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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 Treasury Bond Quotations 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 Credit Risk of Corporate Bonds Secondary Market for Corporate Bonds Characteristics of Corporate Bonds How Corporate Bonds Facilitate Restructuring Globalization of Bond Markets Global Government Debt Markets Eurobond Market Other Types of Long-term Debt Securities Structured Notes Exchange-Traded Notes Auction-Rate Securities 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? 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. ANSWER: The answer may depend on the type of financial institution of concern. Lending institutions are expected to provide credit to creditworthy customers, and junk bonds may be viewed as a form of gambling. These institutions do not invest in junk bonds. Insurance companies may invest in junk bonds, but there is some concern that the confidence in insurance companies could be shaken if there are failures because of defaults on junk bonds held by insurance companies. Perhaps the ideal type of institutional investor in junk bonds is a mutual fund that specializes in investing in junk bonds, since the fund’s objective would be clearly communicated to investors, and only those investors who wanted to accept the high risk would invest in these types of mutual funds. Questions 1. Bond Indenture. What is a bond indenture? What is the function of a trustee, with respect to the bond indenture? ANSWER: The bond indenture is a legal document specifying the rights and obligations of both the issuing firm and the bondholders. It is designed to address all matters related to the bond issue, such as collateral, and call provisions. A trustee represents the bondholders in all matters concerning the bond issue, including the monitoring of the issuing firm’s activities to assure compliance with the terms of the indenture. 2. Sinking-Fund Provision. Explain the use of a sinking-fund provision. How can it reduce the investor’s risk? ANSWER: A sinking-fund provision is a requirement that the firm retire a certain amount of the bond issue each year. This reduces the payments necessary at maturity and therefore can reduce the risk of investors. 3. Protective Covenants. What are protective covenants? Why are they needed? ANSWER: Protective covenants are restrictions placed on the firm issuing bonds, in order to protect the bondholders. For example, they may limit the dividends or corporate officer salaries, or limit the amount of debt the firm can issue. Protective covenants are needed to reduce the risk of bonds. 4. Call Provisions. Explain the use of call provisions on bonds. How can a call provision affect the price of a bond? ANSWER: A call provision allows the issuing firm to purchase its bonds back prior to maturity at a specific price (the call price). Investors require a higher yield to compensate for this provision, other things being equal. 5. Bond Collateral. Explain the use of bond collateral, and identify the common types of collateral for bonds. ANSWER: Bond collateral may be established by the bond issuer as a means of backing the bond. If the issuer defaults on the bonds, the investors would have a claim on the collateral. Some of the more common types of collateral for bonds are mortgages or real property (land and buildings). 6. Debentures. What are debentures? How do they differ from subordinated debentures? ANSWER: Debentures are backed only by the general credit of the issuing firm. Subordinated debentures are junior to the claims of regular debentures, and therefore may have a higher probability of default than regular debentures. 7. Zero-Coupon Bonds. What are the advantages and disadvantages to a firm that issues low- or zero-coupon bonds? ANSWER: From the perspective of the issuing firm, low or zero coupon bonds have the advantage of requiring low or no cash outflow during the life of the bond. The issuing firm is allowed to deduct the amortized discount as interest expense for federal income tax purposes, which adds to the firm’s cash flow. However, the lump-sum payment made to bondholders at maturity can be very large, and could cause repayment problems for the firm. 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. ANSWER: If investors expect interest rates to decrease, they would avoid variable-rate bonds because the return to the investors would be tied to market interest rates. The investors would prefer fixed-rate bonds if interest rates are expected to decrease. If a firm expects that interest rates will decrease, it may consider issuing variable-rate bonds, because the interest paid on the bonds would decline over time with the decline in market interest rates. 9. Convertible Bonds. Why can convertible bonds be issued by firms at a higher price than other bonds? ANSWER: Convertible bonds allow investors to exchange the bonds 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. Because of this feature, the bonds can be issued at a higher price. 10. Global Interaction of Bond Yields. If bond yields in Japan rise, how might U.S. bond yields be affected? Why? ANSWER: If bond yields rise in Japan, there may be an increased flow of funds to purchase these bonds. This reduces the amount of funds available to purchase U.S. bonds. Consequently, U.S. bonds will sell at lower prices than before, implying higher yields than before. 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. ANSWER: Many junk bonds defaulted during the credit crisis, as economic conditions weakened and some issuers of junk bonds failed. The risk premium offered on newly issued junk bonds increased during the credit crisis as investors would only consider purchasing junk bonds if the premium was high enough to compensate for the high degree of risk at that time. 12. New Guidelines for Credit Rating Agencies. Explain the new guidelines for credit rating agencies resulting from the Financial Reform Act of 2010. ANSWER: Credit rating agencies are subject to new reporting requirements in which they must disclose their methodology for determining ratings. They must consider credible information from sources other than the issuer when determining the rating of the issuer's debt. They must establish new internal controls over their operations. They must disclose the performance of their ratings over time, and are to be held accountable if they experienced poor performance. Their ratings analysts are required to take qualifying exams. 13. Impact of Greece Crisis. Explain the conditions that led to the debt crisis in Greece. ANSWER: In spring of 2010, Greece experienced a credit crisis, because of its weak economic conditions and large government budget deficit. As its deficit grew and its economy weakened, investors were concerned that the government of Greece would not be able to repay its debt. In addition, credit rating agencies reduced the ratings on the Greek debt several times. 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. ANSWER: If corporate debt is downgraded, the required rate of return by investors would increase, as the bonds are now perceived to have a higher degree of default risk. Consequently, the price of those bonds would drop, resulting in a capital loss for current investors in those bonds. New investors in these bonds can purchase the bonds at a relatively low price, as this low price compensates for their recognition that the default risk of the bonds has increased. 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. 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. ANSWER: The financial problems of Merrito Inc. signaled that other firms classified in the junk bond category might also experience cash flow problems. Investors quickly sold their holdings because of this signal, and other investors were no longer interested in purchasing these bonds at the prevailing price. The price had to decline to a new equilibrium, which reflects a higher yield that provides a higher risk premium to investors who purchase the junk bonds under these conditions. The impact on the bond prices would be more pronounced for those bonds that have less liquidity, because there are fewer willing buyers of these bonds. Thus, the price has to decline more to attract more buyers that would be willing to buy the bonds that are being unloaded in the secondary market. 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? ANSWER: This question is related to event risk. The bonds held by the insurance company will now be more susceptible to default, because Hartnett Company is more likely to experience cash flow problems. Therefore, the required rate of return on those bonds will increase, and the market value of the bonds will decrease. 17. Exchange-traded Notes. Explain what exchange-traded notes are and how they are used. Why are they risky? ANSWER: 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. Thus, ETNs have more flexibility to use leverage, which means that the funding for the portfolio of debt instruments is complemented with borrowed funds. This creates higher potential return for investors in ETNs, but also results in higher risk. 18. Auction-Rate Securities. Explain why the market for auction-rate securities suffered in 2008. ANSWER: Some of the financial institutions that made a market for the securities were unwilling 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 investment was frozen and could not be sold because there was not sufficient demand. 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? 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. 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.” The likelihood of a firm engaging in an LBO is dependent on whether it can obtain debt financing. If the junk bond market is inactive, the likelihood of obtaining debt financing is low and so is the chance of engaging in an LBO. The market value of the firm’s stock may decline if the likelihood of a takeover is reduced. 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.” When firms use debt to repurchase some of their stock, they create a higher degree of financial leverage. While this can enhance the firm’s return to its remaining shareholders, it results in higher debt payment, and can therefore increase default risk, especially when the economy is stagnant. 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.” 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? The U.S. interest rates will decline if the U.S. inflation rate declines. Consequently, bond prices should rise. This would increase the one-year return on 10-year bonds and 20-year zero-coupon bonds. The return on one-year securities over a one-year horizon is not affected because the securities will mature at the end of the one-year investment horizon. b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon? Why? The 20-year zero-coupon bond would have the highest expected return for a one-year horizon. Longer-term bonds are more sensitive to interest rate movements, and zero-coupon bonds are more sensitive than coupon bonds to interest rate movements. While the expected returns of both types of bonds for a one-year horizon would increase, the zero-coupon bonds would generate a higher return. c. Offer one reason why you might not select the investment that would have the highest expected return over the one-year investment horizon. Your expectations about inflation and therefore interest rates could be wrong. If inflation rises over the one-year period, or other economic conditions (such as economic growth or the budget deficit) change, interest rates could increase during the one-year period. Consequently, the zero-coupon bonds would generate the lowest return over the one-year horizon because they are most sensitive to interest rate movements. Even though you expect the zero-coupon bonds to generate the highest return over the one-year horizon, those bonds are subject to the most interest rate risk. 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: Principal of bond after six months: $1,000 + (1% × $1,000) = $1,010 Interest received during first six months: $1,010 × 3% = $30.30 Principal of bond at the end of the year: $1,010 + (1% × $1,010) = $1,020.10 Interest received during the last six months: $1,020.10 × 3% = $30.60 Total interest received = $30.30 + $30.60 = $60.90 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: Principal of bond after six months: $1,000 – (1% × $1,000) = $990 Interest received during first six months: $990 × 2.5% = $24.75 Principal of bond at the end of the year: $990 – (2% × $990) = $970.20 Interest received during the last six months: $970.20 × 2.5% = $24.26 Total interest received: $24.75 + $24.26 = $49.01 Note that the investor would have received $50 if prices had remained stable during the year. 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. Assume that Carson has two choices to satisfy the increased demand for its products. It could increase production by 10 percent with its existing facilities. In this case, it could obtain short-term financing to cover the extra production expense and then use a portion of the revenue received to finance this level of production in the future. Alternatively, it could issue bonds and use the proceeds to buy a larger facility that would allow for 50 percent more capacity. Carson should not buy a larger facility unless it feels confident that it can fully utilize the space. It should consider using up the excess capacity in its existing facility in the short term, and monitoring economic growth. In this way, it only needs to obtain short-term financing, and can avoid the long-term debt for now. If demand does not increase as anticipated, then it can simply retire the short-term debt when it matures. Conversely, if Carson is confident that demand will 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? No. There is an upward-sloping yield curve, so Carson could obtain short-term financing at a lower interest rate than long-term financing. c. Should Carson consider using a call provision if it issues bonds? Why? Why might Carson decide not to include a call provision on the bonds? The benefit of the call provision is that Carson could retire its bonds before maturity if it wanted to reduce its debt or if interest rates declined and it wanted to refinance at lower rates. Carson would have to pay a higher yield to compensate bondholders if it includes a call provision on the bonds. d. If Carson issues bonds, it would be a relatively small bond offering. Should Carson consider a private placement of bonds? What type of investor might be interested in participating in a private placement? Do you think Carson could offer the same yield on a private placement as it could on a public placement? Explain. Carson could consider a private placement, as it may be able to reduce its transaction costs if it can find an institutional investor that would purchase the bonds. A pension fund or insurance company might be willing to participate as an investor in the private placement market. The investor would need to accept the lack of a secondary market for the bond. Carson would probably have to pay a slightly higher yield on the privately placed bonds to reflect the lack of liquidity (no secondary market) for their bond. Financial institutions such as insurance companies and pension funds commonly purchase bonds. Explain the flow of funds that runs through these financial institutions and ultimately reaches corporations that issue bonds such as Carson Company. Insurance companies receive funds from policyholders who pay insurance premiums. They invest the funds until they are needed to cover insurance claims. They use a portion of their funds to purchase bonds. Thus, the money pay for insurance premiums is channeled to the corporations that issue bonds. Pension funds receive money that they invest for employees until the money is withdrawn after the employees retire. The pension funds purchase bonds. Thus, the money contributed by the employees or their respective employers are channeled to the corporations that issue bonds. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
