Financial Markets and Institutions (2-downloads)

http://www.treasurydirect.gov/RI/OFAnnce.htm

and locate the schedule of auctions. When is the next

auction of 4-week bills? When is the next auction of

13- and 26-week bills? How often are these securi-

ties auctioned?

---

The Bond Market

Preview

The last chapter discussed short-term securities that trade in a market we call

the money market. This chapter talks about the first of several securities that

trade in a market we call the capital market. Capital markets are for securities

with an original maturity that is greater than one year. These securities include

bonds, stocks, and mortgages. We will devote an entire chapter to each major

type of capital market security due to their importance to investors, businesses,

and the economy. This chapter begins with a brief introduction on how the

capital markets operate before launching into the study of bonds. In the next

chapter we will study stocks and the stock market. We will conclude our look at

the capital markets in Chapter 14 with mortgages.

279

12

C H A P T E R

Purpose of the Capital Market

Firms that issue capital market securities and the investors who buy them have

very different motivations than those who operate in the money markets. Firms

and individuals use the money markets primarily to warehouse funds for short

periods of time until a more important need or a more productive use for the

funds arises. By contrast, firms and individuals use the capital markets for long-

term investments.

Suppose that after a careful financial analysis, your firm determines that it needs

a new plant to meet the increased demand for its products. This analysis will be made

using interest rates that reflect the current long-term cost of funds to the firm.

Now suppose that your firm chooses to finance this plant by issuing money market

securities, such as commercial paper. As long as interest rates do not rise, all is well:

When these short-term securities mature, they can be reissued at the same inter-

est rate. However, if interest rates rise, as they did dramatically in 1980, the firm may

find that it does not have the cash flows or income to support the plant because when

the short-term securities mature, the firm will have to reissue them at a higher inter-

est rate. If long-term securities, such as bonds or stock, had been used, the increased

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280

Part 5 Financial Markets

interest rates would not have been as critical. The primary reason that individuals

and firms choose to borrow long-term is to reduce the risk that interest rates will rise

before they pay off their debt. This reduction in risk comes at a cost, however. As you

may recall from Chapter 5, most long-term interest rates are higher than short-term

rates due to risk premiums. Despite the need to pay higher interest rates to bor-

row in the capital markets, these markets remain very active.

Capital Market Participants

The primary issuers of capital market securities are federal and local governments and

corporations. The federal government issues long-term notes and bonds to fund the

national debt. State and municipal governments also issue long-term notes and bonds

to finance capital projects, such as school and prison construction. Governments never

issue stock because they cannot sell ownership claims.

Corporations issue both bonds and stock. One of the most difficult decisions a

firm faces can be whether it should finance its growth with debt or equity. The dis-

tribution of a firm’s capital between debt and equity is its capital structure.

Corporations may enter the capital markets because they do not have sufficient

capital to fund their investment opportunities. Alternatively, firms may choose to

enter the capital markets because they want to preserve their capital to protect

against unexpected needs. In either case, the availability of efficiently functioning

capital markets is crucial to the continued health of the business sector. This was dra-

matically demonstrated during the 2008–2009 financial crisis. With the near col-

lapse of the bond and stock markets, funds for business expansion dried up. This

led to reduced business activity, high unemployment, and slow growth. Only after

market confidence was restored did a recovery begin.

The largest purchasers of capital market securities are households. Frequently,

individuals and households deposit funds in financial institutions that use the funds

to purchase capital market instruments such as bonds or stock.

Capital Market Trading

Capital market trading occurs in either the primary market or the secondary

market. The primary market is where new issues of stocks and bonds are introduced.

Investment funds, corporations, and individual investors can all purchase securities

offered in the primary market. You can think of a primary market transaction as one

where the issuer of the security actually receives the proceeds of the sale. When firms

sell securities for the very first time, the issue is an initial public offering (IPO).

Subsequent sales of a firm’s new stocks or bonds to the public are simply primary

market transactions (as opposed to an initial one).

The capital markets have well-developed secondary markets. A secondary

market is where the sale of previously issued securities takes place, and it is

important because most investors plan to sell long-term bonds before they reach

maturity and eventually to sell their holdings of stock. There are two types of

exchanges in the secondary market for capital securities: organized exchanges

and over-the-counter exchanges. Whereas most money market transactions orig-

inate over the phone, most capital market transactions, measured by volume,

Access initial public offering

news and information,

including advanced search

tools for IPO offerings,

venture capital research

reports, and so on, at

www.ipomonitor.com

.

G O   O N L I N E

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Chapter 12 The Bond Market

281

occur in organized exchanges. An organized exchange has a building where secu-

rities (including stocks, bonds, options, and futures) trade. Exchange rules gov-

ern trading to ensure the efficient and legal operation of the exchange, and the

exchange’s board constantly reviews these rules to ensure that they result in com-

petitive trading.

Types of Bonds

Bonds are securities that represent a debt owed by the issuer to the investor.

Bonds obligate the issuer to pay a specified amount at a given date, generally with

periodic interest payments. The par, face, or maturity value of the bond is the

amount that the issuer must pay at maturity. The coupon rate is the rate of inter-

est that the issuer must pay, and this periodic interest payment is often called the

coupon payment. This rate is usually fixed for the duration of the bond and does

not fluctuate with market interest rates. If the repayment terms of a bond are 

not met, the holder of a bond has a claim on the assets of the issuer. Look at

Figure 12.1. The face value of the bond is given in the upper-right corner. The

interest rate of 8 %, along with the maturity date, is reported several times on

the face of the bond.

Long-term bonds traded in the capital market include long-term government

notes and bonds, municipal bonds, and corporate bonds.

5

8

F I G U R E   1 2 . 1

Hamilton/BP Corporate Bond

Find listed companies,

member information, 

real-time market indices,

and current stock quotes

at

www.nyse.com

.

G O   O N L I N E

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282

Part 5 Financial Markets

Treasury Notes and Bonds

The U.S. Treasury issues notes and bonds to finance the national debt. The differ-

ence between a note and a bond is that notes have an original maturity of 1 to 

10 years while bonds have an original maturity of 10 to 30 years. (Recall from

Chapter 11 that Treasury bills mature in less than one year.) The Treasury currently

issues notes with 2-,3-, 5-, 7-, and 10-year maturities. In addition to the 20-year bond,

the Treasury resumed issuing 30-year bonds in February 2006. Table 12.1 summa-

rizes the maturity differences among Treasury securities. The prices of Treasury

notes, bonds, and bills are quoted as a percentage of $100 face value.

Federal government notes and bonds are free of default risk because the gov-

ernment can always print money to pay off the debt if necessary.

1

This does not mean

that these securities are risk-free. We will discuss interest-rate risk applied to bonds

later in this chapter.

Treasury Bond Interest Rates

Treasury bonds have very low interest rates because they have no default risk. Although

investors in Treasury bonds have found themselves earning less than the rate of infla-

tion in some years (see Figure 12.2), most of the time the interest rate on Treasury

notes and bonds is above that on money market securities because of interest-rate risk.

Figure 12.3 plots the yield on 20-year Treasury bonds against the yield on 90-day

Treasury bills. Two things are noteworthy in this graph. First, in most years, the

rate of return on the short-term bill is below that on the 20-year bond. Second, short-

term rates are more volatile than long-term rates. Short-term rates are more influ-

enced by the current rate of inflation. Investors in long-term securities expect

extremely high or low inflation rates to return to more normal levels, so long-term

rates do not typically change as much as short-term rates.

Treasury Inflation-Protected Securities (TIPS)

In 1997, the Treasury Department began offering an innovative bond designed to

remove inflation risk from holding treasury securities. The inflation-indexed bonds

have an interest rate that does not change throughout the term of the security.

However, the principal amount used to compute the interest payment does change

based on the consumer price index. At maturity, the securities are redeemed at the

greater of their inflation-adjusted principal or par amount at original issue.

The advantage of inflation-indexed securities, also referred to as inflation-

protected securities, is that they give both individual and institutional investors a

chance to buy a security whose value won’t be eroded by inflation. These securities

can be used by retirees who want to hold a very low-risk portfolio.

TA B L E   1 2 . 1

Treasury Securities