Chapter 7

Greek Debt crisis:

-2010 — Greece experienced debt crisis brought on by weak economic conditions and a large government budget deficit. -Credit ratings on Greece were reduced several times. Concern also spread to Spain and Portugal

Global Government Debt Markets.

-Bonds issued by foreign governments are attractive to investors because of the government's ability to meet debt obligations

Liquidity in Secondary Market:

-Bonds issued by large, well known firms are liquid. -Bonds issued by smaller, lesser known firms are less liquid

Municipal Bonds

-Bonds issued by state and local governments -typically promise semiannual interest payments -minimum denomination is usually $5000 -most have call provision

Collateralized Debt Obligations

-Corporate bonds are sometimes packaged by commercial banks into collateralized debt obligations (CDOs). -Investors receive the interest or principal payments generated by the debt securities. -Some CDOs also contain other types of debt such as credit card loans, car loans, and commercial or residential mortgages.

Junk Bonds:

-Corporate bonds perceived as very high risk -Primary investors — mutual funds, life insurance companies, and pension funds -Offer a high yield compared to Treasury yields (Exhibit 7.4)

Bond ratings as a measure of credit risk:

-Corporations hire rating agencies to have their bonds rated. -Higher rated bonds can have a higher price (lower yield) because they are perceived to have a lower credit risk. -Financial Reform Act of 2010 — Credit rating agencies are subject to oversight by a newly established Office of Credit Ratings, housed within the Securities and Exchange Commission

¡Using Bonds to Revise the Capital Structure

-Debt is normally perceived to be a cheaper source of capital than equity as long as the corporation can meet its debt payments. -In some cases, corporations issue bonds and then use the proceeds to repurchase some of their existing stock. This strategy is referred to as a debt-for-equity swap.

Tax Advantages of Municipal Bonds

-Interest income is normally exempt from federal taxes. -Interest income within a particular state is normally exempt from the income taxes (if any) of that state

Low and zero-coupon bonds:

-Issued at a deep discount from par value. -Are purchased mainly for tax-exempt investment accounts.

Federal Agency bonds

-Issued by federal agencies such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) who use the proceeds to purchase mortgages in the secondary market. -During the credit crisis in 2008, Fannie Mae and Freddie Mac experienced financial problems because they had purchased risky subprime mortgages that had a high frequency of defaults. -The federal government rescued Fannie Mae and Freddie Mac so that they could resume issuing bonds and continue to channel funds into the mortgage market.

Savings bonds

-Issued by the Treasury, but they can be purchased from many financial institutions. -Can be purchased with as little as $25. -Interest income on savings bonds is not subject to state and local taxes but is subject to federal taxes.

Corporate Bonds

-Long-term debt securities, issued by corporations, that promise the owner coupon payments (interest) on a semiannual basis. -Minimum denomination is $1,000. -Maturity is typically between 10 and 30 years. -Interest paid by the corporation to investors is tax deductible to the corporation. -Interest income earned on corporate bonds represents ordinary income to the bondholders and is therefore subject to federal taxes and to state taxes.

Treasury bond auctions

-Normally held in the middle of each quarter. -Financial institutions submit bids for their own accounts or for their clients. -Bids are submitted on a competitive or a noncompetitive basis.

Call provisions

-Normally requires a price above par value when bonds are called. The difference between the bond's call price and par value is the call premium. -If market interest rates decline, the firm may sell a new issue of bonds with a lower interest rate and use the proceeds to retire the previous issue by calling the old bonds

Inflation-indexed Treasury bonds

-Provide returns tied to the inflation rate. -Commonly referred to as TIPS (Treasury Inflation-Protected Securities). -The principal value is increased by the amount of the U.S. inflation rate

Credit Risk of Municipal Bonds

-Ratings of Municipal Bonds --Moody's, Standard & Poor's, and Fitch Investors Service assign ratings to municipal bonds based on the ability of the issuer to repay the debt. -Insurance against Credit Risk of Municipal Bonds Some municipal bonds are insured to protect against default.

Corporate Bonds: Private placement

-Small firms that borrow small amounts of funds (such as $30 million) may consider private placements rather than public offerings. -The institutional investors that purchase a private placement include insurance companies, pension funds, and bond mutual funds.

Corporate Bonds: credit risk

-Subject to the risk of default -Yield paid contains a risk premium

Treasury and Federal Agency Bonds

-The U.S. Treasury commonly issues Treasury notes and Treasury bonds to finance federal government expenditures. -The minimum denomination for Treasury notes and bonds is now $100. -Note maturities are less than 10 years whereas bond maturities are 10 years or more. -Receive semiannual interest payments from the Treasury. -Interest is taxed by the federal government as ordinary income, but it is exempt from any state and local taxes.

Stripped Treasury bonds

-The cash flows of bonds are commonly transformed (stripped) by securities firms to create principal only and interest only bonds. -Stripped Treasury securities are commonly called STRIPS (Separate Trading of Registered Interest and Principal of Securities). -STRIPS are not issued by the Treasury but instead are created and sold by various financial institutions.

Trading and Quotations of Municipal Bonds

-Today there are more than 1 million different municipal bonds outstanding and more than 50,000 different issuers. -Many municipal bonds have inactive secondary markets. -Electronic trading of municipal bonds has become very popular.

Bond yields from the ISSUER perspective

-commonly measures by the yield to maturity. -the YTM is the annualized discount rate the equates the future coupon and principle payments to the initial proceeds received from the bond offering.

Bond yield from the INVESTOR perspective

-holding period return is used by bond investors who did not hold the bond until maturity. -yield consists of 2 components : 1. a set of coupon payments, 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.

Commercial Banks and Savings and loan asssociations

-purchase bonds for their asset portfolio. -sometimes place municipal bonds for municipality. -sometimes issue bonds as a source of secondary capital.

Bond Maturity

10-30 years

Convertibility:.

Allows investors to exchange the bond for a stated number of shares of the firm's common stock

Bond collateral:

Bonds can be classified according to whether they are secured by collateral and by the nature of that collateral.

Variable rate bonds:

Long-term debt securities with a coupon rate that is periodically adjusted.

Corporate Bonds: Timing

Some corporations attempt to time their bond offerings when market interest rates are low, so that their cost of financing with bonds will be low.

Using Bonds to Finance a Leveraged Buyout:

The proceeds from debt are used to buy the outstanding shares of stock, so that the firm is owned by a small number of owners.

Corporate Bonds : Public Offering

Underwriters try to place newly issued bonds with institutional investors.

A call provision normally requires an issuing firm to pay a call premium when it calls its bonds. a. True b. False

a

A sinking-fund provision is a requirement that the issuing firm retire a certain amount of the bond issue each year. a. True b. False

a

Bond collateral is usually a mortgage on real property (land and buildings). a. True b. False

a

Bonds that are secured by personal property are called a. chattel mortgage bonds. b. first mortgage bonds. c. second mortgage bonds. d. debentures

a

Corporate bonds are sometimes packaged by commercial banks into ___________, in which investors receive the interest or principal payments generated by the debt securities. a. collateralized debt obligations (CDOs) b. credit default swaps c. reverse loans d. inverted bonds

a

If a firm believes that it will have sufficient cash flows to cover interest payments, it may consider using ________ debt and ________ equity, which implies a ________ degree of financial leverage. a. more; less; higher b. less; more; higher c. more; less; lower d. None of these choices are correct.

a

Interest earned from Treasury bonds _______ subject to federal income tax and ________ subject to state and local taxes. a. is; is not b. is not; is c. is: is d. is not; is not

a

Payments on revenue bonds must be generated by revenues of the project for which the bonds were issued. a. True b. False

a

Stripped bonds are bonds whose cash flows have been transformed into a security representing the principal payment only and a security representing interest payments only. a. True b. False

a

Treasury bonds are registered at the New York Stock Exchange, but the secondary market trading occurs over-the-counter. a. True b. False

a

Using more debt and less equity in the capital structure implies a higher degree of financial leverage. a. True b. False

a

When purchasing bonds, individual investors can use a ________ to specify the maximum price they are willing to pay for a bond. a. limit order b. market order c. stop order d. price order

a

When would a firm most likely call bonds? a. after interest rates have declined b. if interest rates do not change c. after interest rates increase d. just before the time at which interest rates are expected to decline

a

Yields Offered on Municipal Bonds (Exhibit 7.3)

a.The municipal bond must pay a risk premium to compensate for the possibility of default risk. b.The municipal bond must pay a slight premium to compensate for being less liquid than Treasury bonds with the same maturity. The income earned from a municipal bond is exempt from federal taxes allowing municipal bonds to offer a lower yield than Treasury bonds

Revenue bonds

are supported by revenues of the project (tollway, toll bridge, state college dormitory, etc.) for which the bonds were issued.

General obligation bonds

are supported by the municipal government's ability to tax.

Bonds can be issued:

as Bearer bonds or registered bonds

Any issuer of Eurobonds has to issue dollar-denominated bonds. a. True b. False

b

Everything else being equal, which of the following bond ratings is associated with the highest yield? a. A b. Baa c. Aaa d. Aa e. None of these choices are correct.

b

The bond debenture is a legal document specifying the rights and obligations of both the issuing firm and the bondholders. a. True b. False

b

The key difference between a note and a bond is that note maturities are usually less than one year, while bond maturities are one year or more. a. True b. False

b

Which of the following statements is not true regarding STRIPS? a. They are not issued by the Treasury. b. They have to be held until maturity. c. They are backed by the U.S. government. d. They are created and sold by various financial institutions. e. All of these choices are true regarding STRIPS.

b

Which of the following statements is not true regarding zero-coupon bonds? a. They are issued at a deep discount from par value. b. Investors are taxed on the total amount of interest earned at maturity. c. The issuing firm is permitted to deduct the amortized discount as interest expense for federal income tax purposes, even though it does not pay interest until maturity. d. Zero-coupon bonds are purchased mainly for tax-exempt investment accounts, such as pension funds and individual retirement accounts. e. All of the above are true

b

Dealer role in secondary market:

broker bonds between buyers and sellers.

A protective covenant may a. specify all the rights and obligations of the issuing firm and the bondholders. b. require the firm to retire a certain amount of the bond issue each year. c. restrict the amount of additional debt the firm can issue. d. none of the above

c

A variable rate bond allows a. issuers to benefit from rising market interest rates over time. b. investors to benefit from declining rates over time. c. investors to benefit from rising market interest rates over time. d. None of these choices are correct.

c

If interest rates suddenly ________, those existing bonds that have a call feature are ________ likely to be called. a. decline; more b. increase; less c. Answers [decline; more] and [increase; less] are correct. d. increase; more e. decline; less

c

Some bonds are "stripped," which means that a. they have defaulted. b. the call provision has been eliminated. c. they are transferred into principal-only and interest-only securities. d. their maturities have been reduced.

c

The ________ requires that an issuing firm retire a certain amount of a bond issue each year. a. trustee feature b. convertibility feature c. sinking-fund provision d. call feature

c

Which of the following is not an example of a municipal bond? a. general obligation bond b. revenue bond c. Treasury bond d. All of the above are examples of municipal bonds.

c

Which of the following statements is incorrect? a. The income earned from municipal bonds is exempt from federal taxes. b. The municipal bond must pay a risk premium to compensate for the possibility of default risk. c. The Treasury bond must pay a slight premium to compensate for being less liquid than municipal bonds. d. All of these choices are true

c

Bond Classifications

classified according to the type of issuer: treasury bonds, federal agency bonds, municipal bonds, and corporate bonds.

Finance companies

commonly issue bonds as a source of long-term funds

A ________ is secured by personal property; a ________ is a bond unsecured by specific property. a. chattel mortgage bond; first mortgage bond b. first mortgage bond; debenture c. first mortgage bond; chattel mortgage bond d. chattel mortgage bond; debenture e. None of these choices are correct.

d

Which of the following is not a reason for the increased volume in the foreign trading of U.S. securities? a. Primary dealers of U.S. Treasury notes and bonds have opened offices in various foreign cities. b. U.S. corporations are issuing more securities in foreign markets. c. Mutual funds containing U.S. securities are increasingly accessible to foreign investors. d. All of these choices are reasons for the increased volume in the foreign trading of U.S. securities.

d

________ bonds are bonds issued by foreign governments. a. Yankee b. Chattel c. Mortgage d. Sovereign e. None of these choices are correct.

d

The ________ price is the price an investor is ________. a. ask; willing to pay for a bond b. ask; willing to sell a bond for c. bid; willing to pay for a bond d. bid; willing to sell a bond for e. Answers [bid; willing to pay for a bond] and [ask; willing to sell a bond for] are correct.

e

Brokerage firms

facilitate bond trading by matching up buyers and sellers of bonds in the secondary market.

Bonds

long-term debt securities issued by government agencies or corporations

Electronic bond networks:

match institutional investors that wish to sell some bond holdings or purchase additional bonds in the over-the-counter bond market at a lower transaction cost

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 comapnies

purchase bonds for their asset portfolio

pension funds

purchase bonds for their asset portfolio

Competitive bids

specify a price and a dollar amount of securities to be purchased

Noncompetitive bids

specify only a dollar amount of securities to be purchased.

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.

Bond issuer

¡ is obligated to pay interest (or coupon) payments periodically (such as annually or semiannually) and the par value (principal) at maturity.

Trading Treasury bonds

¡Bond dealers serve as intermediaries in the secondary market by matching up buyers and sellers of Treasury bonds. ¡Dealers profit from the spread between the bid and ask prices. ¡Treasury bonds are registered at the New York Stock Exchange, but the secondary market trading occurs over the counter. ¡Online Trading — Investors can also buy bonds through the Treasury Direct program (www.treasurydirect.gov).

Variable-Rate Municipal Bonds

— Have a floating interest rate that is based on a benchmark interest rate.

Sinking fund provision

— a requirement that the firm retire a certain amount of the bond issue each year

Protective covenants

— restrictions placed on the issuing firm that are designed to protect bondholders from being exposed to increasing risk during the investment period

Market order

— the transaction will occur at the prevailing market price.

Limit order

— the transaction will occur only if the price reaches the specified limit.