Bonds

Bonds

Pay a specified coupon at regular intervals (usually semi-annually). And pay face value (= par value) at maturity. Last payment is coupon plus face.

Treasury Auctions

• The U.S. Treasury borrows money primarily by auctioning bonds of various maturities at regular intervals.
  

• They solicit bids from primary dealers of the form “I will buy x bonds at face value if the coupon is at least y.”

• Bidders willing to accept low coupons get their bids filled, and the coupon set on all of the bonds is the lowest that will sell the entire issue.

Treasury Direct

• Individuals can buy bonds at auction via Treasury Direct with simpler bids:

  • “I want x number of bonds.”

• These “noncompetitive” bids are filled first.

• Treasury Direct also sells U.S. Savings Bonds (EE and I) with rates set by the Treasury rather than by auction.

Treasury Inflation Protected Securities (TIPS)

The face value of a TIPs is adjusted for inflation.

How Corporates and Municipals are Issued

• Usually hire an investment bank, who assesses demand from pension funds, insurance companies, brokerages, \(\ldots\)

• Investment bank advises on the coupon needed to sell the bonds near par.

• Investment bank will distribute. It may guarantee sale to company or make “best efforts.”

Bond indenture

• Contract between issuer and investor.

• Obligations and rights of issuer.

  • Obligation to pay coupons and face
  • Obligations may include covenants that limit dividend payments, issuance of additional debt, …
  • Rights may include right to prepay

• Rights of investor

  • Could include right to demand payment upon change of control, for example.

Subordination

• Subordinated (junior) means not getting paid in bankruptcy unless all more senior bonds are paid.

• Junior/senior depends on bond provisions, not time of issue.

• All bonds are typically subordinated to any bank debt.

Municipal bonds

• Municipal bonds in the U.S. are exempt from federal income tax.
• Municipal bonds are also exempt from state income taxes in the state of issue.
• So, NY investors want to hold NY municipals, California investors want to hold California municipals.
• Municipals are issued by states, cities, counties, school boards, fire districts, …
• Tax increment financing allows limited use of municipal bonds to back private investments: sports stadiums, etc.

Bond trading

• The bond market is largely an institutional market. Trades are large and made through dealers.
• An individual can trade bonds through a broker, but it is hard to know if you are getting a good price.
• Usually better to invest through mutual funds or ETFs.

Asset Backed Securities

• Asset backed securities are bonds that are issued by a trust and are to be repaid from income generated by assets held by the trust.
• A major category is mortgage-backed securities, including those issued by FNMA, GNMA, and FHLMC, also known as Fannie Mae , Ginnie Mae, and Freddie Mac.
• There are also securities backed by auto loans, credit card receivables, bank loans to companies, and other bonds.