Chapter 6

Bond Markets

Copyright © 2015 by McGraw-Hill Education. All rights reserved.

Bond and Bond Markets

l Capital markets are markets for equity and debt

instruments with original issue maturities of more
than one year
l Bonds are long-term debt obligations issued by
corporations and government units
l Bond markets are markets in which bonds are
issued and traded
l Treasury notes (T-notes) and bonds (T-bonds)
l Municipal bonds (Munis)
l Corporate bonds

6-2
Bond Market Instruments
Outstanding, 1994 & 2013

6-3
Treasury Notes and Bonds

l Treasury notes and bonds (T-notes and T-

bonds) are issued by the U.S. Treasury to finance
the national debt and other government
expenditures
l The annual federal deficit is equal to annual
expenditures (G) less taxes (T) received
l The national debt (ND) is the sum of historical
annual federal deficits: N
NDt = å (Gt - Tt )
t =1

6-4
Current & Projected Federal Debt
Levels

$30.0

$25.0

$20.0
Trillions $

$15.0

$10.0

$5.0

$0.0
2013 2024

Federal Debt Held by the Public Gross Federal Debt

Data Source: CBO

6-5
Treasury Notes and Bonds

l Default risk free: backed by the full faith and credit of

the U.S. government
l Low returns: low interest rates (yields to maturity)
reflect low default risk
l Interest rate risk: because of their long maturity, T-
notes and T-bonds experience wider price fluctuations
than money market securities when interest rates
change
l Liquidity risk: older issued T-bonds and T-notes trade
less frequently than newly issued T-bonds and T-notes

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Treasury Notes and Bonds

l T-notes have original maturities from over 1 to 10 years

l T-bonds have original maturities > 10 years
l Issued in minimum denominations (multiples) of $100
l May be either fixed principal or inflation-indexed
l inflation-indexed bonds are called Treasury Inflation Protection
Securities (TIPS)
l the principal value of TIPS is adjusted by the percentage change
in the Consumer Price Index (CPI) every six months
l Trade in very active secondary markets
l Prices are quoted as percentages of face value, may be in
32nds or quoted in decimals.

6-7
Sample Treasury Bond Quote

$1,000 par Treasury Bond

Maturity Coupon Bid Asked Chg Asked Yld
11/15/2042 2.750 84.8359 84.8516 0.4297 3.589

l Maturity mo/yr: Month and year, the bond matures November

15, 2042, but it may be callable before that time.
l Coupon: Coupon rate of 2.750% or $27.50 per year but paid
semiannually ($1,000 face).
l 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 the dealer. In this case, 84.8359% of $1,000 or $848.359.

6-8
Sample Treasury Bond Quote

Maturity Coupon Bid Asked Chg Asked Yld

11/15/2042 2.750 84.8359 84.8516 0.4297 3.589

l Asked: 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, 84.9516% of $1,000 or $848.516
l Chg: The change from the prior closing ASKED price. In this
case, the ASKED price increased 0.4297 from the prior
quoted closing ask price

6-9
Sample Treasury Bond Quote

Maturity Coupon Bid Asked Chg Asked Yld

11/15/2042 2.750 84.8359 84.8516 0.4297 3.589

l Asked Yld = Promised compound yield rate if purchased at

the Asked price. In this case, the yield is 3.589%

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Treasury STRIPS

l Separate Trading of Registered Interest and Principal

Securities (STRIPS), a.k.a. Treasury zero bonds or Treasury
zero-coupon bonds
l Financial institutions and government securities brokers and
dealers create STRIPS from T-notes and T-bonds
l STRIPS have the periodic interest payments separated from
each other and from the principal payment
l one set of securities reflects interest payments
l one set of securities reflects principal payments
l STRIPS are used to immunize against interest rate risk

6-11
Accrued Interest and Prices

l 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.

l 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.

6-12
Accrued Interest and Prices

l “Clean” prices are calculated as:

INT
Vb = (PVIFAid / m, Nm ) + M (PVIFid / m, Nm )
m
Vb = the present value of the bond
M = the par value of the bond
INT = annual interest payment (in dollars)
N = the number of years until the bond matures
m = the number of times per year interest is paid
id = interest rate used to discount cash flows on the bond

6-13
Accrued Interest on Bonds

l Accrued interest on T-notes and T-bonds is

calculated as:
INT Actual number of days since last coupon payment
Accrued interest = ´
2 Actual number of days in coupon period

l The full (or dirty) price of a T-note or T-bond is the

sum of the clean price (Vb) and the accrued interest

6-14
Accrued Interest Example

l 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 120.59375. What is the full or
dirty price (sometimes called the invoice price)?

$60 61
Accrued Interest = ´ = $10.05
2 (121+ 61)

l The clean price is 120.59375% of $1,000 or $1,205.9375.

l Thus, the dirty price is $1,205.9375 + $10.05 = $1,215.9875.

6-15
T-Note and Bond Markets

l The primary market of T-notes and T-bonds is

similar to that of T-bills; the U.S. Treasury sells T-
notes and T-bonds through competitive and
noncompetitive single-bid auctions
l 2-year notes are auctioned monthly
l 3-, 5-, and 10-year notes are auctioned quarterly (Feb,
May, Aug, and Nov)
l 30-year bonds are auctioned semi-annually (Feb and Aug)
l Most secondary trading occurs directly through
brokers and dealers

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T-Note and Bond Markets

l Competitive and non-competitive bidders.

l Competitive bidders submit bid yields, highest
bid accepted is call the ‘stop out yield.’
l All noncompetitive bidders and competitive bidders
who bid less than the stop out receive their full
allotment. Bidders at the stop out yield may receive a
prorata share of their allotment.
l T-Note or Bond coupon rate is rounded down from
stop yield to the nearest 1/8th if needed.

6-17
T-Note and Bond Markets

l The stop out yield on a 10 year Treasury is 2.14%. What

price would every successful bidder pay for a $1,000 par
bond?
l The annual coupon will be rounded down to the nearest 1/8th or
to 2 1/8th or 2.125%. The semiannual coupon is
(2.125%/2)*$1,000 = $10.625. Thus:

l 1 - 1.0107-20 $1,000
Price = $10.625 + 20
= $998.6561
0.0107 1.0107

l All investors would pay a quoted price of 99.86561 per

$100 of par

6-18
Municipal Bonds

l Municipal bonds (Munis) are securities issued by state and

local governments
l to fund imbalances between expenditures and receipts
l to finance long-term capital outlays
l Attractive to household investors because interest is exempt
from federal and most local income taxes
l General obligation (GO) bonds are backed by the full faith
and credit of the issuing municipality
l Many GO bonds are insured by a third party to improve the credit rating
and liquidity
l Revenue bonds are sold to finance specific revenue
generating projects

6-19
Municipal Bonds

l Compare Muni returns with fully taxable

corporate bonds by finding the after tax return
for corporate bonds:
ia = ib(1 – t)
ia = after-tax rate of return on a taxable corporate
bond
ib = before-tax rate of return on a taxable bond
t = marginal total income tax rate of the bond holder
l Alternately, convert Muni interest rates to tax
equivalent rates of return: ib = ia/(1 – t)

6-20
Municipal Bond Rates & Taxes

l For a 28% tax bracket, what is the equivalent after

tax rate of a 6% corporate yield?
l ia = 6%(1- 0.28) = 4.32%

l For a 28% tax bracket, what corporate taxable yield

is equivalent to a 4.5% muni bond rate?
l ib = 4.5% / (1-0.28) = 6.25%

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Municipal Bonds

l Primary markets
l firm commitment underwriting: a public offering of Munis made
through an investment bank, where the investment bank
guarantees a price for the newly issued bonds by buying the
entire issue and then reselling it to the public
l best efforts offering: a public offering in which the investment
bank does not guarantee a firm price
l private placement: bonds are sold on a semi-private basis to
qualified investors (generally FIs)
l Secondary markets: Munis trade infrequently due mainly to a
lack of information on bond issuers

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Corporate Bonds

l Corporate bonds are long-term obligations issued

by corporations
l A bond indenture is the legal contract that specifies
the rights and obligations of the issuer and the
holders
l Bearer versus registered bonds
l Term versus serial bonds
l Mortgage bonds are secured debt issues

6-23
Corporate Bonds

l Debentures and subordinated debentures

l Convertible bonds versus non-convertible bonds

icvb = incvb - opcvb

icvb = rate of return on a convertible bond
incvb = rate of return on a nonconvertible bond
opcvb = value of the conversion option

l Stock warrants give bondholders the opportunity to

purchase common stock at a prespecified price

6-24
Corporate Bonds

l Callable bonds versus non-callable bonds

incb = icb - opcvb

incb = rate of return on a noncallable bond
icb = rate of return on a callable bond
opcb = value of the call option

l A sinking fund provision is a requirement that the

issuer retire a certain amount of the bond issue early
as the bonds approach maturity

6-25
Corporate Bonds

l Primary markets are identical to that of Munis

l Secondary markets
l the exchange market (e.g., bond division of the NYSE)
l the over-the-counter (OTC) market
l Bond ratings
l the three major bond rating agencies are Moody’s,
Standard & Poor’s (S&P), and Fitch
l bonds are rated by perceived default risk
l bonds may be either investment or speculative (i.e.,
junk) grade

6-26
Bond Credit Ratings
Bond Credit Ratings (Source: Text Table 6-10)
Explanation Moody’s S&P Fitch
Investment Grade

Best quality; smallest degree of risk Aaa AAA AAA

Aa1 AA+ AA+
High quality; slightly more long-term risk
Aa2 AA AA
than top rating
Aa3 AA- AA-
A1 A+ A+
Upper medium grade; possible impairment
A2 A A
in the future
A3 A- A-
Baa1 BBB+ BBB+
Medium grade; lacks outstanding
Baa2 BBB BBB
investment characteristics
Baa3 BBB- BBB-
Ba1 BB+ BB+

Speculative Grade
Speculative issues; protection may be very
Ba2 BB BB
moderate
Ba3 BB- BB-
Very speculative; may have small B1 B+ B+
assurance of interest and principal B2 B B
payments B3 B- B-
Issues in poor standing; may be in default Caa CCC CCC
Speculative in a high degree; with marked
Ca CC CC
shortcomings
Lowest quality; poor prospects of attaining
C C C
real investment standing
Payment Default D D

6-27
Bond Yield Spreads

Source: alfred.stlouisfed.org

6-28
Corporate Bond Quotes

Issuer Moody’s/S&P/ Yield

Name Symbol Coupon Maturity Fitch High Low Last Change %
Philip Morris
Intl PM3975964 2.625 % 03/06/2023 A2/A/A 95.335 93.521 93.772 0.858 3.388

l Issuer name, ticker symbol and coupon

l Maturity month and year
l Bond rating by the three major ratings agencies
l High, Low, and Last prices in decimal form as a percent of par
l Daily high price was $953.35
l Change is the change from the prior day’s last price
l Yield % is the promised yield to maturity using the last price

6-29
Bond Market Indexes

l Managed by major investment banks

l Reflect both the monthly capital gain and loss on
bonds plus any interest (coupon) income earned
l Changes in values of bond indexes can be used by
bond traders to evaluate changes in the investment
attractiveness of bonds of different types and
maturities

6-30
Bond Market Participants

l The major issuers of debt market securities are federal,

state and local governments, and corporations
l The major purchasers of capital market securities are
households, businesses, government units, and foreign
investors
l Businesses and financial firms (e.g., banks, insurance
companies, and mutual funds) are the major suppliers
of funds for Munis and corporate bonds
l Foreign investors and governments are the major
suppliers of funds for T-notes and T-bonds

6-31
Bond Market Participants

6-32
International Bonds and Markets

l Motivations for international bond investing

l Potentially higher returns
l Better diversification
l Additional complexities in international bond
investing
l Higher risk; political risks higher and potential for
capital flight in lesser developed markets, Greek crisis
in Europe is an example
l Lower recourse in the event of non-repayment
l Foreign exchange rate movements can significantly
impact returns

6-33
International Bonds and Markets

l International bond markets involve unregistered bonds

that are internationally syndicated, offered
simultaneously to investors in several countries, and
issued outside of the jurisdiction of any single country
l Eurobonds are long-term bonds issued outside the
country of the currency in which they are denominated
l Foreign Bonds are long-term bonds issued outside of
the issuer’s home country
l Sovereign Bonds are government issued debt

6-34
International Bonds and Markets

6-35
International Bonds and Markets

6-36