G h a p t e t

Bond MaYkets
Chapter Nauigator
r,trrr What are the major bond markets?
't,r
2r:'" What are the characterlstics of the various bond market securities?

\Mho are the major bond market participants?

What types of securities trade in international bond markets?

Definition of Bond Markets: Chapter Overview

Equity (stocks) and debt (notes, bonds, and mortgages) instruments withgfllgitjryf
more than one veartrade in capital markets. In the next three chapters-. we-To=bl< at
dharacETlST-rcsof the dilferent capital markets. starting in this chapter with bond mar-
kets.1 In Chapter 7, we look at the mortgage markets (e.g., mortgage-backed securities,
asset-backed securities), and in Chapter 8, we describe the equity markets.
-- Bonds are long-term debt obligations issued by corporations and government
units. Proceeds from a bond issue are used to raise funds to support long-term opera-
tions of the issuer (e.g., for capital expenditure projects). In return for the investor's
funds, bond issuers promise to pay a specified amount in the future on the maturity of
the bond (the face value) plus coupon interest on the borrowed funds (the coupon rate
times the face value of the bond). If the terms of the repayment are not met by the bond
issuer, the bond holder (investor) has a claim on the assets of the bond issuer.

1. Although both notes and bonds are issued by agents such as the U.S. government, thefu characteristics
(coupon rate) other than maturity are generally the same. In this chapter, the term bond will mean bonds and notes
in general, except where we distinguish notes by their special maturity features. For example, U.S. Treasury notes
have maturities of o-ver one year up to 10 years. U.S. Treasury bonds have maturities from over 10 years to 30
years at the time of issu?-Ds# Ja
-

Ghapter 6 Bond Markets

Table 6-2 Composition of the U.S. National Debt

(in billions of dollars)
1994 1997 2000 2001

T-bills $ 697.3 $ 701.9 $ 646.9 $ 811.2

T-notes t,882.9 2,t67.6 1,693.5 1,569.7
T-bonds 511 .8 57 6.1 626.5 602.7

Treasury securities $3,092.0 $3,439.6 $2,966.9 $2,983.0

U.S. savings securities 776.4 t82.1 t76.9 190.4
Foreign seriesx 42.0 34.9 21.2 15.4
Government account securitiest l,2ll.1 1,608.5 2,266.t 2,598.4
Other 167.4 141.8 181.0 176.2
Total $4,689.5 $s,407.s $5,6i8.1 $s,943.4

.Dollar-denominated foreign government securities issued by the U.S. Treasury directly t0 foreign governments.

tsecurities held by government trust funds, revolving funds, and special funds such as social security and government
pension funds.

Source: U.S. Treasury Department, Treasury Bulletin, May 2002. www'ustreas.glv

Figure 6-l T-Bill versus T-Note Yields, 1980-March 2002

T-Bill T-Note
- -

98,,99 00 01

In contrast to T-bills, which are sold on a discount basis from face value (see Chap-
ter 5), T-notes and T-bonds pay coupon interest (semiannually). Further, T-bills have an
original maturity of one year or less. Treasury notes have original maturities from over
1 to 10 years, while T-bonds have original maturities from over 10 years. T-notes and
bonds are issued in minimum denominations of $1,000, or in multiples of $1,000. The
Treasury issues two types of notes and bonds: fixed principal and inflation-indexed.
While both types pay interest twice a year, the principal value used to determine the
percentage interest payment (coupon) on inflation-indexed bonds is adjusted to reflect
inflation (measured by the Consumer Price Index). Thus, the semiannual coupon pay-
ments and the final principal payment are based on the inflation adjusted principal
value of the security.
Like T-bills, once issued T:-notes and T-bonds trade in very active secondary mar-
kets. Table 6-3 presents part of a T-note and T-bond (including Treasury STRIPS-see
below) closing price/interest yield quote sheet fromThe Wall Street Jourual for trading
on May 2,2002. Column 1 in the table lists the coupon rate on the Treasury security.
Parl,2 Securities Markets

Table 6-3 Treasury Note and Bond Quote

Treasury Bonds, Notes and Bllls May 2, 2002

Explanatory Notes
Repr$eolalive olerUe.Couter quolalion b.seo on (ansacxons ol l1 million or mo.e, Treasury bond, U.S. Treasury Strips
nol€ and bill quocs are as 0, mld.ahemooi. Colons in lid.and-alked quot! €pGsent 32nds; 101:01
mrans 101 l/32 Net chaoges in 32nds. n lreasury nole, llnlalionlndsed r$ue Trea$ry bill quores in
hundEdlhs, quoled on tems o, a ra€ ol discouot. oays to maludry elculated l6m senlement dare, Ali
lvlay 02 (i 1.49
,EBs a€ t0 matudty and tas€d on $e tsk€o quote, Laies 13-reeh and 26 tr€k !ils are bold,aced. For May 02 np 99:31 99r3i t.49
bod! dilabla pdor D maturiry, relds are compuEd lo he eaiiesl call dale fo( i$ues quoled above par Aug 02 ( 99;18 9918 1.56
rnd lo the matunry dare ,or issu€s hlo* par. 'When issued. Auq 02 . np 99:16 99:16 1.79
sd,ca: esPead/canlor Fiu8erald Nov 02 ( 99:06 99:07 t.52
U. S T,.asury $np! a5 ol 3 p.m [aslen ime, .lso based on rBnsclionr ol I I miltron or nore. Collns
in bid and ashed qrore! Epresent 32ndsi 99i01 m$ns 99 1/32. Nel changes m 32nds. Yelds Glculated
feb 0l (i 98ill 98i14 2.04

on ma asked quobtion. clsrdpped colpon inlerest. bp-T.easury boid, sipped pnncipal, sp Teasury nore,
feb 03 ip 98lt 98111
May 03 (i 97:24 97:24 2.22
stpp.d pirocipal. fo. bmds 6{able pior lo maufly, yields are oomputd lo lhi rairestcall dale,or issues
quoEd above par and b lhe maudy dale ,or issues brlory p6r.
lll 03 (i 9710 97ri0 -1 2.29
Aug 03 (i 9?:01 97102 -i 2i4
Sourca: gear, Sle6ms & Co vla S@d Sofrwire lech0ola6, lnc Aug 0l np q6:23 96.24 -I 260
MIIURITY MAIURITY
A5I( AS( l,loe 03 (i 9611 96:14 -1 240
MlT MO/YR BID ASITD (H6
YI.D RAIE MOAR 8ID ASIGD (HG YI.O ilov 0l np 95123 95:24 -1 1.57
9.12t Miy 09 111106 U1:07 -4 3.36 J.n 04 (i 9Ji02 9t!{ -1 LC8
Government Bo[ds & Notes 6.000 Au9 09n 106:10 106:U -10 4,95 tob 04 (i 94123 94:24 -l 3.05
7.500 May 02r 100106 100:07 ... 0.87 10.379 tlov 09 U5:10 1i5ill -3 3.71 feb 04 np 94'.21 94t22 -l 1.09
6.t0{ May 02n 100i11 100:12 ... 1.38 4.250 .,in 10i 108:tE 108:09 -6 3.03 Miy 04 (i 93.22 91:23 -1
6.625 May 02n 1001I I00lZ -1 l.to 6.500 tEb 10n 109:1{ 109:15 -11 t.ol M.y 04 np 93:18 93:20 -I 3.29
6.250 Juo 02n 100:22 100:21 -l teb I0 lm:U 120:19 -{ i.88 JUI M (i 92:28
6.375 iun 02n lm:21 1m:2{ ... L6t 11,7t0
1.62
92:7? -2 1.40
Miy 10 ll6:2t U6:26 -1 4.05 Aq 04 (i 9tl4 92:15 -,
1.625 02i 10115 10116 -1 0.00 i0.000
3.46.
.,01 5.?r0 Aue lon 104:18 t04:19 -U 5.06 Au9 04 B ,?14 9216 -2 3,45.
6.000 ](l 0?i l0lr00 10101 -l 1.70 12.750 tlov 10 L27:2t 12126 -5 4.2n llov 04 (i 9106 91107 -l 1.67
6.2t0 ill 02n 101:02 10lr0l -I 169 I 500 Jrn l1i 10i$8 103S, -4 3.07 l,lov 04 bp 91f3 91:04 -2 3.71
6.175 Aug 02n 10109 10110 I 1.71 5.00{ feb lln 9911} 9912 -10 5.09 l{o! 04 np 91:08 9109 -2 3.65
6.U, Au, 02n 10U1 10112 i t62 13.8i5 Miy il il4:30 84:31 -6 4.33 Jan 05 (i 90ri6 90117 -'l 3.73
6.2t0 Aug 02n l0lll l0u4 ... I.80 5,tll0 Aus lln 99i04 99$t -i0 5,1I I.l 05 (i 90102 mi03 -3 1.78
5,875 5e, 02n 101:20 101:21 -I 14.000 f.lov 11 138t16 13&21 -5
1.79
4.4A feb 05 hp 90:07 90i08 -2 ).7'2
6,0{0 5e! 02n 101:22 101:21 ... 1.77 3.315 lei 12i 10?12 102:11 -7 1.09 May 05 (i 88i28 88:10 -3
5.750 0(t 02n 101:28 I0l:29 -1 l.8l 4.87\ tob Un !8:06 98:07 -10 9.11 il1ry0t 26 88i28 -3
11.625 ilov 02 105105 105:06 ... 1.80 10.179 llov 12 126:25 116:?5 -7 4.80 bp 88 3.94

5.625 Llov 02n 102:03 102:04 ... 1.90 12.00{ Aug 13 lll:29 lli:3{ -10 4.91 [tay 0, np 88i27 1812, -4 3.92

5.750 l{ov 02n 102:05 102:06 .., 1.92 i3.250 M.y 1,1 148:18 148:19 -12 4.98 May 05 np 88JI 89:00 -3 1.89

5.125 De( 02n 102101 102:02 ... 1.96 12.500 Auq 14 l45r0l 145:02 -11 5.01 iul 0t (i 8!:08 8810 -4 l.9l
Aug 05 (i g7:28
5.625 De( 02n l02r1l 102112 -i 1.96 U,7t0 l,lor l{ 141:06 141i07 -U t.09 87126 -4 ,.99
{.7t0 lan 03n 102i00 102:00 -1 2.01 11.250 Feb 15 152:29 152:30 -12 ,.4, Aug 05 bp 87:13 87:15 -4 4.11

,.500 l,n oln 102:16 i02r17 -l 2.04 10.625 A!9 15 I47r7 147:28 -15 5.50 Aug 05 np 87123 87.25 -5 {.01
6.250 teh 03n 101i05 103:06 -1 ilov 05 (i 87:07 87:09 -4 3.90
9.87, tlov 15 14lil 141104 -15 5.52
2,12
10.750 teb 03 106:21 106:22 -2 2.U 9.2t0 feb 16 13t:06 135:07 -ll 556 t{ov 05 np 8616 8{:18 -4 4.1{
4.$2, teb oln 102i00 102:01 -.1 2.U 7.250 May 16 Ut:2t U5i26 -ll 5.61 flov 0, np th:17 86:19 -4 .4.I2

5.500 teb oln 102:23 102:14 -l 2-12 7.500 tlov 16 U8:13 U8:14 -14 5.6, lan 06 (i r,6100 85$2 -4 dt1
4.210 Mar 03h 101i?6 101;?7 -l 7.17 8,750 Mar 17 l3ll3 t3l;14 -14 5.62 t€b 06 (i 85:14 85:16 -4 4.18

5.500 Mar oln 102:30 102:31 -1 2.i8 8.875 A!9 l7 132.28 BZ:29 -1t ,.63 Feb 06 hp 85101 85:03 -4 4.32

4.000 A[ 03n I01]2I 101,:12 -l LL1 9.125 May 18 116{5 136:07 -1, 5.56 teb 06 np 8t:11 8t:11 -4 4.22
5.750 ADr oln 103i12 103:13 -1 2.26 9.000 l{o! 18 135:11 llt:12 -16 t.67 May 06 (i 84:08 84;10 -5 t.2t
10.750 May 03 108i17 108:18 -2 2.30 8.87! fei t9 134:05 U4:07 -16 5.68 84:01 84:0, -4 435
4.210 May 03n 102:00 l02rm -I 2.14 8.125 Aug 19 126:11 126112 -16 5.70 Jul 06 d 8{:02 &:04 -5 4.16

5,500 M.r 03n 103109 103:10 -l 2.35 8.500 feb 20 130i28 130:29 -16 5.71 .,ul 06 np 8r:10 83:12 -5 4.38

,u 03n 101:19 l01m -l 2.43 8.750 May 20 134:tJ0 134:00 -17 5.ii A!9 06 (i 83:16 8l:18 -5 4.24

,m 0!n 103:10 103:ll -l Zll tlov 06 (i 82:0i g2:10 -t 4.3\

A{9 20 134:05 li4:0i -16 5.71 Fob 07 (i
3.815 lul oln 101120 101:21 -l 2.9I 8.710 teb 21 l2A:14 12411t -16 5.73
80:21 80:26 -5 4.51

5l!D Aug oin 101110 10311 -2 2,tB 7.87,8.125 Miy 21 127:17 I27:I8 -15 5.7i
Feb 07 np
May 07 (i
801, 8r:17
79:10 79:13
-5 4.t8
5.75q Aug oln 103:i0 103.11 -l 2.98 8.12t A!9 21 127:21 l21tl -16 5.71 -5 4.65

Il.l2, Auq 0l 110.23 110:24 -2 2.57 8.000 liov 21 126:i4 126:] -16 M.y 07 np 79:08 79:10 -7 4.66

1.625 Au9 03n 10108 101:09 -l 2.62 7.210 Aug 22 llTtzg Ll7t19 -15 5.14
5.73
Aug 07 d 7815 78:17 -6 4.61

2.750 Srt 030 100:01 100102 -I 2.70 l.$25 dou 22 I22:1i l22rt8 -16 9,74 Aug 07 np 78:04 78:07 -7 4.71

2.?50 0(l 03n 99130 99:31 -l 2.77 Nov 07 (i 711?6 77:29 -6 457
,4.210 [oY 03n 102:02 102:03 -l 2.84 7.129 Feb 23 i16i18 U6:19 -15 ,.i5 feb 08 d 75t25 75127 -s 4.84
Au 2i 106r0i 10,6:02 -14 5,75
11.87, ilov 0l 11114 U3:15 -2 2.83 6.2507.500 24 l2L:25 l2l:29 -ll 5.15
Feb 08 0p 75101 76:04 -7 4.78

3.000 ilov oln 100:04 100:05 -I 2.89 7.625 lov Miy 08 d 7414 74:17 -5 4.94
teb 25 123:18 123:19 -16 5.79 L{.y 08 op 74128
3,210 0e( oln 100:14 100:15 -1 2.96 6.87t Aug 2i U4:06 U4:07 -15 5.76 74125 -1 4.86
3.000 Jan 04n 99:29 99:30 -l 1.04 teb 26 10i:01 10i:04 -14 5,76
Ao9 0g (i Bln 822 -5 4.92
4.75n feb 0{n 102:29 102:30 -2 3.04 6.000 Auq 26 112127 1i2:28 -lt
l,loy 08 (i 72119 12t22 -5 4.95
5.875 teb 04n 104:26 104127 -2 3,06 6.750
6.500 llov 26 109:20 1094 -15 ,.76
5.?6
Nov 08 n, 72:11 72:16 -8 4.92
1.000 feb 04, 99:26 99:27 -1 3.09 6625 tob 27 Ul:lo U1:11 -15 ,.76 Frb 09 (i 70i3I 71.02 -1 ,.10
3.625 [4n04n 100:26 I(0:27 -1 3U 6,375 Ang 27 108$, 108:04 -15 5.76 Mdy 09 (i 69:28 69i1 -7 5.15
3.37, Apr 04n 100:08 100:09 -1 l.2l 6.129 ilov 27 IM:28 1M:29 -14 976 Miy 09 np 7016 70i19 -9 5.42
5.250 Miy 04n l0lr29 I03J0 -2 3.23 A!9 09 (i 69f0 69i03 -7 5.14
7,250 M.y 04n !01125 107i26 -2 3.25 362, Ap,28i
104:12 104i13 -1,6 ,,3i
A{! 28 96:18 9619 -1, 5.75
Aug 09 op 69:10 69:li -10 5.08
t2.i7t Mar 04 117:1, 1!7126 -2 3.14 5,500 Nor 28 9308 -11 5.75
Nov 09 (i 6?i31 68:02 -6 5.18
6.000 Alg 04n 105120 105:21 -3 3.40 9.250 teb 2, 91i07
5.210
9i:08 9109 -13 Nov 09 bp 66tD 66125 -7 9.44
7-250 Aug 04n 108:10 10811 -3 j.81t Apr 29i 108:29 108:30 -17 5.74
3,.42
i.l7
ieD 10 ( 66121 66i24 -6 5.26
13.750 Aug 04 12215 U2:16 -3 3.43 Feb 10 np 67:06 67:09 -10
6.125 A!9 29 105:08 105109 -14 ,.74
5.16
5.87t llov 04f 10516 10517 -] 3.56 6.250 30 lo7tll l'7t12 -L2 5.72 May l0 (i 65117 65t20 -6 ,.32
7.875 Nov 04n U0i08 U0:09 -, 3.,9 ,.37, Lrdy tlb 31 9626 962) -10 5.60 A!9 10 d 64t23 Ui26 -7 ,.tt
11.65 tiov 0{ U9:07 119:08 -4 3,60 3.31t Apr 32i 102:02 I02r03 -17 3.26 A(9 10 np 6r:10 65;13 -10 5.19
7.500 teb 05n U0r0i U0:01 -l l,68 Nov !0 (i 63:30 64i01 -1 5.30
6.100 May otn 107i18 107:19 -4 i.82 fe! 11 (i 5zrl9 62i9 -l t,4L
6.790 M.y orn 108;05 108:06 -t 3.86 tob 11 np 63.21 63124 -9 i.19
12.000 M.y 05 12ii06 123:07 -, 3.81 [,lay 11 d 6i:14 61116 -7 t.46
6.100 A!9 05i 107124 107i25 -t 3,9t Aug 11 (i 60121 50:23 -? 5.45
10.710 Aug 05 120rI7 12018 -t 4.00 Nflud 59124 59:26 -8 5.47
5.750 l'{ov 05n 10514 10515 4 4-07
5.875 l,lov 05i 105:28 105:29 -5 {.06
5.625 teb 06n 105:02 105:03 -5 ,4.15

9.3?5 reb 06 117:30 1U:31 -5 4.I9

4.62i Miy 06n 101:10 101iU -4 4.?6
6.87t May 06n 10917 109:18 -6 4.26
7.000 .lul 06n U0:0t i10:06 -, {.12
6.t00 0d 06i 108:13 108i14 -t {.39
1.500 fiov 06n 9{J8 9{r9 -9 4,.41
3.115 .l.o 07i 103126 l0lr27 -6 2.t0
6.254 reb 07n 107:16 |A?:fi -7 4.48
6.62, May 07n 109:07 109108 -7 {.i4
6.125 Aug 07n 10i;01 107102 -6 4.60
7.875 Nov 07 101:04 103:05 -1 1 89
Jrn 081 10417 10!:18 -7 2.75
F.b 08i 104:02 ilq:B -8 4.68
5.625 May 08n 104117 104:18 -8 4.75
8.375 Aug 08 107104 107:05 -i 2 68
4.710 tiov 08n 99i18 99119 -8 4.82
8.7t0 Nov 08 I08J9 108i20 -2 2.95
3.875 lin 09i 10t:2{ 105:27 -8 2.91
5.500 M.y 09n 103117 103118 -9 4.89

Source: Ihe Wall Street Journal Friday, lVlay 3,2002, p. C.l 2. Reprinted by permission ot The Wall Street Journal. @ 2002

Dow Jones & Company, Inc" All Rights Beserved Worldwide. www.wsj.com

SIRIP
A Treasury security in which the
periodic interest payment is
separated from the final
principal payment.
Ghapter 6 Bond Markets
Figure 6-2 Creation of a Treasury STRIP
1 0-Year Bond
as a Whole
iriiiii.l:l:] i
Xil:lllilil:li:liittl:ll
.r,rr.ri:rizriirirr:rrr::r:r i.r1r,rr,rrrl,,,rl,.,,rr.,,.,,
Note that coupon rates are set at intervais of 0.125 (or % of 1) percent. Column 2 is the
month and year the note or bond matures (an "n" after the year means that the security
is a T:-note-i.e., having an original maturity of 10 years or less). Column 3, labeled
BID, is the close of the day selling price (in percentage terms) available to T:note and
bond holders (i.e., the price dealers are willing to pay T:note and bond holders for their
Treasury securities). Prices are quoted as percentages of the face value on the Treasury
security, in 32nds. For example, using a face value of $ 1,000, the bid price on the 6.125
percent coupon, Aug02 T:note was $1,013.4375 (101'%,Vo X $1,000). Columr 4, labeled
ASKED, is the close of the day purchase price available to investors. Column 5, labeled
CHG, is the change in the asked price from the previous day's close in 32nds-that is,
the February 2008 T-note's price decreased by %, from the previous day. Finally, the last
column, labeled ASK YLD, is the asked price converted into a rate of return (yield to
maturity) on the T:note or T-bond. This yield is calculated using the yield to maturity
formulas found in Chapter 3-it is the interest rate or yield (using semiannual com-
pounding) that makes the price of the security just equal to the present value of the ex-
pected coupon and face value cash flows on the bond (where this yield is the single
discount rate that makes this equality hold).
STRIPS. In 1985, the Treasury began issuing 10-year notes and 30-year bonds2 to fi-
nancial institutions using a book-entry system under a program titled Separate Trading
of Registered Interest and Principal Securities (STRIPS). A STRIP is a Treasury se-
curity in which periodic coupon interest payments can be separated from the each other
and from the final principal payment. As illustrated in Figure 6-2, a STRIP effectively
creates two sets of securities-one set for each semiannual interest payment and one
set for the final principal payment. Each of the components of the STRIP are often re-
ferred to as "Treasury zero bonds" or "Treasury zero-coupon bonds" because investors
in the individual components only receive the single stripped payments (e.g., the third
semiannual coupon) in which they invest. Investors needing a lump sum payment in
the distant future (e.g., life insurers) would prefer to hold the principal portion of the
STRIP. Investors wanting nearer-term cash flows (e.g., commercial banks) would pre-
fer the interest portions of the STRIP. Also, some state lotteries invest the present value
of large lottery prizes in STRIPS to be sure that funds are available to meet required
annual payments to lottery winners. Pension funds purchase STRIPS to match pay-
ment cash flows received on their assets (STRIPS) with those required on their liabil-
ities (pension contract payments).
STRIPs were created by the U.S. Treasury in response to the separate trading of
Treasury security principal and interest that had been developed by securities firms.
2. The U.S. Treasury stopped issuing 30-year bonds rn2002.
 Parl 2 Securities Markets

Specifically, in the early 1980s, Merrill Lynch introduced Treasury Investment Growth
wwwml,Gom Receipts (TIGRs). Menill Lynch purchased Treasury securities, stripped them into one
security representing the principal component only and a separate security for each
coupon payment, and put these individual securities up for resale. The Treasury's cre-
ation of the STRIP was meant to offer a competitive product to the market.
The U.S. Treasury does not issue STRIPs directly to investors. Rathet stripped
Treasury notes and bonds may be purchased only through financial institutions and
govemment securities brokers and dealers, who create the strip components after pur-
chasing the original T:notes or T-bonds (whole) in Treasury auctions (see below). Af-
ter the STRIP components have been created, by requesting that the Treasury separate
each coupon and face value payment on each bond and recording them as separate se-
curities in its book-entry computer system, they can be sold individually in the sec-
ondary markets.3

Example 6-1 Creation of a STRIP

Suppose the Treasury issues a five-year T-note with a par value of $10,000 and an 8
percent coupon rate (paid semiannually, or $400 is paid to the holder every six months
for the next five years) to Citigroup. Citigroup decides to convert the bond into a set of
stripped securities by requesting the Treasury to separate the coupons and face value
of the note into separate securities on its computer system (basically giving each
coupon and face value a separate I.D. or CUSIP number). This means that Citigroup
can then sell 11 different securities: 10 securities associated with each of the semian-
nual coupon payments of $400 and one that pays $10,000 (the face or principal value)
in five years to outside investors. We show the value of each of these securities in Table
6-4, assuming the yield to maturity on each of the stripped securities is 7.90 percent,
and is the same as the bond sold "whole."
Notice that the total present value of the 11 different securities involved with the
STRIP is the same as that of the original T-note before it is stripped, $10,040.65. How-
ever, in general, the bank (Citigroup) will try to sell the 11 stripped securities for a
greater total present value than the bond as a whole. The reason for this is that many
investors desire particular maturity zero-coupon bonds to meet investment goals and
needs. Such goals and needs (such as duration targets-see below) are often harder to
achieve through buying whole T-notes or T-bonds. Consequently, investors are willing
to pay a higher price and thus accept a yield lower than 7.90 percent on the stripped in-
vestments. As a result, the total price Citigroup would get from selling the 11 STRIPS
would exceed $10,040.65.

As mentioned above, STRIPs are attractive investments to investors desiring par-

ticular maturity-zero coupon bonds to meet investment goals and needs. For example,
STRIPs are used as investment securities for individual retirement accounts, Keogh
Plans, and pension funds. Frequently, managers of these types of financial institutions
face the problem of structuring their asset investments so they can pay a given cash
amount to policyholders in some future period. The classic example of this is an insur-
ance policy that pays the holder some lump sum when the holder reaches retirement
age. The risk to the life insurance company manager is that interest rates on the funds
generated from investing the holder's premiums could fall. Thus, the accumulated re-
turns on the premiums invested might not meet the target or promised amount. In ef-
fect, the insurance company would be forced to draw down its reserves and net worth

3. Once a bond is stripped, if an investor purchases each coupon and face value component at a later time,
he or she can ask the Treasury to reconstitute the original bond on its computer system. Thus, the Treasury STRIP
program is highly flexible and STRIPS can be reconstituted as whole bonds.
Ghapter 6 Bond Markets

Thble 6-4 Present Value of STRIP Components of a 1O-Year T-Noie with an 8

Percent Coupon Rate and 7.90 Percent Yield to Maturity
Maturity on Security Cash Flow Present Yalue of
(in years) Received at maturity Cash Flow at7.90 Percent

0.5 $ 4oo $ 384.80

1.0 400 370. 1 8
1.5 400 356.11
2.0 400 342.58
2.5 400 329.56
3.0 400 311.04
3.5 400 304.99
4.0 400 293.40
4.5 400 282.25
5.0 400 271.53
5.0 10,000 6,788.2t
Total $10,040.65

to meet its payout commitments. (See Chapter 15 for a discussion of this risk.) To im-
munize or protect itself against interest rate risk, the insurer can invest in Treasury
zero-coupon bonds (or STRIPS).

Example 6-2 Using a STRIP to Immunize Interest Rate SK

Suppose that it is 2004 and an insurer must make a guaranteed payment to an investor
in five years, 2009. For simplicity, we assume that this target guaranteed payment is
$1,469,000, a lump sum policy payout on retirement, equivalent to investing
$1,000,000 at an annually compounded rate of 8 percent over five years.
To immunize or protect itself against interest rate risk, the insurer needs to deter-
mine which investments would produce a cash flow of exactly $1,469,000 in five
years, regardless of what happens to interest rates in the immediate future. By invest-
ing in a five-year maturity (and duration) Treasury zero-coupon bond (or STRIP), the
insurance company would produce a $1,469,000 cash flow in five years, no matter
what happens to interest rates in the immediate future.
Given a $1,000 face value and an 8 percent yield and assuming annual com-
pounding, the current price per five-year STRIP is $680.58 per bond:
1.000
680.58 : ;
( 1.08 )',
Ifthe insurerbuys 1469 ofthese bonds at a total cost of$1,000,000 in 2004, these
investments would produce $ 1 ,469,000 on maturity in five years. The reason is that the
duration of this bond portfolio exactly matches the target horizon for the insurer's fu-
ture liability to its policyholders. Intuitively, since the STRIP pays no intervening cash
flows or coupons, future changes in interest rates have no reinvestment income effect.
Thus, the return would be unaffected by intervening interest rate changes.

Most T-note and T-bond issues are eligible for the STRIP program. The compo-
nents of a STRIP are sold with minimum face values of $1,000 and in increasing mul-
tiples of $1,000 (e.g., $2,000, $3,000). Thus, the par amount of the securities must be
an amount that will produce semiannual coupon payments of $1,000 or a multiple of
$1,000. The original Treasury note and bond issues that are eligible for the STRIP pro-
gram are usually limited to those with large par values.
Pari 2 Securities Markets

The T-note and bond quote list in Table 6-3 includes a portion of the Treasury
STRIPS that traded on May 2,2002. Look at the two lines for STRIPS maturing in Au-
gust 2004. The first column of the quote lists the month and year the STRIP matures
(e.g., Aug 04). The second column, labeled TYPE, indicates whether the instrument
represent the coupon payments (ci) or the note's principal value (np) from the original
Treasury note. Columns 3 and 4list the bid and asked prices for the STRIPS. Like the
quote for other Treasury securities (discussed above), the BID is the close of the day
selling price (in percentage terms) available to STRIP holders (i.e., the price dealers
are willing to pay T-note and bond holders for their Treasury securities). Prices are
quoted as percentages of the face value on the Treasury security, in 32nds. The ASKED
price is the close of the day purchase price available to investors. Column 5, labeled
CHG, is the change in the asked price from the previous day's close in 32nds. Finally,
the last column, labeled ASK YLD, is the asked price converted into a rate of return
(yield to maturity) on the STRIP. This yield is calculated using the yield to maturity
formulas found in Chapter 3, that is, it is the interest rate or yield (using semiannual
compounding) that makes the price of the security just equal to the present value of the
expected coupon or face value cash flows on the STRIP.

Example 6-3 Calculation of Yield on a STRIP

For the principal (np) STRIP maturing in August 2004 (reported in Table 6-3), the
ASKED price at the close on Thursday, May 2, 2002 (or present value) is 92:16 (:
92t%2, or 92.5 percent). Settlement occurs two business days after purchase, so you re-
ceive actual ownership on Monday, May 6. 2002. When the STRIP matures, on August
15, 2004 (in 2.27945 years), the STRIP holder will receive 100 percent of the face
value (or future value). Using semiannual compounding, the yield to maturity (ytm), or
ASK YLD is calculated as:
92.570 : I ytmlz)zxzzts+s
Solving for ytru, we get:
1,tm
: 3.45Vo

Treasury Note and Bond Yields. Treasury note and bond yield to maturities and
prices are calculated using bond valuation formulas presented in Chapter 3. The gen-
eral bond valuation formula is:

,, : #gvIFA.,tu,.N,,)
-t M(PVIF ir,,,,1,{.)
where

Vp: Present value ofthe bond

M : Par or face value ofthe bond
INT : Annual interest (or coupon) payment on the bond, equals the par value
times the coupon rate
I/ : Number of years until the bond matures
ru : Number of times per year interest is paid
l7 : Interest rate used to discount cash flows on the bond

Example 6-4 Calculation of a T-Note Price from aWall Street

Journal Quote
From Table 6-3, there were two T-notes outstanding on May 2,2002 (with a settlement
date of May 6, 2002), with a maturity on June 30, 2003 (i.e., they were 1.1507 years
from maturity). The first T-note had a coupon rate of 3.875 percent and an ASK YLD
of 2.43 percent (The Wall Street Journal lists yields and prices to /.aa of I percent).
Using the bond valuation formula, the ASKED price on the bond should have been:

accrued interest
That portion of the coupon
payment accrued between the
last coupon payment and the
settlement day.
Ghapter 6 Bond Markets
Vo: 3.8757o
Z
(PVIFAy$q"D,,.,ror1r1) + 1OO(PVIFz.+sr"rz,r.tsotpl)
-- t0t.628t
or to the nearest %r, l0l'%,. The ASKED quote reported in The Wall Street Journal was
indeed ljl'z%2.
For the second June 2003 maturity T:note, the coupon rate was 5.375 percent and
the yield was 2.43 percent. The ASKED price on the bond should have been (and was):
5.315Vo
V"2: ,.,ror(r)) + 100(PVIF2437,/2,
: 103.3353
-(PVIFA2.43Et2.
or to the nearest %,. 103'%2.
Accrued Interest. When an investor buys a T-note or T-bond between coupon pay-
ments, the buyer must compensate the seller for that porlion of the coupon payment ac-
crued between the last coupon payment and the settlement day (normally, settlement
takes place 1 to 2 days after a trade). This amount is called accrued interest. Thus, at
settlement, the buyer must pay the seller the purchase price of the T:note or T-bond
plus accrued interest. The sum of these two is often called the full price or dirty price
of the security. The price without the accrued interest added on is called lhe clean
price.
Accrued interest on a T:note or T-bond is based on the actual number of davs the
bond was held by the seller since the last coupon payment:
INT Actual number of days since last coupon payment
Accrued interest
2 Actual number of days in coupon period
Example 6-5 Calculation of Accrued Interest and Yield to Maturity
on a Bond
OnAugust 2,2004, you purchase a $10,000 T:note that matures on May 15, 2011 (set-
tlement occurs two days after purchase, so you receive actual ownership of the bond
onAugust 4,2004). The coupon rate on the T-note is 5.875 percent and the current
price quoted on the bond is 1 01 - 1 1 (or 101 .3431 57o of the face value of the T-note).
The last coupon payment occurred on May 15, 2004 (81 days before settlement), and
the next coupon payment will be paid on November 15,2004 (103 days from settle-
ment). We illustrate this time line in Figure 6-3.
The accrued interest due to the seller from the buyer at settlement is calculated as:
(5.875Eot2) x 811184 : t.293I4Va
Figure 6-3 Timeline Used to Determine Accrued lnterest on a Bond
Parl, 2 Securities Markets

of the face value of the bond, or $129.3134. The dirty price of this transaction is:
Clean price * Accrued interest: Dirty price
101.343157o + 7.29314Eo : 102.636897a
of the face value of the bond, or $10,263.689 per $10,000 face value bond.
The yield to maturity (which is based on the clean price) on the bond received on
August 4,2004, and maturing on May 15, 2011 (a total of 5 years and 285 days, or
5.7808 years) is:

: ttyY(PVIFArt"7z.
1 01 .3437 5vo r.rros(rr) + 1 00(PVIFytn/2. s.7808(2))

Solving for the yield to -utirity, we get 5.632 percent.

Notice that as the purchase date approaches the coupon interest payment date, the
accrued interest due to the seller from the buyer increases until just before a coupon
payment date the buyer pays the seller fractionally less than the full coupon payment.
However, as the accrued interest portion of the dirty price of the note increases, the
clean price of the note decreases to offset this, keeping the overall price of the noie to
the buyer constant. This is illustrated in Figure 6-4.

Primary and Secondar;, Market Trading in Treasury Notes and

Bonds. As in primary market T-bill sales, the U.S. Treasury sells T-
notes and T-bonds through competitive and noncompetitive Treasury
auctions (see Chapter 5). Table 6-5 shows a recent auction pattern for
T-note and T-bond new issues. The Treasury issues a press release
about a week before each auction announcing the details of the auc-
tion, including the auction date, the amount to be sold, and other de-
tails about the securities to be issued (see In the News box 6-1).

Figure 6-4 Dirty Price of Treasury Note

Price

.COUoonr,Payment Coupon Patyrnehl

'.".r i l.,-:rr.iDatei' Dat6.,, r',,,i.,i.,r,:rrrl

Table 6-5 Auction Pattern for Treasury Notes and Bonds

Security Purchase Minimum General Auction Schedule
2-year note $1,000 Monthly
5-year note $1,000 February, May, August, November
1O-year note $1,000 February, May, August, November

Source; U.S. Treasury, website, Bureau of Public Debt, May 2002. www.ustreas.gov
 Chapter 6 Bond Markets

he Treasury will
auction $25,000 awards will be at the highest
million of 2-year
Yreuswry T* yield of accepted competi-

notes to refund Aut'itrsn $X,AAU tive tenders. The allocation

$24,218 million of publicly frdi{,{ir:n at 2-Yeur percentage applied to bids

held notes maluring April 30, f{r}les awarded at the highest yield
2002, and to raise new cash will be rounded up to the
of approximately $782 mil- next hundredth of a whole

lion. ln addition to the public New York will be included percentage point, e.g.,

holdings, Federal Reserve within the offering amount o{ 17.13Yo.

Banks hold $7,648 million of the auction. These noncom- The notes being offered

the maturing notes for their petitive bids will have a limit today are eligible for the

own accounts, which may of $100 million per account STRIPS program.

be refunded by issuing an and will be accepted in the This offering of Treasury

additional amount of the order of smallest to largest, securities is governed by the

new security. up to the aggregate award terms and conditions set

Up to $1,000 million in limit ol $1,000 million. forth in the Uniform Offering
noncompetitive bids from Treasut:yDirect cus- Circular for the Sale and ls-

Foreign and lnternational tomers requested that we sue of Marketable Book-

Monetary Authority (FIMA) reinvest their maturing hold- Entry Treasury Bills, Notes,

accounts bidding through ttre ings of aBproximately $743 and Bonds (31 CFR Pad 356,

Federal Beserve Bank of million into the 2-year note. as amended).

The auction will be con- Details about the new

ww!fir"88$nr8as-s&w Source: U.S. Treasury website.

Bureau of Public Debt, May 4, ducted in the single'price security are given in the at-
2002. auction format. All competi- tached offering highlights.

Attachment

HIGHLIGHTS.OF TBEASURY OFFERINGS TO THE PUBLIC OF

2-YEAB NOTES TO BE ISSUED APBIL 30, 2OO2

April 17,2002

0fferingAmount .........1.:: $25,000 million

Public0ffering ;...,.. $25,000 million

Description of 0fferinq:
Term and type of security 2-year noies , ,

M-2004

CUSIP number 91 2828 AB 6

Auctiondate... ......, April24,2002

ir:'
lssue date APril30,2OAZ''' . '
Dated date 30,2002-
April l

Maturitydale.. ...... ...,i.,. April 30; 2004 ," " "'

'

lnterestdate... Determined based on the highest

accepted competitive bid
(continues)
Parl, 2 Securities Markets

'Premiumordiscouiit,',rr;:,:..,,. .....:' ;;,,:' ,',Detgfminedatauction.

STRIPS lnformation:
-:',rNroner''l:''
Minimumamount.re-4ruriiedit.:.,;,ri',irri';r',"".t,...'. "
I Oofpus OUSIP numb,el .,.. .,',':91,2820'GY'7 ,:

,,'
'.,DqelQate(s),and,CU$tP,'number(5),,,, : i ,, ,,
",.
',, :,:r
,rfoi,'edditional,TlllT,:(s):, ....:. Ap1it 30,2004-912833YT1 ;, 1 ',

Submission of bids:
Noncompetitive bids:
Accepted in full up to $5 million atthe highest accepted yield.
Foreign and lnternational Monetary Authority (FIMA) bids: Noncompetitive bids submitted through

the Federal Beserve banks as agents for FIMA accounts. Accepted in order of size from small-

ll,.,..t,,:l.ll,,:ll,*it!0,!eigesi:.wiitr..,nO.lmoierthan $100 million awarded per ac0otln!,,The total noncompetitive :

,.',r,,rrr,rr:,,l,rmduni,ewaid0d'.tO..,Fedgrall,Beserve Banks as agents for FlMA;accounts will not exceed $1;00O,,

t,,,,tr:.'.,,..,,,..,,.milliOnirA:$ing,err:bid,thatrwould cause the limit to be exceedOd,w!lt,be lartiallV accepted in lhor,.,,.,r.

amount that brings the aggregate award total to the $1 ,000 million limit. However, if there are

',],'tt:,,r
,i,:lt,,rtw6,:Oi,mOfe,blds of equal amounts that would cause the l1m,itrrtOtB:rexceeded, each will be , ,rl

prorated to avoid exceeding the limit.

Competitive bids:
.,'
,,i1'1,
Must be expressed as a yield with three decimals, eg,,zj,1!3%ti,,,..,, 1 ,,"

(2) Net lAng position {or each bidder must be repoded when,,'the,:.sum,of .the total bid amount, ati',.,,,i

all yields, and the net long position is $2 billion or greaten:r,,,,:rr::r.t,,:t1t,,:t,ti,:,

, ,,,,,,rr,
(3) Net long position must be determined as of one-half horlIr]pi!0ir!0,!he Closing time for rece.ip!
of competitive tenders.
,,,:]:ll,',1.:,]'.l]].:l:.r
'

Maxinutm RecognizediBid at a single Yield ,3'591b,,,0f ,rpublic offeri n g

:3- 5%:0f ,:Publ i c off eri n g

t,ur:r r'Bilrlugfl,Ii!:|1!$i,:Ey eharge to a fund$ account at..Fed.efal,,Besew0r,rBahrk,r00 iSS0a.]date'!,,ro!:'rpaym,en!],i,,:,t],url

Bids may be submitted by government securities dealers, businesses, and individ-

uals through a Federal Reserve Bank until noon Eastern time for noncompetitive bids
and 1 p.u. Eastern time for competitive bids on the day of the auction. Awards are an-
nounced the following day. Table 6-6 shows the results of the two-year T-note auction
of April 24,2002. At this auction, 56.68 percent (or $32,648.2 million) of the submit-
ted bids ($57,596.1 million) were accepted. Further, 4.11 percent ($1,341.5 million) of
the accepted bids at the April 24,2002, Treasury auction were noncompetitive. The
 Ghapter 6 Bond Markets

Table 6-6 Announcement of Treasury Auction Results, April24,2OO2

PUBLIC DEBT NEWS

Departmeni of the Treasury . Bureau o{ the Publtc Debt . Washitrgton, DC 20239

TREASURY SECURITY AUCTION RESULTS

BUREAU OF THE PUBLIC DEBT, WASHINGTON DC

IOR IMMEDIATE RELEASE CONTACT: Office of Fioancing

l-ri I I
202-691 -355A

RESULTS OF TREASURYIS AUCTTON OF 2-YEAR NOTES

Interest Rate: 3 3/82 IEsue Dale: April 30, 2002

series: M-2004 DaLed Date: Apri.I 30, 2oO2
CUSIP No: 9a2A2AAB6 l,{aiurity Date: April 30, 2OO4

High Yield: 3 -3752 price: 100.000

All noncompet.ilive and successful competltive bidders were awarded
securities at the high yield- Tenders at the irigh yield were
allotted 53.87*. A11 tenders at lower yields were accepted in fu1l.
MOUNTS TENDERED A.llD ACCEPTED (i4 Lhousmds)
Tender Type Tendeied Accepted

Competitj-ve $ 48 ,6A6, 442 $ 23 ,65A ,537

Noncompetit ire
FIMA (noncompetitive) 0 0

SUBTOTAL 49 ,94'7 , 9r2 25 ,440 , OO1 1/

Federal Reserve 7 ,644,a30 7 ,64a,aao
TO?AL S 5f , s96 , 062 $ 32 ,648 , L57

Median yield 3.3503:

50? of the amount of accepted competitive teaders
wae tendered at or below that rate. Low yield 3.330*: 58 of the amount
of accepted competltive tenders was tendered at or below that rate.
Bid-io-Cover Ratio = 49,94?,91-2 / 25,OOO,OO1 = 2.AA

1/ Avardg to TREASURY DIRECT = S1,025,941,000

http:/ r.ii"Fs.put Iicdebt,treas.gov

Source: U.S. Treasury, website, Bureau of public Debi, May 4,2002. www.ustreas.gov

auction is a single-bid auction-all bidders pay the same price (the lowest accepted
competitive bid).
Figure 6-5 illustrates the auction results for the two-year T-notes. The highest price
offered on the two-year T-notes was 100.086 percent (or a yield of 3.33 percent) of the
face value of the T-notes. Bids were filled at prices below the high. The lowest accepted
bid price was 100.00 percent (or a yield of 3 .31 5 percent). At this price, all $32,649 mil-
lion in two-year T-notes offered were sold. Atl bidders who submitted prices above
100.00 percent (categories 1 through 5 in Figure 6-5) were awarded in full (winning
bids) at the low price accepted (i.e., 100 percent). Bidders who submitted a price below
100.00 percent (categories 7 and beyond in Figure 6-5) received no allocation of the
auctioned T:notes. Aportion, but not all, of the bids submitted at 100.00 were filled (cat-
egory 6 in Figure 6-5). These bids are filled pro rata at this price. For example, if total
bids in category 6 were $100 mi11ion, but only $25 million in notes remained to be allo-
cated to competitive bidders (given the sc supply curve in Figure 6-5), each bidder
would receive 25 percent (%) of his or her bid quantity at this price. Al1 of the $1,341.5
million noncompetitive bids were accepted at a price of 100.00 percent (which is equal
to the low price paid by the winning competitive bidders).

municipal bonds
Securities issued by state and
local (e.9., county, city, school)
governments.
Par!, 2 Securities Markets
Figure 6-5 Treasury Auction Results
Most secondary market trading of Treasury notes and bonds occurs directly
through broker and dealer trades (see Chapters 5 and 16). For example, according to
the Federal Reserve Bank of New York, the average daily trading volume in T-note and
T-bond issues for the week ended April 24,2002 was $301.69 billion. The Treasury
quotes in Table 6-3 show just a small number of the Treasury securities that traded on
May 2,2002.The full quote listed in The Wall Street Journal shows the hundreds of
different Treasury securities that trade daily.
Municipal Bonds
Municipal bonds are securities issued by state and local (e.g., counties, cities, schools)
governments ($1,688.4 billion outstanding in December 2001) to fund either tempo-
rary 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 from a project are the
source of repayment on municipal bonds.
Municipal bonds are attractive to household investors since interest payments on
municipal bonds (but not capital gains) are exempt from federal income taxes and most
state and local income taxes (in contrast, interest payments on Treasury securities are ex-
empt only from state and local income taxes). As a result, the interest bomowing cost to
state or local government is lower, because investors are willing to accept lower interest
rates on municipal bonds relative to comparable taxable bonds such as corporate bonds.
Municipal Bond Yields. To compare returns from tax-exempt municipal bonds with
those on fully taxable colporate bonds, the after-tax (or equivalent tax-exempt) rate of
return on a taxable bond can be calculated as follows:
i,: iu (1 -,
where
io: After-tax (equivalent tax exempt) rate of return on a taxable corporate bond
ja - Before-tax rate of return on a taxable bond
I : Marginal income tax rate of the bond holder (i.e., the sum of his or her
marginal federal, state, and local taxes)

gGneral obligation
bonds
Bonds backed by the full faith
and credit of the issuer.
reuenue bonds
Bonds sold to finance a specific
revenue-generating project and
are backed by cash flows from
that project.
Ghapter 6 Bond Markets
Example 6-6 Comparison of Municipal Bonds and Fulty Taxable
Corporate Bond Rates
Suppose you can invest in taxable corporate bonds that are paying a 10 percent annual
interest rate or municipal bonds. If your marginal tax rate is 28 percent, the after-tax or
equivalent tax exempt rate of return on the taxable bond is:
l07o (t - .28) : 7.27o
Thus, the comparable interest rate on municipal bonds of similar risk would be 7.2
percent.
Alternatively, the interest rate on a tax-exempt municipal bond can be used to de-
termine the tax equivalent rate of return for a taxable security that would cause an in-
vestor to be just indifferent between the taxable and tax-exempt bonds of the same
default and liquidity risks. Rearranging the equation above,
it:i"/(l-t)
Example 6-7 Conversion of a Municipal Bond Rate to a Tax
Equivalent Rate
You are considering an investment in a municipal bond that is paying io: 6.5 percent
annually. If your marginal tax rate (t) is 2l percent, the tax equivalent rate of interest
on this bond (16) is:
8.228Vo : 6.57o1(I - .21)
Two types ofmunicipal bonds exist: general obligation bonds and revenue bonds.
Table 6-7 shows the amount of both issued in 1990 and 2001. General obligation
(GO) bonds are backed by the full faith and credit of the issuer-that is, the state or
local government promises to use all of its financial resources (e,g., its taxation pow-
ers) to repay the bond. GO bonds have neither specific assets pledged as collateral
backing the bond nor a specific revenue stream identified as a source ofrepayment of
the bond's principal and interest. Because the taxing authority of the government issuer
is promised to ensure repayment, the issuance of new GO bonds generally requires lo-
callaxpayet approval. Possibly because ofthis requirement, and taxpayers'reluctance
to have their taxes increased, general obligation bonds represent a smaller portion of
municipal bonds issued (37 percent in 2001).
Revenue bonds are sold to finance a specific revenue-generating project and are
backed by cash flows from that project. For example, a revenue bond may be issued to
finance an extension of a state highway. To help pay off the interest and principal on
that bond, tolls collected from the use of the highway may be pledged as collateral. If
the revenue from the project is insufficient to pay interest and retire the bonds on ma-
turity as promised-perhaps because motorists are reluctant to use the highway and
Table 6-7 General Obligation and Revenue Bonds lssued, 1990 and 2001
(in millions of dollars)
1990 2001
General obligation bonds $39,610 $100,s19
Revenue bonds 8t,295 170,041
Source! Federal Reserve Bulletin, Table 1 .45, May I 992 and May 2002. www.federalreserve.gov
Pat't 2 Securities Markets

pay the tolls-general tax revenues may not be used to meet these payments. Instead,
the revenue bond goes into default and bond holders are not paid. Thus, revenue bonds
are generally riskier than GO bonds.
Industrial development bonds (IDBs) ale a type of revenue bond issued by munic-
ipalities on behalf of a corporation to help build the economic base of the municipality.
For example, in May 2002, the California Consumer Power and Conservation Financ-
ing Authority issued $30 million of tax-exempt industrial development bonds for 35
manufacturing firms to purchase and install renewable energy systems, buy energy-
efficient equipment, or buy environmentally friendly on-site generation systems.
Unlike a revenue bond, however, the municipality gives its approval for the sale of
the bonds but assumes no legal liability for repayment. Rather, the company for which
the IDBs are issued is liable for repayment. Abuses of the tax exempt or tax reduced
status of IDB bonds led to the passage of federal legislation in 1984 that limited the
amount of IDBs that could be sold in each state. Growth in the use of IDBs was slow
in the 1990s and early 2000s. States had not increased IDB limits since they were in-
troduced in the 1970s and 1980s. At year-end 2001, $157.4 billion of these bonds was
outstanding. At year end 1985, $127.0 billion was outstanding. As a result, inflation-
adjusted values of the limits were quite small by the late 1990s. In 2002, the Council
of Development Finance Agencies (which consists of a national group of state and lo-
cal development agencies) led a push in the U.S. Congress to have the allowable size
of annual IDB issues increased for all states. The legislation has yet to be passed.
Municipal bonds are typically issued in minimum denominations of $5,000. A1-
though trading in these bonds is less active than that of Treasury bonds, a secondary
market exists for municipal bonds. Table 6-8 lists a municipal bond quote sheet from
The Wall Street Journal on May 2,2002. Column 1 lists the (local) govemment issuer.
Column 2lists the coupon rate (generally paid semiannually) on the bond issue. Col-
umn 3, labeled MAI, is the maturity date of the bond issue. Column 4, labeled PRICE,
is the bond price in percentage terms (i.e., 96 :
96 percent of the face value). Column
5, labeled CHG, is the change in the price from the previous day's close. Column 6, la-
beled BID YLD, is the yield to maturity on the municipal bond based on the current
selling price available to the municipal bond holder.
Municipal bonds are not default risk free. Defaults on municipal bonds peaked in
1990 at $1.4 billion, due mainly to a major economic recession in the United States.
Unlike Treasury securities, for which the federal government (in the worst case) can
raise taxes or print money to make promised payments, state and loca1 governments
are limited to their local tax and revenue base as sources of funds for municipal bond
repayment.

Table 6-8 Municipal Bond Quote

IarExempt Bonds
ReDre*nEtive Dri@s for sweBl adw a€&ms tmnE ft rcfundid bonds, b€*d on lnstltuuomltrdBs.
Yeld ls b matudty. H4.
Sure: fte B6d BSr.
Hr &um[ mr ,* *o {B isut 0N[ Mr ]mG (H6 YtD
BD

ffi Ma$osE0AsryRvMlsER 5J25

lE -JA 53 Ma$osrioAertds
tzr)l-Y 9n37, -ltt 5.36
EnlumorrMrRfRsr 5,1fr 07-01"42 5.1?5 A!4X.42 99250 -125 r.*.
Bdgt{0ltysnTmrws( t50, 1}t1-28 98,!00 -.U5 ,.t4 Ma$l,ltrResAutlddl 5.125 08.01"27 98,1b -i2r 526
(.llturni.StBd 5250 040I-30 98,000 -.5il 539 Edt( ,,tro 07-01,-rl 961fi -12t t.2,
,rlD |Tlth&Hghr
(illforniastld t000 0c"01'7 97.2t1 -250 r,2t il(GpFfiRvbd 5.It 10.01"4i 96:tfi -JA fi6
(AstatewidetunDerAthRv 1500 U-0i-32 9'1i1, -.125 5,65 itrttrftlTe4llthfc(p 5.m W"l5-32 97JE -125 t.44
(hllL6enArdlrdhn! fi75 af-0r-]?91J15 -J25 r.rl NYodsFiftil?o 5.N 03-!t-?i, 9&16 -r50 !3fl
{omHlth&fdf( 5.:!?i a7.01"77 99J25 -2h 9.19 NYcbdsFhril20 ilE 03-7r?5 981n -il' r12
{ooktultcoltalim 1000 11.15.25 95:150 -.18 *f llYsEnvirF(turp 5.0m 06-15-?7 96:?5i -251 5:Za
liidix(ovvtrAuthvA 5,000 M01-, 97150 -Jj' tl.i
0maha(00ltftl(orpli[Rv 5.tZ U-Vr42 91.87t -J25 t26
F{ltoito6ATdhFd 5,000 11.01"31 95.875 4b
5A PhB(1 lopr tzirlisr ,,0m 07-01-26 98,000 -,U5 ,14
tsto'Ix wh&rtr 2002 ,,000 U-01.30 94fi0 -2q Phoqnix0vi(nprv(plz 5,210 07-01"32 97.710 .., 5.40
IrdrrllleHltMrAlthAt ',l,t' phoani\ftklhp(tlAz
9,75i VFfr1-32 91125 -240 5.92 t.2m 07-01-27 s8J2t -2q fi9
lLilt6eiolBd5lll ls ,,250 04-01.2i 9&s1i -J25 5.33 portAliiofNYllill2Sthsr 5,000 04-t -32 97.62t -250 5J5
lltpldsFdthk 5.000 06-19-32 95375 -13 r,31 PdoRl@Hwymms 5.000 07{1-32 98.ti0 -250 5.13
hdlanapolhprblnoi!8d 5210 $-AL3B 9737t -B
5.39 llroNv(ipfta] lmFmtRv ,.179 0t-01-r2 99j.50 -ZA 5.q
ldiioapolhpublftpmSd 5:2i 07-01.17 ,7,000 -l2t t.34 s&AniTxstrsysruld 5.000 0tlr-32 94:150 -&E ,.r5
l-A U$DGiffbd! 5J25 $-1!-27 9r.{00 -.r50 r19 TriborgBr6&Tql[Y r.m0 0-01-27 99.819 -Ba t,N
bds
Lorhitnr PbksAth 5.000.07-01-32 99.625 -X2S t29 rnivM.d8DentlskyllJ 5.000 u.01-31 97,7t0 -125 5J5
Lub$eJeEsiSNr KY 5,000 05.1'.36 9tt00 -.8 ,U I $i6wA!(oDpv t000 06"01-26 96,4S0 -l!5 526

Source: Ihe Wall Street JournaLMay 3,2002, p. C] 6. Reprinted by permission ol The Wall Street Journal. @ 2002 Dow
Jones & Company, lnc. All Rights Reserved Worldwide. wtrw.wsj.com
I Ghapter 6 Bond Markets

firm commitment
underwriting
The issue of securities by an
investment bank in which the
investment bank guarantees the
issuer a price for newly issued
securities by buying the whole
issue at a fixed price from the
issuer. It then seeks to resell
these securities to suppliers of
funds (investors) at a higher
price. ' The investment bank can purchase the bonds through competitive bidding against
The Ttading Process for Municipal Bonds. The initial (primary market) sale for mu-
nicipal bonds (and corporate bonds, discussed below) occurs either through a public
offering, using an investment bank serving as a security underwriter, or through a pri-
vate placement to a small group of investors (often financial institutions). Generally,
when a large state or local govemmental unit issues municipals to the public, many in-
vestment banks are interested in underwriting the bonds and the municipais can gener-
ally be sold in a national market. Total dollar volume of these new issues was $342
billion in 2001, down from $241 billion in 2000. Table 6-9lists the activity of the top
10 municipal bond underwriters in 2001.
Public offerings of municipal (and corporate, see below) bonds are most often
made through an investment banking firm (see Chapter 16) serving as the underwriter.
Normally, the investment bank facilitates this transfer using a firm commitment
underwriting, illustrated in Figure 6-6. The investment bank guarantees the munici-
pality (or corporation for a corporate bond) a price for newly issued bonds by buying
the whole issue at a fixed price from the municipal issuer (the bid price). The invest-
ment bank then seeks to resell these securities to suppliers of funds (investors) at a
higher price (the offer price). As a result, the investment bank takes a risk that it may
not be able to resell the securities to investors at a higher price. This may occur if
prices of municipal bonds suddenly fall due to an unexpected change in interest rates
or negative information being released about the issuing municipality. If this occurs,
the investment bank takes a loss on its underwriting of the security. However, the mu-
nicipal issuer is protected by being able to seil the whole issue.
other investment bankers or through direct negotiation with the issuer. In a competitive
sale, the issuer invites bids from a number of underwriters. The investment bank that

Table 6-9 Top Municipal Bond Underwriters

Principal Amount Market Number of
Underwriter (in millions of dollars) Share Issues

Salomon Smith Barney $40,049.0 t2.t% 610

UBS PaineWebber 17 5\"t ) 10.1 667
Merrill Lynch 23,902.5 7.2 273
Morgan Stanley t9,811.4 6.0 3t6
Bear, Stearns 11 ,5t3.5 5.3 t77
Lehman Brothers t6,978.4 5.1 231
Goldman Sachs 16,854.5 5.1 198
J.P. Morgan Securities 10,298.5 3.1 131
Dresdner Kleinwort Benson 6,120.4 2.0 12
Banc of America Securities 6,390.6 t.9 311

Industry totals $342 billion

Source Thomson Financial Securities Data, May 2002. vwwv.tfibcm.com

Figure 6-5 Firm Commitment Underwriting of a Municipal or Corporate

Bond lssue

Sells,,Bonds, Q.elFi.,Bgjn

ffi:,:,1,11,,:,,.,,'.,1,

ravs.,eiu.,nrica Pa)r€,.'Pffei Pliee

I i r : l: r r l': r i: I r Ir : i ,
l:: i.: r I ', I
l - ',
i r ,

'

best efforts
underwriting
The issue of securities in which
the undeMriter does not
guarantee a price to the issuer
and acts more as a placing or
distribution agent on a fee basis
related to its success in placing
the issue.
Para 2 Securities Markets
submits the highest bid to the issuer wins the bid. The underwriter may use a syndicate
of other underwriters and investment banks to distribute (sell) the issue to the public.
Most state and local governments require a competitive municipal bond issue to be an-
nounced in a trade publication, e.g., the Bond Buyer. With a negotiated sa1e, the in-
vestment bank obtains the exclusive right to originate, underwrite, and distribute the
new bonds through a one-on-one negotiation process. With a negotiated sale, the in-
vestment bank provides the origination and advising services to the issuers. Most states
require that GO bonds be issued through competitive bids.
Some municipal (and corporate) securities are offered on a best efforts (under'
writing) basis in which the underwriter does not guarantee a firm price to the issuer (as
with a firm commitment offering) and acts more as a placing or distribution agent for
a fee. With best efforts offerings, the underwriters incur no risk of mispricing the se-
curity since they seek to sell the bonds at the price they can get in the market. In return
the underwriters receive a fee. Further, the underwriters offer the securities at a price
originally set by the municipality. Thus, the underwriters do not incur the expense of
establishing the market price for the customer. Often, knowing that the underwriters
have not put any of their own funds into the issue, investors in best efforts issues are
not willing to pay as much for the bonds as with a firm commitment issue.
In a private placement, a municipality (or corporation), sometimes with the help of
an investment bank, seeks to find a large institutional buyer or group of buyers (usu-
ally less than 10) to purchase the whole issue. To protect smaller individual investors
against a lack of disclosure, the Security and Exchange Act of 1934 requires publicly
traded securities to be registered with the Securities and Exchange Commission (SEC).
Private placements, on the other hand, can be unregistered and can be resold only to
large, financially sophisticated investors (see below). These large investors supposedly
possess the resources and expertise to analyze a security's risk.
Privately placed bonds (and stocks) have traditionally been among the most illiq-
uid securities in the bond market, with only the very largest financial institutions or in-
stitutional investors being able or willing to buy and hold them in the absence of an
active secondary market. In April 1990, however, the Securities and Exchange Com-
mission (SEC) amended its Regulation 144A. This allowed large investors to begin
trading these privately placed securities among themselves even though, in general,
privately placed securities do not satisfy the stringent disclosure and inforrnational re-
quirements that the SEC imposes on approved publicly registered issues. Rule 144.{
private placements may now be underwritten by investment banks on a finn commit-
ment basis. Of the total $443.53 billion in private debt (municipal and corporate)
placements in 2001, $411.35 billion (92.7 percent) were Rule 1444placements. Credit
Suisse First Boston was the lead underwriter of Rule 144,{ debt placements in 2001
(underwriting $54.01 billion, 13.13 percent of the total placements).
Issuers of privately placed bonds tend to be less well known (e.g., medium-sized
municipalities and corporations). As a result of a lack of information on these issues,
and the resulting possibility of greater risk, interest rates paid to holders of privately
placed bonds tend to be higher than on publicly placed bond issues. Although Rule
1444 has improved the liquidity of privately placed bonds, this market is still less liq-
uid than the public placement market. Another result of the increased attention to this
market by investment banks is that the interest premiums paid by borrowers of pri-
vately placed issues over public issues have decreased'
Although the SEC defined large investors as those with assets of $100 million or
more-which excludes all but the very wealthiest household savers-it is reasonable
to ask how long this size restriction will remain. As they become more sophisticated
and the costs of information acquisition fall, savers will increasingly demand access to
the private placement market. In such a world, savers would have a choice not only be-
tween the secondary securities from financial institutions and the primary securities
publicly offered by municipalities and corporations but also between publicly offered
(registered) securities and privately offered (unregistered) securities.

Gorpolate bonds
Long-term bonds issued by
corporations,
bond indenture
The legal contract that specifies
the rights and obligations of the
bond issuer and the bond
holders.
www.nyse.Gom
bearer bonds
Bonds with coupons attached to
the bond. The holder presents
the coupons to the issuer for
payments of interest when they
come due.
registered bond
A bond in which the owner is
recorded by the issuer and the
coupon payments are mailed to
the registered owner.
Ghapter 6 Bond Markets
The secondary market for municipal bonds is thin (i.e., trades are relatively infre-
quent). Thin trading is mainly a result of a lack of information on bond issuers, as well
as special features (such as covenants) that are built into those bond's contracts. Infor-
mation on municipal bond issuers (particularly of smaller government units) is gener-
ally more costly to obtain and evaluate, although this is in part offset by bond rating
agencies (see below). In a similar fashion, bond rating agencies generate information
about corporate and sovereign (country) borowers as well.
Corporate Bonds
Corporate bonds are all long-term bonds issued by corporations ($5,661.6 billion out-
standing in December 2001,57.2 percent of all outstanding long-term bonds). The
minimum denomination on publicly traded corporate bonds (that, in contrast to pri-
vately placed corporate bonds, require sEC registration) is $1,000, and coupon-paying
corporate bonds generally pay interest semiannually.
Th@e[egalContraClthatspecifieStherightSandobIigations
ol'the bqtd issuer and the ber of
co\tenants assocra-GifffifE-f,b'oTfrissue. These bond covenants describe rules and re-
strictions placed on the bond issuer and bond holders. As described below, these
covenants include such rights for the bond issuer as the ability to call the bond issue
and restrictions as to Iimits on the ability of the issuer to increase dividends. By legally
documenting the rights and obligations of all parties involved in a bond issue, the bond
indenture helps lower the risk (and therefore the interest cost) of the bond issue. All
matters pertaining to the bond issuer's performance regarding any debt covenants as
well as bond repayments are overseen by a trustee (frequently a bank trust department)
who is appointed as the bond holders' representative or "monitor." The signature of a
trustee on the bond is a guarantee of the bond's authenticity. The trustee also acts as the
transfer agent for the bonds when ownership changes as a result of secondary market
sales and when interest payments are made from the bond issuer to the bond holder.
The trustee also informs the bond holders if the finn is no longer meeting the terms of
the indenture. In this case, the trustee initiates any legal action on behalf of the bond
holders against the issuing firm. In the event of a subsequent reorganization or liqui-
dation of the bond issuer, the trustee continues to act on behalf of the bond holders to
protect their principal.
Table 6-10 presents a bond market quote sheet from The Wall Street Journal for
May 2,2002, for colporate bonds traded on the New york Stock Exchange (NysE).
Look at the second quote posted in Table 6-10. Column 1 of the quote lists the issuer
:
(AES cp), the coupon rate (8 percent), and the year of maturity (8 year 200g). col-
umn 2, labeled cllR YLD, is the cument yield on the bond (or the coupon rate divided
by the current pdce, 8 percent + 79.5 percent : 10.1 percent). column 3, labeled vol-,
is the trading volume for the bond in thousands of dollars (36 : 53u,000). column 4,
labeled cl-osE, is the closing price of the bond on May 2 inpercentage terms (79.5 :
79.5 percent of $1,000 : $795). Column 5, labeled NET cHG, is the change in the clos-
ing price from the previous day, in percentage terms ( - 1.00 : - 1 .00 percent).
Bond Characteristics. Corporate (and Treasury) bonds have many different charac-
teristics that differentiate one issue from another. We list and briefly define these char-
acteristics in Table 6-11, and we describe them in detail below.
Bearer versus Registered Bonds. Cotporate bonds can be bearer bonds or registered
bonds. With bearer bonds, coupons are attached to the bond and the holder (bearer) at
the time of the coupon payment gets the relevant coupon paid on presentation to the is-
suer (i.e., gets the bond coupon "clipped"). with a registered bond, the bond holder's
(or owner's) identification information is kept in an electronic record by the issuer and
the coupon payments are mailed or wire-transferred to the bank account of the registered
Part 2 Securities Markets

Table 6-l O Corporate Bond Market Quote

U.'S. .B;@angb'Bonds
4 p.m, ff lhu6day, May 2, 2OO2

BFlanatory l{otes
(l,R t{sI
(l.0sEft6
Por New Yorl atrd American
B0!t0s YtD toi
Sonds
Yield ls Cucnt yield. Honywll?ro9 -., 30 62.15 0,25
cv-ConYertible bond. rf.Cetlli. lllPwr6li0l 6.5 10 9988-L25
@res. old-CEllEd. dc-Deep dls- lllPEr 6Yr05 6.4 2, 105
coBnt. cc.Eump*n curency unlts. lllPwr?,iz5 7.6 5 98 -0.13
f.Doalt ln rlal ll'ttalian llp" kd" lnldstl7.gso7 !1.$ 7 4,
Danish konei m.Mg&red Dohds, lBii7,i02 7"1 85 10175
,egotlablllg impaked by maturity, .r8Mr1i0e ,.5 3 97.63 -0.88
na.No aErual. r"RegisteEd. rpRe- t8M7liJ3 6.e 15 toe -113
ducBd principal, 8t, s$Stamped. lBMEtjl9 7.2 r00 116 r38
t Floaring Et3, wd-when distrib- IBMT!z5 6., 3, 10188 0.25
uted, tr"Wlth wamrts. r-Er lntcr lBil6)128 A.7 1 97
est, trl{rlthout wamnB, are6 6,!
.,PM(i!o5li08 Nl 0.75
75
colpon, JOLTkt3 i.4 102 0,tl
10
vr.ln bankruptcy or tselvship or 86!n8,i06 1, 7B 79 1.50
b6ing $o€anlzed under the Bark. (&BHm71l04 7.5 41 10, 0.13
ruplcy Asl or secudtles NUmEd (&8Hm9i/,06 9.2 :0 104.18 Ort
by such mmpanles. tlliy8ri06 ?.{ 5 113.2, 0.i0
tioncl6:i03 6.3 35 10L50 038
U(mt7li06 tJ {61 79,18-238
NNil YORK AONDS l"{(str,108 7.8 175 71 -L(0
Cotloratlon Eords l,lQnt6liz8 10,2 12 63.88-aU
flR [[r Lurent6,45s29t 62 -L'A
10,4
soilDs Yt! vol (ll}'Ectc 105 98 -0,?t
MBllA828s25 &5
0 10 9&63-0,13
Mallwell5s02
IErjTi*6]fEE@ Malangrit4 o 14 9138-lU
AEr(p858 10.1 16 79.90 -L00 l&r07sB2 7.0 10 10003
AMR9d6 9.5 62. 94.6' 025 lru0r31 <t 5 42
or6rJ02 6.5 99.63 -0.{1 M(Dd6f05 6,5 13 102 -038
ATT6?io4 7.01472'?' 99.88 -1.63 M(Dnl8U 7,5 10 118 -L00
ArIrliM 6.03816 9r.B -0.2t thnflts8sz7 7.9 l0 1017t 0.13
An7{5 7.41028 94.88 -1.i3 iltiefieli,,i23 1.0 35 9&2, 015
An7li06 7.8 868 96 -1.88 tlyrel 5i'r03 5.8 2, 100,63 -L88
71"07
ATI 8,31694 93 -4.r0 $YTeltfio3 .u 10 10L75 oli
AT16!09 7.2!666 83.6? L63 $fie17,?4 7.{ 34 9&$
ATT8li22 9.93726 82,38 Z$3 tlYlel6til0 &2 75 9825 0J3
An&,ir24 9.92062 AL,S r88 ItYirl 71i?3 7.5 8 10L75
ATT835'25 10.!u43 83.2t 0.r0 Hnel670s23 6.8 2i 9&63 138
An6l,i2, 9.1 arl 7l L13 NYI€l7s3l 71. 16 9&2t
A1r81"31 r1.524n 8L50 L3s oiESU 11s03 1!! 40 ,9.63 -038
Apadr9ii02 9.3 10 100 -3.25 PillPi?.92s23 7.7 A 103 -0.50
viAmw9li08f .., 10 t5 PhilP7)iz8 7,1 103 100 -0.25
Bauqnlili28 8.6 83.13 L13I kmtls!91i06 90 ?9 102.50 -0.50
Bdyview9s0T 9.2 10 98 -0.U PSvE661i02 6.1 ?0 1!0.2 -0J2
.Bellso 0/i8 7.1 "9 9013 -12i PSvE67s24 7.0 1t 99.50
Brlho1TroS 6,6 50 106rt 0'50 QHr6.88!07 w 153 U6 200
Eelbol6t'Sg 6.2 ?5 104.63 0.38 RQys1oiil03 7.5 30 10113 -0.63
Belholtr,'r09 9.9 2{8 99,14 BeyoTobSli0S &3 20 105.2t -0.25
Bellsol75?5 7.1 90 ,8.75 L63 R!ynIot81i07 83 8 106 0.r0
SelholE]i32 7.9 17 10438 0.63 fieyntob9r,i13 8.t 10 108.25 0.50
Bellnlltiil 7.1 22 $2 Royftribl?1. ... D 37 u5
BolkoTTl'r33 7.9 38 99.50 Ryds9sl6 s-6 25 $5
BellsoT61i33 i.4 265 9Lr0 -L63 Safiry9.6550{ 9.0 10 10725-11l
BellsTTll35 7.6 70 100.50 -0.75 Svdorp6f08 o 20 91 200
... 78
{Beth58.4r!0rl 16.B 5ilimcrsllM 0 44 73 2.00
BluesnE)iU {Y 10 9413-0.88 Solertrnzrl{20 -. 4 45 -LCl
Eord$8i"16 10J 4 80 -100 lva1l'i, 7.1 6 106 4.75
B.sGlts6538 9.6 76 6L2, L13 NAltiAS 6.9 30 104.63 0.13
(allonPlls[5lLB 25 w TVA5li43 f,8 100 101.75 0.?5
(allonPl0ll04ll8 40 87 TmI{irT-g8$! 7.5 20 10r.88 1i8
(hkgflrrllo5 o 60 tM 0.i0 IneYtuSl!507 7.8 l8 104.10
ftesoiE7,io4 7.8 20 101 -2.m Tme!rl!71i08 7.2 il NL25 -0.75
ChespkEE|iu 8.5 10 100 ime|]vil9)ii3 8.5 U 107.50 -0.50
Chio10.56!09 10.0 28 105,50 -0.50 1mwar9.15l:3 &5 10 10i.r0 1.50
ckk0l91"04 9J 11? 100J3 -015 lollgEjl06 8.4 5104
(@urBil03 0 40 114.t0-150 lHilfio5.85s08 7.3 86 94.13
(@u61i{M (v 109 60 USVI;st6li02 6.1 6 100 I00
(onsQ( 8)i03 9.0 35 9013 013 r)Us68li0t, ... 25 83 0.88
(onso10ri04 l2l 76 87 UtdAir10,6i504 ll3
258 8038 -263
(oiseto10,,i02 103 7 108 UtdAklL?1514 133 60 81 -4'00
(rowo[ 7i'r02 7.4 179 36.31 -0.06 $lebb9s06 8.8 87 l0LlJ
WebbDel9li09 8.9 3 105.38 -0.13
Diir 9ii84 9.8 l8 100.75
Xerox(t7Jll2 1U 343 69 -5.00
DeloD[ 4.9s08 e 1 97.25 -0.2,
FffilEn Borda
7503 6.9 5 10L38
Do{e
o I
Dolezil3 7.7 45 L02
gB
0U Ashan(5so3
Fei0S8[02 &I 20 10022 0.03 Emgl(A5io4 ry 240 70
t5tlat.2s08 (v 3 108.63 -0.75 ilatll6fiiryr09 7.1 1 103.63
fotdc 6YP8 6.5 90 98;5t -0.50 SROtUt'ro4A tZ8 81 97.75 0,75

fo!r5ea5?r29 ... 45 32 saa(ntuliMBlL9 20 97

GB(88'i0i 8.6 77 97 0.50 5ea(ot10}i03 ltl 15 97'75 025

6MA 7!02 6.9 3 10LlJ
6MA6li0? 6.6 2 101
6MA8|i03 &i 10 10?,41
6MA61;08 6.1 {0 ioo
GMAd(65U 6,4 35 94
6ltlA zrl2 ... 5t .467 -L$B
6MAT1, ... A 168
Heru?!o1 6.9 2J 1tL50 0.lj
Hewlpkdztu ... J 45 -f-4
Hex(el7so3 o 72
HiltonSs06 <t 72
HollnqrSri0S &3 I 104 200
Hollnqr9,i0,69.0 9 10288 0.75
Honywll lrll3 -. 5 95
0.16 sea(nt91i0i 9.8 116 961t-0b
lelMex4llM 0 U131 -100
-L19 TelAreuri04 aJ ?75 5325 L75
038 TmMarMxo: ... U 9Lr0
TrolllnrMx 06 o 63 80 -0,50
-0,50
AMHX BOI'IDS
ABll(12%02 a 70 97.50 4.t0
lehohet 04 -. 16 83 0'50
bhhld?ntlo4 - 30 9138-0.88
89.50 338 lehPrudmi!06 -. 10 97
9?!50 lt25 l,€hMP.D 02 ... ,0 96 -4.50
tdrYCGBs0S 9.6 38 83.25-4.75
iliinfl*4s05 w 1 94.1t-0.25
T6mputr03f -. 165 t6 L50

Source: Ihe Watl Street Journal,May 3,2002, p. C12. Reprinted by permission ot The Wall Street Journal. @ 2002 Dow

Jones & Company, lnc. All Rights Reserved Worldwide. www.wsi.con/


term bonds
Bonds in which the entire issue
matures on a single date.
serial bonds
Bonds that mature on a series
of dates, with a portion of the
issue paid off on each.
mortgage bonds
Bonds issued to finance specifrc
projects, which are pledged as
collateral for the bond issue.
dehentures
Bonds backed solely by the
general credit of the issuing
firm, unsecured by specific
assets or collateral.
Chapter 6 Bond Markets
Table 6-l I Bond Characteristics
Bearer Bonds-bonds on which coupons are attached. The bond holder presents the coupons
to the issuer for payments of interest when they come due.
Registered Bonds-with a registered bond, the owner's identification information is recorded
by the issuer and the collpon payments are mailed to the registered owner.
Term Bonds-bonds in which the entire issue matures on a single date.
Serial Bonds-bonds that mature on a series of dates, with a portion of the issue paid off on
each.
Mortgage Bonds-bonds that are issued to finance specific projects that are pledged as
collateral for the bond issue.
Equipment Tlust Certificates-bonds collateralized with tangible non-real estate propefty
(e.g., railcars and airplanes).
Debentures-bonds 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.
r @4s-bondsthatmaybeexchangedforanothersecurityoftheissuingfirmat
the discrerion ol the bond holder.
Stock Warrants-bonds that give the bond holder an opportunity ro purchase common stock
at a specified price up to a specified date.
Callable Bonds-bonds that allow the issuer to force the bond holder to seli the bond back to
the issuer at a price above the par value (at the call price).
Sinking Fund Provisions-bonds that include a requirement that the issuer retire a certain
amount of the bond issue each year.
owner. Because of the lack of security with bearer bonds. they have largely been re-
placed by registered bonds in the United States.
Tenn vetsus Seriol Bonds. Most corporate bonds are term bonds, meaning that the en-
tire issue matures on a single date. Some colporate bonds (and most municipal bonds),
on the other hand, are serial bonds, meaning that the issue contains many maturity
dates, with a portion of the issue being paid off on each date. For economic reasons,
many issuers like to avoid a "crisis at matudty." Rather than having to pay off one very
large principal sum at a given time in the future (as with a term issue), many issueri
like to stretch out the period over which pnncipal payments are made-especially if
the corporation's earnings are quite volatile.
Mortgctge Boncls. Corporations issue mortgage bonds to finance specific projects
that are pledged as collateral for the bond issue. Thus, mortgage bond issues are se-
cured debt issues.a Bond holders may legally take title to the collateral to obtain pay-
ment on the bonds if the issuer of a mortgage bond defaults. Because motgage bonds
are backed with a claim to specific assets ofthe corporate issuer, they are less risky in-
vestments than unsecured bonds. As a result, mortgage bonds have lower yields to
bond holders than unsecured bonds. Equipment trust certificates are bonds collateral-
ized with tangible (movable) non-real estate property such as railcars and airplanes.
Debentures cmd Subortlinated Debenture.s. Bonds backed solely by the general credit-
worthiness of the issuing firm, unsecured by specific assets or collateral, are called
debentures. Debenture holders generally receive their promised payments only after the
4. Open-end mortgage bonds allow the firm to issue additional bonds in the future, using the same assets as
collateral and giving the same priority of claim against those assets. Closed-end mortgage bonds prohibit the finn
from issuing additional bonds using the same assets as collateral and giving the same priority of claim against
those assets.

subordinated
debentures
Bonds that are unsecured and
are junior in their rights to
mortgage bonds and regular
debentures.
Gonuertible bonds
Bonds that may be exchanged
for another security of the
issuing firm at the discretion of
the bond holder.
Palt 2 Securities Markets
secured debt holders, such as mofigage bond holders, have been paid. Subordinated
debentures are also unsecured, and they are junior in their rights to mortgage bonds and
regular debentures. In the event of a default, subordinated debenture holders receive a
cash distribution only after all nonsubordinated debt has been repaid in full. As a result,
subordinated bonds are the riskiest type ofbond and generally have higher yields than
nonsubordinated bonds. In many cases, these bonds are terned high-yield or junk bonds
because of their below investment grade credit ratings (see below).
Convertible Bonds. Convertible bonds are bonds that may be exchanged for another
security of the issuing firm (e.g., common stock) at the discretion of the bond holder.
If the market value of the securities the bond holder receives with conversion exceeds
the market value of the bond, the bond holder can retuffI the bonds to the issuer in ex-
change for the new securities and make a profit. As a result, conversion is an attractive
option or feature to bond holders. Thus, convertible bonds are hybrid securities in-
volving elements of both debt and equity. They give the bond holder an investment op-
portunity (an option) that is not available with nonconvertible bonds. As a result, the
yield on a convertible bond is usually lower (generally,2to 5 percentage points) than
that on a nonconvertible bond:
irrb: inrrb - oPrrb
where
op,,b: Value of the conversion option to the bond holder
Example 6-8 Analysis of a Convertible Bond
In2004,Titan Corporation had a convertible bond issue outstanding. Each bond, with
a face value of $ 1 ,000, could be converted into common shares at a tate of 285 .7 1
shares of stock per $1,000 face value bond (the conversion rate), or $3.50 per share. In
J:une2004, Titan's common stock was trading (on the NYSE) at $9.375 per share.
While this might look like conversion would be very profitable, Titan's convertible
bondsweretrading at261.875 percentof thefacevalueof thebond, or$2,678.15-
To determine whether or not it is profitable to convert the bonds into common
stock in Titan Corp., the conversion value of each bond can be calculated as:
Conversion value ': current market price of common X conversion rate
stock received on conYerslon
If a bond holder were to convert Titan Corp. bonds into stock, each bond (wotth
$2,678.15) could be exchanged fot 285.71 shares of stock worth $9.375' The conver-
sion value of the bonds is:
$9.375 x 28s.71: $2,678.s3
Thus, there is virtually no difference in dollar value of the investment to the investor if
he or she holds Titan's debt or its common stock equivalent.
Figure 6-7 illustrates the value of a convertible bond as a function of the issuing
firm's asset value. The horizontal axis plots the firm's value, which establishes an up-
per bound for the value of the convertible bond (since it cannot trade for more than the
value of the firm's assets).Thus, the value of the issuing firm line that bisects the fig-
ure at a 45' angle, also represents the issuing firm's value and sets an upper bound for
the value of the convertible bond. In addition, the figure plots the values of the firm's
convertible and nonconvertible bonds. At low firm values, the values of both bonds
drop off as bankruptcy becomes more likely. Note that the nonconvertible bond's value
does not increase at higher firm asset values since bond holders receive only their

stock warranb
Bonds issued with stock
warrants attached giving the
bond holder an opportunity to
purchase common stock at a
specified price up to a specified
date.
Gall prouision
A provision on a bond issue that
allows the issuer to force the
bond holder to sell the bond
back to the issuer at a price
above the par value (or at the
call price).
Gall plemium
The difference between the call
price and the face value on the
bond.
Chapter 6 Bond Markets
Figure 6-7 Value of a Convertible Bond
valte'oJ
ls,suing,lFi
?r::ri:i:l:i :t:ril:,,r:l
promised payments and no more. However, the convertible bond values rise directly
with the firm's asset value. Specifically, at low firm asset values the convertible bond
value acts more like a nonconvertible bond, trading at only a slight premium over the
nonconvertible bond. When the issuing firm's value is high, however, the convertible
will act more like a stock, selling for only a slight premium over the conversion value.
In the middle range, the convertible bond will trade as a hybrid security, acting partly
like a bond and partly like a stock.
Most convertible bond issues are set up so that it is not initially profitable to con-
vert to stock. Usually the stock price must increase 15 to 20 percent before it becomes
profitable to convert the bond to the new security.
Stock Watants. Bonds can also be issued with stock warrants attached. Similar to
convertible bonds, bonds issued with stock warrants attached give the bond holder an
opportunity to detach the warrants to purchase common stock at a prespecified price
up to a prespecified date. In this case, however, ifthe bond holder decides to purchase
the stock (by returning or exercising the warrant), the bond holder does not have to re-
turn the underlying bond to the issuer (as under a convertible bond). Instead, he or she
keeps the bond and pays for additional stock at a price specified in the warrant. Bond
holders will exercise their warrants if the market vaiue of the stock is greater than the
price at which the stock can be purchased through the warrant. Further, the bond holder
may sell the warrant rather then exercise it, while maintaining ownership of the under-
lying bond.
Callable Bonds. Many cotporate bond issues include a call provision, which allows
the issuer to require the bond holder to sell the bond back to the issuer at a given (call)
price-usually set above the par value of the bond. The difference between the call
price and the face value on the bond is the call premium. Many caltable bond issues
have a deferred call provision in which the right to call the bond is deferred for a pe-
riod of time after the bond is issued (generally 10 years). Bonds are usually called in
when interest rates drop (and bond prices rise) so that the issuer can gain by calling in
the old bonds (with higher coupon rates) and issuing new bonds (with lower coupon
rates).
For example, in 2002, May Department stores co. had a $250 million callable
sinking fund (see below) debenture issue outstanding. The face value of each bond was
$1,000. The issue, with a maturity date of June 15, 2018, was callable as a whole or in

sinking fund provision
A requirement that the issuer
retire a cefiain amount of the
bond issue each year.
Patl 2 Securities Markets
Table 6-12 Call Schedule for May Department Stores Co. Sinking Fund
Debenture Due 2018
Year Call Price
2002 103.1637o
2003 t03.225
2004 102.688
2005 102.150
2006 101.613
2007 101 .075
2008 100.538
Sourre May Department Stores Co., Annual Report, 2001.
part not less than 30 days nor more than 60 days following June 14 of each year be-
tween the yeas 2002 and 2008, as listed in Table 6*12. Thus, if the bonds are called in
2006, the bond holder will receive $1,016.13 per bond called in. Note that as the bond
approaches maturity, the call premium declines. The closer the bond is to maturity, the
smaller the premium required for forcing bond holders to give up the bonds early.
A call provision is an unattractive feature to bond holders. since the bond holder
may be forced to return the bond to the issuer before he or she is ready to end the in-
vestment and the investor can only reinvest the funds at a lower interest rate. As a re-
sult, callable bonds have higher yields (generally between 0.05 and 0.25 percent) than
comparable noncallable bonds :
irrb: irt - oPct,
where
op,b : Value of the issuer's option to call the debt early
Sinking Fund Provisions. Many bonds have a sinking fund provision, which is a re-
quirement that the issuer retire a certain amount of the bond issue early over a number
of years, especially as the bond approaches maturity. The bond issuer provides the
funds to the trustee by making frequent payments to a sinking fund. This sinking fund
accumulates in value and is eventuaily used to retire the entire bond issue at maturity
or to retire a specified dollar amount of bonds either by purchasing them in the open
market or by randomly calling bonds to be retired. In this case, the selected bonds are
called and redeemed. Once the bonds are called they cease to earn interest. The bond
holders must surrender their bonds to receive their principal.s For example, the May
Department Stores Co. callable sinking fund debenture issue discussed above required
that the firm put $12.5 million per year from 1999 through 2011 (19 years) into a sink-
ing fund, or a total of $237.5 million of the $250 million total would be accumulated
before maturity.
Since it reduces the probabiiity of default at the maturity date (the "crisis at matu-
rity"), a sinking fund provision is an attractive feature to bond holders. Thus, bonds
with a sinking fund provision are less risky to the bond holder and generally have
lower yields than comparable bonds without a sinking fund provision.
The Trading Process for Corporate Bonds. Primary sales of corporate bond issues
occur through either a public sale (issue) or a private placement in a manner identical
to that discussed for municipal bonds (see above). In 2001, a total of $1,208.87 billion
of (corporate and municipal) debt was issued, of which $443.53 billion was privately
placed.
5. If the bond holder does not turn the bonds in for redemption, they continue to be outstanding and are ob-
ligations ofthe issuer. However, the issuer's obligation is limited to refunding only the principal, since interest
payments stopped on the call date.
 Ghapter 6 Bond Markets

There are two secondary markets in corporate bonds: the exchange market (e.g.,
the NYSE) and the over-the-counter (OTC) market. The major exchange for corporate
bonds is the New York Stock Exchange Fixed Income Market. Most of the trading on
the NYSE's bond market is complered through its Auromated Bond System (ABS),
which is a fully automated trading and information system that allows subscribing
firms to enter and execute bond orders through terminals in their ofTices. Users receive
immediate execution reports and locked-in prices on their tracles. Notice the small
amount of trading volume reported for NYSE bonds in Table 6-10. The average daily
dollar valr"re of bond trading totaied $10.8 million :.r.2002 in a marker with $5.66 tril-
lion of bonds outstanding. This is because less than 1 percent of all corporate bonds
trade on exchanges such as the NYSE.
Most bonds are traded OTC among rr-rajor bond dealers such as Salon-ron Smith
Barney and UBS Paine Webber. The OTC direct, interdealer market totally dominates
trading in corpolate bonds. Virtually all large trades are carried out on the OTC mar-
ket, even for bonds listed on an exchange. Indeed. the NYSE bond market is consid-
ered the "odd-lot" market for bonds. Thus. prices reported on the exchanges (like those
in Table 6-10) are generally considered to be inexact estimates of prices associated
with large transactions. Thus. in contrast to TreasLrrt secr-rrities, secondary market trad-
ing of corporate bonds can involve a significant de_sree of liquidity risk.

Ll,:nd ffiatit'lgs
As mentioned above, the inability of investors ro ge t infolrnation pertaining to the risk,
especially default risk, on bonds, at a reasonable cost. can result in thinly traded mar-
kets. In Chapter 3, we examined the impact of interest rare lisk (i.e., interest rate
changes) on bond prices. Specitically, 'uve demonstrated that bonds u,ith longer matr-r-
dties (durations) and low coupon rates experience larger price chanees for a given
change in interest rates than bonds with short matnrities anci hi-sh coupon rates. (i.e.,
bonds with longer maturities and lower collpon rates are subject to greater interest
rate rlsk). More importantly, bond investors need to measllre the degree of default risk
on a bond.
Large bond investors, traders, and mana-eers often evaluate default risk by con-
ducting their own analysis of the issuer. incluclin-s an assessment of the bond issuer's
financial ratios (see Chapter 2l) and securin' prices. Small investors are not generally
capable of generating the same extensive infbnnation and thus frequently rely on bond
ratings provided by the bond rating agencies. The two major bond rating agencies are
swEryHW"6{rf&&&fl y$"r;sE$E Moody's and Standard & Poor's (s&P).6 Both companies rank bonds based on the per-
ceived probability of issuer default and assign a rating based on a letter grade. Table
wFrisL4f ,sfr ffi ffi dffi $'d&Fu€fi 6-13 summarizes these rating systems and provides a brief definition of each. The
$Eee5'$"G@fin highest credit quality (lowest default lisk) that rating agencies assign is a triple-A (Aaa
for Moody's and AAA for S&P). Bonds u,,ith a triple-A raring have the lowest interesr
spread over similar maturity Treasury secr-rrities. As the assessed default risk increases,
Moody's and S&P lower the credit rating assigned on a bond issue, and the interest
spread over similar maturity Treasuries paid to bond holders generally increases.T Fig-
ure 6-8 shows the rates on 10-year Treasury securities versus Aaa-rated and Baa-rated
bonds from 1980 through March 2002.The risk premium over this period on Aaa-rated
bonds was 0.99 percent and on Baa-rated bonds was 2.09 percent. The cumulative de-
fault rates on these bonds over a 10-year period after issuance is 0.03 percent on Aaa-
rated bonds and 3.98 percent on Baa-rated bonds.s

6. Other credit rating agencies include Fitch IBCA. Inc. (www.fitchibca.com) ancl Duff and Phelps Cre<iit
Rating Services (www.dcrco.corn).
T Note that S&P and Moody's sometimes disagree on ratings (recently differences occur about 15 per-cent
of the time). When thrs occurs, a bond is said to have a "split" rating.
8. See E. L Altman and B. Karlin, "Detirult ancl Returns on High-Ield Boncls: Analysis through 2000 and
Delault Outlook." working paper, New York University Salomon Center, January 2001.
Part 2 Securities Markets

Table 6-{3 Bond Credit Ratings

Explanation Moody's S&P

Best quality; smallest degree of risk Aaa AAA

High quality; slightly more long-term risk than top rating Aa1 AA+
Aa2 AA
Aa3 AA-
Upper medium grade; possible impairment in the future A1 A+
A2 A
A3 A-
Medium grade; lack outstanding investment characteristics Baal BBB+
BaaL BBB
Baa3 BBB-
Speculative issues; protection may be very moderate Ba1 BB+
Ba2 BB
Ba3 BB-
Very speculative; may have small assurance B1 B+
of interest and principal payments B2 B
B3 B-
Issuesin poor standing; may be in default Caa CCC
Speculative in a high degree; with marked shortcomings Ca CC
Lowest quatity; poor prospects of attaining C C
real investment standing D

Source: Moody's and Standard & Poor's websites. www.moodys.cam; wwtw.standardandpoars.cam

Figure 6-8 Rates on Treasury Bonds, Aaa-Rated Bonds, and Baa-

Rated Bonds

'l
Q-{ssr T-Bond
-* Aaa-Rated Corporate
Bonds
gss-ftstsd Corporate
- Bonds

r::iaa:.::,lla:::i:li::ai:l::

ill:i:a,l:i.€it

89.89 9l:rse

Source! Federal Reserve Board website, "Research and Data," May 2002. wilw.federalreserve.gov

Rating agencies consider several factors in determining and assigning credit rat-
ings on bond issues. For example, a financial analysis is conducted ofthe issuer's op-
erations and its needs, its position in the industry, and its overall financial strength and
ability to pay the required interest and principal on the bonds. Rating agencies analyze
the issuer's liquidity, profitability, and debt capacity. Then for each particular issue,

junk bond
Bond rated as speculative or
less than investment grade
(below Baa by Moody's and BBB
by S&P) by bond-rating
agencies.
Ghapter 6 Bond Markets
rating agencies evaluate the nature and provisions ofthe debt issue (e.g., the covenants
and callability of the bond), and the protection afforded by, and relative position of, the
debt issue in the event of bankruptcy, rcorganization, or other arrangements under the
laws of bankruptcy and other laws affecting creditors' rights.e
Bonds rated Baa or better by Moody's and BBB or better by S&P are considered
to be investment grade bonds. Financial institutions (e.g., banks, insurance companies)
are generally prohibited by state and federal law from purchasing anything but invest-
ment grade bond securities.lo Bonds rated below Baa by Moody's and BBB by S&p
are considered to be speculative-grade bonds and are often termed junk bonds, or
high-yield bonds. The issuance of speculative bonds was rare prior to the economic
downturn of the late 1970s. Given the risk involved with speculative
bonds and the ready availability of investment grade bonds, invest-
ment banks had a difficult time marketing the more speculative bonds
to primary bond market investors. The market grew significantly in
the late 1990s, with smaller and medium-sized firms, unqualified to
issue investment-grade debt securities, issuing long-term debt in this
market. For example, in 1990, $503.3 million in corporate "high-
yield" straight debt was issued. in 200i, $85.6 billion was issued, an
increase of 169 percent.
Bond Market lndexes
Table 6-14 lists major bond market indexes as of May 2,2002. Data
in this table gives investors general information on retums of bonds
from various types of issuers (e.g., Treasuries, municipals, and coqpo-
rate bonds) and various maturities. The indexes are those managed by
major investment banks (e.g., Lehman Brothers, Merrill Lynch) and
reflect both the monthly capital gain and loss on bonds in the index
plus any interest (coupon) income earned. Changes in the values of
these broad market indexes can be used by bond traders to evaluate
changes in the investment attractiveness of bonds of different types
and maturities.
Bond markets bring together suppliers and demanders of long-term funds.
We have just seen that 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.
Figure 6-9 shows the percentage of each type of bond security held by each of these
groups. Notice that financial firms so-called "business financial" (e.g., banks, insur-
ance companies, mutual funds) are the major suppliers of funds for two of the three
types of bonds. Financial firms hold 20.85 percent of all Treasury notes and bonds,
62.41 percent of municipal bonds, and.57.25 percent of the corporate bonds outstand-
ing. In addition to their direct investment reported in Figure 6-9, households often de-
posit excess funds in financial firms (such as mutual bond funds and
pension funds) that use these funds to purchase bond market securi-
ties. Thus, much of the business and financial holdings of bond secu-
rities shown in Figure 6-9 reflect indirect investments of households
in the bond market.
9. However, in recent years rating agencies have been criticized as slow to react. Perhaps the best example
of this was the failure to downgrade Enron (the largest corporate bankruptcy in U.S. history) in the months lead-
ing up to its failure in 2001.
10. For example, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 rescinded the
ability of savings associations to purchase and hold below-investment-grade bonds (see Chapter 14).
 Parl 2 Securities Markets

Thble 6-14 Major Bond Market lndexes

Malor Bond lndexes

tlis. Tlsasrry socudtl.s 52-WEEl( YTD
Lehmn Erothers (toSE tgt (H6 I (HG Hr6H rou/ E iII c (H(
lntermediate 679629 -U.65 -0.19 6823.78 6353.64 +6.40 +130
long-term 10757.56 -62.88 -0.62 10726.90 9305.67 +6.14 *2-U
fumDosite 752737 -?5J2 -033 7696.71 6983.79 +6.35 +1J9

Blosd Med(st lehman &others (Dreliminary)

tj.s. Aggregate 929.03 - L43 -0.15 9U.85 852.03 *7.83 +2.17
U.S..Gov'V(redit 1057L9 - 1.70 -0.16 70n.96 973.23 +7.74 +1.49

U.S, CoQorate Dobt lsos Menill Lyndr

orporate Mnster 1711.30 - L83 -0.23 7230,20 37?8.12 i6.07 +0.46
Hiqh Yield 537.05 - 0.81 -0.15 537.86 49128 +3.rA "3.44
Yankee Bonds 896.72 - 3.10 -0.34 907.35 831.56 +6.81 4.98
MortEaEFBacksd S€cudtlos {urent rcurcn; Merill Lnd: De(. 31. 1986=100

Ginrle Mae (GlrlMA) 38?.32 - 228 -0.59 3&4.60 357.51 "5.69

*r,97
Fannie Mae (FNMA) 377.71 - 2.17 -0.57 379.94 352.U +6.37 +2.22
rreddie Ma( (FHLMC) 230.50 - L34 -0.58 Z3LU 215.38 +6.0, +?.23
Tax-Eompt Secudues Merill Lynrh; Dec 2Z 1.999

6f; B0nd Buy€r Mufli 10400 - 0.19 -{.18 108.09 101.25 +L77 *87
7-12 Yt G.0. 173.34 - 0.08 -0.05 rB.M L62.75 +6.90 *3.65
12-22 Yr G.0. 180.50 - 0.21 -0.U 18125 169.24 +6.65 +3.05
22+ Yr Rpvpnup 770.75 - 0.14 -0.08 112.64 159,64 a6.90 +2.57

Source: Ihe Wall Street Journal, May 3,2002, p. C2. Reprinted by permission ol The Wall Street Journal. @ 2002 Dow

Jones & Company, lnc. All Rights Reserved Worldwide. wwv.wsjcom

Figure 6-9 Bond Market Securities Held by Various Groups of Market Participants, December 2001

Households
14.74"/"

*lncludes Treasury
bills, notes, and bonds
Source: Federal Reserve Board, website, "FIow of FundsAccounts," March 2002. www.federalreserve.gov

Figure 6-10 shows the yield to maturity on various types of bonds (e.g., 3O-year Trea-
sury bonds, municipal bonds, and high-grade corporate bonds) from 1980 through
March 2002. While the general trends in yields were quite similar over this period (i.e.,
yield changes are highly conelated), yield spreads among bonds can vary as default
risk, tax status, and marketability change. For example, yield spread differences can
change when characteristics of a particular type of bond are perceived to be more or
less favorable to the bond holder (e.g., relative changes in yield spreads can result
when the default risk increases for a firm that has one bond issue with a sinking fund