Chapter 6

Bond Markets

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

Bond and Bond Markets

⚫ Capital markets are markets for equity and debt

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

6-3
Bond Market Instruments
Outstanding, 1994 & 2013

6-4
Treasury Notes and Bonds

⚫ 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
⚫ The annual federal deficit is equal to annual
expenditures (G) less taxes (T) received
⚫ The national debt (ND) is the sum of historical
annual federal deficits: N
NDt =  (Gt − Tt )
t =1

6-5
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

6-6
Treasury Notes and Bonds
⚫ Default risk free: backed by the full faith and credit of
the U.S. government
⚫ Low returns: low interest rates (yields to maturity)
reflect low default risk
⚫ 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
⚫ Liquidity risk: older issued T-bonds and T-notes trade
less frequently than newly issued T-bonds and T-notes
⚫ Newly issued Treasuries are called ‘on the run’ and older
Treasuries are called ‘off the run’.

6-7
Treasury Notes and Bonds

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

⚫ T-bonds have original maturities > 10 years
⚫ Issued in minimum denominations (multiples) of $1000
⚫ May be either fixed principal or inflation-indexed
⚫ inflation-indexed bonds are called Treasury Inflation Protection
Securities (TIPS)
⚫ the principal value of TIPS is adjusted by the percentage change
in the Consumer Price Index (CPI) every six months
⚫ Trade in very active secondary markets
⚫ Prices are quoted as percentages of face value, may be in
32nds or quoted in decimals.

6-8
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

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

15, 2042, but it may be callable before that time.
⚫ Coupon: Coupon rate of 2.750% or $27.50 per year but paid
semiannually ($1,000 face), set an intervals of 0.125%.
⚫ 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.

6-9
Sample Treasury Bond Quote

Maturity Coupon Bid Asked Chg Asked Yld

11/15/2042 2.750 84.8359 84.8516 0.4297 3.589

⚫ 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
⚫ 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
⚫ Asked Yld = Promised compound yield rate if purchased at
the Asked price. In this case, the yield is 3.589%

6-10
Sample Treasury Bond Quote

⚫ In a Treasury bond quote with a $1,000 face value, you

find the bid is equal to 100:24 and the ask is equal to
100:26. You could buy this bond for $1,008.125.
A. TRUE
B. FALSE

6-12
Treasury STRIPS

⚫ Separate Trading of Registered Interest and Principal

Securities (STRIPS). Treasury zero bonds or Treasury zero-
coupon bonds
⚫ Financial institutions and government securities brokers and
dealers create STRIPS from T-notes and T-bonds
⚫ STRIPS have the periodic interest payments separated from
each other and from the principal payment
⚫ one set of securities reflects interest payments (commercial
banks, state lotteries, pension funds)
⚫ one set of securities reflects principal payments (life insurers)
⚫ STRIPS are used to immunize against interest rate risk

6-13
Treasury STRIPS

6-14
Treasury STRIPS

6-15
Treasury STRIPS
An 20-year T-bond can be stripped into how
many separate securities?

A. 20

B. 21

C. 40

D. 41

E. 42

6-16
Treasury STRIPS

6-17
Treasury STRIPS
A life insurer owes $1,100,000 in ten years. To fund this
outflow, the insurer wishes to buy STRIPS that mature in ten
years. The STRIPS have a $10,000 face value per STRIP and
pay a 8 percent APR with semiannual compounding. How
much must the insurer spend now to fully fund the outflow
(to the nearest dollar)?

(10,000/1.0420) * (1,100,000/10,000) = $502,026

6-18
Caculate the Yield on Treasury
STRIPS
You buy a principal STRIP maturing in six years. The price
quote per hundred of par for the STRIP is 85.75 percent.
Using semiannual compounding, what is the promised yield
to maturity on the STRIP?

85.75%= 100%/(1+YTM/2)2x6

YTM=2.58%

6-19
Treasury Inflation Protection
Securities (TIPS)

⚫ A ten-year, inflation-indexed bond has a par value of

$10,000 and a coupon rate of 8 percent. During the first
six months since the bond was issued, the inflation rate
was 2 percent. Based on this information,
⚫ What is the principal amount used to determine the first
coupon payment?
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 = $10,000 × 1.02 = 10,200
⚫ what will the coupon payment after six months be ?

Coupon − payment = $10,000  1.02  (0.08 / 2) = $408

6-20
Treasury Inflation Protection
Securities (TIPS)

⚫ A ten-year, inflation-indexed bond has a par value of

$10,000 and a coupon rate of 8 percent. During the first
six months since the bond was issued, the inflation rate
was 2 percent. Next, During the second six months since
the bond was issued, the inflation rate was 5 percent.
Based on this information, what will the coupon payment
after the second six months be ?
Coupon − payment = $10,000  1.02  1.05  (0.08 / 2) = $428.4

6-21
Treasury Inflation Protection
Securities (TIPS)

⚫ With TIPS, the security's coupon rate is changed every

six months by the inflation rate as measured by the CPI.
⚫ A. TRUE
⚫ B. FALSE

6-23
Accrued Interest and Prices

⚫ 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.
⚫ Clean price: The price of a bond net of accrued interest; this is
the price that is typicaily quoted.
⚫ Dirty price: The price of a bond including accrued interest,
also known as the full or invoice price. This is the price the
buyer actually pays.

6-24
Accrued Interest on Bonds

6-25
Accrued Interest and Prices

⚫ “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

6-26
Accrued Interest and Prices

6-27
Accrued Interest on Bonds

⚫ A T-bond with a $1,000 par is quoted at 98:14

bid, 98:15 ask. The clean price for you to buy
this bond is …………

6-28
Accrued Interest on Bonds

⚫ 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

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

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

6-29
Accrued Interest Example

6-30
Accrued Interest 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 120.59375. What is the full or
dirty price (sometimes called the invoice price)?

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

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

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

6-32
T-Note and Bond Markets

⚫ 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
⚫ 2-year notes are auctioned monthly
⚫ 3-, 5-, and 10-year notes are auctioned quarterly (Feb,
May, Aug, and Nov)
⚫ 30-year bonds are auctioned semi-annually (Feb and Aug)
⚫ Most secondary trading occurs directly through
brokers and dealers

6-33
T-Note and Bond Markets

⚫ Competitive and non-competitive bidders.

⚫ Competitive bidders submit bid yields, highest
bid accepted is call the ‘stop out yield.’
⚫ 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.
⚫ T-Note or Bond coupon rate is rounded down from
stop yield to the nearest 1/8th if needed.

6-34
T-Note and Bond Markets

6-35
T-Note and Bond Markets

6-36
Municipal Bonds

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

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

6-37
Municipal Bonds

⚫ 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
⚫ Alternately, convert Muni interest rates to tax
equivalent rates of return: ib = ia/(1 – t)

6-38
Municipal Bond Rates & Taxes

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

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

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

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

6-39
Municipal Bonds

⚫ Primary markets
⚫ 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
⚫ best efforts offering: a public offering in which the investment
bank does not guarantee a firm price
⚫ private placement: bonds are sold on a semi-private basis to
qualified investors (generally FIs)
⚫ Secondary markets: Munis trade infrequently due mainly to a
lack of information on bond issuers

6-41
Municipal Bonds

6-42
Corporate Bonds

6-43
Corporate Bonds

⚫ Corporate bonds are long-term obligations issued

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

6-44
Corporate Bonds

⚫ Debentures and subordinated debentures

⚫ 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

⚫ Stock warrants give bondholders the opportunity to

purchase common stock at a prespecified price

6-45
Corporate Bonds

⚫ 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

⚫ A sinking fund provision is a requirement that the

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

6-46
Corporate Bonds

⚫ A callable bond is one where the issuer is

required to retire a certain amount of the
outstanding bonds each year to ensure that all
the bond principal is paid by final maturity.
⚫ A. TRUE
⚫ B. FALSE

⚫ Callable bonds have lower required yields than

similar convertible bonds, ceteris paribus.
⚫ A. TRUE
⚫ B. FALSE

6-47
Corporate Bonds

⚫ Primary markets are identical to that of Munis

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

6-48
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

6-49
Bond Yield Spreads

Source: alfred.stlouisfed.org

6-50
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

⚫ Issuer name, ticker symbol and coupon

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

6-51
Bond Market Indexes

⚫ Managed by major investment banks

⚫ Reflect both the monthly capital gain and loss on
bonds plus any interest (coupon) income earned
⚫ 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

6-52
Bond Market Participants

⚫ The major issuers of debt market securities are federal,

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

6-53
Bond Market Participants

6-54
International Bonds and Markets

⚫ Motivations for international bond investing

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

6-55
International Bonds and Markets

⚫ 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
⚫ Eurobonds are long-term bonds issued outside the
country of the currency in which they are denominated
⚫ Foreign Bonds are long-term bonds issued outside of
the issuer’s home country
⚫ Sovereign Bonds are government issued debt

6-56
International Bonds and Markets

6-57
International Bonds and Markets

6-58