Chapter Six Bond Markets Mc GrawHill Irwin 1

Chapter Six Bond Markets Mc. Graw-Hill /Irwin 1 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Overview of the Bond Markets • A bond is a promise to make periodic coupon payments and to repay principal at maturity; breech of this promise is an event of default • Bonds carry original maturities greater than one year so bonds are instruments of the capital markets • Issuers are corporations and government units Mc. Graw-Hill /Irwin 2 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Bond Market Instruments Outstanding, 1994 -2001 ($Bn) Mc. Graw-Hill /Irwin 3 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Types of Treasury Instruments • • T-Bills T-Notes T-Bonds Strips Maturity < 1 Year Maturity 1 to 10 Years Maturity 10 to 30 Years Other Agency Bonds Mc. Graw-Hill /Irwin 4 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Composition of the U. S. National Debt ($Bn) Mc. Graw-Hill /Irwin 5 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Municipal Bonds (Munis) • Securities issued by state and local governments to fund either temporary imbalances between operating expenditures and receipts or to finance long-term capital outlays for activities such as school construction, public utility construction or transportation systems • Tax receipts or revenues generated are the source of repayment • Attractive to household investors because interest (but not capital gains) are tax exempt Mc. Graw-Hill /Irwin 6 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Tax Exemption and Muni Yields ia = ib(1 - t) Where: ia = After-tax (equivalent tax exempt) rate of return on a taxable bond ib = Before-tax rate of return on a taxable bond t = Income tax rate of the marginal bond holder Example: You can invest in taxable corporate bonds that are paying 10% annually on munis. Your marginal tax rate is 28%. The aftertax rate of return on the taxable bond is: 10%(1 -. 28) = 7. 2% Mc. Graw-Hill /Irwin 7 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Types of Municipal Bonds • General Obligation Bonds – bonds backed by the full faith and credit of the issuer • Revenue Bonds – bonds sold to finance a specific revenue generating project and are backed by cash flows from that project Mc. Graw-Hill /Irwin 8 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Top Municipal Bond Underwriters Underwriter Principal Amount (in millions $$) Salomon Smith Barney UBS Paine Webber Merrill Lynch Morgan Stanley Bear, Stearns Lehman Brothers Goldman Sachs J. P. Morgan Securities Dresdner Kleinwort Benson Banc of America Securities Industry totals Mc. Graw-Hill /Irwin $40, 049. 0 33, 587. 2 23, 902. 5 19, 811. 4 17, 513. 5 16, 978. 4 16, 854. 5 10, 298. 5 6, 720. 4 6, 390. 6 Market Share 12. 1% 10. 1% 7. 2% 6. 0% 15. 3% 5. 1% 3. 1% 2. 0% 1. 9% No. of Issues 610 667 273 316 177 231 198 131 12 311 $342 billion 9 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Contracting Choices with the Underwriter • Firm commitment underwriting – the issue of securities in which the investment bank guarantees the corp. a price for newly issued securities by buying the whole issue at a fixed price from the corporate issuer then seeks to resell to suppliers of funds (investors) at a higher price • Best efforts underwriting – the issue of securities in which the underwriter does not guarantee a price to the issuer and acts more as a placing or distribution agent, bank acts as agent on a fee basis related to its success in placing the issue Mc. Graw-Hill /Irwin 10 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Types of Corporate Bonds • Bearer bonds – coupons attached that are presented by the holder to the issuer for interest payments when due • Registered bonds – the owner of the bond is recorded by the issuer and coupon payments are mailed to the registered owner • Term bonds – entire issue matures on a single date • Serial bonds – mature on a series of dates Mc. Graw-Hill /Irwin 11 (continued) Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Types of Corporate Bonds • Mortgage bonds – issued to finance specific projects which are pledged as collateral • Equipment Trust Certificates – bonds collateralized with tangible non-real estate property • Debentures – backed solely by the general credit of the issuing firm and unsecured by specific assets or collateral • Subordinated debentures – unsecured debentures that are junior in their rights to mortgage bonds and regular debentures (continued) Mc. Graw-Hill /Irwin 12 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Types of Corporate Bonds • Convertible bonds – may be exchanged for another security of the issuing firm at the discretion of the bond holder • Stock Warrant – give the bond holder an opportunity to purchase common stock at a specified price up to a specified date • Callable bonds – allow the issuer to force the bond holder to sell the bond back to the issuer at a price above the par value (call price) • Sinking Fund bonds – bonds that include a requirement that the issuer retire a certain amount of the bond issue each year Mc. Graw-Hill /Irwin 13 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Bond Credit Ratings Explanation Moody’s Investment grade categories: Best quality; smallest degree of risk Aaa High quality; slightly more long-term Aa 1 risk than top rating Aa 2 Aa 3 Upper medium grade; possible A 1 impairment in the future A 2 A 3 Medium grade; lack outstanding Baa 1 investment characteristics Baa 2 Baa 3 S&P AAA AA+ AA AA AAA+ ABBB+ BBB(continued) Mc. Graw-Hill /Irwin 14 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Bond Credit Ratings Explanation Moody’s Speculative investment grades: Speculative issues; protection may Ba 1 be very moderate Ba 2 Ba 3 Very speculative; may have small B 1 assurance of interest and principle B 2 payment B 3 Issues in poor standing; may be in default Caa Speculative in a high degree Ca Lowest quality; poor prospects of attaining C real investment standing Mc. Graw-Hill /Irwin 15 S&P BB+ BB BBB+ B BCCC CC C D Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Eurobonds, Foreign Bonds, Brady Bonds and Sovereign Bonds • Eurobonds – long-term bonds issued and sold outside the country of the currency in which they are denominated (e. g. , dollar-denominated bonds issued in Europe or Asia) • Foreign Bonds – long-term bonds issued by firms and governments outside of the issuer’s country, usually denominated in the currency of the country in which they are issued Mc. Graw-Hill /Irwin 16 Copyright © 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved.