Explain how bond markets have become globally integrated

Explain how bond markets have become globally integrated

The specific objectives of this chapter are to:

· provide a background on bonds,

· describe the different types of bonds and their characteristics,

· explain how bond markets have become globally integrated, and

· describe other types of long-term debt securities.

From this chapter through Chapter 12 , the focus is on capital market securities. These chapters are distinctly different from the previous chapter on money market securities in that they employ a long-term rather than a short-term perspective. This chapter and the following focus on bond markets, which facilitate the flow of long-term debt from surplus units to deficit units.

7-1 BACKGROUND ON BONDS

Bonds are long-term debt securities that are issued by government agencies or corporations. The issuer of a bond is obligated to pay interest (or coupon) payments periodically (such as annually or semiannually) and the par value (principal) at maturity. An issuer must be able to show that its future cash flows will be sufficient to enable it to make its coupon and principal payments to bondholders. Investors will consider buying bonds for which the repayment is questionable only if the expected return from investing in the bonds is sufficient to compensate for the risk.

Bonds are often classified according to the type of issuer. Treasury bonds are issued by the U.S. Treasury, federal agency bonds are issued by federal agencies, municipal bonds are issued by state and local governments, and corporate bonds are issued by corporations.

Most bonds have maturities of between 10 and 30 years. Bonds are classified by the ownership structure as either bearer bonds or registered bonds. Bearer bonds require the owner to clip coupons attached to the bonds and send them to the issuer to receive coupon payments. Registered bonds require the issuer to maintain records of who owns the bond and automatically send coupon payments to the owners.

Bonds are issued in the primary market through a telecommunications network. Exhibit 7.1 shows how bond markets facilitate the flow of funds. The U.S. Treasury issues bonds and uses the proceeds to support deficit spending on government programs. Federal agencies issue bonds and use the proceeds to buy mortgages that are originated by financial institutions. Thus, they indirectly finance purchases of homes. Corporations issue bonds and use the proceeds to expand their operations. Overall, by allowing households, corporations, and the U.S. government to increase their expenditures, bond markets finance economic growth.

WEB

finance.yahoo.com/bonds

Summary of bond market activity and analysis of bond market conditions.

7-1a Institutional Participation in Bond Markets

All types of financial institutions participate in the bond markets, as summarized in Exhibit 7.2 . Commercial banks, savings institutions, and finance companies commonly issue bonds in order to raise capital to support their operations. Commercial banks, savings institutions, bond mutual funds, insurance companies, and pension funds are investors in the bond market. Financial institutions dominate the bond market in that they purchase a large proportion of bonds issued.

Exhibit 7.1 How Bond Markets Facilitate the Flow of Funds

Exhibit 7.2 Participation of Financial Institutions in Bond Markets

FINANCIAL INSTITUTION

PARTICIPATION IN BOND MARKETS

Commercial banks and savings and loan associations (S&Ls)

· • Purchase bonds for their asset portfolio.

· • Sometimes place municipal bonds for municipalities.

· • Sometimes issue bonds as a source of secondary capital.

Finance companies

· • Commonly issue bonds as a source of long-term funds.

Mutual funds

· • Use funds received from the sale of shares to purchase bonds. Some bond mutual funds specialize in particular types of bonds, while others invest in all types.

Brokerage firms

· • Facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.

Investment banking firms

· • Place newly issued bonds for governments and corporations. They may place the bonds and assume the risk of market price uncertainty or place the bonds on a best-efforts basis in which they do not guarantee a price for the issuer.

Insurance companies

· • Purchase bonds for their asset portfolio.

Pension funds

· • Purchase bonds for their asset portfolio.

7-1b Bond Yields

The yield on a bond depends on whether it is viewed from the perspective of the issuer of the bond, who is obligated to make payments on the bond until maturity, or from the perspective of the investors who purchase the bond.

Yield from the Issuer’s Perspective The issuer’s cost of financing with bonds is commonly measured by the yield to maturity, which reflects the annualized yield that is paid by the issuer over the life of the bond. 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. It is based on the assumption that coupon payments received can be reinvested at the same yield.

EXAMPLE

Consider an investor who can purchase bonds with 10 years until maturity, a par value of $1,000, and an 8 percent annualized coupon rate for $936. The yield to maturity on these bonds can be determined by using a financial calculator as follows:

INPUT

10

936

80

1000

Function Key

N

PV

PMT

FV

CPT

I

Answer

9%

Notice that the yield paid to investors consists of two components: (1) a set of coupon payments and (2) the difference between the par value that the issuer must pay to investors at maturity and the price it received when selling the bonds. In this example and in most cases, the biggest component of the yield to maturity is the set of coupon payments. The yield to maturity does not include the transaction costs associated with issuing the bonds. When those transaction costs are considered, the issuer’s actual cost of borrowing is slightly higher than the yield to maturity.

WEB

money.cnn.com/markets/bondcenter

Yields and information on all types of bonds for various maturities.

Yield from the Investor’s Perspective An investor who invests in a bond when it is issued and holds it until maturity will earn the yield to maturity. Yet many investors do not hold a bo

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