ch4 bond market.ppt

1、Chapter 4,Bond Markets,Chapter Outline,Background on Bonds,What are bonds? Bonds represents long-term debt securities that are issued by government agencies or corporations. Return Principal (face value, par value) Interest payment paid periodically (annually or semiannually) Maturities 10 30 years,

2、Background on Bonds,Classification Owner structure Bearer bonds (BB): require the owner to clip coupons attached to the bonds Registered bonds (RB): require the issuer to maintain records of who owns the bond and automatically send coupon payments to the owners Issuer Treasury (Treasury bonds and no

3、tes) State and local governments (municipal bonds) Corporations (corporate bonds) back,Bond Market Securities,Treasury notes and bonds Municipal bonds Corporate bonds,Treasury notes and bonds,Basic information Primary market Secondary market STRIPS (Separate Trading of Registered Interest and Princi

4、pal Securities) TIPS (Treasury Inflation Protection Securities) Savings Bonds,Basic information of T-notes and T-bonds,Notes: less than 10 years Bonds: 10 years or more Active secondary market T-notes and T-bonds comprise about 25% of total bond markets Default risk free Pay coupon interest semiannu

5、ally Par value: minimum $1,000 back,Primary Market,The Treasury sells T-notes and T-bonds through auctions Normally held in the middle of each quarter Bids may be submitted by government securities dealers, businesses, and individuals Bids can be competitive or noncompetitive Competitive bids specif

6、y a price the bidder is willing to pay and a dollar amount of securities to be purchased Noncompetitive bids specify only a dollar amount of securities to be purchased,Primary Market,The Salomon Brothers scandal In a 1990 bond auction, Salomon Brothers purchased 65 percent of the bonds issued (excee

7、ding the 35 percent maximum) Salomon resold the bonds at higher prices to other institutions In August of 1991, the Treasury Department temporarily barred Salomon Brothers from bidding on Treasury securities In May 1992 Salomon paid fines of $190 million to the SEC and Justice Department Salomon cre

8、ated a reserve fund of $100 million to cover claims from civil lawsuits back,Secondary Market,Daily transaction volume: $200 million Brokers and dealers 2000 30 primary dealers Dealers Make the secondary market Profit from the spread between bid price and ask price Spread is very narrow Brokers Inte

9、rmediary between the investors and the bond dealers Charge a fee $40 - $70 for $10,000 Treasury bond transactions Institutional investors tend to contact the bond dealers directly back,STRIPS,STRIP: a Treasury security in which periodic coupon interest payments can be separated from each other and f

10、rom the final principal payment. Creation of a Treasury STRIP One set: each semiannual interest payment (IO) One set: final principal payment (PO),Coupon Stripping: Creating Zero-Coupon Treasury Securities,Par: $100 million Coupon: 10%, semiannual Maturity: 10 years,Coupon: $5 million Receipt in 6 m

11、onths,Security,Cash flow,Coupon: $5 million Receipt in 1 year,Coupon: $5 million Receipt in 1.5 year,Coupon: $5 million Receipt in 10 years,Corpus: $100 million Receipt in 10 years,Zero-coupon Treasury securities created,Maturity value $5 million Receipt in 6 months,Maturity value $5 million Receipt

12、 in 1 year,Maturity value $5 million Receipt in 1.5 year,Maturity value $5 million Receipt in 10 years,Maturity value $100 million Receipt in 10 years,STRIPS,Each of the components of the STRIP: “Treasury zero bonds” or “Treasury zero-coupon bonds” Because investors in the individual components only

13、 receive the single stripped payments (e.g., the third semiannual coupon) Investors Needing a lump sum payment in the distant future prefer to hold the principal portion Wanting nearer-term cash flows prefer the interest portions,STRIPS,Who create STRIPS The U.S. Treasury does not issue STRIPS direc

14、tly to investors Brokers and dealers, after purchasing the original T-notes or T-bonds in auctions Sold in the secondary markets 1982 1985,Example: Creation of a STRIP,Suppose the Treasury issues a five-year T-note with a par value of $10,000 and an 8% coupon rate (paid semiannually, or $400 is paid

15、 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 a

16、nd face value a separate I.D.). Citigroup then can sell 11 different securities: 10 securities with each of the semiannual coupon payments of $400 and one that pays $10,000 (the face value or principal value) in five years to outside investors.,Present value of STRIP Components with an 8% coupon rat

17、e and 7.9% yield to maturity,Example: Creation of a STRIP,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 The bank (Citigroup) will try to sell the 11 stripped securities for a greater total p

18、resent value than the bond as a whole. The reason is that many investors desire particular maturity zero-coupon bonds to meet investment goals and needs. Consequently, investors are willing to pay a higher price. example The total price Citigroup would get from selling the 11 STRIPS would exceed $10

19、,040.65,Example,An insurance 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 holders premiums could fall. Thus, the accumulated returns on the premiums in

20、vested might not meet the target or promised amount. To immunize or protect itself against interest rate risk, the insurer can invest in Treasury zero-coupon bonds (STRIPS),Example: using a STRIP to Immunize against Interest Rate Risk,Suppose that it is 2007 and an insurer must make a guaranteed pay

21、ment is $1,469,000, a lump sum policy payment on retirement, equivalent to investing $1,000,000 at an annually compounded rate of 8% over 5 years. To immunize or protect itself against interest rate risk, the insurer needs to determine which investments would produce a cash flow of exactly $1,469,00

22、0 in five years, regardless of what happens to interest rate in the immediate future. By investing a 5-year maturity STRIP, the insurance company would produce a $1,469,000 cash flow in five years.,Example: using a STRIP to Immunize against Interest Rate Risk,Given a $1,000 face value and an 8% yiel

23、d and assuming annual compounding, the current price per 5-year STRIP is If the insurer buys 1,469 bonds at a total cost of $1,000,000 in 2007, these investments would produce $1,469,000 on maturity in five years. The duration of this bond portfolio exactly matches the target horizon for the insurer

24、s future liability to its policyholders STRIP has no cash flow or coupons, future changes in interest rates have no reinvestment income effect. back,TIPS,In 1997, the Treasury started issuing inflation-indexed bonds that provide a return tied to the inflation rate Coupon rate Principal,Computing the

25、 Interest Payment of a TIPS,A 10-year bond has a par value of $1,000 and a coupon rate of 5 percent. During the first six months after the bond was issued, the inflation rate was 1.3 percent. By how much does the principal of the bond increase? What is the coupon payment after six months? Inflation-

26、indexed bonds are popular in high-inflation countries such as Brazil,Example: interest payment of TIPS,On January1, 2007, an investor purchases a TIPS bond with an original principal of $100,000, a 4% annual coupon rate, and 10 years to maturity. The first 6 months, inflation rate is 0.5% The inflat

27、ion-adjusted principal = $100,0001.005 = $100,500 The interest payment at the end of first 6 months = $100,0001.0052%= $2,010 The second 6 months, inflation rate is 1% The inflation-adjusted principal = $100,5001.01=$101,505 The interest payment at the end of second 6 months = $101,5052%= $2,030.10

28、This process is applied every six months over the life of the bond back,Savings Bonds,Issued by the Treasury Safest Have a 30-year maturity and no secondary market Not liquid Sold at discounted price Small denomination: $25 at least for $50 face value savings bond Can be redeemed before maturity, wi

29、th a penalty equal to the last 3 months of interest back,Municipal Bonds,Issued by state and local governments Attractive to household investors Interest payment on municipal bonds are exempt from federal income taxes and most state and local income taxes Interest payment on Treasury securities are

30、exempt only from sate and local income taxes Interest payment on corporate bonds are taxable,Compare the yield of municipal bonds and corporate bonds,ia = ib (1-t) ia: After-tax rate of return on a taxable corporate bond ib: Before-tax rate of return on a taxable bond t: Marginal income tax rate of

31、the bond holder,Comparison of Municipal Bonds and Taxable Corporate Bond,Suppose you can invest in taxable corporate bonds that are paying a 10% annual interest rate or municipal bonds. If your marginal tax rate is 28% (i.e. the sum of federal, local, and state taxes on the last dollar of interest i

32、ncome), the after-tax rate of return on the taxable bond is: 10% (1-28%) = 7.2%,Types of municipal bonds,Airport revenue bonds, College and university revenue bonds, Hospital revenue bonds Water revenue bonds,Characteristics of Municipal Bonds,Minimum denomination: $5,000 Secondary market: less acti

33、ve than Treasury securities Default risk Second in safety: less than 0.5 percent of all municipal bonds issued since 1940 have defaulted Some municipal bonds are insured against default Results in a higher cost for the investor,Municipal Bond Ratings:,General obligation bonds Issuers debt structure

34、and overall debt burden Issuers ability and political discipline to maintain sound budgetary policy Local taxes available to the issuer Issuers overall socioeconomic environment Revenue bonds Whether or not the project being financed will generate sufficient cash flow to satisfy the obligations due

35、bondholders.,Issuing and Trading,Primary market Public offering underwriter Firm Commitment Underwriting Best-efforts Offering Private placement Secondary market trading Inactive Lack of information,Firm Commitment Underwriting,The investment bank guarantees by buying the whole issue at a fixed pric

36、e from the municipal issuer The investment bank resell these securities to suppliers of funds (investors) at a higher price The investment bank can purchase the bonds Through competitive bidding The issuer invites bids from a number of underwriters Through direct negotiation with the issuer The inve

37、stment obtain the exclusive right back,Best-Efforts Offering,The investment does not guarantee a firm price to the issuer and acts more as a placing or distribution agent for a fee. back,Private Placement,A municipality seeks to find a large institutional buyer or group of buyers (usually fewer than

38、 10) to purchase the whole issue The most illiquid securities in the bond market Very large financial institutions being able to hold them 1990, large investors are allowed to trade privately placed bonds among themselves,Municipal Bonds Yield,The yield offered by municipal bonds will be higher/ low

39、er than a Treasury bond? Risk premium to compensate for the possibility of default risk Slight premium to compensate for being less liquid Tax advantages more than offset the two disadvantages back,Corporate Bonds,Basic information Basic Features of a corporate bond issue bond indentures Maturity Se

40、curity Provisions for Paying off bonds Bonds with Special Features Bond Ratings How corporate bonds facilitate restructuring,Basic information of Corporate Bonds,Corporate bonds are all long-term bonds issued by corporations (57.9% of all outstanding long-term bonds) Minimum denomination: $1,000 Cou

41、pon payment semiannually Types of issuers of corporate bonds Utilities Transportation Industrial Banks and finance companies Investor groups Institutional investors: life insurance companies, pension funds (50%) Households, foreign investors, depository institutions, non-life insurance companies, mu

42、tual funds, securities brokers and dealers,Bond Indenture,bond indenture: a legal contract specifies the rights and obligations of the issuer and the bondholder Contains a number of covenants which describes rules and restrictions placed on the bond issuer and bond holder The issuers ability to call

43、 the bond Restrictions to limit the ability of issuer to increase dividends or limit corporate officers salaries the firm can pay,Maturity of Bonds,Term Bonds: entire issue matures on a single date (bullet-maturity, bullet bonds) Notes Bonds Serial Bonds: the issue contains many maturity dates For e

44、conomic reasons: avoid a “crisis at maturity”,Security for Bonds,Mortgage bond Real property (lien) Collateral trust bonds Debentures: solely by the general creditworthiness Subordinated debentures Junior in their rights to mortgage bonds, regular debentures, and other general creditors Riskiest typ

45、e of bond, higher yields Junk bonds Guaranteed bond,Provisions for Paying Off Bonds,Call provision: allowing the issuer an option to buy back all or part of the issue prior to maturity Sinking fund provision: requirement that the issuer retire a certain amount of the bond issue early over a number o

46、f years, especially as the bond approaches maturity.,Call Provision,icvb = incvb opcvb opcvb: Value of the conversion option to the bond holder 2-5% lower Call protection/ refunding protection Call premium Call risk or timing risk Market value Reinvest,Example for callable bonds,Sinking Fund Provisi

47、on,Bond with maturity of 20 years Retire 5% each year Retire 5% each year beginning in the fifth year Reduce credit risk,Bonds with Special Features,Prior to 1970s: simple structure Since 1970s: special features Convertible and exchangeable bonds Issues of debt with warrants Putable bonds Zero-coupo

48、n bonds 1981 Attractiveness Floating-rate securities,Convertible Bonds and Exchangeable Bonds,Convertible bonds are bonds that grants the bondholder the right to convert the bond to a predetermined number of shares of common stock of the issuer Investors are willing to accept a lower rate of interes

49、t on convertible bonds Exchangeable bond grants the bondholder the right to exchange the bonds for the common stock of a firm other than the issuer of the bond.,Analysis of a Convertible Bond,In 2007, Titan Corporation had a convertible bond issue outstanding. Each bond, with a face value of $1,000,

50、 could be converted into common shares at a rate of 285.71 shares of stock per $1,000 face value bond (the conversion rate), or $3.50 per share. In June 2007, Titans common stock was trading at $9.375 per share. Titans convertible bonds were trading at 267.875 percent of the face value of the bond.

51、is it profitable to convert the bonds into common stock?,Conversion value= Current market price of common stock received on conversion Conversion rate In this case Conversion value = $9.375 285.71 = $2,678.53 Bonds price = $2,678.75 Virtually no difference if he holds Titans debt or its common stock

52、.,Analysis of a Convertible Bond,Issues of debt with warrants,Attached with bonds Gives the bond holder an opportunity to detach the warrants to purchase common stock at a prespecified price up to a prespecified date. (same as convertible bonds) If the bond holder decides to purchase the stock, the

53、bond holder does not have to return the underlying bond to the issuer. (different from convertible bonds),Putable Bonds,A putable bond grants the bondholder the right to sell the issue back to the issuer at par value on designated dates.,Floating-Rate Securities,The coupon interest on floating-rate

54、securities is reset periodically to follow changes in the level of some predetermined benchmark rate. Example: the coupon rate may be reset every 6 months to a rate equal to a spread of 100 basis points over the six-month Treasury bill rate. Attractiveness,Bond Ratings,Bond Ratings,Accumulated defau

55、lt rates is 0.03% on Aaa, and 9.63% on Baa. Investment-grade bonds Baa or better: Moodys BBB or better: S&P Speculative-grade bonds (junk bonds) below Baa by Moodys below BBB by S&P Financial institutions (banks, insurance companies) are generally prohibited by state and federal law from purchasing

56、anything but investment-grade bond. About two-thirds of junk bonds are used to finance takeovers,Size of the junk bond market Currently about 3,700 junk bond offerings exist with a market value of $80 billion 70 large issuers of junk bonds each have more than $1 billion in debt outstanding Contagion

57、 effects Specific adverse information may discourage investors from investment in junk bonds,High-Yield Bonds,How corporate bonds facilitate restructuring,Using bonds to finance a leveraged buyout An LBO is typically financed with senior debt and subordinated debt Bank loans: 60% Bonds issues: 30% O

58、wn capital: 10% 1988, over 100 LBOs From public to private Takeover price premium 30%-40% Increase managerial efficiency Reduce the equity interest of the firm down to a small group of people (management and other employees) Concerns about corporate debt levels,Case study: LBO of KKR by KKR,1988, am

59、ount: $24.7billion KKRs equity investment: $1.4billion, 6% of purchase price Debt: long-term bonds and bank loans Before: long-term debt was less than equity After: long-term debt was more than 12 times equity Interest expenses were more than 5 times Prices of RJR bonds declined by 20% when the LBO was announced 1990, 1991 issue stock to reduce degree of financial leverage,Using bonds to revise the capital structure debt-for-equity swap: issue bonds and use the proceeds to repurchase some o