1 Chapter 7 Bond Markets Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline Background on bonds Treasury and federal agency bonds Municipal bonds Corporate bonds Institutional use of bond markets Globalization of bond markets 3 Background on Bonds Bonds represents long-term debt securities that are issued by government agencies or corporations Interest payments occur annually or semiannually Par value is repaid at maturity Most bonds have maturities between 10 and 30 years Bearer bonds require the owner to clip coupons attached to the bonds Registered bonds require the issuer to maintain records of who owns the bond and automatically send coupon payments to the owners 4 Background on Bonds (cont’d) Bond yields The issuer’s cost of financing is measured by the yield to maturity The annualized yield that is paid by the issuer over the life of the bond Equates the future coupon and principal payments to the initial proceeds received Does not include transaction costs associated with issuing the bond Earned by an investor who invests in a bond when it is issued and holds it until maturity The holding period return is used by investors who do not hold a bond to maturity 5 Treasury and Federal Agency Bonds The U.S. Treasury issues Treasury notes or bonds to finance federal government expenditures Note maturities are usually less than 10 years Bonds maturities are 10 years or more An active secondary market exists The 30-year bond was discontinued in October 2001 6 Treasury and Federal Agency Bonds (cont’d) Treasury bond auction Normally held in the middle of each quarter Financial institutions submit bids for their own accounts or for clients Bids can be competitive or noncompetitive Competitive bids specify a price the bidder is willing to pay and a dollar amount of securities to be purchased Noncompetitive bids specify only a dollar amount of securities to be purchased 7 Treasury and Federal Agency Bonds (cont’d) Treasury bond auction (cont’d) The Salomon Brothers scandal In a 1990 bond auction, Salomon Brothers purchased 65 percent of the bonds issued (exceeding the 35 percent maximum) Salomon resold the bonds at higher prices to other institutions In August of 1991, the Treasury Department temporarily barred Salomon Brothers from bidding on Treasury securities In May 1992 Salomon paid fines of $190 million to the SEC and Justice Department Salomon created a reserve fund of $100 million to cover claims from civil lawsuits 8 Treasury and Federal Agency Bonds (cont’d) Trading Treasury bonds Bond dealers serve as intermediaries in the secondary market and also take positions in the bonds 30 primary dealers dominate the trading Profit from the bid-ask spread Conduct trading with the Fed during open market operations Typical daily volume is about $200 billion Online trading TreasuryDirect program (http://www.treasurydirect.gov) 9 Treasury and Federal Agency Bonds (cont’d) Treasury bond quotations Published in financial newspapers The Wall Street Journal Barron’s Investor’s Business Daily Bond quotations are organized according to their maturity, with the shortest maturity listed first Bid and ask prices are quoted per hundreds of dollars of par value Online quotations at http://www.investinginbonds.com http://www.federalreserve.gov/releases/H15/ 10 Treasury and Federal Agency Bonds (cont’d) Stripped Treasury bonds One security represents the principal payment and a second security represents the interest payments Investors who desire a lump sum payment can choose the PO part Investors desiring periodic cash flows can select the IO part Degrees of interest rate sensitivity vary Several securities firms create their own versions of stripped securities Merrill Lynch’s TIGRs The Treasury created the STRIPS program in 1985 . 1 Chapter 7 Bond Markets Financial Markets and Institutions, 7e, Jeff Madura Copyright. ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 2 Chapter Outline Background on bonds Treasury and federal agency bonds