholders from being exposed to increasing risk during the investment periodOften limit the amount of dividends and corporate officers’ salaries the firm can pay25Corporate Bonds (cont’d)Characteristics of corporate bonds (cont’d)Call provisions:Require the firm to pay a price above par value when it calls its bondsThe difference between the call price and par value is the call premiumAre used to:Issue bonds with a lower interest rateRetire bonds as required by a sinking-fund provisionAre a disadvantage to bondholders26Corporate Bonds (cont’d)Bond collateralTypically, collateral is a mortgage on real propertyA first mortgage bond has first claim on the specified assetsA chattel mortgage bond is secured by personal propertyUnsecured bonds are debenturesSubordinated debentures have claims against the firm’s assets that are junior to the claims of mortgage bonds and regular debentures27Corporate Bonds (cont’d)Low- and zero-coupon bonds:Are issued at a deep discount from par valueRequire annual tax payments although the interest will not be received until maturityHave the advantage to the issuer of requiring low or no cash outflowVariable-rate bonds:Allow investors to benefit from rising market interest rates over timeAllow issuers of bonds to benefit from declining rates over timeConvertibility Convertible bonds allow investors to exchange the bond for a stated number of shares of common stockInvestors are willing to accept a lower rate of interest on convertible bonds28Corporate Bonds (cont’d)Trading corporate bondsBonds are traded through brokers, who communicate orders to bond dealersA market order transaction occurs at the prevailing market priceA limit order transaction will occur only if the price reaches a specified limitBonds listed on the NYSE are traded through the automated Bond System (ABS)Online trading is possible at: Bonds (cont’d)Corporate bond quotationsMore than 2,000 bonds are traded on the NYSE with a market value of more than $2 trillionCorporate bond prices are reported in eighthsCorporate bond quotations normally include the volume of trading and the yield to maturity30Corporate Bonds (cont’d)Junk bondsJunk bonds have a high degree of credit riskAbout two-thirds of junk bonds are used to finance takeoversSize of the junk bond marketCurrently about 3,700 junk bond offerings exist with a market value of $80 billionParticipation in the junk bond market70 large issuers of junk bonds each have more than $1 billion in debt outstandingPrimary investors in junk bonds are mutual funds, life insurance companies, and pension fundsThe junk bond secondary market consists of 20 bond traders31Corporate Bonds (cont’d)Junk bonds (cont’d)Risk premium of junk bondsThe typical premium is between 3 and 7 percent above Treasury bonds with the same maturityPerformance of junk bondsIn the early 1990s, the popularity of junk bonds declined because ofInsider trading allegationsThe financial problems of a few major issuers of junk bondsThe financial problems in the thrift industryIn the late-1990s, junk bonds performed well with few defaults32Corporate Bonds (cont’d)Junk bonds (cont’d)Contagion effects in the junk bond marketSpecific adverse information may discourage investors from investment in junk bondsIvan Boesky admitting to insider trading violationsDrexel Burnham Lambert’s bankruptcy filing33Corporate Bonds (cont’d)How corporate bonds facilitate restructuringUsing bonds to finance a leveraged buyoutAn LBO is typically financed with senior debt and subordinated debtLBO activity increased dramatically in the later 1980sMany firms with excessive financial leverage resulting from LBOs reissued stock in the 1990s 34Corporate Bonds (cont’d)How corporate bonds facilitate restructuring (cont’d)Using bonds to revise the capital structureDebt is perceived to be a cheaper source of capital than equity as long as the corporation can meet its debt paymentsSometimes, corporations issue bonds and use the proceeds for a debt-for-equity swapCorporations with an excessive amount of debt can conduct an equity-for-debt swap35Institutional Use of Bond MarketsAll financial institutions participate in bond marketsOn any given day, commercial banks, bond mutual funds, insurance companies, and pension funds are dominant participantsA financial institution’s investment decisions will often simultaneously affect bond market and other financial market activity36Globalization of Bond MarketsBond markets have become increasingly integrated as a result of frequent cross-border investments in bondsLow-quality bonds issued globally by governments and large corporations are global junk bondsThe global development of the bond market is primarily attributed to bond offerings by country governments (sovereign bonds)37Globalization of Bond Markets (cont’d)Eurobond marketBonds denominated in various currencies are placed in the Eurobond marketDollar-denominated bearer bonds are available in the Eurobond marketUnderwriting syndicates help place Eurobond issues38