Module 2.2

Question 1

Background on Bonds (1 of 3)

Answer 1

Long-term debt securities issued by government agencies or corporations.
The issuer is obligated to pay interest (or coupon) payments periodically (such as annually or semiannually) and the par value (principal) at maturity.
Bonds are often classified according to the type of issuer: treasury bonds, federal agency bonds, municipal bonds, and corporate bonds.
Most bonds have maturities of between 10 and 30 years.
Can be issued as bearer bonds or registered bonds.
Bonds are issued in the primary market through a telecommunications network. (Exhibit 7.1)

Question 2

Institutional Participation in Bond Markets

Answer 2

Commercial banks, savings institutions, and finance companies commonly issue bonds in order raise capital to support their operations.
Investors — commercial banks, savings institutions, bond mutual funds, insurance companies, and pension funds

Question 3

Bond Yields

Answer 3

Yield from the Issuer’s Perspective
Commonly measured by the yield to maturity.
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.
Yield from the Investor’s Perspective
Holding period return is used by bond investors who do not hold the bond until maturity.
Yield consists of two components:
a set of coupon payments and
the difference between the par value that the issuer must pay to investors at maturity and the price it received when selling the bonds.

Question 4

Treasury and Federal Agency Bonds

Answer 4

The U.S. Treasury commonly issues Treasury notes and Treasury bonds to finance federal government expenditures.
The minimum denomination for Treasury notes and bonds is now $100.
Note maturities are less than 10 years whereas bond maturities are 10 years or more.
Receive semiannual interest payments from the Treasury.
Interest is taxed by the federal government as ordinary income, but it is exempt from any state and local taxes.

Question 5

Treasury bond auctions

Answer 5

Normally held in the middle of each quarter.
Financial institutions submit bids for their own accounts or for their clients.
Bids are submitted on a competitive or a noncompetitive basis.
Competitive bids specify a price and a dollar amount of securities to be purchased.
Noncompetitive bids specify only a dollar amount of securities to be purchased.

Question 6

Trading Treasury bonds

Answer 6

Bond dealers serve as intermediaries in the secondary market by matching up buyers and sellers of Treasury bonds.
Dealers profit from the spread between the bid and ask prices.
Treasury bonds are registered at the New York Stock Exchange, but the secondary market trading occurs over the counter.
Online Trading — Investors can also buy bonds through the Treasury Direct program (www.treasurydirect.gov).
Online Quotations — Treasury bond prices are accessible online at www.investinginbonds.com.

Question 7

Stripped Treasury bonds

Answer 7

The cash flows of bonds are commonly transformed (stripped) by securities firms to create principal only and interest only bonds.
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.

Question 8

Inflation-indexed Treasury bonds

Answer 8

Provide returns tied to the inflation rate.
Commonly referred to as TIPS (Treasury Inflation-Protected Securities).
The principal value is increased by the amount of the U.S. inflation rate.
Savings bonds
Issued by the Treasury, but they can be purchased from many financial institutions.
Can be purchased with as little as $25.
Interest income on savings bonds is not subject to state and local taxes but is subject to federal taxes.

Question 9

Federal Agency bonds

Answer 9

Issued by federal agencies such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) who use the proceeds to purchase mortgages in the secondary market.
During the credit crisis in 2008, Fannie Mae and Freddie Mac experienced financial problems because they had purchased risky subprime mortgages that had a high frequency of defaults.
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.

Question 10

Municipal bonds

Answer 10

Issued by state and local governments.
General obligation bonds are supported by the municipal government’s ability to tax.
Revenue bonds are supported by revenues of the project (tollway, toll bridge, state college dormitory, etc.) for which the bonds were issued.
Typically promise semiannual interest payments.
Minimum denomination of municipal bonds is usually $5,000.
Most municipal bonds contain a call provision

Question 11

Credit Risk of Municipal Bonds

Answer 11

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.
Insurance against Credit Risk of Municipal Bonds
Some municipal bonds are insured to protect against default

Question 12

Variable-Rate Municipal Bonds

Answer 12

— Have a floating interest rate that is based on a benchmark interest rate.
Tax Advantages of Municipal Bonds
Interest income is normally exempt from federal taxes.
Interest income within a particular state is normally exempt from the income taxes (if any) of that state.
Trading and Quotations of Municipal Bonds
Today there are more than 1 million different municipal bonds outstanding and more than 50,000 different issuers.
Many municipal bonds have inactive secondary markets.
Electronic trading of municipal bonds has become very popular.

Question 13

Yields Offered on Municipal Bonds

Answer 13

The municipal bond must pay a risk premium to compensate for the possibility of default risk.
The municipal bond must pay a slight premium to compensate for being less liquid than Treasury bonds with the same maturity.
The income earned from a municipal bond is exempt from federal taxes allowing municipal bonds to offer a lower yield than Treasury bonds.

Question 14

Corporate Bonds

Answer 14

Long-term debt securities, issued by corporations, that promise the owner coupon payments (interest) on a semiannual basis.
Minimum denomination is $1,000.
Maturity is typically between 10 and 30 years.
Interest paid by the corporation to investors is tax deductible to the corporation.
Interest income earned on corporate bonds represents ordinary income to the bondholders and is therefore subject to federal taxes and to state taxes.

Question 15

Corporate Bond Offerings

Answer 15

Public offering: Underwriters try to place newly issued bonds with institutional investors.
Timing: Some corporations attempt to time their bond offerings when market interest rates are low, so that their cost of financing with bonds will be low.
Private placement:
Small firms that borrow small amounts of funds (such as $30 million) may consider private placements rather than public offerings.
The institutional investors that purchase a private placement include insurance companies, pension funds, and bond mutual funds.
Credit risk of corporate bonds:
Subject to the risk of default
Yield paid contains a risk premium

Question 16

Corporate Bond Offerings (cont.)

Answer 16

Bond ratings as a measure of credit risk:
Corporations hire rating agencies to have their bonds rated.
Higher rated bonds can have a higher price (lower yield) because they are perceived to have a lower credit risk.
Financial Reform Act of 2010 — Credit rating agencies are subject to oversight by a newly established Office of Credit Ratings, housed within the Securities and Exchange Commission.
Junk Bonds:
Corporate bonds perceived as very high risk
Primary investors — mutual funds, life insurance companies, and pension funds
Offer a high yield compared to Treasury yields (Exhibit 7.4)

Question 17

Secondary Market for Corporate Bonds

Answer 17

Dealer role in secondary market: broker bonds between buyers and sellers.
Liquidity in Secondary Market:
Bonds issued by large, well known firms are liquid.
Bonds issued by smaller, lesser known firms are less liquid.
Electronic bond networks: 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.
Types of orders through brokers:
Market order — the transaction will occur at the prevailing market price.
Limit order — the transaction will occur only if the price reaches the specified limit.

Question 18

Secondary Market for Corporate Bonds (Con’d)

Answer 18

Trading Online:
More orders to buy and sell corporate bonds are being placed online.
Some online bond brokerage services now charge a commission instead of posting a bid and ask spread.

Question 19

Characteristics of Corporate Bonds

Answer 19

Sinking fund provision — a requirement that the firm retire a certain amount of the bond issue each year
Protective covenants — restrictions placed on the issuing firm that are designed to protect bondholders from being exposed to increasing risk during the investment period
Call provisions
Normally requires a price above par value when bonds are called. The difference between the bond’s call price and par value is the call premium.
If market interest rates decline, the firm may sell a new issue of bonds with a lower interest rate and use the proceeds to retire the previous issue by calling the old bonds.

Question 20

Characteristics of Corporate Bonds (Cont.)

Answer 20

Bond collateral: Bonds can be classified according to whether they are secured by collateral and by the nature of that collateral.
Low and zero-coupon bonds:
Issued at a deep discount from par value.
Are purchased mainly for tax-exempt investment accounts.
Variable rate bonds: Long-term debt securities with a coupon rate that is periodically adjusted.
Convertibility: Allows investors to exchange the bond for a stated number of shares of the firm’s common stock.

Question 21

How Corporate Bonds Finance Restructuring

Answer 21

Using Bonds to Finance a Leveraged Buyout: 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.
Using Bonds to Revise the Capital Structure
Debt is normally perceived to be a cheaper source of capital than equity as long as the corporation can meet its debt payments.
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.

Question 22

Collateralized Debt Obligations

Answer 22

Corporate bonds are sometimes packaged by commercial banks into collateralized debt obligations (CDOs).
Investors receive the interest or principal payments generated by the debt securities.
Some CDOs also contain other types of debt such as credit card loans, car loans, and commercial or residential mortgages.

Question 23

Collateralized Debt Obligations (Cont)

Answer 23

The CDO is segmented into slices (“tranches”), and cash flows are prioritized by seniority.
Each tranche is rated by a credit rating agency
Senior tranches may receive a very high credit rating, whereas tranches with lower priority receive lower credit ratings.
The investment in a tranche is priced to generate an expected return to investors that compensates them for their risk.

Question 24

Global Government Debt Markets

Answer 24

Bonds issued by foreign governments are attractive to investors because of the government’s ability to meet debt obligations.
Greek Debt crisis:
2010 — Greece experienced debt crisis brought on by weak economic conditions and a large government budget deficit.
Credit ratings on Greece were reduced several times.
Concern also spread to Spain and Portugal (Exhibit 7.5)

Question 25

Eurobond Market

Answer 25

An underwriting syndicate of securities firms participates in the Eurobond market by placing the bonds issued.
The issuer of Eurobonds can choose the currency in which the bonds are denominated

Question 26

Structured Notes

Answer 26

The amount of interest and principal to be paid is based on specified market conditions.
Risk of Structured Notes
In the early 1990s, Orange County, California, suffered losses and filed for bankruptcy due to investments in structured notes.
Because of the difficulty in assessing the risk of structured notes, some investors rely on credit ratings. However, credit rates of structured notes have not always served as accurate indicators of risk.

Question 27

Other Types of Long-Term Debt

Answer 27

Exchange-traded notes
Debt instruments in which the issuer promises to pay a return based on the performance of a specific debt index.
Typically mature in 10 to 30 years and are not secured by assets.
Auction-rate securities
A way for 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.