Chapter 7
Bond Markets
Outline
Background on Bonds
Institutional Participation in Bond Markets
Bond Yields
Treasury and Federal Agency Bonds
Treasury Bond Auction
Trading Treasury Bonds
Stripped Treasury Bonds
Inflation-Indexed Treasury Bonds
Savings Bonds
Federal Agency Bonds
Municipal Bonds
Credit Risk of Municipal Bonds
Variable-Rate Municipal Bonds
Tax Advantages of Municipal Bonds
Trading and Quotations of Municipal Bonds
Yields Offered on Municipal Bonds
Corporate Bonds
Corporate Bond Offerings
Secondary Market for Corporate Bonds
Characteristics of Corporate Bonds
How Corporate Bonds Facilitate Restructuring
Collateralized Debt Obligations (CDOs)
Globalization of Bond and Loan Markets
Global Government Debt Markets
Eurobond Market
Other Types of Long-term Debt Securities
Structured Notes
Exchange-Traded Notes
Auction-Rate Securities
Chapter 7: Bond Markets ❖ 2
Key Concepts
1. Explain how financial institutions participate in bond markets.
2. Identify the more popular types of bonds, and elaborate where necessary.
3. Provide some opinions on potential problems with using excessive financial leverage, which lead to
leveraged buyouts. Explain the role of the bond markets in facilitating corporate capital restructuring.
POINT/COUNTER-POINT:
Should Financial Institutions Invest in Junk Bonds?
WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion.
ANSWER: The answer may depend on the type of financial institution of concern. Lending institutions
Questions
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 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 Greece 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.
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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. Yet,
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 Meritto’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?
Chapter 7: Bond Markets ❖ 6
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ANSWER: The bond market enables the Treasury to finance government expenditures by issuing
Treasury notes and bonds in exchange for funding that can be spent. The Treasury notes and bonds
market consists of investors that are willing to receive a low yield on their investment in order to
avoid credit risk. However, there may be a debt limit at which those investors begin to fear that the
U.S. government might not be capable of making its debt payments, under which those investors are
no longer willing to accept the risk-free rate on Treasury notes and bonds.
CRITICAL THINKING QUESTION
Integration of Bond Markets Wrtie a short essay on the integration of bond markets. Explain why
adverse conditions within one bond market (such as a particular country) commonly spread to other bond
markets.
ANSWER
When creditors provide funding in the bond market, it is for a long period of time. There is much
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.”
Chapter 7: Bond Markets ❖ 7
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If investors expect a tax cut, they recognize that the benefits from tax-free municipal bonds will be
reduced. Therefore, they sell municipal bonds immediately in response to this expectation, and
purchase corporate bonds. The sale of municipal bonds causes lower prices and higher yields of
municipal bonds, while the purchase of corporate bonds results in higher prices and lower yields
of corporate bonds.
Managing in Financial Markets
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 would 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 a 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?
ANSWER:
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?
ANSWER:
Flow of Funds Exercise
Financing in the Bond Markets
If the economy continues to be strong, Carson Company may need to increase its production capacity by
about 50 percent over the next few years to satisfy demand. It would need financing to expand and
accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also
recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions
to reduce inflation. It needs funding to cover payments for supplies. It is also considering the issuance of
stock or bonds to raise funds in the next year.
a. Assume that Carson has two choices to satisfy the increased demand for its products. It could
increase production by 10 percent with its existing facilities. In this case, it could obtain short–
term financing to cover the extra production expense and then use a portion of the revenue
received to finance this level of production in the future. Alternatively, it could issue bonds and
use the proceeds to buy a larger facility that would allow for 50 percent more capacity.
Carson should not buy a larger facility unless it feels confident that it can fully utilize the space.
It should consider using up the excess capacity in its existing facility in the short term, and
Chapter 7: Bond Markets ❖ 9
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monitoring economic growth. In this way, it only needs to obtain short-term financing, and can
avoid the long-term debt for now. If demand does not increase as anticipated, then it can simply
retire the short-term debt when it matures. Conversely, if Carson is confident that demand will
increase and continue to be strong in the long run, it can issue long-term bonds to finance its
expansion.
b. Carson currently has a large amount of debt, and its assets have already been pledged to back up
its existing debt. It does not have additional collateral. At this time, the credit risk premium it
would pay is similar in the short-term and long-term debt markets. Does this imply that the cost
of financing is the same in both markets?
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.
Insurance companies receive funds from policyholders who pay insurance premiums. They invest