Chapter 7 – Bond Market

Problems

1. Inflation-Indexed Treasury Bond. Assume that the U.S. economy

experienced deflation during the year, and that the consumer price index
decreased by 1 percent in the first six months of the year, and by 2 percent
during the second six months of the year. If an investor had purchased
inflation-indexed Treasury bonds with a par value of $10,000 and a coupon
rate of 5 percent, how much would she have received in interest during the
year?
ANSWER:

Principal of bond after six months: $1,000 – (1% × $1,000) = $990

Interest received during first six months: $990 × 2.5% = $24.75
Principal of bond at the end of the year: $990 – (2% × $990) = $970.20
Interest received during the last six months: $970.20 × 2.5% = $24.26
Total interest received: $24.75 + $24.26 = $49.01
Note that the investor would have received $50 if prices had remained stable during the year.

2. Inflation-Indexed Treasury Bond. An inflation-indexed Treasury bond has a par value of

$1,000 and a coupon rate of 6 percent. An investor purchases this bond and holds it for one year.
During the year, the consumer price index increases by 1 percent every six months. What are the
total interest payments the investor will receive during the year?

ANSWER:
Principal of bond after six months: $1,000 + (1% × $1,000) = $1,010
Interest received during first six months: $1,010 × 3% = $30.30
Principal of bond at the end of the year: $1,010 + (1% × $1,010) = $1,020.10
Interest received during the last six months: $1,020.10 × 3% = $30.60
Total interest received = $30.30 + $30.60 = $60.90

Flow of Funds Exercise

Financing in the Bond Markets

If the economy continues to be strong, Carson Company may need to increase its production capacity by
about 50 percent over the next few years to satisfy demand. It would need financing to expand and
accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also
recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions
to reduce inflation. It needs funding to cover payments for supplies. It is also considering the issuance of
stock or bonds to raise funds in the next year.

a. Assume that Carson has two choices to satisfy the increased demand for its products. It could increase
production by 10 percent with its existing facilities. In this case, it could obtain short-term financing to
cover the extra production expense and then use a portion of the revenue received to finance this level of
production in the future. Alternatively, it could issue bonds and use the proceeds to buy a larger facility
that would allow for 50 percent more capacity.

Carson should not buy a larger facility unless it feels confident that it can fully utilize the space. It should
consider using up the excess capacity in its existing facility in the short term, and monitoring economic
growth. In this way, it only needs to obtain short-term financing, and can avoid the long-term debt for
now. If demand does not increase as anticipated, then it can simply retire the short-term debt when it
matures. Conversely, if Carson is confident that demand will and continue to be strong in the long run, it
can issue long-term bonds to finance its expansion.

b. Carson currently has a large amount of debt, and its assets have already been pledged to back up its
existing debt. It does not have additional collateral. At this time, the credit risk premium it would pay is
similar in the short-term and long-term debt markets. Does this imply that the cost of financing is the
same in both markets?

No. There is an upward-sloping yield curve, so Carson could obtain short-term financing at a lower
interest rate than long-term financing.

c. Should Carson consider using a call provision if it issues bonds? Why? Why might Carson decide not
to include a call provision on the bonds?

The benefit of the call provision is that Carson could retire its bonds before maturity if it wanted to
reduce its debt or if interest rates declined and it wanted to refinance at lower rates.
Carson would have to pay a higher yield to compensate bondholders if it includes a call provision on the
bonds.

d. If Carson issues bonds, it would be a relatively small bond offering. Should Carson consider a private
placement of bonds? What type of investor might be interested in participating in a private placement? Do
you think Carson could offer the same yield on a private placement as it could on a public placement?
Explain.

Carson could consider a private placement, as it may be able to reduce its transaction costs if it can find
an institutional investor that would purchase the bonds. A pension fund or insurance company might be
willing to participate as an investor in the private placement market. The investor would need to accept
the lack of a secondary market for the bond.

Carson would probably have to pay a slightly higher yield on the privately placed bonds to reflect the
lack of liquidity (no secondary market) for their bond.

e. Financial institutions such as insurance companies and pension funds commonly purchase bonds.
Explain the flow of funds that runs through these financial institutions and ultimately reaches
corporations that issue bonds such as Carson Company.

Insurance companies receive funds from policyholders who pay insurance premiums. They invest the
funds until they are needed to cover insurance claims. They use a portion of their funds to purchase
bonds. Thus, the money pay for insurance premiums is channeled to the corporations that issue bonds.

Pension funds receive money that they invest for employees until the money is withdrawn after the
employees retire. The pension funds purchase bonds. Thus, the money contributed by the employees or
their respective employers are channeled to the corporations that issue bonds.