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 