BOND MARKETS I

Section A. Discuss the following questions in your tutorial class

1) Contrast investors’ use of capital markets with their use of money markets.
Investors use capital markets for long-term investment purposes. They use money markets,
which have lower yields, primarily for temporary or transaction purposes.
2) What are the primary capital market securities, and who are the primary
purchasers of these securities?
Stocks and bonds. Most of these are purchased by and owned by households. They do this
through financial intermediaries
3) After a careful financial analysis, MacTab top management determines that it
needs to raise funds by issuing debt instruments to finance a new plant to meet
the increased demand for its products. As issuing a short-term debt instrument is
cheaper than a long-term bond, one of the managers of MacTab suggests
financing this plant by issuing money market securities, such as commercial
paper. As a financial analyst, evaluate the manager’s suggestion.
As long as interest rates do not rise, all is well: When these short-term securities mature, they
can be reissued at the same interest rate. However, if interest rates rise, as they did
dramatically in 1980, the firm may find that it does not have the cash flows or income to
support the plant because when the short-term securities mature, the firm will have to reissue
them at a higher interest rate. If long-term securities, such as bonds or stock, had been used,
the increased interest rates would not have been as critical. The primary reason that
individuals and firms choose to borrow long-term is to reduce the risk that interest rates will
rise before they pay off their debt. This reduction in risk comes at a cost, however. Most
long-term interest rates are higher than short-term rates due to risk premiums. Despite the
need to pay higher interest rates to borrow in the capital markets, these markets remain very
active.
4) What are the three types of information an investor can obtain from looking at a
bond certificate? Define each of these.
The par value is the amount the issuer will pay the holder when the bond matures. The
coupon interest rate is multiplied times the par value to determine the interest payment the
issuer must make each year. The maturity date is when the issuer must pay the holder the
par value.
5) Explain what a sinking fund is and whether investors like bonds that contain this
feature?
A sinking fund contains funds set aside by the issuer of a bond to pay for the redemption of
the bond when it matures. Because a sinking fund increases the likelihood that a firm will
have the funds to pay off the bonds as required, investors like the feature. As a result, interest
rates are lower on securities with sinking funds.
 6) Discuss three characteristics of corporate bonds in details.
- Restrictive covenants:
A loan covenant is a condition in a commercial loan or bond issue that requires the borrower
to fulfil certain conditions or which forbids the borrower from undertaking certain actions, or
which possibly restricts certain activities to circumstances when other conditions are met.
Affirmative loan covenant – I will follow – requires the borrower – e.g. periodically filing
financial statement with the bank
Negative loan covenant – I will not – restrict the borrower – e.g. taking on new debt,
participating in mergers etc… must get lender approval before doing stuff.
- Call provisions:
It is a stipulation on the contract for a bond or other fixed instruments that allows the issuer to
repurchase and retire the debt security. A call provision refers to a clause in a bond
purchase…
- Conversion:
A convertible bond is a fixed income corporate debt security that yields interest payments but
can be converted into a predetermined number of common stock or equity shares. The
conversion from the bond to stock can be done at certain times during the bond’s life
7) The inflation rate has been unusually low for years and it has been ignored
easily. However, over time, like a 30-year retirement, it can still do a lot of
damage. After 20 years, inflation averaging the Federal Reserve's target of 2
percent would reduce a dollar's buying power to 67 cents. For long-term
investors, investments on stocks and real estate offer some inflation protection.
However, bonds can be badly hurt by inflation, which erodes the value of the
bond's principal and interest earnings, often driving bond prices down. As a
financial consultant recommend a bond to a conservative investor who is
concerned with maintain purchasing power. Explain the reason underlying your
recommendation.

8) You are a financial analyst providing consultancy to a fund manager who has
decided to invest in bonds backed by the full faith and credit of the government.
You inform the fund manager that the results of your analysis indicate a decline
in interest rates in the future. The fund manager tells you that he intends to take
greater exposure to price movements. As the financial analyst, recommend a
bond to the fund manager. Explain the reason underlying your recommendation.

9) Compare general obligation bonds and revenue bonds.

General obligation bonds, also called GOs, are bonds that are backed by the “full faith and
credit” of the issuer, with no specific project identified as the source of funds to repay the
bond obligation.

In other words, the municipal issuer can make interest and principal payments using any
source of revenue available to them, such as tax revenues, fees, or the issuance of new
securities. This means that if the municipality encounters fiscal difficulty, it can raise taxes to
offset the shortfall. GOs are therefore seen as being relatively safe, and defaults are rare.
It is far less likely that an entire municipal government will face serious financial difficulty
than for a specific municipal project to fail to generate its anticipated income. Investors can
buy GO bonds directly, but there are several mutual funds and exchange-traded funds (ETFs)
that make the process easier by specializing in general obligation securities. Among them is
Vanguard's Tax-Exempt Bond ETF (symbol VTEB), a passively managed municipal bond
index security. Investing in a municipal bond fund or ETF offers a degree of diversification
unavailable to all but the most affluent investors.
Revenue bonds are another type of muni bond that is backed by the revenue generated by a
specific project being financed by the bond issue. In other words, the money raised by the
bond offering directly finances the project, and the project—once complete—generates the
revenues to pay back the interest and principal on the bonds to investors.
Projects could include hospitals, airports, toll roads, housing projects, convention centres,
bridges, and similar endeavours. Revenue bonds are generally of higher risk than general
obligation bonds, and as a result, they typically offer higher yields.