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

6-2
Bond Market Instruments
Outstanding, 1994 & 2013

6-3
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

6-4
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

⚫ 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

6-6
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 $100
⚫ 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
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

⚫ 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).
⚫ 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

⚫ 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

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 Yld = Promised compound yield rate if purchased at

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

6-10
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.

6-11
 Accrued Interest and Prices
⚫ “Clean” prices are calculated as:

Vb = the present value of the bond

M = the par value of the bond
INT = annual interest / coupon payment (in dollars)
T = the number of years until the bond matures
m = the number of times per year interest / coupon is paid
rd = interest rate used to discount cash flows on the bond

6-12
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

*** INT/2 as bonds are normally paid semi-annually

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

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

6-13
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.

6-16
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

6-17
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)

6-18
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%

6-19
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

6-20
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

6-21
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

6-22
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

6-23
Bond Market Participants

6-24
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

6-25
International Bonds and Markets

6-26
International Bonds and Markets

6-27