12

CHAPTER

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 mort-
gages. 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.

308

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 CHAPTER 12   The Bond Market 309

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 reis-
sued at the same interest rate. However, if interest rates rise, as they did dra-
matically in 1980, the firm will still have to reissue, now at a higher rate. It may
find that it does not have the cash flows or income to support the plant at this
increased rate. If long-term securities, such as bonds or stock, had been used, the
increased 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 inter-
est 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 borrow 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 called 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
dramatically 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 mar-
ket 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.

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 310 PART 5  Financial Markets

Capital Market Trading

Capital market trading occurs in either the primary market or the secondary mar-
ket. 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 mar-
ket is where the sale of previously issued securities takes place. Secondary markets
are critical in capital markets because most investors plan to sell long-term bonds at
some point before they mature. 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 originate over the phone,
GO most capital market transactions, measured by volume, occur in organized exchanges.
ONLINE An organized exchange has a building where securities (including stocks, bonds,
Find listed companies,
member information, real-time
options, and futures) trade. Exchange rules govern trading to ensure the efficient
market indices, and current and legal operation of the exchange, and the exchange’s board constantly reviews
stock quotes at www.nyse.com. these rules to ensure that they result in competitive 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 (they all mean the
same thing) is the amount that the issuer must pay at maturity. The coupon rate
is the rate of interest 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 the bond in Figure 12.1. The face value of the bond is given in the upper-right
corner. The interest rate of 8 58%, 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.

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 cur-
rently issues notes with 2-, 3-, 5-, 7-, and 10-year maturities. The Treasury resumed
issuing 30-year bonds in February 2006. Table 12.1 summarizes the maturity differ-
ences among Treasury securities. The prices of Treasury notes, bonds, and bills are
quoted as a percentage of $100 face value.

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 CHAPTER 12   The Bond Market 311

FIGURE 12.1   Hamilton/BP Corporate Bond

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. 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.1
Although investors in 10-year Treasury bonds earned less than the rate of inflation
during the 1970s and early 1980s (see Figure 12.2), since then the interest rate on
those bonds has been above the inflation rate and is also above the interest rate on
money market securities because of interest-rate risk.

TABLE 12.1   Treasury Securities

Type Maturity

Treasury bill Less than 1 year

Treasury note 1 to 10 years
Treasury bond 10 to 30 years

1
We noted in Chapter 11 that Treasury bills were also considered risk-free of default except that budget
stalemates in 1996, 2011, and 2013 almost caused default. The same small chance of default applies to
Treasury bonds.

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 312 PART 5  Financial Markets

Rate (%)
14

12 10-Year Bonds

10

4 Inflation

0
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

FIGURE 12.2   Interest Rate on Treasury Bonds and the Inflation Rate, 1973–2016
(January of each year)
Source: http://www.federalreserve.gov/releases and https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/
TextView.aspx?data=reallongtermrate.

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
influenced by the expected rate of inflation. Investors in long-term securities expect

Rate (%)
16

14

12
20-Year Treasury Bonds
10

6
90-Day
4 Treasury Bills

0
1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

FIGURE 12.3   Interest Rate on Treasury Bills and Treasury Bonds, 1974–2016 (January of
each year)
Source: http://www.federalreserve.gov/releases/h15/data.htm.

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 CHAPTER 12   The Bond Market 313

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. They are offered
by the Treasury with maturities of 5, 10, and 30 years.

Treasury STRIPS
In addition to bonds, notes, and bills, in 1985 the Treasury began issuing to deposi-
tory institutions bonds in book entry form called Separate Trading of Registered
Interest and Principal Securities, more commonly called STRIPS. Recall from
Chapter 11 that to be sold in book entry form means that no physical document
exists; instead, the security is issued and accounted for electronically. This allowed
for the creation of a new security. A STRIPS separates the periodic interest payments
from the final principal repayment. When a Treasury fixed-principal or inflation-
indexed note or bond is “stripped,” each interest payment and the principal pay-
ment becomes a separate zero-coupon security. Each component has its own
identifying number and maturity and can be held or traded separately. For example,
a Treasury note with five years remaining to maturity consists of a single principal
payment at maturity and 10 interest payments, one every six months for five years.
When this note is stripped, each of the 10 interest payments and the principal pay-
ment becomes a separate security. Thus, the single Treasury note becomes 11 secu-
rities that can be traded individually. STRIPS are also called zero-coupon securities
because the only time an investor receives a payment during the life of each STRIPS
component is when it matures.
Before the government introduced these securities, the private sector had cre-
ated them indirectly. In the early 1980s, Merrill Lynch created the Treasury
Investment Growth Fund (TIGRs, pronounced “tigers”), in which it purchased
Treasury securities and then stripped them to create principal-only securities and
interest-only securities. Currently, more than $50 billion in stripped Treasury secu-
rities are outstanding.

Agency Bonds
Congress has authorized a number of U.S. agencies, also known as government-
sponsored enterprises (GSEs), to issue bonds. The government does not explicitly
guarantee agency bonds, though most investors feel that the government would not
allow the agencies to default. Issuers of agency bonds include the Student Loan
Marketing Association (Sallie Mae), the Farmers Home Administration, the Federal

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 314 PART 5  Financial Markets

Housing Administration, the Veterans Administrations, and the Federal Land Banks.
These agencies issue bonds to raise funds that are used for purposes that Congress
has deemed to be in the national interest. For example, Sallie Mae helps provide
student loans to increase access to college.
The risk on agency bonds is actually very low. They are usually secured by the
loans that are made with the funds raised by the bond sales. In addition, the federal
agencies may use their lines of credit with the Treasury Department should they
have trouble meeting their obligations. Finally, it is unlikely that the federal govern-
ment would permit its agencies to default on their obligations. This was evidenced
by the bailout of the Federal National Mortgage Association (Fannie Mae) and the
Federal Home Loan Mortgage Corporation (Freddie Mac) in 2008. Faced with port-
folios of subprime mortgage loans, they were at risk of defaulting on their bonds
before the government stepped in to guarantee payment. The bailout is discussed
in the following case.

CASE

The 2007–2009 Financial Crisis and the Bailout of

Fannie Mae and Freddie Mac
Because it encouraged excessive risk taking, the peculiar structure of Fannie Mae
and Freddie Mac—private companies sponsored by the government—was an acci-
dent waiting to happen. Many economists predicted exactly what came to pass: a
government bailout of both companies, with huge potential losses for American
taxpayers.
As we will discuss in Chapter 18, when there is a government safety net for
financial institutions, there needs to be appropriate government regulation and
supervision to make sure these institutions do not take on excessive risk. Fannie
and Freddie were given a federal regulator and supervisor, the Office of Federal
Housing Enterprise Oversight (OFHEO), as a result of legislation in 1992, but this
regulator was quite weak, with only a limited ability to rein them in. This outcome
was not surprising: These firms had strong incentives to resist effective regulation
and supervision because it would cut into their profits. This is exactly what they did:
Fannie and Freddie were legendary for their lobbying machine in Congress, and they
were not apologetic about it. In 1999 Franklin Raines, at the time Fannie’s CEO, said,
“We manage our political risk with the same intensity that we manage our credit and
interest-rate risks.”* Between 1998 and 2008 Fannie and Freddie jointly spent over
$170 million on lobbyists, and from 2000 to 2008 they and their employees made
over $14 million in political campaign contributions.
Their lobbying efforts paid off: Attempts to strengthen their regulator, OFHEO,
in both the Clinton and Bush administrations came to naught, and remarkably this
was even true after major accounting scandals at both firms were revealed in 2003
and 2004, in which they cooked the books to smooth out earnings. (It was only in
July 2008, after the cat was let out of the bag and Fannie and Freddie were in seri-
ous trouble, that legislation was passed to put into place a stronger regulator, the
Federal Housing Finance Agency, to supersede OFHEO.)

*
Quoted in Nile Stephen Campbell, “Fannie Mae Officials Try to Assuage Worried Investors,” Real
Estate Finance Today, May 10, 1999.

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 CHAPTER 12   The Bond Market 315

With a weak regulator and strong incentives to take on risk, Fannie and Fred-
die grew like crazy, and by 2008 had purchased or were guaranteeing over $5 tril-
lion of mortgages or mortgage-backed securities. The accounting scandals might
even have pushed them to take on more risk. In the 1992 legislation, Fannie and
Freddie had been given a mission to promote affordable housing. What better way
to do this than to purchase subprime and Alt-A mortgages or mortgage-backed
securities (discussed in Chapter 8)? The accounting scandals made this motivation
even stronger because they weakened the political support for Fannie and Fred-
die, giving these companies even greater incentives to please Congress and sup-
port affordable housing by the purchase of these assets. By the time the subprime
financial crisis hit in force, they had over $1 trillion of subprime and Alt-A assets on
their books. Furthermore, they had extremely low ratios of capital relative to their
assets: Indeed, their capital ratios were far lower than for other financial institu-
tions like commercial banks.
By 2008, after many subprime mortgages went into default, Fannie and Freddie
had booked large losses. Their small capital buffer meant that they had little cushion
to withstand these losses, and investors started to pull their money out. With Fannie
and Freddie playing such a dominant role in mortgage markets, the U.S. govern-
ment could not afford to have them go out of business because this would have
had a disastrous effect on the availability of mortgage credit, which would have had
further devastating effects on the housing market. With bankruptcy imminent, the
Treasury stepped in with a pledge to provide up to $200 billion of taxpayer money to
the companies if needed. This largess did not come for free. The federal government
in effect took over these companies by putting them into conservatorship, requir-
ing that their CEOs step down, and by having their regulator, the Federal Housing
Finance Agency, oversee the companies’ day-to-day operations. In addition, the gov-
ernment received around $1 billion of senior preferred stock and the right to pur-
chase 80% of the common stock if the companies recovered. After the bailout, the
prices of both companies’ common stock were less than 2% of what they had been
worth only a year earlier.
The sad saga of Fannie Mae and Freddie Mac illustrates how dangerous it was
for the government to set up GSEs that were exposed to a classic conflict-of-interest
problem because they were supposed to serve two masters: As publicly traded cor-
porations, they were expected to maximize profits for their shareholders, but as
government agencies, they were obliged to work in the interests of the public. In
the end, neither the public nor the shareholders were well served. With the housing
market recovery, Fannie Mae and Freddy Mac have been able to pay dividends back
to the government on its $187 billion investment. By October of 2016, the two agen-
cies had paid $250 billion in dividends to the treasury.

Municipal Bonds
Municipal bonds are securities issued by local, county, and state governments. The
proceeds from these bonds are used to finance public interest projects, such as
schools, utilities, and transportation systems. Interest earned on municipal bonds
that are issued to pay for essential public projects are exempt from federal taxation.
As we saw in Chapter 5, this allows the municipality to borrow at a lower cost

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 316 PART 5  Financial Markets

GO because investors will be satisfied with lower interest rates on tax-exempt bonds.
ONLINE You can use the following equation to determine what tax-free rate of interest is
Access www.bloomberg.com/
equivalent to a taxable rate:
markets/rates/index.html for
details on the latest municipal
Equivalent tax-free rate = taxable interest rate * (1 - marginal tax rate)
bond events, experts’ insights
and analyses, and a munici-
pal bond yields table.

EXAMPLE 12.1
 Municipal Suppose that the interest rate on a taxable corporate bond is 5% and that the marginal
Bonds tax is 28%. Suppose a tax-free municipal bond with a rate of 3.75% was available.
Which security would you choose?
Solution
The tax-free equivalent municipal interest rate is 3.6%.

Equivalent tax@free rate = taxable interest rate * (1 - marginal tax rate)

where
Taxable interest rate = 0.05
Marginal tax rate = 0.28
Thus,

Equivalent tax@free rate = 0.05 * (1 - .28) = 0.036 = 3.6%

Since the tax-free municipal bond rate (3.75%) is higher than the equivalent tax-free
rate (3.6%), choose the municipal bond.

There are two types of municipal bonds: general obligation bonds and revenue
bonds. General obligation bonds do not have specific assets pledged as security
or a specific source of revenue allocated for their repayment. Instead, they are
backed by the “full faith and credit” of the issuer. This phrase means that the issuer
promises to use every resource available to repay the bond as promised. Most gen-
eral obligation bond issues must be approved by the taxpayers because the taxing
authority of the government is pledged for their repayment.
Revenue bonds, by contrast, are backed by the cash flow of a particular
revenue-generating project. For example, revenue bonds may be issued to build a
toll road, with the tolls being pledged as repayment. If the revenues are not suffi-
cient to repay the bonds, they may go into default, and investors may suffer losses.
This occurred on a large scale in 1983, when the Washington Public Power Supply
System (since called “WHOOPS”) used revenue bonds to finance the construction
of two nuclear power plants. As a result of falling energy prices and tremendous cost
overruns, the plants never became operational, and buyers of these bonds lost $2.25
billion. This remains the largest public debt default on record. Revenue bonds tend
to be issued more frequently than general obligation bonds (see Figure 12.4). Note
that the low interest rates seen in recent years have prompted municipalities to
issue near record amounts of bonds.

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 CHAPTER 12   The Bond Market 317

Amount Issued
($ billions)

500
General obligation bonds
450
Revenue bonds
400

350

300

250

200

150

100

50

0
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

FIGURE 12.4   Issuance of Revenue and General Obligation Bonds, 1984–2015 (End of
year)
Source: http://www.federalreserve.gov/econresdata/releases/govsecure/current.htm.

Risk in the Municipal Bond Market

Municipal bonds are not default-free. For example, a study by Fitch Ratings reported
a 0.63% default rate on municipal bonds. Default rates are higher during periods
when the economy is weak. Clearly, governments are not exempt from financial
distress. Unlike the federal government, local governments cannot print money, and
there are real limits on how high they can raise taxes without driving the population
away.

Corporate Bonds
GO
When large corporations need to borrow funds for long periods of time, they may
ONLINE issue bonds. Most corporate bonds have a face value of $1,000 and pay interest
Access http://bonds.yahoo.com semiannually (twice per year). Most are also callable, meaning that the issuer may
for information on 10-year
redeem the bonds prior to maturity after a specified date.
Treasury yield, composite
bond rates for U.S. Treasury The bond indenture is a contract that states the lender’s rights and privileges
bonds, municipal bonds, and and the borrower’s obligations. Any collateral offered as security to the bondholders
corporate bonds. is also described in the indenture.
The degree of risk varies widely among different bond issues because the risk
of default depends on the company’s health, which can be affected by a number of
variables. The interest rate on corporate bonds varies with the level of risk, as we
discussed in Chapter 5. Figure 12.5 shows that bonds with lower risk and a higher

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 318 PART 5  Financial Markets

Interest Rate
(%)
18

16

14
BBB

12

10

8
AAA
6

0
1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

FIGURE 12.5   Corporate Bond Interest Rates, 1973–2015 (End of year)

Source: http://www.federalreserve.gov/releases/h15/data.htm.

rating (AAA being the highest) have lower interest rates than more risky bonds
(BBB). The spread between the differently rated bonds varies over time. The spread
between AAA and BBB rated bonds has historically averaged a little over 1%. As the
financial crisis unfolded, investors seeking safety caused the spread to hit a record
3.38% in December 2008. A bond’s interest rate also depends on its features and
characteristics, which are described in the following sections.

Characteristics of Corporate Bonds

At one time bonds were sold with attached coupons that the owner of the bond
clipped and mailed to the firm to receive interest payments. These were called
bearer bonds because payments were made to whoever had physical possession of
the bonds. The Internal Revenue Service did not care for this method of payment,
however, because it made tracking interest income difficult. Bearer bonds have now
been largely replaced by registered bonds, which do not have coupons. Instead,
the owner must register with the firm to receive interest payments. The firms are
required to report to the IRS the name of the person who receives interest income.
Despite the fact that bearer bonds with attached coupons have been phased out, the
interest paid on bonds is still called the “coupon interest payment,” and that interest
payment divided by a bond’s par value is the coupon interest rate.

Restrictive Covenants  A corporation’s financial managers are hired, fired,

and compensated at the direction of the board of directors, which represents the

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 CHAPTER 12   The Bond Market 319

corporation’s stockholders. This arrangement implies that the managers will be more
interested in protecting stockholders than in protecting bondholders. You should
recognize this as an example of the moral hazard problem introduced in Chapter 2
and discussed further in Chapter 7. Managers might not use the funds provided
by the bonds as the bondholders might prefer. Since bondholders cannot look to
managers for protection when the firm gets into trouble, they must impose rules
and restrictions on managers designed to protect the bondholders’ interests. These
are known as restrictive covenants. They usually limit the amount of dividends
the firm can pay (to conserve cash for interest payments to bondholders) and the
ability of the firm to issue additional debt. Other financial policies, such as the firm’s
involvement in mergers, may also be restricted. Restrictive covenants are included
in the bond indenture. Typically, the interest rate is lower the more restrictions
are placed on management through these covenants because the bonds will be
considered safer by investors.

Call Provisions  Most corporate indentures include a call provision, which states
that the issuer has the right to force the holder to sell the bond back. The call
provision usually requires a waiting period between the time the bond is initially
issued and the time when it can be called. The price bondholders are paid for the
bond is usually set at the bond’s par price or slightly higher (usually by one year’s
interest cost). For example, a 10% coupon rate $1,000 bond may have a call price
of $1,100.
If interest rates fall, the price of the bond will rise. If rates fall enough, the price
will rise above the call price, and the firm will call the bond. Because call provisions
put a limit on the amount that bondholders can earn from the appreciation of a
bond’s price, investors do not like call provisions.
A second reason that issuers of bonds include call provisions is to make it pos-
sible for them to buy back their bonds according to the terms of the sinking fund.
A sinking fund is a requirement in the bond indenture that the firm pay off a portion
of the bond issue each year. This provision is attractive to bondholders because it
reduces the probability of default when the issue matures. Because a sinking fund
provision makes the issue more attractive, the firm can reduce the bond’s interest
rate.
A third reason firms usually issue only callable bonds is that firms may have to
retire a bond issue if the covenants of the issue restrict the firm from some activity
that it feels is in the best interest of stockholders. Suppose that a firm needed to
borrow additional funds to expand its storage facilities. If the firm’s bonds carried a
restriction against adding debt, the firm would have to retire its existing bonds
before issuing new bonds or taking out a loan to build the new warehouse.
Finally, a firm may choose to call bonds if it wishes to alter its capital structure.
A maturing firm with excess cash flow may wish to reduce its debt load if few attrac-
tive investment opportunities are available.
Because bondholders do not generally like call provisions, callable bonds must
have a higher yield than comparable noncallable bonds. Despite the higher cost,
firms still typically issue callable bonds because of the flexibility this feature pro-
vides the firm.

Conversion  Some bonds can be converted into shares of common stock. This
feature permits bondholders to share in the firm’s good fortunes if the stock price
rises. Most convertible bonds will state that the bond can be converted into a certain

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 320 PART 5  Financial Markets

number of common shares at the discretion of the bondholder. The conversion ratio
will be such that the price of the stock must rise substantially before conversion is
likely to occur.
Issuing convertible bonds is one way firms avoid sending a negative signal to the
market. In the presence of asymmetric information between corporate insiders and
investors, when a firm chooses to issue stock, the market usually interprets this
action as indicating that the stock price is relatively high or that it is going to fall in
the future. The market makes this interpretation because it believes that managers
are most concerned with looking out for the interests of existing stockholders and
will not issue stock when it is undervalued. If managers believe that the firm will
perform well in the future, they can, instead, issue convertible bonds. If the manag-
ers are correct and the stock price rises, the bondholders will convert to stock at a
relatively high price that managers believe is fair. Alternatively, bondholders have
the option not to convert if managers turn out to be wrong about the company’s
future.
Bondholders like a conversion feature. It is very similar to buying just a bond
but receiving both a bond and a stock option (stock options are discussed fully in
Chapter 24). The price of the bond will reflect the value of this option and so will be
higher than the price of comparable nonconvertible bonds. The higher price received
for the bond by the firm implies a lower interest rate.

Types of Corporate Bonds

A variety of corporate bonds are available. They are usually distinguished by the
type of collateral that secures the bond and by the order in which the bond is paid
off if the firm defaults.

Secured Bonds  Secured bonds are ones with collateral attached. Mortgage
bonds are used to finance a specific project. For example, a building may be the
collateral for bonds issued for its construction. In the event that the firm fails to
make payments as promised, mortgage bondholders have the right to liquidate the
property in order to be paid. Because these bonds have specific property pledged
as collateral, they are less risky than comparable unsecured bonds. As a result, they
will have a lower interest rate.
Equipment trust certificates are bonds secured by tangible non-real-estate
property, such as heavy equipment and airplanes. Typically, the collateral backing
these bonds is more easily marketed than the real property backing mortgage bonds.
As with mortgage bonds, the presence of collateral reduces the risk of the bonds and
so lowers their interest rates.

Unsecured Bonds  Debentures are long-term unsecured bonds that are backed
only by the general creditworthiness of the issuer. No specific collateral is pledged
to repay the debt. In the event of default, the bondholders must go to court to seize
assets. Collateral that has been pledged to other debtors is not available to the
holders of debentures. Debentures usually have an attached contract that spells
out the terms of the bond and the responsibilities of management. The contract
attached to the debenture is called an indenture. (Be careful not to confuse the
terms debenture and indenture.) Debentures have lower priority than secured
bonds if the firm defaults. As a result, they will have a higher interest rate than
otherwise comparable secured bonds.

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 CHAPTER 12   The Bond Market 321

Subordinated debentures are similar to debentures except that they have a

lower priority claim. This means that in the event of a default, subordinated
debenture holders are paid only after nonsubordinated bondholders have been paid
in full. As a result, subordinated debenture holders are at greater risk of loss.
Variable-rate bonds (which may be secured or unsecured) are a financial inno-
vation spurred by increased interest-rate variability in the 1980s and 1990s. The
interest rate on these securities is tied to another market interest rate, such as the
rate on Treasury bonds, and is adjusted periodically. The interest rate on the bonds
will change over time as market rates change.

Junk Bonds  Recall from Chapter 5 that all bonds are rated by various credit-rating
agencies according to their default risk. These companies study the issuer’s financial
characteristics and make a judgment about the issuer’s possibility of default. A bond
with a rating of AAA has the highest grade possible. Bonds at or above Moody’s
Baa or Standard and Poor’s BBB rating are considered to be of investment grade.
Those rated below this level are usually considered speculative (see Table 12.2).
Speculative-grade bonds are often called junk bonds. Before the late 1970s, primary
issues of speculative-grade securities were very rare; almost all new bond issues
consisted of investment-grade bonds. If companies ran into financial difficulties,
their bond ratings would fall, sometimes into the junk bond range. Holders of these
downgraded bonds found that they were difficult to sell because no well-developed
secondary market existed. It is easy to understand why investors would be leery of
these securities, as they were usually unsecured.
In 1977 Michael Milken, at the investment banking firm of Drexel Burnham
Lambert, recognized that there were many investors who would be willing to take
on greater risk if they were compensated with greater returns. First, however,
Milken had to address two problems that hindered the market for low-grade bonds.
The first was that they suffered from poor liquidity. Whereas underwriters of
investment-grade bonds continued to make a market after the bonds were issued,
no such market maker existed for junk bonds. Drexel agreed to assume this role as
market maker for junk bonds. Making a market meant that Drexel agreed to stand
ready to buy or sell these bonds at all times. That ensured the existence of a second-
ary market, an important consideration for investors, who seldom want to hold the
bonds to maturity.
The second problem with the junk bond market was that a very real chance
existed that the issuing firms would default on their bond payments. By comparison,
the default risk on investment-grade securities was negligible. To reduce the prob-
ability of losses, Milken acted much as a commercial bank for junk bond issuers. He
would renegotiate the firm’s debt or advance additional funds if needed to prevent
the firm from defaulting. Milken’s efforts substantially reduced the default risk, and
the demand for junk bonds soared.
During the early and mid-1980s, many firms took advantage of junk bonds to
finance the takeover of other firms. When a firm greatly increases its debt level (by
issuing junk bonds) to finance the purchase of another firm’s stock, the increase in
leverage makes the bonds high risk. Frequently, part of the acquired firm is eventu-
ally sold to pay down the debt incurred by issuing the junk bonds. Some 1,800 firms
accessed the junk bond market during the 1980s.
Milken and his brokerage firm were very well compensated for their efforts.
Milken earned a fee of 2% to 3% of each junk bond issue, which made Drexel the

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 322 PART 5  Financial Markets

TABLE 12.2   Debt Rating Descriptions

Standard &
Poor’s Moody’s Definition

AAA Aaa Best quality and highest rating. Capacity to pay interest
and repay principal is extremely strong. Smallest degree
of investment risk.
AA Aa High quality. Very strong capacity to pay interest and
repay principal and differs from AAA/Aaa in a small
degree.
A A Strong capacity to pay interest and repay principal.
Possess many favorable investment attributes and are
considered upper-medium-grade obligations. Somewhat
more susceptible to the adverse effects of changes in
circumstances and economic conditions.
BBB Baa Medium-grade obligations. Neither highly protected
nor poorly secured. Adequate capacity to pay interest
and repay principal. May lack long-term reliability and
protective elements to secure interest and principal
payments.
BB Ba Moderate ability to pay interest and repay principal. Have
speculative elements and future cannot be considered
well assured. Adverse business, economic, and financial
conditions could lead to inability to meet financial
obligations.
B B Lack characteristics of desirable investment. Assurance of
interest and principal payments over long period of time
may be small. Adverse conditions likely to impair ability
to meet financial obligations.
CCC Caa Poor standing. Identifiable vulnerability to default and
dependent on favorable business, economic, and
financial conditions to meet timely payment of interest
and repayment of principal.
CC Ca Represent obligations that are speculative to a high
degree. Issues often default and have other marked
shortcomings.
C C Lowest-rated class of bonds. Have extremely poor
prospects of attaining any real investment standard. May
be used to cover a situation where bankruptcy petition
has been filed, but debt service payments are continued.
CI Reserved for income bonds on which no interest is being
paid.
D Payment default.
NR No public rating has been requested.
(+) or (–) Ratings from AA to CCC may be modified by the addition
of a plus or minus sign to show relative standing within
the major rating categories.

Source: Federal Reserve Bulletin.

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 CHAPTER 12   The Bond Market 323

most profitable firm on Wall Street in 1987. Milken’s personal income between 1983
and 1987 was in excess of $1 billion.
Unfortunately for holders of junk bonds, both Milken and Drexel were caught
and convicted of insider trading. With Drexel unable to support the junk bond
market, 250 companies defaulted between 1989 and 1991. Drexel itself filed bank-
ruptcy in 1990 due to losses on its own holdings of junk bonds. Milken was sen-
tenced to three years in prison for his part in the scandal. Fortune magazine
reported that Milken’s personal fortune still exceeded $400 million.2
The junk bond market had largely recovered since its low in 1990, but the finan-
cial crisis in 2008 again reduced the demand for riskier securities. This market
behavior was rational, considering that in 2008 the default rate on speculative-grade
bonds was three times that of investment-grade bonds.

Financial Guarantees for Bonds

Financially weaker security issuers frequently purchase financial guarantees to
lower the risk of their bonds. A financial guarantee ensures that the lender (bond
purchaser) will be paid both principal and interest in the event the issuer defaults.
Large, well-known insurance companies write what are actually insurance policies
to back bond issues. With such a financial guarantee, bond buyers no longer have to
be concerned with the financial health of the bond issuer. Instead, they are inter-
ested only in the strength of the insurer. Essentially, the credit rating of the insurer
is substituted for the credit rating of the issuer. The resulting reduction in risk low-
ers the interest rate demanded by bond buyers. Of course, issuers must pay a fee to
the insurance company for the guarantee. Financial guarantees make sense only
when the cost of the insurance is less than the interest savings that result.
In 1995 J.P. Morgan introduced a new way to insure bonds called the credit
default swap (CDS). In its simplest form a CDS provides insurance against default
in the principal and interest payments of a credit instrument. Say you decided to
buy a GE bond and wanted to insure yourself against any losses that might occur
should GE have problems. You could buy a CDS from a variety of sources that would
provide this protection.
In 2000 Congress passed the Commodity Futures Modernization Act, which
removed derivative securities, such as CDSs, from regulatory oversight. Additionally,
it preempted states from enforcing gaming laws on these types of securities. The
effect of this regulation was to make it possible for investors to speculate on the
possibility of default on securities they did not own. Consider the idea that you
could buy life insurance on anyone you felt looked unhealthy. Insurance laws pre-
vent this type of speculation by requiring that you must be in a position to suffer a
loss before you can purchase insurance. The Commodity Futures Modernization Act
removed this requirement for derivative securities. Thus, speculators could, in
essence, legally bet on whether a firm or security would fail in the future.
Between 2000 and 2008, major CDS players included AIG, Lehman Brothers,
and Bear Stearns. The amount of CDSs outstanding mushroomed to over $62 trillion
by its peak in 2008. To put that figure in context, the Gross National Product of the
entire world is around $50 trillion. In 2008 Lehman Brothers failed, Bear Stearns

2
A complete history of Milken was reported in Fortune (September 30, 1996): 80–105.

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 324 PART 5  Financial Markets

TABLE 12.3   Sample Violations and Fines in the Bond Market

Violation Fine

Excessive trading $5,000 to $110,000

Excessive markups $5,000 to $146,000
Failure to supervise $5,000 to $73,000
Fraud/Misrepresentation $2,500 to $146,000
Late reporting $5,000 to $146,000
Net capital deficiencies $1,000 to $73,000
Outside business activities $2,500 to $73,000
Recordkeeping violations $1,000 to $146,000
Sale of unregistered securities $2,500 to $73,000
Unsuitable recommendations $2,500 to $110,000

was acquired by J.P. Morgan for pennies on the dollar, and AIG required a $182 bil-
lion government bailout. This topic is discussed in greater detail in Chapter 21,
“Insurance and Pension Funds.”

Oversight of the Bond Markets

Stocks typically sell in public markets where bid and ask prices are readily available
and transparent. By contrast, bonds typically trade over the counter, where transac-
tion details can be hidden from the public. To open this market to scrutiny, in 2002
the Securities and Trade Commission created a trade reporting and compliance
engine (TRACE). TRACE has two significant missions:

1. Rules that say which bond transactions must be publicly reported.

2. The establishment of a trading platform that makes transaction data readily
available to the public.

TRACE is under the Financial Industry Regulatory Authority (FINRA). All compa-
nies that trade securities are required to be members of FINRA. FINRA was for-
merly the National Association of Securities Dealers (NASD). In 2007 it was created
to consolidate the regulatory and oversight functions of NASD with those of the New
York Stock Exchange.
The most common violations of rules that result in fines or charges relate to
anti–money laundering, the distribution of securities, quality of markets, reporting
and recordkeeping, sales practices, and supervision. Sample violations and the range
of fines that can be assessed are shown in Table 12.3.

Current Yield Calculation

Chapter 3 introduced interest rates and described the concept of yield to maturity.
If you buy a bond and hold it until it matures, you will earn the yield to maturity.
This represents the most accurate measure of the yield from holding a bond.

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 CHAPTER 12   The Bond Market 325

Current Yield
The current yield is an approximation of the yield to maturity on coupon bonds
that is often reported because it is easily calculated. It is defined as the yearly cou-
pon payment divided by the price of the security,
C
ic = (1)
P
where ic = current yield
P = price of the coupon bond
C = yearly coupon payment
This formula is identical to the formula in Equation 5 of Chapter 3, which
describes the calculation of the yield to maturity for a perpetuity. Hence for a per-
petuity, the current yield is an exact measure of the yield to maturity. When a cou-
pon bond has a long term to maturity (say, 20 years or more), it is very much like a
perpetuity, which pays coupon payments forever. Thus, you would expect the cur-
rent yield to be a rather close approximation of the yield to maturity for a long-term
coupon bond, and you can safely use the current yield calculation instead of looking
up the yield to maturity in a bond table. However, as the time to maturity of the
coupon bond shortens (say, it becomes less than five years), it behaves less and less
like a perpetuity and so the approximation afforded by the current yield becomes
worse and worse.
We have also seen that when the bond price equals the par value of the bond,
the yield to maturity is equal to the coupon rate (the coupon payment divided by
the par value of the bond). Because the current yield equals the coupon payment
divided by the bond price, the current yield is also equal to the coupon rate when
the bond price is at par. This logic leads us to the conclusion that when the bond
price is at par, the current yield equals the yield to maturity. This means that the
nearer the bond price is to the bond’s par value, the better the current yield will
approximate the yield to maturity.
The current yield is negatively related to the price of the bond. In the case of
our 10% coupon rate bond, when the price rises from $1,000 to $1,100, the current
yield falls from 10% ( = $100/$1,000) to 9.09% ( = $100/$1,100). As Table 3.1 in
Chapter 3 indicates, the yield to maturity is also negatively related to the price of
the bond; when the price rises from $1,000 to $1,100, the yield to maturity falls from
10% to 8.48%. In this we see an important fact: The current yield and the yield to
maturity always move together; a rise in the current yield always signals that the
yield to maturity has also risen.

EXAMPLE 12.2
Current Yield What is the current yield for a bond that has a par value of $1,000 and a coupon interest
rate of 10.95%? The current market price for the bond is $921.01.
Solution
The current yield is 11.89%.

C
ic =
P

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 326 PART 5  Financial Markets

where
C = yearly payment = 0.1095 * $1,000 = $109.50
P = price of the bond = $921.01
Thus,

$109.50
ic = = 0.1189 = 11.89%
$921.01

The general characteristics of the current yield (the yearly coupon payment
divided by the bond price) can be summarized as follows: The current yield bet-
ter approximates the yield to maturity when the bond’s price is nearer to
the bond’s par value and the maturity of the bond is longer. It becomes a
worse approximation when the bond’s price is further from the bond’s par
value and the bond’s maturity is shorter. Regardless of whether the current
yield is a good approximation of the yield to maturity, a change in the current yield
always signals a change in the same direction of the yield to maturity.

Finding the Value of Coupon Bonds

Before we look specifically at how to price bonds, let us first look at the general
theory behind computing the price of any business asset. Luckily, the value of all
financial assets is found the same way. The current price is the present value of all
future cash flows. Recall the discussion of present value from Chapter 3. If you have
the present value of a future cash flow, you can exactly reproduce that future cash
flow by investing the present value amount at the discount rate. For example, the
present value of $100 that will be received in one year is $90.90 if the discount rate
is 10%. An investor is completely indifferent between having the $90.90 today or
having the $100 in one year. This is because the $90.90 can be invested at 10% to
provide $100.00 in the future ($90.90 * 1.10 = $100). This represents the essence
of value. The current price must be such that the seller is indifferent between con-
tinuing to receive the cash flow stream provided by the asset and receiving the offer
price.
One question we might ask is why prices fluctuate if everyone knows how value
is established. It is because not everyone agrees about what the future cash flows
are going to be. Let us summarize how to find the value of a security:

1. Identify the cash flows that result from owning the security.
2. Determine the discount rate required to compensate the investor for holding
the security.
3. Find the present value of the cash flows estimated in step 1 using the discount
rate determined in step 2.

The rest of this chapter focuses on how one important asset is valued: bonds. In
the next chapter we discuss stock valuation. The unifying theme is that prices
(value) are always determined the same way. They are simply the present value of

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 CHAPTER 12   The Bond Market 327

the future cash flows. This concept applies to bonds, stocks, businesses, buildings,
and any other investment.

Finding the Price of Semiannual Bonds

Recall that a bond usually pays interest semiannually in an amount equal to the
coupon interest rate times the face amount (or par value) of the bond. When the
bond matures, the holder will also receive a lump sum payment equal to the face
amount. Most corporate bonds have a face amount of $1,000. Basic bond terminol-
ogy is reviewed in Table 12.4.
The issuing corporation will usually set the coupon rate close to the rate avail-
able on other similar outstanding bonds at the time the bond is offered for sale.
Unless the bond has an adjustable rate, the coupon interest payment remains
unchanged throughout the life of the bond.
The first step in finding the value of the bond is to identify the cash flows the
holder of the bond will receive. The value of the bond is the present value of these
cash flows. The cash flows consist of the interest payments and the final lump sum
repayment.
In the second step these cash flows are discounted back to the present using an
interest rate that represents the yield currently available on other bonds of like risk
and maturity.
The technique for computing the price of a simple bond with annual cash flows
was discussed in detail in Chapter 3. Let us now look at a more realistic example.
Most bonds pay interest semiannually. To adjust the cash flows for semiannual pay-
ments, divide the coupon payment by 2, since only half of the annual payment is
paid each six months. Similarly, to find the interest rate effective during one-half of
the year, the market interest rate must be divided by 2. The final adjustment is to

TABLE 12.4   Bond Terminology

Coupon interest rate The stated annual interest rate on the bond. It is usually fixed
for the life of the bond.
Current yield The coupon interest payment divided by the current market
price of the bond.
Face amount The maturity value of the bond. The holder of the bond will
receive the face amount from the issuer when the bond
matures. Face amount is synonymous with par value.
Indenture The contract that accompanies a bond and specifies the terms
of the loan agreement. It includes management restrictions,
called covenants.
Market rate The interest rate currently in effect in the market for securities
of similar risk and maturity. The market rate is used to value
bonds.
Maturity The number of years or periods until the bond matures and the
holder is paid the face amount.
Par value The same as face amount, the maturity value of the bond.
Yield to maturity The yield an investor will earn if the bond is purchased at the
current market price and held until maturity.

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 328 PART 5  Financial Markets

double the number of periods because there will be two periods per year. Equation 2
shows how to compute the price of a semiannual bond:3

C>2 C>2 C>2 C>2 F

Psemi = + 2
+ 3
+ g+ + (2)
1 + i>2 (1 + i>2) (1 + i>2) (1 + i>2)2n (1 + i>2)2n

where Psemi = price of semiannual coupon bond

C = yearly coupon payment
F = face value of the bond
n = years to maturity date
i = annual market interest rate

EXAMPLE 12.3
Bond Valuation, Let us compute the price of a sample bond. Suppose the bonds have a 10% coupon
Semiannual rate, a $1,000 par value (maturity value), and mature in two years. Assume semiannual
compounding and that market rates of interest are 12%.
Payment Bond
Solution
1. Begin by identifying the cash flows. Compute the coupon interest payment by
multiplying 0.10 times $1,000 to get $100. Since the coupon payment is made
each six months, it will be one-half of $100, or $50. The final cash flow consists
of repayment of the $1,000 face amount of the bond. This does not change
because of semiannual payments.
2. We need to know what market rate of interest is appropriate to use for computing
the present value of the bond. We are told that bonds being issued today with
similar risk and maturity have coupon rates of 12%. Divide this amount by 2 to
get the interest rate over six months. This provides an interest rate of 6%.
3. Find the present value of the cash flows. Note that with semiannual compound-
ing the number of periods must be doubled. This means that we discount the
bond payments for four periods.
Solution: Equation
$100>2 $100>2 $100>2 $100>2 $1,000
P = + + + 4
+
(1 + .06) (1 + .06) 2
(1 + .06) 3
(1 + .06) (1 + .06)4
P = $47.17 + $44.50 + $41.98 + $39.60 + $792.10 = $965.35
Solution: Financial Calculator
N = 4
FV = $1,000

3
There is a theoretical argument for discounting the final cash flow using the full-year interest rate
with the original number of periods. Derivative securities are sold, in which the principal and interest
cash flows are separated and sold to different investors. The fact that one investor is receiving semian-
nual interest payments should not affect the value of the principal-only cash flow. However, virtually
every text, calculator, and spreadsheet computes bond values by discounting the final cash flow using
the same interest rate and number of periods as is used to compute the present value of the interest
payments. To be consistent, we will use that method in this text.

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 CHAPTER 12   The Bond Market 329

I = 6%
PMT = $50
Compute PV = price of bond = $965.35.
Note that the most common mistake students make is to confuse when to use the cou-
pon rate and when to use the market rate. The coupon rate is used only to compute the
interest payments that will be received. The market rate is used to discount the interest
payment back to the present.

Notice that the market price for the bond in Example 3 is below the $1,000 par
value of the bond. When the bond sells for less than the par value, it is selling at a
discount. When the market price exceeds the par value, the bond is selling at a
premium.
What determines whether a bond will sell for a premium or a discount? Suppose
that you are asked to invest in an old bond that has a coupon rate of 10% and $1,000
par. You would not be willing to pay $1,000 for this bond if new bonds with similar
risk were available yielding 12%. The seller of the old bond would have to lower the
price on the 10% bond to make it an attractive investment. In fact, the seller would
have to lower the price until the yield earned by a buyer of the old bond equaled the
yield on similar new bonds. This means that as interest rates in the market rise, the
value of bonds with fixed coupon rates falls. Similarly, as interest rates available in
the market on new bonds fall, the value of old fixed-coupon-rate bonds rises.

Investing in Bonds
Bonds represent one of the most popular long-term alternatives to investing in
stocks (see Figure 12.6). Bonds are lower risk than stocks because they have a
higher priority of payment. This means that when the firm is having difficulty meet-
ing its obligations, bondholders get paid before stockholders. Additionally, should
the firm have to liquidate, bondholders must be paid before stockholders.
Even healthy firms with sufficient cash flow to pay both bondholders and stock-
holders frequently have very volatile stock prices. This volatility scares many inves-
tors out of the stock market. Bonds are the most popular alternative. They offer
relative security and dependable cash payments, making them ideal for retired
investors and those who want to live off their investments.
Many investors think that bonds represent a very low risk investment, since the
cash flows are relatively certain. It is true that high-grade bonds seldom default;
however, bond investors face fluctuations in price due to market interest-rate move-
ments in the economy. As interest rates rise and fall, the value of bonds changes in
the opposite direction. As discussed in Chapter 3, the possibility of suffering a loss
because of interest-rate changes is called interest-rate risk. The longer the time
until the bond matures, the greater will be the change in price. This does not cause
a loss to those investors who do not sell their bonds; however, many investors do not
hold their bonds until maturity. If they attempt to sell their bonds after interest rates
have risen, they will receive less than they paid. Interest-rate risk is an important
consideration when deciding whether to invest in bonds.

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 330 PART 5  Financial Markets

Amount Issued
($ billions)
2,600
2,400
2,200
2,000
1,800 Stock Issued
Bonds Issued
1,600
1,400
1,200
1,000
800
600
400
200
0
83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

FIGURE 12.6   Bonds and Stocks Issued, 1983–2015

Source: http://www.federalreserve.gov/econresdata/releases/corpsecure/current.htm.

SUMMARY
1. The capital markets exist to provide financing for tures also contain many provisions that make them
long-term capital assets. Households, often through more or less attractive to investors, such as a call
investments in pension and mutual funds, are net option, convertibility, or a sinking fund.
investors in the capital markets. Corporations and 4. The value of any business asset is computed the same
the federal and state governments are net users of way, by computing the present value of the cash flows
these funds. that will go to the holder of the asset. For example, a
2. The three main capital market instruments are bonds, commercial building is valued by computing the pres-
stocks, and mortgages. Bonds represent borrowing by ent value of the net cash flows the owner will receive.
the issuing firm. Stock represents ownership in the We compute the value of bonds by finding the pres-
issuing firm. Mortgages are long-term loans secured ent value of the cash flows, which consist of periodic
by real property. Only corporations can issue stock. interest payments and a final principal payment.
Corporations and governments can issue bonds. In 5. The value of bonds fluctuates with current market
any given year, far more funds are raised with bonds prices. If a bond has an interest payment based on a
than with stock. 5% coupon rate, no investor will buy it at face value
3. Firm managers are hired by stockholders to protect if new bonds are available for the same price with
and increase their wealth. Bondholders must rely on interest payments based on 8% coupon interest. To
a contract called an indenture to protect their inter- sell the bond, the holder will have to discount the
ests. Bond indentures contain covenants that restrict price until the yield to the holder equals 8%. The
the firm from activities that increase risk and hence amount of the discount is greater the longer the term
the chance of defaulting on the bonds. Bond inden- to maturity.

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 CHAPTER 12   The Bond Market 331

KEY TERMS
bond indenture, p. 317 general obligation bonds, p. 316 Separate Trading of Registered
call provision, p. 319 initial public offering (IPO), p. 310 Interest and Principal Securities
coupon rate, p. 310 interest-rate risk, p. 329 (STRIPS), p. 313
credit default swap (CDS), p. 323 junk bonds, p. 321 sinking fund, p. 319
current yield, p. 325 premium, p. 329 TRACE, p. 324
discount, p. 329 registered bonds, p. 318 zero-coupon securities,
financial guarantees, p. 323 restrictive covenants, p. 319 p. 313
FINRA, p. 324 revenue bonds, p. 316

QUESTIONS
1. Contrast investors’ use of capital markets with their 7. What does it mean when a bond is referred to as
use of money markets. a convertible bond? Would a convertible bond be
2. Differentiate between primary and secondary capital more or less attractive to a bond holder than a
markets. What is an initial public offering (IPO)? non-convertible bond?
3. What two characteristics make bonds a more popular 8. A call provision on a bond allows the issuer to redeem
long-term alternative to investing in stocks? the bond at will. Investors do not like call provisions and
so require higher interest on callable bonds. Why do
4. Does it seem right to you that one could buy insur-
issuers continue to issue callable bonds anyway?
ance on anyone who looks unhealthy? Why?
9. What are restrictive covenants? Why are they associ-
5. Distinguish between an investment-grade bond and
ated with interest rates of bonds?
a junk bond.
10. What is the difference between general obligation
6. As interest rates in the market change over time, the
bonds and revenue bonds?
market price of bonds rises and falls. The change in the
value of bonds due to changes in interest rates is a risk 11. What are the risks an investor would face when mak-
incurred by bond investors. What is this risk called? ing an investment in corporate bonds?

Q U A N T I TAT I V E P R O B L E M S
1. You are considering buying a bond that matures in a. If both bonds had a required rate of return of 10%,
10 years from today. The par value of the bond is what would the bonds’ prices be?
$10,000 and the coupon rate is 7%. If the current b. Explain what it means when a bond is selling at
market interest rates are 5%, what is the bond price a discount, a premium, or at its face amount (par
today if the coupon is paid annually? value). Based on results in part (a), would you
2. What is the current yield to maturity on the zero cou- consider both bonds to be selling at a discount,
pon bond that has a face amount (or par value) of premium, or at par?
$1,000 and the current market price for the bond is c. Re-calculate the prices of the bonds if the required
$850? The bond matures in 4 years. return falls to 9%.
3. Suppose there are two bonds you are considering: 4. An investor has the following options:
a. To buy a two-year $1,000 zero-coupon bond at a
Bond A Bond B market price of $860.
b. To buy a two-year $1,000 bond with an annual
Maturity (years) 20 30 interest of 3% for $900.
Coupon rate (%) 12 8 Assuming annual payments, which option do you
(paid semiannually) think the investor should choose? (Hint: Base your
Par value $1,000 $1,000 answer on the yield to maturity concept.)

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 332 PART 5  Financial Markets

5. Consider the following cash flows. All market interest 3 years. Calculate the current yield for both bonds if
rates are 12%. both have a coupon rate equal to 5%. Which current
yield is a better approximation of the yield to matu-
Year 0 1 2 3 4 rity? (Assume a yearly coupon payment.)
11. A $1,000 par bond with an annual coupon has only
Cash Flow 160 170 180 230
one year until maturity. Its current yield is 7.621%
and its yield to maturity is 12%. What is the price of
a. What price would you pay for these cash flows?
the bond?
What total wealth do you expect after 2.5 years
if you sell the rights to the remaining cash flows? 12. A one-year premium bond with a face value of $10,000
Assume interest rates remain constant. has been purchased for $11,150. What is the yield to
maturity? What is the yield on a discount basis? (See
b. Immediately after buying these cash flows, all mar-
Chapters 3 and 12.)
ket interest rates drop to 11%. What is the impact
on your total wealth after 2.5 years? 13. Sun Corporation has a convertible bond with face
value of $1,000, coupon rate of 6%, and with annual
6. An investor is considering two bonds. One is a corpo-
payments for 5 years. The bond can be converted
rate bond yielding 12%, and is currently selling at par.
into 25 shares of common equity (currently trading
The marginal tax rate is 28%. The other is a municipal
at $45 per share).What will be the best option for the
bond with a coupon rate of 9.50%. Which should the
investor—to convert the bonds or to sell them? The
investor choose?
market rate is 7%.
7. Suppose a municipal bond offers a yield to maturity
14. Your company owns the following bonds:
of 5% and a same maturity corporate bond offers a
4% yield. For which values of the marginal tax rate
would an investor prefer to buy the corporate bond? Bond Market Value Duration
8. A & B Corporation issued bonds for 10 years, with
face value of $10,000 and a 6% annual coupon rate. A $13 million 2
What is the current market price of the bond if the B $18 million 4
market rate is 8%? Assume semi-annual payments. C $20 million 3
9. Refer to the previous problem. How would your
answer change if the market rate falls to 6%? If general interest rates rise from 8% to 8.5%, what is
10. Consider two $10,000 face-value corporate bonds. the approximate change in the value of the portfolio?
One is currently selling for $9,980 and matures in 15 (Review Chapter 3.)
years. The other bond sells for $9,350 and matures in

WEB EXERCISE
The Bond Market calculator/index. Under Retirement find the cal-
1. Stocks tend to get more publicity than bonds, but culator “How should I allocate my assets?” After
many investors, especially those nearing or in retire- answering the questionnaire, discuss whether you
ment, find that bonds are more consistent with their agree with the recommended asset destination.
risk preferences. Go to http://finance.yahoo.com/

M12_MISH5006_09_GE_C12.indd 332 06/11/17 10:56 AM