Financial Transaction

7 Bond Markets

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ provide a background on bonds,

· ▪ describe the different types of bonds and their characteristics,

· ▪ explain how bond markets have become globally integrated, and

· ▪ describe other types of long-term debt securities.

From this chapter through  Chapter 12 , the focus is on capital market securities. These chapters are distinctly different from the previous chapter on money market securities in that they employ a long-term rather than a short-term perspective. This chapter and the following focus on bond markets, which facilitate the flow of long-term debt from surplus units to deficit units.

7-1 BACKGROUND ON BONDS

Bonds are long-term debt securities that are issued by government agencies or corporations. The issuer of a bond is obligated to pay interest (or coupon) payments periodically (such as annually or semiannually) and the par value (principal) at maturity. An issuer must be able to show that its future cash flows will be sufficient to enable it to make its coupon and principal payments to bondholders. Investors will consider buying bonds for which the repayment is questionable only if the expected return from investing in the bonds is sufficient to compensate for the risk.

   Bonds are often classified according to the type of issuer. Treasury bonds are issued by the U.S. Treasury, federal agency bonds are issued by federal agencies, municipal bonds are issued by state and local governments, and corporate bonds are issued by corporations.

   Most bonds have maturities of between 10 and 30 years. Bonds are classified by the ownership structure as either bearer bonds or registered bonds. Bearer bonds require the owner to clip coupons attached to the bonds and send them to the issuer to receive coupon payments. Registered bonds require the issuer to maintain records of who owns the bond and automatically send coupon payments to the owners.

   Bonds are issued in the primary market through a telecommunications network.  Exhibit 7.1  shows how bond markets facilitate the flow of funds. The U.S. Treasury issues bonds and uses the proceeds to support deficit spending on government programs. Federal agencies issue bonds and use the proceeds to buy mortgages that are originated by financial institutions. Thus, they indirectly finance purchases of homes. Corporations issue bonds and use the proceeds to expand their operations. Overall, by allowing households, corporations, and the U.S. government to increase their expenditures, bond markets finance economic growth.

WEB

finance.yahoo.com/bonds

Summary of bond market activity and analysis of bond market conditions.

7-1a Institutional Participation in Bond Markets

All types of financial institutions participate in the bond markets, as summarized in  Exhibit 7.2 . Commercial banks, savings institutions, and finance companies commonly issue bonds in order to raise capital to support their operations. Commercial banks, savings institutions, bond mutual funds, insurance companies, and pension funds are investors in the bond market. Financial institutions dominate the bond market in that they purchase a large proportion of bonds issued.

Exhibit 7.1 How Bond Markets Facilitate the Flow of Funds

Exhibit 7.2 Participation of Financial Institutions in Bond Markets

FINANCIAL INSTITUTION	PARTICIPATION IN BOND MARKETS
Commercial banks and savings and loan associations (S&Ls)	· • Purchase bonds for their asset portfolio. · • Sometimes place municipal bonds for municipalities. · • Sometimes issue bonds as a source of secondary capital.
Finance companies	· • Commonly issue bonds as a source of long-term funds.
Mutual funds	· • Use funds received from the sale of shares to purchase bonds. Some bond mutual funds specialize in particular types of bonds, while others invest in all types.
Brokerage firms	· • Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.
Investment banking firms	· • Place newly issued bonds for governments and corporations. They may place the bonds and assume the risk of market price uncertainty or place the bonds on a best-efforts basis in which they do not guarantee a price for the issuer.
Insurance companies	· • Purchase bonds for their asset portfolio.
Pension funds	· • Purchase bonds for their asset portfolio.

7-1b Bond Yields

The yield on a bond depends on whether it is viewed from the perspective of the issuer of the bond, who is obligated to make payments on the bond until maturity, or from the perspective of the investors who purchase the bond.

Yield from the Issuer's Perspective  The issuer's cost of financing with bonds is commonly measured by the yield to maturity, which reflects the annualized yield that is paid by the issuer over the life of the bond. The yield to maturity is the annualized discount rate that equates the future coupon and principal payments to the initial proceeds received from the bond offering. It is based on the assumption that coupon payments received can be reinvested at the same yield.

EXAMPLE

Consider an investor who can purchase bonds with 10 years until maturity, a par value of $1,000, and an 8 percent annualized coupon rate for $936. The yield to maturity on these bonds can be determined by using a financial calculator as follows:

INPUT	10	936	80	1000
Function Key	N	PV	PMT	FV	CPT	I
Answer						9%

   Notice that the yield paid to investors consists of two components: (1) a set of coupon payments and (2) the difference between the par value that the issuer must pay to investors at maturity and the price it received when selling the bonds. In this example and in most cases, the biggest component of the yield to maturity is the set of coupon payments. The yield to maturity does not include the transaction costs associated with issuing the bonds. When those transaction costs are considered, the issuer's actual cost of borrowing is slightly higher than the yield to maturity.

WEB

money.cnn.com/markets/bondcenter

Yields and information on all types of bonds for various maturities.

Yield from the Investor's Perspective  An investor who invests in a bond when it is issued and holds it until maturity will earn the yield to maturity. Yet many investors do not hold a bond to maturity and therefore focus on their holding period return, or the return from their investment over a particular holding period. If they hold the bond for a very short time period (such as less than one year), they may estimate their holding period return as the sum of the coupon payments plus the difference between the selling price and the purchase price of the bond, as a percentage of the purchase price. For relatively long holding periods, a better approximation of the holding period yield is the annualized discount rate that equates the payments received to the initial investment.

   Since the selling price to be received by investors is uncertain if they do not hold the bond to maturity, their holding period yield is uncertain at the time they purchase the bond. Consequently, an investment in bonds is subject to the risk that the holding period return will be less than expected. The valuation and return of bonds from the investor's perspective are discussed more thoroughly in the following chapter.

7-2 TREASURY AND FEDERAL AGENCY BONDS

The U.S. government, like many country governments, commonly wants to use a fiscal policy of spending more money than it receives from taxes. Under these conditions, it needs to borrow funds to cover the difference between what it wants to spend versus what it receives. To facilitate its fiscal policy, the U.S. Treasury issues Treasury notes and Treasury bonds to finance federal government expenditures. The Treasury pays a yield to investors that reflects the risk-free rate, as it is presumed that the Treasury will not default on its payments. Because the Treasury notes and bonds are free from credit (default) risk, they enable the Treasury to borrow funds at a relatively low cost. However, there might be a limit at which any additional borrowing by the U.S. government could cause investors to worry about the Treasury's ability to cover its debt payments. Some other countries (such as Greece, Spain, and Portugal) have already reached that point, and the governments of those countries have to offer a higher yield on their bonds to compensate investors for the credit risk.

   The minimum denomination for Treasury notes and bonds is now $100. The key difference between a note and a bond is that note maturities are less than 10 years whereas bond maturities are 10 years or more. Since 2006, the Treasury has commonly issued 10- year Treasury bonds and 30-year Treasury bonds to finance the U.S. budget deficit. An active over-the-counter secondary market allows investors to sell Treasury notes or bonds prior to maturity.

WEB

www.treasurydirect.gov

Details about Treasury bonds.

   Investors in Treasury notes and bonds receive semiannual interest payments from the Treasury. Although the interest is taxed by the federal government as ordinary income, it is exempt from any state and local taxes. Domestic and foreign firms and individuals are common investors in Treasury notes and bonds.

7-2a Treasury Bond Auctions

The Treasury obtains long-term funding through Treasury bond offerings, which are conducted through periodic auctions. Treasury bond auctions are normally held in the middle of each quarter. The Treasury announces its plans for an auction, including the date, the amount of funding that it needs, and the maturity of the bonds to be issued. At the time of the auction, financial institutions submit bids for their own accounts or for their clients.

   As discussed in  Chapter 6 , bids can be submitted on a competitive or a noncompetitive basis. Competitive bids specify a price that 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 (subject to a maximum limit). The Treasury ranks the competitive bids in descending order according to the price bid per $100 of par value. All competitive bids are accepted until the point at which the desired amount of funding is achieved. The Treasury uses the lowest accepted bid price as the price applied to all accepted competitive bids and all noncompetitive bids. Competitive bids are commonly used because many bidders want to purchase more Treasury bonds than the maximum that can be purchased on a noncompetitive basis.

7-2b Trading Treasury Bonds

Bond dealers serve as intermediaries in the secondary market by matching up buyers and sellers of Treasury bonds, and they also take positions in these bonds. About 2,000 brokers and dealers are registered to trade Treasury securities, but about 20 so-called primary dealers dominate the trading. These dealers make the secondary market for the Treasury bonds. They quote a bid price for customers who want to sell existing Treasury bonds to the dealers and an ask price for customers who want to buy existing Treasury bonds from them. The dealers profit from the spread between the bid and ask prices. Because of the large volume of secondary market transactions and intense competition among bond dealers, the spread is extremely narrow. When the Federal Reserve engages in open market operations, it normally conducts trading with the primary dealers of government securities. The primary dealers also trade Treasury bonds among themselves.

   Treasury bonds are registered at the New York Stock Exchange, but the secondary market trading occurs over the counter (through a telecommunications network). The typical daily transaction volume in government securities (including money market securities) for the primary dealers is about $570 billion. Most of this trading volume occurs in the United States, but Treasury bonds are traded worldwide. They are traded in Tokyo from 7:30 P.M. to 3:00 A.M. New York time. The Tokyo and London markets overlap for part of the time, and the London market remains open until 7:30 A.M., when trading begins in New York.

   Investors can contact their broker to buy or sell Treasury bonds. The brokerage firms serve as an intermediary between the investors and the bond dealers. Discount brokers usually charge a fee of between $40 and $70 for Treasury bond transactions valued at $10,000. Institutional investors tend to contact the bond dealers directly.

Online Trading  Investors can also buy bonds through the Treasury Direct program ( www.treasurydirect.gov ). They can have the Treasury deduct their purchase from their bank account. They can also reinvest proceeds received when Treasury bonds mature into newly issued Treasury bonds.

Online Quotations  Treasury bond prices are accessible online at  www.investinginbonds.com . This website provides the spread between the bid and the ask (offer) prices for various maturities. Treasury bond yields are accessible online at  www.federalreserve.gov/releases/H15/ . The yields are updated daily and are given for several different maturities.

7-2c Stripped Treasury Bonds

The cash flows of Treasury bonds are commonly transformed (stripped) by securities firms into separate securities. A Treasury bond that makes semiannual interest payments can be stripped into several individual securities. One security would represent the payment of principal upon maturity. Each of the other securities would represent payment of interest at the end of a specified period. Consequently, investors could purchase stripped securities that fit their desired investment horizon.

   For example, consider a 10-year Treasury bond that pays an interest payment semiannually, for a total of 20 separate interest payments over the life of the bond. If this Treasury bond was stripped, its principal payment would be separated from the interest payments, and therefore would represent a new security that pays only the principal at the end of 10 years. In addition, all 20 interest rate payment portions of the Treasury bond would be separated into individual securities, so that one security would represent payment upon its maturity of 6 months, a second security would represent payment upon its maturity of 12 months, a third security would represent payment upon its maturity of 18 months, and so on. All newly formed securities are zero-coupon securities, because each security has only one payment that occurs upon its maturity.

   Stripped Treasury securities are commonly called STRIPS (Separate Trading of Registered Interest and Principal of Securities). STRIPS are not issued by the Treasury but instead are created and sold by various financial institutions. They can be created for any Treasury security. Because they are components of Treasury securities, they are backed by the U.S. government. They do not have to be held until maturity, since there is an active secondary market. STRIPS have become quite popular over time.

7-2d Inflation-Indexed Treasury Bonds

The Treasury periodically issues inflation-indexed bonds that provide returns tied to the inflation rate. These bonds, commonly referred to as TIPS (Treasury Inflation-Protected Securities), are intended for investors who wish to ensure that the returns on their investments keep up with the increase in prices over time. The coupon rate offered on TIPS is lower than the rate on typical Treasury bonds, but the principal value is increased by the amount of the U.S. inflation rate (as measured by the percentage increase in the consumer price index) every six months.

EXAMPLE

Consider a 10-year, inflation-indexed bond that has a par value of $10,000 and a coupon rate of 4 percent. Assume that, during the first six months since the bond was issued, the inflation rate (as measured by the consumer price index) was 1 percent, in which case the principal of the bond is increased by $100 (0.01 × $10,000). Thus the coupon payment after six months will be 2 percent (half of the yearly coupon rate) of the new par value, or 0.02 × $10,100 = $202. Assume that the inflation rate over the next six months is 3 percent. Then the principal of the bond is increased by $303 (0.03 × $10, 100), which results in a new par value of $10,403. The coupon payment at the end of the year is based on the coupon rate and the new par value, or 0.02 × $10,403 = $208.06. This process is applied every six months over the life of the bond. If prices double over the 10-year period in which the bond exists, the par value of the bond will also double and thus will be equal to $20,000 at maturity.

   Inflation-indexed government bonds have become popular in many countries, including Australia and the United Kingdom. They are especially desirable in countries where inflation tends to be high, such as Brazil and Turkey. Inflation-indexed bonds are also popular in the United States. The Treasury historically focused on TIPS with 10-year maturities but is now offering TIPS with 5-year and 20-year maturities as well.

7-2e Savings Bonds

Savings bonds are issued by the Treasury, but they can be purchased from many financial institutions. They are attractive to small investors because they can be purchased with as little as $25. Larger denominations are also available. The Series EE savings bond provides a market-based rate of interest, and the Series I savings bond provides a rate of interest that is tied to inflation. The interest accumulates monthly and adds value to the amount received at the time of redemption.

   Savings bonds have a 30-year maturity and do not have a secondary market. The Treasury does allow savings bonds issued after February 2003 to be redeemed any time after a 12-month period, but there is a penalty equal to the last three months of interest.

   Like other Treasury securities, the interest income on savings bonds is not subject to state and local taxes but is subject to federal taxes. For federal tax purposes, investors holding savings bonds can report the accumulated interest either on an annual basis or not until bond redemption or maturity.

7-2f Federal Agency Bonds

Federal agency bonds are issued by federal agencies. The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) issue bonds and use the proceeds to purchase mortgages in the secondary market. Thus they channel funds into the mortgage market, thereby ensuring that there is sufficient financing for homeowners who wish to obtain mortgages. Prior to September 2008, these bonds were not backed by the federal government. During the credit crisis in 2008, however, Fannie Mae and Freddie Mac experienced financial problems because they had purchased risky subprime mortgages that had a high frequency of defaults. Consequently, the agencies were unable to issue bonds because investors feared that they might default. In September 2008, the federal government rescued Fannie Mae and Freddie Mac so that they could resume issuing bonds and continue to channel funds into the mortgage market.

7-3 MUNICIPAL BONDS

Like the federal government, state and local governments frequently spend more than the revenues they receive. To finance the difference, they issue municipal bonds, most of which can be classified as either general obligation bonds or revenue bonds. Payments on general obligation bonds are supported by the municipal government's ability to tax, whereas payments on revenue bonds must be generated by revenues of the project (toll way, toll bridge, state college dormitory, etc.) for which the bonds were issued. Revenue bonds are more common than general obligation bonds. There are more than 44,000 state and local government agencies that issue municipal bonds in order to finance their spending on government projects. The market value of these bonds is almost $4 trillion.

   Revenue bonds and general obligation bonds typically promise semiannual interest payments. Common purchasers of these bonds include financial and nonfinancial institutions as well as individuals. The minimum denomination of municipal bonds is usually $5,000. A secondary market exists for them, although it is less active than the one for Treasury bonds.

   Most municipal bonds contain a call provision, which allows the issuer to repurchase the bonds at a specified price before the bonds mature. A municipality may exercise its option to repurchase the bonds if interest rates decline substantially because it can then reissue bonds at the lower interest rate and thus reduce its cost of financing.

7-3a Credit Risk of Municipal Bonds

Both types of municipal bonds are subject to some degree of credit (default) risk. If a municipality is unable to increase taxes, it could default on general obligation bonds. If it issues revenue bonds and does not generate sufficient revenue, it could default on these bonds.

   Municipal bonds have rarely defaulted, and some investors consider them to be safe because they presume that any government agency in the U.S. can obtain funds to repay its loans. However, some government agencies have serious budget deficits because of excessive spending, and may not be able to repay their loans. Recent economic conditions have reduced the amount of tax revenue that many government agencies have received, and have caused larger deficits for the agencies that have not reduced their spending.

   During weak economic conditions, some state and local governments avoid tough decisions about reducing employment or pension obligations. But this results in a larger budget deficit, which requires additional municipal bond offerings to cover the deficits. Consequently, there is a concern that a municipal bond credit crisis could occur if municipalities do not attempt to correct their large budget deficits. As investors recognize the increased credit risk of municipal bonds, they require higher risk premiums as compensation.

   Some investors are concerned that municipalities will file for bankruptcy not as a last resort, but as a convenient way to avoid their obligations. That is, they might consider placing the burden on the bondholders rather than correcting the budget deficit with higher taxes or less government spending.

   There is very limited disclosure about the financial condition of the state and local governments that issue these bonds. The issuance of municipal securities is regulated by the respective state government, but critics argue that an unbiased regulator would be more appropriate. Better disclosure of financial information by state and local governments could help investors assess the potential default risk of some municipal bonds before they purchase them.

Ratings of Municipal Bonds  Because there is some concern about the risk of default, investors commonly monitor the ratings of municipal bonds. Moody's, Standard & Poor's, and Fitch Investors Service assign ratings to municipal bonds based on the ability of the issuer to repay the debt. The ratings are important to the issuer because a better rating means investors will require a smaller risk premium, in which case the municipal bonds can be issued at a higher price (lower yield). Some critics suggest that the ratings of municipal bonds have not been sufficiently downgraded to reflect the financial condition of municipalities in recent years.

Insurance against Credit Risk of Municipal Bonds  Some municipal bonds are insured to protect against default. The issuer pays for this protection so that it can issue the bond at a higher price, which translates into a higher price paid by the investor. Thus investors indirectly bear the cost of the insurance. Also, there still is the possibility that the insurer will default on its obligation of insuring the bonds. Thus if both the municipal bond and the bond insurer default, the investor will incur the loss. For this reason, investors should know what company is insuring the bonds and should assess its financial condition. During the credit crisis, MBIA (the largest insurer of bonds) experienced major losses because it insured many bonds that ultimately defaulted. Although MBIA issued new bonds to boost its capital level, its credit rating was downgraded by rating agencies.

   Whereas about 50 percent of newly issued municipal bonds in 2006 were insured, fewer than 10 percent of newly issued municipal bonds in 2010 were insured. This reduction may be due to fewer insurance companies that are willing to insure bonds as a result of the credit crisis. It may also be attributed to investors recognizing that insured bonds still exhibit the risk that the insurer is unable to meet its obligations if many of the bonds it is insuring default at the same time.

7-3b Variable-Rate Municipal Bonds

Variable-rate municipal bonds have a floating interest rate that is based on a benchmark interest rate: the coupon payment adjusts to movements in the benchmark. Some variable-rate municipal bonds are convertible to a fixed rate until maturity under specified conditions. In general, variable-rate municipal bonds are desirable to investors who expect that interest rates will rise. However, there is the risk that interest rates may decline over time, which would cause the coupon payments to decline as well.

7-3c Tax Advantages of Municipal Bonds

One of the most attractive features of municipal bonds is that the interest income is normally exempt from federal taxes. Second, the interest income earned on bonds that are issued by a municipality within a particular state is normally exempt from the income taxes (if any) of that state. Thus, investors who reside in states that impose income taxes can reduce their taxes further.

7-3d Trading and Quotations of Municipal Bonds

There are hundreds of bond dealers that can accommodate investor requests to buy or sell municipal bonds in the secondary market, although five dealers account for more than half of all the trading volume. Bond dealers can also take positions in municipal bonds.

   Investors who expect that they will not hold a municipal bond until maturity should consider only bonds that feature active secondary market trading. Many municipal bonds have an inactive secondary market, so it is difficult to know the prevailing market values of these bonds. Although investors do not pay a direct commission on trades, they incur transaction costs in the form of a bid-ask spread on the bonds. This spread can be large, especially for municipal bonds that are rarely traded in the secondary market.

   Electronic trading of municipal bonds has become very popular, in part because it enables investors to circumvent the more expensive route of calling brokers. A popular bond website is  www.ebondtrade.com . Such websites provide access to information on municipal bonds and allow online buying and selling of municipal bonds.

7-3e Yields Offered on Municipal Bonds

The yield offered by a municipal bond differs from the yield on a Treasury bond with the same maturity for three reasons. First, the municipal bond must pay a risk premium to compensate for the possibility of default risk. Second, the municipal bond must pay a slight premium to compensate for being less liquid than Treasury bonds with the same maturity. Third, as mentioned previously, the income earned from a municipal bond is exempt from federal taxes. This tax advantage of municipal bonds more than offsets their two disadvantages and allows municipal bonds to offer a lower yield than Treasury bonds. The yield on municipal securities is commonly 20 to 30 percent less than the yield offered on Treasury securities with similar maturities.

   Movements in the yield offered on newly issued municipal bonds are highly correlated with movements in the yield offered on newly issued Treasury securities with similar maturities. Notice in Exhibit 7.3 that there has been a general decline in yields offered by municipal bonds since the financial crisis of 2008, which is attributed to the Fed's monetary policy that reduced long-term interest rates (and therefore yields offered on long-term debt). The temporary reversal of municipal bond rates in 2011 was due to an increase in credit risk, as investors became more aware that some municipalities had large budget deficits and might not be capable of repaying their debt.

Exhibit 7.3 Yield Offered on General Obligation Municipal Bonds over Time

7-4 CORPORATE BONDS

Corporate bonds are long-term debt securities issued by corporations that promise the owner coupon payments (interest) on a semiannual basis. The minimum denomination is $1,000, and their maturity is typically between 10 and 30 years. However, Boeing, Chevron, and other corporations have issued 50-year bonds, and Disney, AT&T, and the Coca-Cola Company have even issued 100-year bonds.

   The interest paid by the corporation to investors is tax deductible to the corporation, which reduces the cost of financing with bonds. Equity financing does not offer the same tax advantage because it does not involve interest payments. This is a major reason why many corporations rely heavily on bonds to finance their operations. Nevertheless, the amount of funds a corporation can obtain by issuing bonds is limited by its ability to make the coupon payments.

   The interest income earned on corporate bonds represents ordinary income to the bondholders and is therefore subject to federal taxes and to state taxes, if any. For this reason, corporate bonds do not provide the same tax benefits to bondholders as do municipal bonds.

7-4a Corporate Bond Offerings

Corporate bonds can be placed with investors through a public offering or a private placement.

Public Offering  Corporations commonly issue bonds through a public offering. A corporation that plans to issue bonds hires a securities firm to underwrite the bonds. The underwriter assesses market conditions and attempts to determine the price at which the corporation's bonds can be sold and the appropriate size (dollar amount) of the offering. The goal is to price the bonds high enough to satisfy the issuer but also low enough so that the entire bond offering can be placed. If the offering is too large or the price is too high, there may not be enough investors who are willing to purchase the bonds. In this case, the underwriter will have to lower the price in order to sell all the bonds. The issuer registers with the Securities and Exchange Commission (SEC) and submits a prospectus that explains the planned size of the offering, its updated financial condition (supported by financial statements), and its planned use of the funds. Meanwhile, the underwriter distributes the prospectus to other securities firms that it invites to join a syndicate that will help place the bonds in the market. Once the SEC approves the issue, the underwriting syndicate attempts to place the bonds. A portion of the bonds that are registered can be shelved for up to two years if the issuer wants to defer placing the entire offering at once.

   Underwriters typically try to place newly issued corporate bonds with institutional investors (e.g., pension funds, bond mutual funds, and insurance companies) because these investors are more likely to purchase large pieces of the offering. Many institutional investors may plan to hold the bonds for a long-term period, but they can be sold to other investors should their plans change.

   For some bond offerings, the arrangement between the underwriter and the issuer is a firm commitment, whereby the underwriter guarantees the issuer that all bonds will be sold at a specified price. Thus the issuer knows the amount of proceeds that it will receive. The underwriter is exposed to the risk if it cannot sell the bonds. Normally, the underwriter will only agree to a firm commitment if it has already received strong indications of interest from institutional investors. Alternatively, the underwriter may agree to a best efforts arrangement, in which it attempts to sell the bonds at a specified price, but makes no guarantee to the issuer.

 USING THE WALL STREET JOURNAL: Bond Yield Quotations

The Wall Street Journal provides bond yield quotations for various types of bonds classified by type of bond, rating of issuer, or maturity, as shown here. The yields are quoted under the column “Latest.” The range of yields that were offered over the previous 52 weeks for a given type of bond is also disclosed. Investors closely monitor the yields offered on bonds.

Source: Reprinted with permission of the Wall Street Journal, Copyright © 2013 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

Private Placement  Some corporate bonds are privately placed rather than sold in a public offering. A private placement does not have to be registered with the SEC. Small firms that borrow relatively small amounts of funds (such as $30 million) may consider private placements rather than public offerings, since they may be able to find an institutional investor that will purchase the entire offering. Although the issuer does not need to register with the SEC, it must still disclose financial data in order to convince any prospective purchasers that the bonds will be repaid in a timely manner. The issuer may hire a securities firm to place the bonds because such firms are normally better able to identify institutional investors interested in purchasing privately placed debt.

   The institutional investors that commonly purchase a private placement include insurance companies, pension funds, and bond mutual funds. Because privately placed bonds do not have an active secondary market, they tend to be purchased by institutional investors that are willing to invest for long periods of time. The SEC's Rule 144A creates liquidity for privately placed securities by allowing large institutional investors to trade privately placed bonds (and some other securities) with each other even when the securities need not be registered with the SEC.

Credit Risk of Corporate Bonds  Corporate bonds are subject to the risk of default, and the yield paid by corporations that issue bonds contains a risk premium to reflect the credit risk. The general level of defaults on corporate bonds is a function of economic conditions. When the economy is strong, firms generate higher revenue and are better able to meet their debt payments. When the economy is weak, some firms may not generate sufficient revenue to cover their operating and debt expenses and hence default on their bonds. In the late 1990s, when U.S. economic conditions were strong, the default rate was less than 1 percent. However, this rate exceeded 3 percent in 2002 and during the credit crisis of 2008–2009, when economic conditions were weak. In 2008 when the credit crisis began, the value of bonds that defaulted exceeded $100 billion, versus only $3.5 billion in 2007.

Bond Ratings as a Measure of Credit Risk  When corporations issue bonds, they hire rating agencies to have their bonds rated. Corporate bonds that receive higher ratings can be placed at higher prices (lower yields) because they are perceived to have lower credit risk. For example, Coca-Cola and IBM issued bonds in 2012 at a yield of less than 2 percent. Their cost of borrowing funds was almost as low as that of the U.S. Treasury.

   Some corporations obtain bond ratings in order to verify that their bonds qualify for at least investment-grade status (i.e., a rating of medium quality or above). Commercial banks will only consider investing in bonds that have been given an investment-grade rating.

   A corporate bond's rating may change over time if the issuer's ability to repay the debt changes. Many investors rely on the rating agencies to detect potential repayment problems on debt. During the credit crisis, however, the rating agencies were slow to downgrade their ratings on some debt securities that ultimately defaulted.

   As a result of the Financial Reform Act of 2010, credit rating agencies are subject to oversight by a newly established Office of Credit Ratings, which is housed within the Securities and Exchange Commission. The credit rating agencies are subject to new reporting requirements that mandate disclosure of their methodology for determining ratings. When assigning a rating to an issuer of debt, the agencies must consider credible information from sources other than the issuer. They must also establish new internal controls over their operations. Rating agencies must disclose the performance of their ratings over time and are to be held accountable for poor performance. Their ratings analysts are required to take qualifying exams, and the rating systems should become more transparent overall. Finally, agencies can be sued for issuing credit ratings that they should have known were inaccurate.

   However, the act did not change the fee structure, whereby debt issuers pay fees to credit rating agencies in order to have their debt rated. Some critics argue that, as long as the agencies are paid by the issuers whose debt they are rating, the potential exists for agencies to inflate those ratings.

Junk Bonds  Corporate bonds that are perceived to have very high risk are referred to as junk bonds. The primary investors in junk bonds are mutual funds, life insurance companies, and pension funds. Some bond mutual funds invest only in bonds with high ratings, but there are more than a hundred high-yield mutual funds that commonly invest in junk bonds. High-yield mutual funds allow individual investors to invest in a diversified portfolio of junk bonds with a small investment. Junk bonds offer high yields that contain a risk premium (spread) to compensate investors for the high risk. Typically, the premium is between 3 and 7 percentage points above Treasury bonds with the same maturity.

   Although investors always require a higher yield on junk bonds than on other bonds, they also require a higher premium when the economy is weak because there is a greater likelihood that the issuer will not generate sufficient cash to cover the debt payments.  Exhibit 7.4  shows the spread between junk bond yields and Treasury yields over time. During the credit crisis of 2008–2009, risk premiums on newly issued junk bonds exceeded 10 percent. The high premium was required because junk bonds valued at more than $25 billion defaulted during the credit crisis.

   Nevertheless, the junk bond market remains popular. Some corporations issued junk bonds in 2012 as a means of financing because interest rates were so low, although they still paid a high risk premium. Many of the firms that issued junk bonds recently did so to refinance their operations, by replacing their existing debt that had higher interest rates. Investors may be more willing to purchase junk bonds when it is used for this type of purpose than when it is used to support acquisitions or other types of corporate expansion. In addition, many institutional investors (such as bond mutual funds) have been more willing to invest in junk bonds since the yields on more highly rated bonds are so low.

Exhibit 7.4 Risk Premiums of Junk Bonds versus Other Corporate Bonds over Time

7-4b Secondary Market for Corporate Bonds

Corporate bonds have a secondary market, so investors who purchase them can sell them to other investors if they prefer not to hold them until maturity. The value of all corporate bonds in the secondary market exceeds $5 trillion. Corporate bonds are listed on an over-the-counter market or on an exchange such as the American Stock Exchange (now part of NYSE Euronext). More than a thousand bonds are listed on the New York Stock Exchange (NYSE). Corporations whose stocks are listed on the exchange can list their bonds for free.

Dealer Role in Secondary Market  The secondary market is served by bond dealers, who can play a broker role by matching up buyers and sellers. Bond dealers also have an inventory of bonds, so they can serve as the counterparty in a bond transaction desired by an investor. For example, if an investor wants to sell bonds that were previously issued by the Coca-Cola Company, bond dealers may execute the deal either by matching the sellers with investors who want to buy the bonds or by purchasing the bonds for their own inventories. Dealers commonly handle large transactions, such as those valued at more than $1 million. Information about the trades in the over-the-counter market is provided by the National Association of Securities Dealers' Trade Reporting and Compliance Engine, which is referred to as TRACE.

Liquidity in Secondary Market  Bonds issued by large, well-known corporations in large volume are liquid because they attract a large number of buyers and sellers in the secondary market. Bonds issued by small corporations in small volume are less liquid because there may be few buyers (or no buyers) for those bonds in some periods. Thus investors who wish to sell these bonds in the secondary market may have to accept a discounted price in order to attract buyers. About 95 percent of the trading volume of corporate bonds in the secondary market is attributed to institutional investors.

   Often, a particular company issues many different bonds with variations in maturity, price, and credit rating. Having many different bonds allows investors to find a bond issued by a particular company that fits their desired maturity and other preferences. However, such specialized bonds may exhibit reduced liquidity because they may appeal to only a small group of investors. The trading of these bonds will require higher transaction costs, because brokers require more time to execute transactions for investors.

Electronic Bond Networks  Electronic bond networks have recently been established that can match institutional investors that wish to sell some bond holdings or purchase additional bonds in the over-the-counter bond market at a lower transaction cost. Trading platforms have been created by financial institutions such as J.P. Morgan and Goldman Sachs so that institutional investors can execute bond trades in the secondary market. The institutional investors that wish to purchase bonds can use the platforms to identify bond holdings that are for sale by other institutional investors in the secondary market, and can purchase the bonds electronically, without relying on bond dealers. They pay a small fee (percentage of their transactions) for the use of the trading platforms. However, the participation by investors in electronic bond networks is limited, so that institutional investors interested in purchasing bonds cannot always find the bonds that they wish to purchase.

   The NYSE developed an electronic bond trading platform for the bonds sold on its exchange as part of its strategy to increase its presence in the corporate bond market. It allows greater transparency, as investors have access to real-time data and can more easily monitor the prices and trading volume of corporate bonds.

Types of Orders through Brokers  Individual investors buy or sell corporate bonds through brokers, who communicate the orders to bond dealers. Investors who wish to buy or sell bonds can normally place a market order; in this case, the desired transaction will occur at the prevailing market price. Alternatively, they can place a limit order; in this case, the transaction will occur only if the price reaches the specified limit. When purchasing bonds, investors use a limit order to specify the maximum limit price they are willing to pay for a bond. When selling bonds, investors use a limit order to specify a minimum limit price at which they are willing to sell their bonds.

Trading Online  Orders to buy and sell corporate bonds are increasingly being placed online. For example, popular online bond brokerage websites are  www.schwab.com  and  http://us.etrade.com . The pricing of bonds is more transparent online because investors can easily compare the bid and ask spreads among brokers. This transparency has encouraged some brokers to narrow their spreads so that they do not lose business to competitors.

WEB

http://averages.dowjones.com

Links to corporate bond indexes so that you can monitor the general performance of corporate bonds.

   Some online bond brokerage services, such as Fidelity and Vanguard, now charge a commission instead of posting a bid and ask spread, which ensures that investors can easily understand the fee structure. There is also a standard fee for every trade, whereas bid and ask spreads may vary among bonds. For example, the fee may be $2 per bond with a $25 minimum. Thus an investor who purchases 30 bonds would pay a total fee of $60 (computed as 30 × $2). Online bond brokerage services can execute transactions in Treasury and municipal bonds as well. Their fees are generally lower for Treasury bond than for corporate bond transactions but higher for municipal bond transactions.

7-4c Characteristics of Corporate Bonds

Corporate bonds can be described in terms of several characteristics. The bond indenture is a legal document specifying the rights and obligations of both the issuing firm and the bondholders. It is comprehensive (normally several hundred pages) and is designed to address all matters related to the bond issue (collateral, payment dates, default provisions, call provisions, etc.).

   Federal law requires that, for each bond issue of significant size, a trustee be appointed to represent the bondholders in all matters concerning the bond issue. The trustee's duties include monitoring the issuing firm's activities to ensure compliance with the terms of the indenture. If the terms are violated, the trustee initiates legal action against the issuing firm and represents the bondholders in that action. Bank trust departments are frequently hired to perform the duties of trustee.

   Bonds are not as standardized as stocks. A single corporation may issue more than 50 different bonds with different maturities and payment terms. Some of the characteristics that differentiate one bond from another are identified here.

Sinking-Fund Provision  Bond indentures frequently include a sinking-fund provision, a requirement that the firm retire a certain amount of the bond issue each year. This provision is considered to be an advantage to the remaining bondholders because it reduces the payments necessary at maturity.

   Specific sinking-fund provisions can vary significantly among bond issues. For example, a bond with 20 years until maturity could have a provision to retire 5 percent of the bond issue each year. Or it could have a requirement to retire 5 percent each year beginning in the fifth year, with the remaining amount to be retired at maturity. The actual mechanics of bond retirement are carried out by the trustee.

WEB

www.investinginbonds.com

This website contains much data and other useful information about corporate bonds.

Protective Covenants  Bond indentures normally place restrictions on the issuing firm that are designed to protect bondholders from being exposed to increasing risk during the investment period. These so-called protective covenants frequently limit the amount of dividends and corporate officers' salaries the firm can pay and also restrict the amount of additional debt the firm can issue. Other financial policies may be restricted as well.

   Protective covenants are needed because shareholders and bondholders have different expectations of a firm's management. Shareholders may prefer that managers use a relatively large amount of debt because they can benefit directly from risky managerial decisions that will generate higher returns on investment. In contrast, bondholders simply hope to receive their principal back, with interest. Since they do not share in the excess returns generated by a firm, they would prefer that managerial decisions be conservative. Protective covenants can prevent managers from taking excessive risk and therefore cater to the preferences of bondholders. If managers are unwilling to accept some protective covenants, they may not be able to obtain debt financing.

Call Provisions  Most corporate bonds include a provision allowing the firm to call the bonds. A call provision normally requires the firm to pay a price above par value when it calls its bonds. The difference between the bond's call price and par value is the call premium. Call provisions have two principal uses. First, if market interest rates decline after a bond issue has been sold, the firm might end up paying a higher rate of interest than the prevailing rate for a long period of time. Under these circumstances, the firm may consider selling a new issue of bonds with a lower interest rate and using the proceeds to retire the previous issue by calling the old bonds.

EXAMPLE

Four years ago, Mirossa Company issued 1 0-year bonds that offered a yield of 11 percent. Since then, interest rates have declined, and Mirossa's credit rating has improved. It could issue 10-year bonds today for a yield of 7 percent. The company is sure that it will need funding for the next 10 years. Therefore, it issues new 10-year bonds at a yield of 7 percent and uses some of the proceeds to call (buy back) the bonds issued four years ago. It reduces its cost of financing as a result of calling these bonds. Ten years from today, Mirossa Company will repay the principal on the newly issued bonds.

   Second, a call provision may be used to retire bonds as required by a sinking-fund provision. Many bonds have two different call prices: a lower price for calling the bonds to meet sinking-fund requirements and a higher price if the bonds are called for any other reason.

   Bondholders normally view a call provision as a disadvantage because it can disrupt their investment plans and reduce their investment returns. As a result, firms must pay slightly higher rates of interest on bonds that are callable, other things being equal.

Bond Collateral  Bonds can be classified according to whether they are secured by collateral and by the nature of that collateral. Usually, the collateral is a mortgage on real property (land and buildings). A first mortgage bond has first claim on the specified assets. A chattel mortgage bond is secured by personal property.

   Bonds unsecured by specific property are called debentures (backed only by the general credit of the issuing firm). These bonds are normally issued by large, financially sound firms whose ability to service the debt is not in question. Subordinated debentures have claims against the firm's assets that are junior to the claims of both mortgage bonds and regular debentures. Owners of subordinated debentures receive nothing until the claims of mortgage bondholders, regular debenture owners, and secured short-term creditors have been satisfied. The main purchasers of subordinated debt are pension funds and insurance companies.

Low- and Zero-Coupon Bonds  Low-coupon bonds and zero-coupon bonds are long-term debt securities that are issued at a deep discount from par value. Investors are taxed annually on the amount of interest earned, even though much or all of the interest will not be received until maturity. The amount of interest taxed is the amortized discount. (The gain at maturity is prorated over the life of the bond.) Low- and zero-coupon corporate bonds are purchased mainly for tax-exempt investment accounts (such as pension funds and individual retirement accounts).

   To the issuing firm, these bonds have the advantage of requiring low or no cash outflow during their life. Additionally, the firm is permitted to deduct the amortized discount as interest expense for federal income tax purposes, even though it does not pay interest.

Variable-Rate Bonds  Variable-rate bonds (also called floating-rate bonds) are long-term debt securities with a coupon rate that is periodically adjusted. Most of these bonds tie their coupon rate to the London Interbank Offer Rate (LIBOR), the rate at which banks lend funds to each other on an international basis. The rate is typically adjusted every three months.

WEB

finance.yahoo.com/bonds/composite_bond_rates

Yields on all types of bonds for various maturities.

   Variable-rate bonds became very popular in 2004, when interest rates were at low levels. Because most investors presumed that interest rates were likely to rise, they were more willing to purchase variable-rate than fixed-rate bonds. In fact, the volume of variable-rate bonds exceeded that of fixed-rate bonds during this time.

Convertibility  A convertible bond allows investors to exchange the bond for a stated number of shares of the firm's common stock. This conversion feature offers investors the potential for high returns if the price of the firm's common stock rises. Investors are therefore willing to accept a lower rate of interest on these bonds, which allows the firm to obtain financing at a lower cost.

7-4d How Corporate Bonds Finance Restructuring

Firms can issue corporate bonds to finance the restructuring of their assets and to revise their capital structure. Such restructuring can have a major impact on the firm's degree of financial leverage, the potential return to shareholders, the risk to shareholders, and the risk to bondholders.

Using Bonds to Finance a Leveraged Buyout  A leveraged buyout (LBO) involves the use of debt to purchase shares and take a company private. The proceeds from debt are used to buy the outstanding shares of stock, so that the firm is owned by a small number of owners. In order to be able to cover the large debt payments, the owners might sell some of the assets of the firm for cash.

   Many firms that engaged in an LBO go public once they have improved their operating performance. They typically use some of the proceeds from the stock issuance to retire a portion of their outstanding debt, thus reducing periodic interest payments on the debt. This process is more feasible for firms that can issue shares of stock for high prices because the proceeds will retire a larger amount of outstanding debt. Firms commonly go public during a period when stock prices are generally high because, under these conditions, they will be able to sell their stock at a higher price.

Using Bonds to Revise the Capital Structure  Corporations commonly issue bonds in order to revise their capital structure. If they believe that they will have sufficient cash flows to cover their debt payments, they may consider using more debt and less equity, which implies a higher degree of financial leverage. Debt is normally perceived to be a cheaper source of capital than equity as long as the corporation can meet its debt payments. Furthermore, a high degree of financial leverage allows the firm's earnings to be distributed to a smaller group of shareholders. In some cases, corporations issue bonds and then use the proceeds to repurchase some of their existing stock. This strategy is referred to as a debt-for-equity swap.

   When corporations use an excessive amount of debt, they may be unable to make their debt payments. Hence they may seek to revise their capital structure by reducing their level of debt. In an equity-for-debt swap, corporations issue stock and use the proceeds to retire existing debt.

7-5 GLOBALIZATION OF BOND MARKETS

In recent years, financial institutions such as pension funds, insurance companies, and commercial banks have often purchased foreign bonds. For example, the pension funds of General Electric, United Technologies Corporation, and IBM frequently invest in foreign bonds with the intention of achieving higher returns for their employees. Many public pension funds also invest in foreign bonds for the same reason. Because of the frequent cross-border investments in bonds, bond markets have become increasingly integrated among countries. In addition, mutual funds containing U.S. securities are accessible to foreign investors.

7-5a Global Government Debt Markets

One of the most important global markets is the market for government debt. In general, bonds issued by foreign governments (referred to as sovereign bonds) are attractive to investors because of the government's ability to meet debt obligations. Even so, some country governments have defaulted on their bonds. These countries include Argentina (1982, 1989, 1990, 2001), Brazil (1986, 1989, 1991), Costa Rica (1989), Russia and other former Soviet republics (1993, 1998), and the former Yugoslavia (1992). Given that sovereign bonds are exposed to credit risk, credit ratings are assigned to them by Moody's and Standard & Poor's.

Greek Debt Crisis  In the spring of 2010, Greece experienced a credit crisis brought on by weak economic conditions and a large government budget deficit. As Greece's deficit grew and its economy weakened, investors were concerned that the Greek government would not be able to repay its debt. Moreover, credit rating agencies reduced the ratings on the Greek debt several times. The concern about Greece also spread to Spain and Portugal.  Exhibit 7.5  shows the risk premiums for various governments in the eurozone relative to the German bond yield. The risk premium offered by Greece was similar to that offered by the other countries shown in  Exhibit 7.5  during 2009. In 2010, however, the risk premium on Greek government debt reached 7 percentage points while risk premiums for the other countries ranged between only 1 and 3 percent above the yield offered on German government debt.

Exhibit 7.5 Risk Premiums on Debt Issued by Governments of Eurozone Countries

   In May 2010, the eurozone countries and the International Monetary Fund (IMF) agreed to provide loans to the Greek government totaling $110 billion euros over a three-year period. The agreement called for the eurozone countries to extend loans of $80 billion and for the IMF to extend loans of $30 billion. As a condition of receiving the loans, the government of Greece was required to reduce its budget deficit over time. The government plans to reduce its spending and to increase taxes in order to reduce its budget deficit.

WEB

www.bloomberg.com

Yield curves of major countries' government securities.

   The weak economy in Greece caused a decline in the Greek demand for products in other European countries, which weakened some European economies. It also caused financial losses for banks in Greece and other European countries. In 2011 and 2012, the governments of Portugal and Spain also experienced debt repayment problems. Consequently, these governments had only limited access to debt in bond markets.

7-5b Eurobond Market

Non-U.S. investors who desire dollar-denominated bonds may use the Eurobond market if they prefer bearer bonds to the registered corporate bonds issued in the United States. They may also use the Eurobond market simply because they are more familiar with bond placements within their own country.

   An underwriting syndicate of securities firms participates in the Eurobond market by placing the bonds issued. It normally underwrites the bonds, guaranteeing a particular value to be received by the issuer. Thus, the syndicate is exposed to underwriting risk: the risk that it will be unable to sell the bonds above the price that it guaranteed the issuer.

   The issuer of Eurobonds can choose the currency in which the bonds are denominated. The financing cost of issuing bonds depends on the currency chosen. In some cases, a firm may denominate the bonds in a currency with a low interest rate and use earnings generated by one of its subsidiaries to cover the payments. For example, if the coupon rate on a Eurobond denominated in Swiss francs is 5 percentage points lower than the rate on a dollar-denominated bond, a U.S. firm may consider issuing Swiss franc-denominated bonds and converting the francs to dollars for use in the United States. Then it could instruct a subsidiary in Switzerland to cover the periodic coupon payments with earnings that the subsidiary generates. In this way, a lower financing rate would be achieved without exposure to exchange rate risk.

7-6 OTHER TYPES OF LONG-TERM DEBT SECURITIES

In recent years, other types of long-term debt securities have been created. Some of the more popular types are discussed here.

7-6a Structured Notes

Firms may borrow funds by issuing structured notes. For these notes, the amount of interest and principal to be paid is based on specified market conditions. The amount of the repayment may be tied to a Treasury bond price index or even to a stock index or a particular currency. Sometimes issuers use structured notes to reduce their risk. For example, a structured product may specify that the principal payment will decline if bond prices decline. A bond portfolio manager that needs to borrow funds could partially insulate the portfolio risk by using structured notes, because the required repayments on the notes would decline if the bond market (and therefore the manager's bond portfolio) performed poorly.

   Structured notes became popular in the 1990s, when many participants took positions in the notes in their quest for a high return. One of the reasons for the popularity of structured notes is that some investors may be able to use them to bet indirectly on (or against) a specific market that some restrictions prevent them from betting on directly.

EXAMPLE

The pension fund manager at Cicero Company wants to invest in Brazilian bonds, but the fund has specific restrictions against investing in emerging markets. The restrictions are intended to prevent the manager from taking excessive risk, because she is investing the money that will provide pensions for Cicero's employees when they retire. However, the manager's annual bonus is directly tied to how well the portfolio performs, so she wants to pursue strategies that might generate large returns. She can invest in a structured note issued by a highly rated securities firm that provides large payments when Brazilian bonds perform well. The pension fund's investment holdings will show that it owns a structured product issued by a highly rated securities firm. In this way, the manager circumvents the restrictions and her portfolio has a chance to generate a higher return, but it is also exposed to substantial risk.

Risk of Structured Notes  In the early 1990s, the portfolio manager responsible for managing more than $7 billion on behalf of Orange County, California, invested in structured notes that would earn high returns if interest rates declined. The portfolio manager guessed wrong and interest rates increased, which caused the values of the notes to decline substantially. The portfolio manager attempted to make up for the losses by borrowing funds and investing more money in structured notes, but these investments also performed poorly. In 1994, Orange County filed for bankruptcy.

   Many other state and local governments also suffered losses because their portfolio managers had invested in structured notes. The portfolio managers took excessive risks with the state and local government money. These managers benefited directly by receiving substantial bonuses or raises when their investments generated high returns. Their investments were questioned only after they suffered losses.

   Given the difficulty in assessing the risk of structured notes, some investors rely on credit ratings for such risk assessment. However, credit ratings of structured notes have not always served as accurate indicators of risk. The structured notes purchased by Orange County were, in fact, rated AAA. Apparently, neither the portfolio manager nor the rating agencies understood the risk of those structured notes. The credit ratings of structured notes have been revised frequently over time, and most of the revisions have been downward.

7-6b Exchange-Traded Notes

Exchange-traded notes (ETNs) are debt instruments in which the issuer promises to pay a return based on the performance of a specific debt index after deducting specified fees. The debt typically has a maturity of 10 to 30 years and is not secured by assets, which means that investors are subject to default risk. Common issuers of ETNs are securities firms such as Goldman Sachs and Morgan Stanley. Exchange-traded notes can contain commodities and foreign currencies. They are not legally defined as mutual funds and so are not subject to mutual fund regulations. Therefore, ETNs have more flexibility to use leverage, which means that the funding for the portfolio of debt instruments is enhanced by borrowed funds. The leverage creates higher potential return for investors in ETNs, but it also results in higher risk. Leverage magnifies any gain that investors receive but it magnifies any loss.

7-6c Auction-Rate Securities

Auction-rate securities have been used since the 1980s as a way for specific borrowers (e.g., municipalities and student loan organizations) to borrow for long-term periods while relying on a series of short-term investments by investors. Every 7 to 35 days, the securities can be auctioned off to other investors, and the issuer pays interest based on the new reset rate to the winning bidders. The market for auction-rate securities reached $330 billion in 2008. Corporations and individuals with available cash are typical investors in auction-rate securities. Investors can invest for a long-term period or can liquidate their securities to fit their preferred investment horizon. When investors want to sell, the financial institutions that served as intermediaries either repurchase the securities or find other willing buyers.

   The auction-rate market suffered in 2008 because some financial institutions were unable to find other buyers and no longer wanted to repurchase the securities. Consequently, when investors wanted to sell their securities at an auction, the financial institutions told them that their investments were frozen and could not be sold for lack of sufficient demand. The values of some of these securities declined substantially, and investors claimed that they had not been informed of the limited liquidity and the risks involved. In response to pressure from the SEC and state regulators, some financial institutions agreed to buy back the securities at face value from individuals who had previously purchased them. These problems occurred after the credit crisis began, when many financial institutions already were holding other types of securities (such as securities backed by subprime mortgages) whose values and liquidity had declined substantially.

SUMMARY

· ▪ Bonds are issued to finance government expenditures, housing, and corporate expenditures. Many financial institutions, such as commercial banks, issue bonds to finance their operations. In addition, most types of financial institutions are major investors in bonds. bonds, municipal bonds, and corporate bonds. The issuers are perceived to have different levels of credit risk. In addition, the bonds have different degrees of liquidity and different provisions. Thus, quoted yields at a given point in time vary across bonds.

· ▪ Bonds can be classified in four categories according to the type of issuer: Treasury bonds, federal agency

· ▪ Bond yields vary among countries. Investors are attracted to high bond yields in foreign countries, causing funds to flow to those countries. Consequently, bond markets have become globally integrated.

· ▪ Structured notes are long-term debt instruments that allow investors to bet indirectly on or against a specific market that they cannot bet on directly because of restrictions. Exchange-traded notes (ETNs) are debt instruments in which the issuer promises to pay a return based on the performance of a specific debt index after deducting specified fees. They are not legally defined as mutual funds and therefore are not subject to mutual fund regulations. They also have more flexibility to use leverage, which can achieve higher returns for investors but also results in higher risk.

POINT COUNTER-POINT

Should Financial Institutions Invest in Junk Bonds?

Point  Yes. Financial institutions have managers who are capable of weighing the risk against the potential return. They can earn a significantly higher return when investing in junk bonds than the return on Treasury bonds. Their shareholders benefit when they increase the return on the portfolio.

Counter-Point  No. The financial system is based on trust in financial institutions and confidence that the financial institutions will survive. If financial institutions take excessive risk, the entire financial system is at risk.

Who Is Correct?  Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Bond Indenture What is a bond indenture? What is the function of a trustee with respect to the bond indenture?

· 2. Sinking-Fund Provision Explain the use of a sinking-fund provision. How can it reduce the investor's risk?

· 3. Protective Covenants What are protective covenants? Why are they needed?

· 4. Call Provisions Explain the use of call provisions on bonds. How can a call provision affect the price of a bond?

· 5. Bond Collateral Explain the use of bond collateral, and identify the common types of collateral for bonds.

· 6. Debentures What are debentures? How do they differ from subordinated debentures?

· 7. Zero-Coupon Bonds What are the advantages and disadvantages to a firm that issues low- or zero-coupon bonds?

· 8. Variable-Rate Bonds Are variable-rate bonds attractive to investors who expect interest rates to decrease? Explain. Would a firm that needs to borrow that the financial institutions will survive. If financial institutions take excessive risk, the entire financial system is at risk. Who Is Correct? Use the Internet to learn more about this issue and then formulate your own opinion. funds consider issuing variable-rate bonds if it expects that interest rates will decrease? Explain.

· 9. Convertible Bonds Why can convertible bonds be issued by firms at a higher price than other bonds?

· 10. Global Interaction of Bond Yields If bond yields in Japan rise, how might U.S. bond yields be affected? Why?

· 11. Impact of Credit Crisis on Junk Bonds Explain how the credit crisis affected the default rates of junk bonds and the risk premiums offered on newly issued junk bonds.

· 12. New Guidelines for Credit Rating Agencies Explain the new guidelines for credit rating agencies resulting from the Financial Reform Act of 2010.

· 13. Impact of Greek Debt Crisis Explain the conditions that led to the debt crisis in Greece.

· 14. Bond Downgrade Explain how the downgrading of bonds for a particular corporation affects the prices of those bonds, the return to investors that currently hold these bonds, and the potential return to other investors who may invest in the bonds in the near future.

Advanced Questions

· 15. Junk Bonds Merrito, Inc., is a large U.S. firm that issued bonds several years ago. Its bond ratings declined over time and, about a year ago, the bonds were rated in the junk bond classification. Nevertheless, investors were buying the bonds in the secondary market because of the attractive yield they offered. Last week, Merrito defaulted on its bonds, and the prices of most other junk bonds declined abruptly on the same day. Explain why news of Merrito's financial problems could cause the prices of junk bonds issued by other firms to decrease, even when those firms had no business relationships with Merrito. Explain why the prices of those junk bonds with less liquidity declined more than those with a high degree of liquidity.

· 16. Event Risk An insurance company purchased bonds issued by Hartnett Company two years ago. Today, Hartnett Company has begun to issue junk bonds and is using the funds to repurchase most of its existing stock. Why might the market value of those bonds held by the insurance company be affected by this action?

· 17. Exchange-Traded Notes Explain what exchange-traded notes are and how they are used. Why are they risky?

· 18. Auction-Rate Securities Explain why the market for auction-rate securities suffered in 2008.

· 19. Role of Bond Market Explain how the bond market facilitates a government's fiscal policy. How do you think the bond market could discipline a government and discourage the government from borrowing (and spending) excessively?

Interpreting Financial News

Interpret the following statements made by Wall Street analysts and portfolio managers.

· a. “The values of some stocks are dependent on the bond market. When investors are not interested in junk bonds, the values of stocks ripe for leveraged buyouts decline.”

· b. “The recent trend in which many firms are using debt to repurchase some of their stock is a good strategy as long as they can withstand the stagnant economy.”

· c. “Although yields among bonds are related, today's rumors of a tax cut caused an increase in the yield on municipal bonds, while the yield on corporate bonds declined.”

Managing in Financial Markets

Forecasting Bond Returns As a portfolio manager for an insurance company, you are about to invest funds in one of three possible investments: (1) 10-year coupon bonds issued by the U.S. Treasury, (2) 20-year zero-coupon bonds issued by the Treasury, or (3) one-year Treasury securities. Each possible investment is perceived to have no risk of default. You plan to maintain this investment for a one-year period. The return of each investment over a one-year horizon will be about the same if interest rates do not change over the next year. However, you anticipate that the U.S. inflation rate will decline substantially over the next year, while most of the other portfolio managers in the United States expect inflation to increase slightly.

· a. If your expectations are correct, how will the return of each investment be affected over the one-year horizon?

· b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon? Why?

· c. Offer one reason why you might not select the investment that would have the highest expected return over the one-year investment horizon.

PROBLEMS

· 1. 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?

· 2. 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?

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 issuing 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 by obtaining short-term financing to cover the extra production expense and then using 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. Which alternative should Carson select?

· 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?

· 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?

· 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.

· 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.

INTERNET/EXCEL EXERCISE

Go to  finance.yahoo.com/bonds and click on“Composite Bond Rates.” Compare the rate of a 10-year Treasury bond to a 10-year municipal bond. Which type of bond would offer you a higher annual yield based on your tax bracket, given that the municipal bond is not subject to federal income taxes? Determine the premium contained in the yield of a 10-year corporate A-rated bond as compared with the 10-year Treasury bonds. Compare that premium to the premium that existed one month ago. Did the premium increase or decrease? Offer an explanation for the change. Is the change attributed to economic conditions?

WSJ EXERCISE

Impact of Treasury Financing on Bond Prices

The Treasury periodically issues new bonds to finance the deficit. Review recent issues of the Wall Street Journal or check related online news to find a recent article on such financing. Does the article suggest that financial markets are expecting upward pressure on interest rates as a result of the Treasury financing? What happened to prices of existing bonds when the Treasury announced its intentions to issue new bonds?

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. Treasury bond AND yield

· 2. Treasury bond AND return

· 3. bond AND federal agency

· 4. stripped Treasury bond

· 5. inflation-indexed Treasury bond

· 6. municipal bond AND risk

· 7. [name of a specific financial institution] AND bond

· 8. bond AND private placement

· 9. junk bond AND financing

· 10. structured notes