Chap 6

• Capital markets


  Markets that trade debt (bonds and mortgages) and equity (stocks) instruments with maturities of more than one year
• Bond


  Long-term debt obligation issued by corporations and government units
• Bond markets

  Markets in which bonds are issued and traded
• Composition of the U.S. National Debt

  • T-Notes and Bonds
  • T-Bills
  • Government Account Securities
  • Other
• Treasury notes and bonds

  • They are backed by the full faith and credit of the U.S. government and are, therefore, default risk free
  • They experience wider price fluctuations than money market instruments as interest rates change (subject to interest rate risk)
  • Older "off the run" issues may be less liquid than newly issued "on the run" issues (subject to illiquidity risk)
• Types of Treasury securities


  • Fixed principal
  • Inflation-indexed
• Treasury STRIPS allow investors to hold the interest and principal components of eligible Treasury notes and bonds as separate securities
• Treasury STRIPS offer no interest payment, investors receive payment only at maturity
• STRIPS are created by the US Treasury in response to the separate trading of Treasury security principal and interest that had been developed by securities firms
• The US Treasury does not issue STRIPS directly to investors, rather stripped Treasury notes and bonds may be purchased only through financial institutions and government securities brokers and dealers
• STRIPS


  Securities created by separating the principal and coupon payments of a Treasury security into individual components (the principal payment and the coupon payments) that can be traded separately
• Bond price quoted in financial press is the clean price (price without accrued interest)
• Accrued interest


  Portion of coupon payment accrued between last coupon payment and settlement day
• Dirty price


  Clean price plus accrued interest
• TIPS (Treasury Inflation Protected Securities)


  Bonds where principal value increases/decreases with inflation/deflation as measured by CPI
• Calculation of inflation-adjusted principal and coupon payments on TIPS

  1. Multiply original principal by semiannual inflation rate to get inflation-adjusted principal

  2. Multiply inflation-adjusted principal by semiannual coupon rate to get coupon payment
• TIPS yields are real yields, spread between TIPS and non-TIPS yields is market's estimate of average annual inflation
• Primary and secondary market trading in Treasury notes and bonds

  1. Treasury sells through competitive and noncompetitive auctions

  2. Auction details announced in press release

  3. Bids submitted by dealers, businesses, individuals

  4. Awards announced next day

  5. Single-price auction, all pay same price
• Coupon rate set as stop-out yield rounded down to nearest 1/8 percent
• Security's price set for yield to maturity to equal auction's stop-out yield
• Stop-out yield


  The highest accepted yield in a bond auction
• Bond auction process


  1. Bids at or above the stop-out yield are filled on a pro-rata basis

  2. Bids below the stop-out yield are rejected
• Single-price auction process went into effect for Treasury bond auctions

  1985
• Prior to 1985, the Treasury used a discriminatory auction process
• Municipal bonds


  Securities issued by state and local governments to fund temporary imbalances or finance long-term capital outlays
• Municipal bonds


  • Interest payments are exempt from federal income taxes and most state and local income taxes
  • Interest borrowing cost to the issuer is lower as investors accept lower interest rates
• Bond insurance

  • Ensures payment to bondholders if the issuer defaults
  • Helps improve the credit rating of the bond issue and lower interest rates
• After-tax (equivalent tax-exempt) yield

  The yield on a taxable bond that would make an investor indifferent between it and a tax-exempt municipal bond of similar risk
• Calculation of after-tax (equivalent tax-exempt) yield

  • r_a = r_b(1-t)

  where r_a = after-tax yield, r_b = before-tax yield, t = marginal tax rate
• General obligation (GO) bonds

  Backed by the full faith and credit of the issuer, requiring local taxpayer approval
• Revenue bonds


  Backed by cash flows from the specific revenue-generating project being financed, riskier than GO bonds
• Municipal bonds are typically issued in minimum denominations of $5,000
• A secondary market exists for municipal bonds, though trading is less active than for Treasury bonds
• Years


  • 2010
  • 2011
  • 2013
  • 2016
• General obligation bonds


  • $39,610
  • $100,519
  • $130,497
  • $137,529
  • $95,970
  • $116,215
  • $56,767
• Through March
• Source: Federal Reserve Board website, "New Security Issues." www.federalreserve.gov
• Chapter 6 Bond Markets
• Bond Quote Details


  • Issue
  • Coupon
  • Mat.
  • Price
  • YTM
• Bond price in percentage terms (i.e., 119 3/4=119.75 percent of the face value)