Week 5: Bond Markets

I. Bond Background
a. Long term debt securities
b. Issued by governments and corporations
c. The issuer pays interest on a periodic basis
d. The issuer also pays back the par value at maturity
II. Major types of Bonds
a. Treasury and Federal Agency
i. Treasury note
1. Maturity: less than 10 years
2. Credit risk: none
3. Tax: federal, not state or local
4. Secondary market: highly liquid
ii.Treasury Bond
1. Maturity: 10 years or more
2. Credit risk: none
3. Tax: federal, not state or local
4. Secondary market: highly liquid
iii.Treasury bond auctions
1. The Treasury utilizes auctions to sell bonds
a. Announces bond auction and parameters
of the bonds it intends to sell
2. Competitive bids
a. Buyer specifies a price and $ amount to
be purchased
3. Noncompetitive bids
a. Specify a $ amount to be purchased
subject to a maximum
4. Treasury ranks the competitive bids in
descending order based on price bid per $100
of par value
5. Treasury then accepts bids up to the amount of
funding needed
6. Lowest bid price is applied to all accepted bids
iv.Example #1: simulate a bond auction in class
1. Each participant has a designated $ amount of
bonds to purchase and needs to determine the
price they are willing to pay
2. Competitive bids designate a price (quoted as
yield in this case)
3. Treasury parameters
a. Desire to raise $500,000
b. $1000 increments
c. noncompetitive bids capped at $75,000
 4. Build demand schedule from competitive bids–
aggregate all noncompetitive bids and
determine price
v.Stripped Treasury bonds
1. A Treasury bond is “stripped” of its interest
payments
2. The result is two securities
a. The principal payment (principal only)
b. The interest payments (interest only)
3. Not issued by Treasury – created by financial
firms from Treasury securities
4. Secondary market: highly liquid
vi.Treasury inflation-protected securities (TIPS)
1. Principal value is indexed to inflation and
adjusted every six months
2. Secondary market – active, but not as liquid as
traditional Treasury bonds
vii.Savings bonds
1. Maturity: 30 years
2. Secondary market: none, but can be redeemed
at the Treasury with a penalty
3. Taxation: Subject to federal taxation but not
state and local
viii.Federal Agency bonds
1. Issued by federal agencies
2. Government National Mortgage Association
(Ginnie Mae)
3. Federal National Mortgage Association (Fannie
Mae)
b. Municipal Bonds
i. Issued by state and local governments
1. General obligation bonds
2. Revenue bonds
ii.Credit risk: some credit risk
1. Less than 0.5% have defaulted since 1940
2. Rating agencies routinely rate municipal bonds
iii.Tax: normally exempt from federal tax
iv.Liquidity: slightly less liquid than Treasury bonds
c. Corporate Bonds
i. Semiannual coupon payments
ii.Maturity: 10-30 years
iii.Credit risk based on corporation
iv.Offering:
1. Public offering
2. Private Placement
v.Characteristics
 1. Sinking fund provision
2. Protective covenants
3. Call provisions
4. Collateral (secured vs unsecured)
5. Low and zero-coupon
6. Variable rate bonds
7. Convertibility
vi.Yields and risks
1. Review of corporate bond credit spread puzzle
2. Default rates and contagion
3. Ratings
4. Junk bonds
d. Rating Agencies

Moody's S&P Fitch

Long Term Short Term Long Term Short Term Long Term Short Term
Aaa AAA AAA Prime
Aa1 AA+ AA+
A-1+ A1+
Aa2 AA AA High grade
P-1
Aa3 AA- AA-
A1 A+ A+
A-1 A1
A2 A A Upper medium grade
A3 A- A-
P-2 A-2 A2
Baa1 BBB+ BBB+
Baa2 BBB BBB Lower medium grade
P-3 A-3 A3
Baa3 BBB- BBB-
Ba1 BB+ BB+
Non Investment grade
Ba2 BB BB
speculative
Ba3 BB- BB-
B B
B1 B+ B+
B2 B B Highly Speculative
B3 B- B-
Caa1 Not Prime CCC+ Substantial risks
Caa2 CCC Extremely speculative
C CCC C
Caa3 CCC- In default with little
Ca CC prospect for recovery
/ DDD
/ D / DD / In default
/ D